International Business: Introduction,

Concept, Definition
 
With the globalization of the world economy, there has been a concomitant rise in the number of
companies that operate globally. Though international business as a concept has been around
since the time of the East India Company and continued into the early decades of the 20th
century, there was a lull in the international expansion of companies because of the Two World
Wars. After that, there was a hesitant move towards internationalizing the operations of
multinational companies.

What really provided a fillip to the global expansion of companies was the Chicago School of
Economic Thought propelled by the legendary economist, Milton Friedman, which championed
neoliberal globalization. This ideology, which started in the early 1970s gradually, became a
major force to reckon with in the 1980s and became the norm in the 1990s. The result of all this
was the frenzied expansion of global companies across the world.

Thus, international businesses grew in scope and size to the point where at the moment; the
global economy is dominated by multinationals from all countries in the world. What was
primarily a phenomenon of western corporations has now expanded to include companies from
the East (from countries like India and China). This module examines the phenomenon of
international businesses from different aspects like the characteristics of international business,
their effect on the local, target economies, and the ways and means with which they would have
to operate and succeed in the global competition for ideas and profits.

Above all, international businesses have to ensure that they blend the global outlook and the
local adaptation resulting in a “Glocal” phenomenon wherein they would have to think global
and act local. Further, international businesses need to ensure that they do not fall afoul of
local laws and at the same time repatriate profits back to their home countries. Apart from
this, the questions of employability and employment conditions that dictate the operations of
global businesses have to be taken into consideration as well.

Considering the fact that many third world countries are liberalizing and opening up their
economies, there can be no better time than now for international businesses. This is balanced by
the countervailing force of the ongoing economic crisis that has dealt a severe blow to the global
economy. The third force that determines international businesses are that not only is the third
world countries eager to welcome foreign investment, they seek to emulate the international
businesses and become like them. Hence, these aspects would be discussed in detail in the
subsequent articles.

Finally, international businesses have to ensure that they have a set of operating procedures and
norms that are sensitive to the local culture and customs and at the same time, they stick to their
 brand that has been developed for global markets. This is the challenge that we discussed earlier
as “Glocal” orientation.

Any business that involves operations in more than one country can be called an international
business. International business is related to the trade and investment operations done by entities
across national borders.

Firms may assemble, acquire, produce, market, and perform other value-addition-operations on
international scale and scope. Business organizations may also engage in collaborations with
business partners from different countries.

Apart from individual firms, governments and international agencies may also get involved in
international business transactions. Companies and countries may exchange different types of
physical and intellectual assets. These assets can be products, services, capital, technology,
knowledge, or labor.

Internationalization of Business

Let’s try to explore the reasons why a business would like to go global. It is important to note
that there are many challenges in the path of internationalization, but we’ll focus on the positive
attributes of the process for the time-being.

There are five major reasons why a business may want to go global −

 First-mover Advantage− It refers to getting into a new market and enjoy the advantages
of being first. It is easy to quickly start doing business and get early adopters by being first.
 Opportunity for Growth− Potential for growth is a very common reason of
internationalization. Your market may saturate in your home country and therefore you may set
out on exploring new markets.
 Small Local Markets− Start-ups in Finland and Nordics have always looked at
internationalization as a major strategy from the very beginning because their local market is
small.
 Increase of Customers− If customers are in short supply, it may hit a company’s
potential for growth. In such a case, companies may look for internationalization.
 Discourage Local Competitors− Acquiring a new market may mean discouraging other
players from getting into the same business-space as one company is in.

Advantages of Internationalization

There are multiple advantages of going international. However, the most striking and impactful
ones are the following four.

Product Flexibility
 International businesses having products that don’t really sell well enough in their local or
regional market may find a much better customer base in international markets. Hence, a
business house having global presence need not dump the unsold stock of products at deep
discounts in the local market. It can search for some new markets where the products sell at a
higher price.

A business having international operations may also find new products to sell internationally
which they don’t offer in the local markets. International businesses have a wider audience and
thus they can sell a larger range of products or services.

Less Competition

Competition can be a local phenomenon. International markets can have less competition where
the businesses can capture a market share quickly. This factor is particularly advantageous when
high-quality and superior products are available. Local companies may have the same quality
products, but the international businesses may have little competition in a market where an
inferior product is available.

Protection from National Trends and Events

Marketing in several countries reduces the vulnerability to events of one country. For example,
the political, social, geographical and religious factors that negatively affect a country may be
offset by marketing the same product in a different country. Moreover, risks that can disrupt
business can be minimized by marketing internationally.

Learning New Methods

Doing business in more than one country offers great insights to learn new ways of
accomplishing things. This new knowledge and experience can pave ways to success in other
markets as well.

Globalization

Although globalization and internationalization are used in the same context, there are some
major differences.

 Globalization is a much larger process and often includes the assimilation of the markets
as a whole. Moreover, when we talk about globalization, we take up the cultural context as well.
 Globalization is an intensified process of internationalizing a business. In general terms,
global companies are larger and more widespread than the low-lying international business
organizations.
 Globalization means the intensification of cross-country political, cultural, social,
economic, and technological interactions that result in the formation of transnational business
 organization. It also refers to the assimilation of economic, political, and social initiatives on a
global scale.
 Globalization also refers to the costless cross-border transition of goods and services,
capital, knowledge, and labor.

Factors Causing Globalization of Businesses

There are many factors related to the change of technology, international policies, and cultural
assimilation that initiated the process of globalization. The following are the most important
factors that helped globalization take shape and spread it drastically.

The Reduction and Removal of Trade Barriers

After World War II, the General Agreement on Tariffs and Trade (GATT) and the WTO have
reduced tariffs and various non-tariff barriers to trade. It enabled more countries to explore their
comparative advantage. It has a direct impact on globalization.

Trade Negotiations

The Uruguay Round of negotiations (1986–94) can be considered as the real boon for
globalization. It is considerably a large set of measures which was agreed upon exclusively for
liberalized trade. As a result, the world trade volume increased by 50% in the following 6 years
of the Uruguay Round, paving the way for businesses to span their offerings at an international
level.

Transport Costs

Over the last 25 years, sea transport costs have plunged 70%, and the airfreight costs have
nosedived 3–4% annually. The result is a boost in international and multi-continental trade flows
that led to Globalization.

Growth of the Internet

Expansion of e-commerce due to the growth of the Internet has enabled businesses to compete
globally. Essentially, due to the availability of the Internet, consumers are interested to buy
products online at a low price after reviewing best deals from multiple vendors. At the same
time, online suppliers are saving a lot of marketing costs.

Growth of Multinational Corporations

Multinational Corporations (MNCs) have characterized the global interdependence. They

encompass a number of countries. Their sales, profits, and the flow of production is reliant on
several countries at once.
The Development of Trading Blocs

The ‘regional trade agreement’ (RTA) abolished internal barriers to trade and replaced them with
a common external tariff against non-members. Trading blocs actually promote globalization and
interdependence of economies via trade creation.

International Business: Scope,

Trends, Challenges and Opportunities
 THESTREAK20 FEB 2019 2 COMMENTS

Scope

International business is much broader than international trade. It includes not only international
trade (i.e., export and import of goods and services), but also a wide variety of other ways in
which the firms operate internationally. International Management professionals are familiar
with the language, culture, economic and political environment, and business practices of
countries in which multinational firms actively trade and invest.

Major forms of business operations that constitute international business are as follows.

(i) Merchandise exports and imports: Merchandise means goods that are tangible, i.e., those
that can be seen and touched. When viewed from this perceptive, it is clear that while
merchandise exports means sending tangible goods abroad, merchandise imports means bringing
tangible goods from a foreign country to one’s own country.

(ii) Service exports and imports: Service exports and imports involve trade in intangibles. It is
because of the intangible aspect of services that trade in services is also known as invisible trade.

(iii) Licensing and franchising: Permitting another party in a foreign country to produce and
sell goods under your trademarks, patents or copy rights in lieu of some fee is another way of
entering into international business. It is under the licensing system that Pepsi and CocaCola are
produced and sold all over the world by local bottlers in foreign countries.

(iv) Foreign investments: Foreign investment is another important form of international

business. Foreign investment involves investments of funds abroad in exchange for financial
return. Foreign investment can be of two types: direct and portfolio investments.
Trends

As the economy grows slowly at home, your business may have to look at selling internationally
to remain profitable. Before examining foreign markets, you have to be aware of the major
trends in international business so you can take advantage of those that might favor your
company. International markets are evolving rapidly, and you can take advantage of the
changing environment to create a niche for your company.

Growing Emerging Markets

Developing countries will see the highest economic growth as they come closer to the standards
of living of the developed world. If you want your business to grow rapidly, consider selling into
one of these emerging markets. Language, financial stability, economic system and local cultural
factors can influence which markets you should favor.

Demographic Shifts

The population of the industrialized world is aging while many developing countries still have
very youthful populations. Businesses catering to well-off pensioners can profit from a focus on
developed countries, while those targeting young families, mothers and children can look in
Latin America, Africa and the Far East for growth.

Speed of Innovation

The pace of innovation is increasing as many new companies develop new products and
improved versions of traditional items. Western companies no longer can expect to be
automatically at the forefront of technical development, and this trend will intensify as more
businesses in developing countries acquire the expertise to innovate successfully.

More Informed Buyers

More intense and more rapid communications allow customers everywhere to purchase products
made anywhere around the globe and to access information about what to buy. As pricing and
quality information become available across all markets, businesses will lose pricing power,
especially the power to set different prices in different markets.

Increased Competition

As more businesses enter international markets, Western companies will see increased
competition. Because companies based in developing markets often have lower labor costs, the
challenge for Western firms is to keep ahead with faster and more effective innovation as well as
a high degree of automation.
Slower Growth

The motor of rapid growth has been the Western economies and the largest of the emerging
markets, such as China and Brazil. Western economies are stagnating, and emerging market
growth has slowed, so economic growth over the next several years will be slower. International
businesses must plan for profitability in the face of more slowly growing demand.

Clean Technology

Environmental factors are already a major influence in the West and will become more so
worldwide. Businesses must take into account the environmental impact of their normal
operations. They can try to market environmentally friendly technologies internationally. The
advantage of this market is that it is expected to grow more rapidly than the overall economy.

Challenges and Opportunities

Inevitably such challenges and opportunities vary between companies and sectors but some
frequently cited opportunities and challenges include:

Opportunities Challenges

Access to customers in New competition for existing

new countries customers in domestic markets

Learning about customers Adjusting products to local tastes

in new markets and cultural peculiarities

Access to new, cheaper

Global financial contagion
sources of finance

Costs of meeting a multitude of

Government incentives to
local/national laws and
relocate
regulations

Access to regional trading

agreements/avoidance of Exchange rate fluctuations
trade barriers
 Economies of scale Managing long supply chains

New competition for local

Access to new resources
resources (e.g. more demand for
(e.g. cheap of skilled
labour pushing up local wage
labour, natural resources)
costs)

Cross-cultural communication e.g.

  language barriers, differing body
language and etiquette

Corporate social responsibility

 
issues

Capricious political
  environments/political risk /bias
in favour of domestic companies

Meaning and Importance of

International Competitive Advantage
 THESTREAK20 FEB 2019 1 COMMENT

Participation in international business allows countries to take advantage of their comparative

advantage.

The concept of comparative advantage means that a nation has an advantage over other nations
in terms of access to affordable land, resources, labor, and capital. In other words, a country will
export those products or services that utilize abundant factors of production. Further, companies
with sufficient capital may seek another country that is abundant in land or labor, or companies
may seek to invest internationally when their home market becomes saturated.

Participation in international business allows countries to take advantage of specialized expertise

and abundant factors of production to deliver goods and services into the international
marketplace. This has the benefit of increasing the variety of goods and services available in the
marketplace.
 International business also increases competition in domestic markets and introduces new
opportunities to foreign markets. Global competition encourages companies to become more
innovative and efficient in their use of resources.

For consumers, international business introduces them to a variety of goods and services. For
many, it enhances their standard of living and increases their exposure to new ideas, devices,
products, services, and technologies.

The Growth of International Business

The prevalence of international business has increased significantly during the last part of the
twentieth century, thanks to the liberalization of trade and investment and the development of
technology. Some of the significant elements that have advanced international business include:

 The formation of the World Trade Organization (WTO) in 1995

 The inception of electronic funds transfers
 The introduction of the euro to the European Union
 Technological innovation that facilitates global communication and transportation
 The dissolution of a number of communist markets, thus opening up many economies to private
business

Today, global competition affects nearly every company—regardless of size. Many source
suppliers from foreign countries and still more compete against products or services that
originate abroad. International business remains a broad concept that encompasses the smallest
companies that may only export or import with one other country, as well as the largest global
firms with integrated operations and strategic alliances around the globe.

The Challenges and Considerations of International Business

Because nation-states have unique government systems, laws and regulations, taxes, duties,
currencies, cultures, practices, etc. international business is decidedly more complex that
business that operates exclusively in domestic markets.

The major task of international business involves understanding the sheer size of the global
marketplace. There are currently more than 200 national markets in the world, presenting a
seemingly endless supply of international business opportunities. However, the diversity between
nations presents unique considerations and a plethora of hurdles, such as:

 National wealth disparities: Wealth disparities among nations remain vast.

 Regional diversity according to wealth and population: North America is home to just 5
percent of the world’s population, yet it controls almost one-third of the world’s gross domestic
product.
 Cultural/linguistic diversity: There are more than 10,000 linguistic/cultural groups in the world.
 Country size and population diversity: There were about 60 countries at the start of the
twentieth century; by 2000, this number grew to more than 200.
Some of the challenges considered by companies and professionals involved in international
business include:

Economic Environment

The economic environment may be very different from one country to the next. The economy of
countries may be industrialized (developed), emerging (newly industrializing), or less developed
(third world). Further, within each of these economies are a vast array of variations, which have
a major effect on everything from education and infrastructure to technology and healthcare.

A nation’s economic structure as a free market, centrally planned market, or mixed market also
plays a distinct role in the ease at which international business efforts can take place. For
example, free market economies allow international business activities to take place with little
interference. On the opposite end of the spectrum, centrally planned economies are government-
controlled. Although most countries now function as free-market economies, China—the world’s
most populous country—remains a centrally planned economy.

Political Environment

The political environment of international business refers to the relationship between

government and business, as well as the political risk of a nation. Therefore, companies involved
in international business must expect to deal with different types of governments, such as multi-
party democracies, one-party states, dictatorships, and constitutional monarchies.

Some governments may view foreign businesses as positive, while other governments may view
them as exploitative. Because international companies rely on the goodwill of the government,
international business must take the political structure of the foreign government into
consideration.

International firms must also consider the degree of political risk in a foreign location; in other
words, the likelihood of major governmental changes taking place. Just a few of the issues of
unstable governments that international companies must consider include riots, revolutions, war,
and terrorism.

Cultural Environment

The cultural environment of a foreign nation remains a critical component of the international
business environment, yet it is one of the most difficult to understand. The cultural environment
of a foreign nation involves commonly shared beliefs and values, formed by factors such as
language, religion, geographic location, government, history, and education.

It is common for many international firms to conduct a cultural analysis of a foreign nation as to
better understand these factors and how they affect international business efforts.
Competitive Environment

The competitive environment is constantly changing according to the economic, political, and
cultural environments. Competition may exist from a variety of sources, and the nature of
competition may change from place to place. It may be encouraged or discouraged in favor of
cooperation, and the relationship between buyers and sellers may be friendly or hostile. The level
of technological innovation is also an important aspect of the competitive environment as firms
compete for access to the newest technology.

Framework for Assessing

Competitiveness: Various Approaches
 THEINTACTFRONT9 JAN 2019 2 COMMENTS
Global competitiveness is a multidimensional concept and has various definitions.

Thus, according to Rapkin, et al. competitiveness is “…a political and economic concept that
affect military, political and scientific potential of the country and is an integral factor in the
relative position of the country in the international political economy.”

Krugman defines competitiveness as a concept equivalent of productivity. On the other hand, he

claims that competitiveness is “wrong and dangerous definition” if to apply for the international
level.

According to Porter, this concept deals with the policy and institutions in the state that promotes
long-term growth. “National competitiveness” corresponds to the economic structures and
institutions of the state for economic growth within the structure of global economy.

Another outstanding definition states, that competitiveness “… refers to a country’s ability to

create, produce, distribute, and/or service products in international trade while earning rising
returns on its resources”.

Kulikov claims that there are real and nominal competitiveness. Real competitiveness requires
openness and fairness of markets, the quality and innovation of products and services in the
country of origin and the continued growth of life standard of its citizens. Therefore, the actual
degree of competitiveness is a possibility of national industries to have a free and fair market of
goods and services that meet the requirements of both domestic and foreign markets, and
simultaneous growth of real income. Since the nominal competitiveness can be achieved by a
particular government policy, creating a macroeconomic environment for domestic producers
through direct state subsidies and wage restraint. Thus, the real competitiveness is possible only
if national companies are able to effectively design, produce goods and sell them at prices and
quality that meets both external and internal customers’ requirements – without direct subsidies,
control of wages and unemployment.

Thus, it can be inferred, that competitiveness reflects the favourable position of the national
economy in the global space. This position can be reflected in many areas, mainly in the field of
international trade as the country’s ability to strengthen this position.

The competitiveness of the national economy is its concentrated expression of economic,

scientific, technological, organizational, managerial, marketing and other capabilities. This
concept embodies an ability of a state to achieve high rates of economic growth, ensure a steady
increase in real wages, promotion of domestic firms on the world market.

In this regard, economies that are more competitive tend to be able to produce higher levels of
income for their citizens, thus achieve a higher level of the quality of life. In other words,
competitiveness can be described as the ability of an economy to produce, promote and sell
goods and services in the global economy.

It can be inferred, that a more competitive economy is the one that is likely to grow faster over
the medium to long run.

The term itself came into use in the USA, in 1985. Than it became famous worldwide.
Nowadays the principle of competitiveness is one of the most important components of
qualitative analysis, trying to assess a country’s attractiveness and its engagement in global
processes.

Given this importance of maintaining competitiveness, governments of different countries

targeted their policies towards becoming more competitive and gaining their niche in this
globalized world. Thus, national governments’ principal goal is to establish an environment that
fosters wellbeing for its citizens by addressing health, safety, environmental issues and laws.
Undoubtedly, this goal can be achieved through effective management and allocation of
resources, and active political interventions. Therefore, it becomes imperative for governments to
coordinate a comprehensive approach towards trade and investment that incorporates a
competition orientation6. However, governmental bodies and decision makers must be cognizant
of the fact that their nation’s competitiveness depends upon their ability to sustain trade and
attract foreign investment.

Competitiveness is, perhaps, one of the widely discussed, criticized phenomena of international
economics. This fact explains existing of many theories discussing features of competitiveness.

Global competitiveness owes its origin to the theory of comparative advantage, which
historically was an antithesis to the perspective of the mercantilists. They believed in exports and
recommended strict government control of all economic activity with economic nationalistic
ideas. Mercantilists’ approach became a cornerstone to the many other theories that came into
use later. Among them are Ricardo’s theory of comparative advantage and Heckscher-Ohlin’s
factor abundance theory (according to this theory, countries will produce and export those goods
 and services in which they have a comparative advantage in price or factor cost). Initially
Heckscher-Ohlin’s theory takes two factors as basic indicators determining competitive
advantages. Later some studies went beyond the two-factor analysis.

Another theory is ascribed to the Bank of England. According to this theory, competitiveness
should be measured in terms of relative indicators (i.e. relative export prices, relative export
productivity, relative unit labor cost, etc.).

Using a slightly different approach, the Economics and Statistics Department of Organization for
Economic Cooperation and Development (OECD) measures competitiveness as a sum of export
and import competitiveness.

One of the most well-known theories of national competitiveness is Michael Porter’s ‘National
Diamond’7, which represents a useful grouping of the concepts appropriate to analysis of
competitiveness and trade, thus is usually viewed in the context of case studies used to assess the
prospects of an industry, product or economic activity. According to prof. Porter, there are four
driving factors, cornerstones in the competitiveness, entitled as “diamond”;

Many international, national, non-governmental organizations assess the level of competitiveness

of various countries.

Historically the first attempt made by the IMD World Competitiveness Center 9, which publishes
its “World competitiveness yearbook” since 1989. One of the most outstanding characteristics of
the WCY is that it is the first comprehensive annual report and a worldwide reference pointing
on the competitiveness of countries. The yearbook provides benchmarks and trends, statistics and
survey data based on extensive research. According to the WCY a country’s competitiveness is
assessed and ranked according to how they manage their competencies to achieve long-term
value creation. According to the methodology report published by the IMD World
Competitiveness Center, an economy’s GDP and productivity cannot be assesses as the only
important indicators for its competitiveness, political, social and cultural dimensions also play a
vital role in the process of formatting competitive advantages 10. Thus, governments need to
provide an environment for business enterprises. This environment is to be characterised by
efficient infrastructures, institutions and policies that encourage sustainable value creation by
these enterprises.

According to the WCY, observed countries’ ranking is calculated as the composite index. The
latter is based on nearly 340 indicators that measure competitiveness. Comparative data on the
abovementioned indicators are collected through various international, national, regional sources,
statistic databases, as well as from surveys conducted within business communities, government
agencies. The above-mentioned indicators are grouped in four major sets described as follows.

1. A country’s economic Performance (assessed through 78 macroeconomic indicators);

2. Government Efficiency (government policy supports national competitiveness or not).
These set includes 70 indicators;
3. Business Efficiency – 67 indicators;
4. Infrastructure (do they fulfil business requirements or not) – 114 indicators.

The above-mentioned indicators are described in detail in the Table 1.

Economic Government’s
Business efficiency Infrastructure
performance efficiency

Extent to which
Extent to which basic,
Macroeconomic Extent to which enterprises are
technological,
evaluation of the government policies performing in an
scientific and human
domestic are conductive to innovative, profitable
resources meet the
economy (5 sub- competitiveness (5 and responsible
needs of business (5
factors) sub-factors) manner (5 sub-
sub-factors)
factors)

 Domestic,
Public finance Productivity  Basic infrastructure
economy,

 International  Technological
Fiscal policy Labour market
trade infrastructure

International Institutional  Scientific

Finance
investment framework infrastructure

Management Health and

Employment Business legislation
practices environment

 Prices (78 Societal framework Attitudes and values

Educations (96 criteria)
criteria) (70 criteria) (67 criteria)

Table 1: Indicators are grouped in four major sets.

Each of these four sets is, in turn, divided into 5 sub-sectors. Thus, the ranking is based on 20
sub-factors. When describing the methodology of the WCY, it should also be noted that the
methodology has changed since 1989. These changes have been applied in accordance with the
challenges and changes of the global economy. It is notable, that WCY methodology relies on
four dimensions shaping a country’s competitiveness and determining countries’ development
 strategies and participation in international division of labour. These four dimensions are listed
as follows;

1. Attractiveness vs. aggressiveness;

2. Proximity vs. globalism;
3. Assets vs. processes;
4. Individual risk taking vs. social cohesiveness.

To sum up, the WCY methodology emphasizes the multifaceted nature of the competitiveness
concept. One of the outstanding characteristics of this methodology is that it aggregates a set of
indicators, which determine the overall competitiveness index and rankings of the countries
included in the WCY database.

Another well-known and broadly used approach in assessment of the competitiveness is The
Global Competitiveness Report (Index) published (measured) by the World economic forum
international organization11. The Report was first published in 1979, when the world was facing
the worst and longest lasting financial and economic crisis of the last 80 years – in order to get
the pre-crisis situation. The Global Competitiveness Report ranks countries based on the Global
Competitiveness Index (calculated since 2004), taking into account the country’s ability to
ensure welfare for their citizens, which depends on the effectiveness of using all resources of a
given country.

The Global Competitiveness index is a comprehensive tool, that measures the competitiveness of
148 countries, contains 3 sub-indexes: basic requirements, efficiency enhancers, innovation and
sophistication factors that are based on 12 pillars (institutions, infrastructure, macroeconomic
environment, health and primary education, higher education and training, etc.) including 119
indicators 12 pillars of competitiveness are:

1. Institutions;
2. Infrastructure;
3. Macroeconomic environment;
4. Health and primary education;
5. Higher education and training;
6. Goods market efficiency;
7. Labour market efficiency;
8. Financial market development;
9. Technological readiness;
10. Market size;
11. Business sophistication;
12. Innovation.

The 12 pillars are grouped in 3 sub-indexes described below in Table 2.

Basic requirements Efficiency enhancers Innovation and

 sophistication

Higher education and

Institutions Business sophistication
training

Infrastructure Goods market efficiency Innovation

Macroeconomic
Labor market development  
environment

Health and primary Financial Market

 
education development

  Technological readiness  

  Market size  

Table 2: 12 pillars are grouped in 3 sub-indexes.

The GCI is calculated as a weighted average of its components. The Harvard Institute proposes
one of well-known methodologies in assessment of competitiveness for International
Development (HIID). This methodology assesses competitiveness as the ability of a national
economy to achieve sustained high rates of economic growth, mainly focusing on the
competitiveness possibilities of economies in transition. The HIID mainly follows the theoretical
and methodological approaches of GCR and is based on the WEF’s competitiveness definition
presented in the Global Competitiveness Report. The main feature of this methodology is that it
puts emphasis on the initial conditions of transition and the ability of the countries to improve the
competitive positions of their economies. Thus, the HIID differentiates three main types or initial
conditions in transition, presented in the Table 3.

Fixed Hard Soft

These conditions are Refer to government

These conditions can be changed but not
invariant and cannot policy and can be
quickly
be changed changed easily
 (Geography, (The quality of institutions, industrial (Tax code,
topography, natural structure, ownership, public attitudes, international relations
resource endowment, composition of economic output, level and agreements, laws,
culture, history, and quality of human and physical capital regulating
climate, etc.) stocks, etc.) frameworks, etc.)

Table 3: Three main types or initial conditions in transition.

The HIID calculates the overall competitiveness index basing on scores of its indices or factors,
collecting statistical data of international and national organizations and of survey data.

The HIID overall competitiveness index is composed of the following components;

 Openness of the economy,

 Government’s efficiency,
 Infrastructure,
 Technology,
 Financial sector,
 Efficiency of institutions,
 Management and labour.

International Monetary System

 THEINTACTFRONT17 JUL 2018 3 COMMENTS

Paper Currency Standard & Purchasing Power Parity 

With the breakdown of the gold standard during the period of the First World War, gold
parities and free movements of gold ceased, therefore the mint par of exchange lost
significance in the exchange markets.

Exchange rates fluctuated far beyond the traditional gold points and there was complete
confusion. Hence, to explain this phenomenon and the problem of determination of the
equilibrium exchange between inconvertible currencies, the theory of purchasing power parity
was enunciated.

The basic idea underlying the purchasing power parity theory is that the foreign currencies
are demanded by the nationals of a country because it has power to command goods in its
own country.
When domestic currency of a nation is exchanged for foreign currency, what is in fact done is
that domestic purchasing power is exchanged for foreign purchasing power. It follows that the
main factor determining the exchange rate is the relative purchasing power of the two currencies.

For, when two currencies are exchanged, what is exchanged, in fact, is the internal
purchasing power of the two currencies.

Thus, the equilibrium rate of exchange should be such that the exchange of currencies would
involve the exchange of the equal amounts of purchasing power. It is the parity of the purchasing
power that determines the exchange rate. Thus, the purchasing power theory states that exchange
rate tends to rest at the point at which there is equality between the respective purchasing power
of the currencies. In other words, rate of exchange between two inconvertible paper currencies
tends to close to their purchasing power ratio. Hence,

The Purchasing Power Theory

(PPT) seeks to explain that under the system of autonomous paper standard the external
value of a currency depends ultimately and essentially on the domestic purchasing power of
that currency relative to that of another currency.

The PPT has been presented in two versions, namely

(1) Absolute Version of Purchasing Power Parity and

(2) Relative Version of Purchasing Power Parity.

Absolute Purchasing Power Parity

The absolute version of the purchasing power parity theory stresses that the exchange rates
should normally reflect the relation between the internal purchasing power of the various
national currency units.

The price of a tradable commodity in one country should theoretically be equal to the price of the
same commodity in another country, after adjusting for the foreign exchange rate. The theory is
known as the international law of one price. When the international law one price applied to the
representative good or basket of goods, it is called the absolute purchasing power parity
condition.

To illustrate the point, let us assume that a representative collection of goods costs Rs.9,625/- in
India and US$ 195 in USA. As per the Absolute PPP theory, the exchange rate between US$ and
Indian Rupee is the ratio of two price indices.

Spot price (In Indian Rupee) = Price Index of India/ Price Index of USA

Spot Rate = PRupee / PUSA

As per the example mentioned above, the exchange rate would be;

Spot (in Rupee) = 9625/195 = Rs.47.5128

The theoretical argument behind the Absolute PPP condition is that a country’s goods are
relatively cheap internationally; goods market arbitrage  would create pressure on both foreign
prices and goods prices to correct, and thereby conform to uniform international prices.

Relative Purchasing Power Parity

Purchasing Power for two currencies can be different not because of differences in their internal
purchasing power, but some other factors also.

Relative purchasing power parity relates the change in two countries’ expected inflation rates to
the change in their exchange rates. Inflation reduces the real purchasing power of a nation’s
currency.

If a country has an annual inflation rate of 5%, that country’s currency will be able to purchase
5% less real goods at the end of one year. Relative purchasing power parity examines the relative
changes in price levels between two countries and maintains the exchange rates, which will
compensate for inflation differentials between the two countries.

The relationship can be expressed as follows, using indirect quotes:

St / S0 = (1 + iy) ÷ (1 + ix) t

Where,

S0 is the spot exchange rate at the beginning of the time period (measured as the “y” country
price of one unit of currency x)

St  is the spot exchange rate at the end of the time period.

iy  is the expected annualized inflation rate for country y, which is considered to be the foreign
country.

Ix  is the expected annualized inflation rate for country x, which is considered to be the domestic
country.

Example

The annual inflation rate is expected to be 8% in the India and that for the US is 3%. The current
exchange rate is Rs.46.5500/- per US $. What would the expected spot exchange rate be in six
months for Indian Rupee relative to US$.
Answer:

So the relevant equation is:

St / S0 = (1 + iy) ÷ (1 + ix)

= S6month ÷ Rs.46.5500 = (1.08 ÷ 1.03)0.5

Which implies S6month = (1.023984) × Rs.46.550 = Rs.47.6665.

So the expected spot exchange rate at the end of six months would be Rs.47.6665 per US$.

Inflation, taxes, quality of products, and other circumstances that change the market also
have bearing on the price or internal purchasing power. All these factors need to be
adjusted while estimating the exchange rate under in-convertible paper currency standard.
PPP theory may not reflect the true exchange rate in the short-run however; it actually
indicates the fundamental equilibrium exchange rate in the long-run.

International Monetary System – The Bretton Woods System

Attempts were initiated to revive the Gold Standard after the World War I, but it collapsed
entirely during the Great Depression of the 1930s.

It was felt that adherence to the Gold Standard prevented countries from expanding the
money supply significantly so as to revive economic activity.

However, after the Second World War, representatives of most of the world’s leading nations
met at Bretton Woods, New Hampshire, in 1944 to create a new international monetary system.

United States of America, at that time, was accounted for over half of the world’s
manufacturing capacity and held most of the world’s gold, the leaders decided to tie world
currencies to the US dollar, which, in turn, they agreed should be convertible into gold at
$35 per ounce. Under the Bretton Woods system, Central Banks of participating countries
were given the task of maintaining fixed exchange rates between their currencies and the
US-dollar.

They did this by intervening in foreign exchange markets. If a country’s currency was too high
relative to the US-dollar, its central bank would sell its currency in exchange for US-dollars,
driving down the value of its currency. Conversely, if the value of a country’s money was too
low, the country would buy its own currency, thereby driving up the price. The purpose of the
Bretton Woods meeting was to set up new system of rules, regulations, and procedures for the
major economies of the world.
The principal goal of the agreement was economic stability for the major economic powers of
the world. The system was designed to address systemic imbalances without upsetting the system
as a whole.

The Bretton Woods System continued until 1971. By that time, high inflation and trade
deficit in the USA were undermining the value of the dollar. Americans urged Germany
and Japan, both of which had favorable payments balances, to appreciate their currencies.

But those nations were reluctant to take that step, since raising the value of their currencies
would increase prices for their goods and hurt their exports. Finally, the USA abandoned the
fixed value of the US-dollar and allowed it to “float” against other currencies, which led to
collapse of the Bretton Woods System.

The Bretton Woods system established the US Dollar as the reserve currency of the world. It also
required world currencies to be pegged to the US-dollar rather than gold. The demise of

Bretton woods started in 1971 when Richard Nixon took the US off of the Gold Standard to stem
the outflow of gold. By 1976 the principles of Bretton Woods were abandoned all together and
the world currencies were once again free floating.

World leaders tried to revive the system with the so-called “Smithsonian Agreement” in

1971, but the effort could not yield. Economists call the resulting system a “managed float
regime,” meaning that even though exchange rates most currencies float, central Banks till
intervene to prevent sharp changes.

As in 1971, countries with large trade surpluses often sell their own currencies in an effort to
prevent them from appreciating. Similarly, countries with large trade deficits buy their own
currencies in order to prevent depreciation, which raises domestic prices. But there are limits to
what can be accomplished through intervention, especially for countries with large trade deficits.
Eventually, a country that intervenes to support its currency may deplete its international
reserves, making it unable to continue support the currency and potentially leaving it unable to
meet its international obligations.

At present almost all countries having their own paper currencies standard which is
neither linked to gold or US-dollar or any other foreign currencies and they have adopted
the currency system which is “managed floating” in nature.

The Mint Par Parity Theory

This theory is associated with the working of the international gold standard. Under this system,
the currency in use was made of gold or was convertible into gold at a fixed rate. The value of
the currency unit was defined in terms of certain weight of gold, that is, so many grains of gold
to the rupee, the dollar, the pound, etc. The central bank of the country was always ready to buy
and sell gold at the specified price.
The rate at which the standard money of the country was convertible into gold was called
the mint price of gold.

If the official British price of gold was £6 per ounce and of the US price of gold $12 per ounce,
they were the mint prices of gold in the respective countries. The exchange rate between dollar
and pound would be fixed at $12/£6 =2, which in other words, one pound is equal to two dollar.

This rate is called mint parity rate or mint par of exchange because it was based on the mint price
of gold. However, the actual exchange rate between these currencies would vary above or below
the mint parity rate by the cost of shipping gold between two countries. To illustrate this,
suppose the US has a deficit in its balance of payments with Britain. The difference between the
value of imports and exports will have to be paid in gold by the US importers because the
demand for pounds exceeds the supply of pounds. But the transshipment of gold involves cost.
Suppose the shipping cost of gold from the US to Britain is 5 cents. So the US importers would
have to pay $2.05 per £1. This is exchange rate, which is equivalent to US gold

Because currencies were convertible in gold, then nations could ship gold among themselves to
adjust their “balance of payments.”

In theory, all nations should have an optimal balance of payments of zero, i.e. they should
not have either a trade deficit or trade surplus.

For example, in a bilateral trade relationship between Australia and Brazil, if Brazil had a trade
deficit with Australia, then Brazil could pay Australia gold. Now that Australia had more gold, it
could issue more paper money since it now had a greater supply of gold to support new bills.

With an increase of paper bills in the Australian economy, inflation, i.e. a rise in prices due to an
overabundance of money, would occur. The rise in prices would subsequently lead to a drop in
exports, because Brazil would not want to buy the more expensive Australian goods.

Subsequently, Australia would then return to a zero balance of payments because its trade
surplus would disappear.

Likewise, when gold leaves Brazil, the price of its goods should decline, making them more
attractive for Australia. As a result, Brazil would experience an increase in exports until its
balance of payments reached zero. Therefore, the gold standard would ideally create a natural
balancing effect to stabilize the money supply of participating nations.

The Gold Standard in Operation

However, the operation of the gold standard in reality caused many problems. When gold left a
nation, the ideal balancing effect would not occur immediately. Instead, recessions and
unemployment would often occur. This was because nations with a balance of payments deficit
often neglected to take appropriate measures to stimulate economic growth. Instead of altering
tax rates or increasing expenditures – measures which should stimulate growth – governments
opted to not interfere with their nations’ economies. Thus, trade deficits would persist, resulting
in chronic recessions and unemployment.

With the outbreak of the First World War in 1914, the international trading system broke down
and nations valued their currencies by fiat instead, i.e. governments took their currencies off the
gold standard and simply dictated the value of their money. Following the war, some nations
attempted to reinstate the gold standard at pre-war rates, but drastic changes in the global
economy made such attempts futile. Britain, which had previously been the world’s financial
leader, reinstated the pound at its pre-war gold value, but because its economy was much weaker,
the pound was overvalued by approximately 10%. Consequently, gold swept out of Britain, and
the public was left with valueless notes, creating a surge in unemployment. By the time of the
Second World War, the inherent problems of the gold standard became apparent to governments
and economists alike.

Following the second world war, the International Monetary Fund replaced the gold
standard as a means for nations to address balance of payments problems with what
became a “gold-exchange” standard.

Currencies would be exchangeable not in gold but in the predominant post-war currencies of the
allied nations: British sterling, or more importantly, the U.S. dollar. Under the new International
Monetary Fund approach, governments had a more pronounced role in managing their
economies. Ideally, governments would hold dollars in “reserve.” If an economy needed an
influx of money because of a balance of payments deficit, the government could exchange its
reserve dollars for its own currency, and then inject this money into its economy. The dollar
would ideally remain stable since the U.S. government agreed to exchange dollars for gold at a
price of $35 an ounce. Thus, world currencies were officially off the gold standard. However,
they were exchangeable for dollars. Because dollars were still exchangeable for gold, the “gold-
exchange” standard became the prevailing monetary exchange system for many years.

The effect of the gold-exchange system was to make the United States the center for
international currency exchange. However, due to the inflationary effects of the Vietnam War
and the resurgence of other economies, the United States could no longer comply with its
obligation to exchange dollars for gold. Its own gold supply was rapidly declining. In 1971,

President Richard Nixon removed the dollar from gold, ending the predominance of gold in the
international monetary system.

In retrospect, the gold standard had many weaknesses. Its foremost problem was that its
theoretical balancing effect rarely worked in reality. A much more efficient means to resolve
balance of payments problems is through government intervention in their economies and the
exchange of reserve currencies. Today, very few commentators propose a return to the gold
standard.

International Monetary Fund

  THEINTACTFRONT17 JUL 2018 6 COMMENTS

The International Monetary Fund (IMF) is an international organization of 189

countries, working to foster global monetary cooperation, secure financial stability, facilitate
international trade, promote high employment and sustainable economic growth, and reduce
poverty around the world. It now plays a central role in the management of balance of payments
difficulties and international financial crises. The IMF also works to improve the economies of
its member countries.

The organization’s objectives stated in the Articles of Agreement are:

To promote international monetary co-operation, international trade, high employment,

exchange-rate stability, sustainable economic growth, and making resources available to member
countries in financial difficulty

Other objective includes:

 To facilitate the expansion and balanced growth of International Trade

 To establish a multilateral system of payments

Facts
⇒ Abbreviation: IMF

⇒ Formation: 7 July 1944

⇒ Type: International Financial Institution

⇒ Purpose: Promote international monetary co-operation, facilitate international trade, foster

sustainable economic growth, and make resources available to members experiencing balance of
payments difficulties

⇒ Headquarters: Washington, D.C., United States

⇒ Membership: 189 countries

⇒ Managing Director: Christine Lagarde

⇒ Main Organ: Board of governors

⇒ Parent Organization: United Nations

⇒ Staff: 2,700

Functional Departments

Functions: The IMF has three principal functions and activities: surveillance of financial and
monetary conditions in its member countries and of the world economy, financial assistance to
help countries overcome major balance of payments problems, and technical assistance and
advisory services to member countries
 It works to foster global growth and economic stability
 It helps to achieve macroeconomic stability and reduce poverty
 The IMF provides alternate sources of financing
 It oversee the fixed exchange rate arrangements between countries
 It helps national governments to manage their exchange rates and allowing these governments
to prioritise economic growth
 It helps to provide short-term capital to aid the balance of payments.
 The IMF was also intended to help mend the pieces of the international economy after the Great
Depression and World War II
 To provide capital investments for economic growth and projects such as infrastructure
 To examining the economic policies of countries with IMF loan agreements to determine if a
shortage of capital was due to economic fluctuations or economic policy.
 The IMF also researched what types of government policy would ensure economic recovery.
 A particular concern of the IMF was to prevent financial crisis, from spreading and threatening
the entire global financial and currency system
 The IMF negotiates conditions on lending and loans under their policy of conditionality

Purpose of IMF

1. Promote International monetary cooperation

2. Expansion and balanced growth of international trade
3. Promote exchange rate stability
4. The elimination of restrictions on the international flow of capital
5. Make resources of the fund available to the members
6. Help establish multilateral system of payments and eliminate foreign exchange restrictions.
7. Shorten the duration and lessen the degree of disequilibrium in international balances of
payment.
8. Foster economic growth and high levels of employment.
9. Temporary financial assistance to countries to help the balance of payments adjustments

Success of IMF

1. International Monetary Cooperation

2. Reconstruction of European Countries
3. Multilateral System of Foreign Payments
4. Increase in International Liquidity
5. Increase in International Trade
6. Special Aid to Developing Countries
7. Providing Statistical Information
8. Helpful in Times of Difficulties
9. Easiness & Flexibility in Making International Payments

Failures of IMF

1. Lack of Stability in Exchange Rate

2. Lack of Stability in the Price of Gold
3. Inability to Remove Restrictions on Foreign Trade
4. Rich Nations Club
5. No help for development projects
6. No Solution of International Liquidity
7. Interference in Domestic Economies
8. Inability to tackle the Monetary Crisis of August 1971
9. Less Aid for Developing Countries
10. High Rate of Interest

India & IMF

India is a founder member of IMF. Earlier India was made a permanent Executive Director of the
Board of Directors. At present India is no longer a permanent director. India is now an elected
member of IMF.India’s rank is 13th among 185 member nations.

Advantages from Membership of IMF to India:

 Facility of Foreign Exchange

 Freedom from British Pound
 Membership of the World Bank
 Importance of India in International Sector
 Economic Consultation
 Help during Emergency
 Financial help for five Year Plans
 Special Drawing Rights
 Help in Foreign Exchange Crisis
 Profit from Sale of Gold

→ The relationship between the IMF and India has grown strong over the years. In fact, the
country has turned into a creditor to the IMF. India and IMF must continue to boost their
relationship this way, as it will prove to be advantageous for both.

→ The IMF’s primary purpose is to safeguard the stability of the international monetary system
—the system of exchange rates and international payments that enables countries (and their
citizens) to buy goods and services from each other.

→ The IMF works to foster global growth and economic stability. It provides policy advice and
financing to members in economic difficulties and also works with developing nations to help
them achieve macroeconomic stability and reduce poverty.

World Bank
 THESTREAK11 DEC 2018 3 COMMENTS
The World Bank is an international financial institution that provides loans to developing
countries for capital programs. It comprises two institutions: the International Bank for
Reconstruction and Development (IBRD) and the International Development
Association (IDA). The World Bank is a component of the World Bank Group, and a member of
the United Nations Development Group.

The World Bank’s official goal is the reduction of poverty. According to its Articles of
Agreement, all its decisions must be guided by a commitment to the promotion of foreign
investment and international trade and to the facilitation of Capital investment.

During World War II, in the year 1944, a decision for the establishment of two institutions was
taken in a Conference held at Bretton Woods in America. The institutions to be established were

(1) International Monetary Fund and

(2) International Bank for Reconstruction and Development or World Bank.

The objective of IMF was to stabilize exchange rates by removing temporary balance of
payments deficits. On the other hand, the objective of the International Bank for Reconstruction
and Development (IBRD) or the World Bank was the reconstruction of war-ravaged economies
and provision of necessary capital for the economic development of underdeveloped countries.
The bank was established in 1945 and started its function in June 1945. The World Bank is an
inter-governmental institution and corporate in form. Its capital is wholly owned by its member
countries.

Objectives of the World Bank

The main objectives of the World Bank are:

(1) Reconstruction and Development

The main objective of the bank is to reconstruct the war devastated economies like Britain,
France, Holland etc. and to provide economic assistance to underdeveloped countries like India,
Pakistan, Sri Lanka, Burma etc.

 (2) Encouragement to Capital Investment

An other important objective of the Bank is to encourage private investors to invest capital
underdeveloped countries, by means of guarantee of participation in loans and other investment
made by private investors and when private capital is not available on reasonable terms, to
supplement private investment by providing on suitable conditions finance for productive
purposes out of its own capital, funds raised by it and its other resources.

(3) Encouragement to International Trade

The third objective of the bank is to encourage international trade. It aims at promoting long-
range growth of international trade and maintenance of equilibrium in member’s international
balance of payments, so that standard of living of the people of member-countries is raised.

(4) Establishment of Peace Time Economy 

The fourth objective of the Bank is to help the member-countries changeover from war-time
economy to peace-time economy.

(5) Environmental Protection 

Global environmental protection is also an objective of Bank. To this end, World Bank gives
substantial financial assistance to those underdeveloped countries which are engaged in the task
of environmental protection.

(6) Maintenance of equilibrium in balance of payment

To promote long term balanced growth of international trade and the maintenance of equilibrium
in balance of payments of member countries by encouraging long term international investment
so as to develop productive resources of members and thereby raising its productivity, the
standard of living and labor conditions.

Capital of the World Bank

Initially, the authorized capital of the World Bank was to the tune of $ 10,000 million, which was
divided into 1,00,000 shares of $ 1,00,000 each. All these shares were made available to member
countries only. As per the system of the Bank, out of each share.

(a) 2 per cent in payable in gold or U.S. dollars;

(b) 18 per cent of the subscription is to be paid in terms of member’s own currency;

(c) The remaining 80 per cent of the subscription is not immediately collected from the members
but can be called up by the Bank as a Callabh fund whenever it requires to meet its obligation.
Thus it is observed that only 20 per cent of the total capital is called by the Bank and the same is
available for its lending purposes.

The capital of the World Bank has also been increased time to time with the consent of its
members. After the admission of new members, the authorized capital of the Bank has been
increased to $ 171 billion. In its annual meeting held in September 1983, the World Bank
decided to go in for a selective capital increase of 8.4 billion dollars and accordingly the share
holding of different member countries were suitably adjusted.
Achievements

The following are the major achievements of World Bank:

(i) Membership

The total membership of the Bank has increased from a mere 30 countries initially to 68
countries in 1960 and then to 151 countries in 1988.

(ii) Increase in Working Capital

The bank has been increasing its Working Capital from time to time. Accordingly, it has raised
its capital by selling its securities and bonds at different times to different countries like USA,
UK etc. Accordingly, its capital has trebled during the past 40 years. In September, 1987, the
Bank approved on increase in general of 74.8 billion dollars in its capital and thereby raised its
lendable resources to 170 billion dollars.

(iii) Increase in Subscribed Capital

The Bank has also raised its subscribed capital from $ 10,000 million initially to $ 19,300 million
in 1960 and then to $ 91,436 million in 1988. As a result of following such process, the lending
capacity of the Bank has expanded.

(iv) Loan Approval

The amount of approval of loan to the member countries has been increasing and accordingly the
amount increased from $ 659 million in 1960 to $ 14,762 million in 1988.

(v) Loan Disbursement

The volume of loan disbursement by the Bank among its members has also been increasing and
accordingly the volume of loan disbursement has increased from $ 544 million in 1960 to $
11,636 million in 1988.

(vi) Total Loan

The World Bank has advanced a significant amount of loan to its member countries. During the
past 40 years of its existence since inception (up to June, 1989) the Bank had lent to the extent of
$ 1,36,596 million to 115 member countries for various developmental projects.

(vii) Loans for Productive Purposes

The World Bank is granting loans to member countries for productive purposes, especially for
the development of agriculture, irrigation, electricity and transportation projects. Economic
development of a country depends on the basic infrastructure. Therefore, the Bank is lending for
these aforesaid projects for this rapid economic development.

(viii) Technical Assistance

As per provisions of the Bank, the World Bank has been sending technical missions to member
countries for collecting necessary information regarding the functioning of their economies. The
Bank has been giving technical assistance to its member countries in order to solve their
complicated economic problems and for assessing economic resources of the country and setting
up of priorities for development programmes.

(ix) New Loan Strategy

In recent years, the Bank has introduced new loan strategy for giving more emphasis of financing
different schemes for influencing the well being of the poor masses of member developing
countries, especially for the purpose of agricultural marketing, forestry, fishery, development of
feeder roads in rural areas, rural electrification, spread of education in rural areas etc. In respect
of industry, the Bank made provision for direct lending to industries, more emphasis on heavy
industries, fertilizer industry, labour intensive small scale industry etc.

(x) Assistance to Underdeveloped Countries

(a) Financial assistance for the promotion of development;

(b) Developing ‘third window’ to advance loan at lower rate of interest to the underdeveloped
countries;

(c) Providing technical assistance;

(d) Organizing meetings of creditor countries for providing loan to developing countries such as
Aid India Club etc.;

(e) Setting up of subsidiary financial institutions like International Finance Corporation (IFC),
International Development Association (IDA) for providing soft and concessional finance to
developing countries etc.

(xi) Settlement of Disputes

The World Bank has been playing an important role in the settlement of international disputes
successfully for the promotion of world peace. Accordingly it has resolved Indus river water
dispute between India and Pakistan and Suez Canal dispute between England and Egypt.
Foreign Direct Investment and
Foreign Institutional Investment
 THEINTACTFRONT8 JAN 2019 3 COMMENTS

A foreign direct investment (FDI) is an investment in the form of a controlling ownership in a

business in one country by an entity based in another country. It is thus distinguished from a
foreign portfolio investment by a notion of direct control.

The origin of the investment does not impact the definition, as an FDI: the investment may be
made either “inorganically” by buying a company in the target country or “organically” by
expanding the operations of an existing business in that country.

Broadly, foreign direct investment includes “mergers and acquisitions, building new facilities,
reinvesting profits earned from overseas operations, and intra company loans”. In a narrow
sense, foreign direct investment refers just to building new facility, and a lasting management
interest (10 percent or more of voting stock) in an enterprise operating in an economy other than
that of the investor.

FDI is the sum of equity capital, long-term capital, and short-term capital as shown in the
balance of payments. FDI usually involves participation in management, joint-venture, transfer
of technology and expertise. Stock of FDI is the net (i.e., outward FDI minus inward FDI)
cumulative FDI for any given period. Direct investment excludes investment through purchase of
shares.

FDI, a subset of international factor movements, is characterized by controlling ownership of a

business enterprise in one country by an entity based in another country. Foreign direct
investment is distinguished from foreign portfolio investment, a passive investment in the
securities of another country such as public stocks and bonds, by the element of “control”.
According to the Financial Times, “Standard definitions of control use the internationally agreed
10 percent threshold of voting shares, but this is a grey area as often a smaller block of shares
will give control in widely held companies. Moreover, control of technology, management, even
crucial inputs can confer de facto control.

Impact of Foreign Direct Investment on  Economy

Foreign Direct Investment (FDI) plays an important role in the growth and development of an
economy. It is more important where domestic savings is not sufficient to generate funds for
capital investment. Not only it supplements the investment requirements of an economy but also
it brings new technology, managerial expertise and adds to foreign exchange reserves.

FDI inflow is more beneficial particularly to developing and emerging countries than the
developed ones. IMF has defined FDI as “a category of international investment that reflects the
objective of a resident entity in one economy (direct investor or parent enterprise) obtaining a
lasting interest and control in an enterprise resident in another economy (direct investment
enterprise)”.

Prior to 1980s, economic theories were not delving extensively on the aspects of foreign direct
investment and Multi-lateral enterprises (MNEs). During last three decades globalization has
been the key to almost all countries’ economic policies. An important aspect of globalization is
FDI inflows from home countries to host countries.

Though there is no general rule of developed and developing countries as home and host
countries respectively, however, mostly it is seen that FDI flows from developed countries to
developing and emerging countries. There has been growing competition among developing and
emerging countries to attract FDI. India is not left behind in this regard.

FDI is believed to play many important roles in the host countries. It has different effects on
different countries based on the host country policies, investment climate and other domestic
macroeconomic conditions.

The first and foremost is, it acts as a capital supplement to the domestic capital for investment
demand. Apart from capital it brings new, innovative technology to the host countries. In many
countries it also promotes competition among the domestic firms to improve their level of
technology adoption.

Effectively, they invest more in research and development (R & D) to upgrade their technology.
With increased investment as supplement to domestic capital, it also generates more employment
opportunities. With keen interest in the investee firms through FDI, the foreign firms improve
their managerial competence, which also improves managerial skills in the country through
competition and dissemination of the new ideas and skills.

The firms with improved technology and competition produce quality products, which are
exportable, thus it improves the level of export and degree of openness of the host countries.
With foreign partners, there are better tie ups with the importing firms abroad for potential
exportable domestic products. With improvement in exports the foreign exchange earnings of the
host countries gets boosted. Capital flow through FDI and improved export earnings can also
increase the level of foreign exchange reserve in the host countries.

With higher foreign exchange reserve, the demand for domestic currency will go up. Hence the
domestic currency of the host country is expected to appreciate as against the basket of foreign
currencies mostly of trade partners.

FDI is also believed to improve the Gross domestic product (GDP) of the host country through
improved production and competition among the domestic firms. With improved production and
more employment, it also can improve gross domestic capital formation (GDCF) which cater to
the increasing requirement of domestic investment in the country. Further, with competition,
improvement in technology, the performance of the investee firms as well as other domestic
firms can improve. Thus it can have a positive impact on return on capital and thereby on the
stock prices.

Keeping in view the above mentioned relationships between inward FDI and other
macroeconomic variables, which has already been found by some of the earlier researchers, this
study tries to empirically establish the relationship between FDI and other macroeconomic
variables in Indian context after undergoing some of the existing work in this area across
economies.

Foreign Portfolio Investment (FPI)

Foreign Portfolio Investment (FPI) is an investment by foreign entities and non-residents in

Indian securities including shares, government bonds, corporate bonds, convertible securities,
infrastructure securities etc.  The intention is to ensure a controlling interest in India at an
investment that is lower than FDI, with flexibility for entry and exit.

Foreign Institutional Investment (FII)

Foreign Portfolio Investment (FPI) is an investment by foreign entities in securities, real property
and other investment assets. Investors include mutual fund companies, hedge fund companies
etc. The intention is not to take controlling interest, but to diversify portfolio ensuring hedging
and to gain high returns with quick entry and exit.

The differences in FPI and FII are mostly in the type of investors and hence the terms FPI and
FII are used interchangeably.

The Securities Market in India is regulated by Securities and Exchange Board of India (SEBI).
Refer to the article on SEBI to get more information on this topic.

FDI and their impact on the economy

 THESTREAK10 DEC 2018 2 COMMENTS

A foreign direct investment (FDI) is an investment in the form of a controlling ownership in

a business in one country by an entity based in another country. It is thus distinguished from
a foreign portfolio investment by a notion of direct control.

The origin of the investment does not impact the definition, as an FDI: the investment may
be made either “inorganically” by buying a company in the target country or “organically” by
expanding the operations of an existing business in that country.

Broadly, foreign direct investment includes “mergers and acquisitions, building new
facilities, reinvesting profits earned from overseas operations, and intra company loans”. In
a narrow sense, foreign direct investment refers just to building new facility, and a lasting
management interest (10 percent or more of voting stock) in an enterprise operating in an
economy other than that of the investor.

FDI is the sum of equity capital, long-term capital, and short-term capital as shown in the
balance of payments. FDI usually involves participation in management, joint-venture,
transfer of technology and expertise. Stock of FDI is the net (i.e., outward FDI minus inward
FDI) cumulative FDI for any given period. Direct investment excludes investment through
purchase of shares.

FDI, a subset of international factor movements, is characterized by controlling ownership of

a business enterprise in one country by an entity based in another country. Foreign direct
investment is distinguished from foreign portfolio investment, a passive investment in the
securities of another country such as public stocks and bonds, by the element of “control”.
According to the Financial Times, “Standard definitions of control use the internationally
agreed 10 percent threshold of voting shares, but this is a grey area as often a smaller
block of shares will give control in widely held companies. Moreover, control of technology,
management, even crucial inputs can confer de facto control.

Impact of Foreign Direct Investment on  Economy

Foreign Direct Investment (FDI) plays an important role in the growth and development of
an economy. It is more important where domestic savings is not sufficient to generate funds
for capital investment. Not only it supplements the investment requirements of an economy
but also it brings new technology, managerial expertise and adds to foreign exchange
reserves.

FDI inflow is more beneficial particularly to developing and emerging countries than the
developed ones. IMF has defined FDI as “a category of international investment that reflects
the objective of a resident entity in one economy (direct investor or parent enterprise)
obtaining a lasting interest and control in an enterprise resident in another economy (direct
investment enterprise)”.

Prior to 1980s, economic theories were not delving extensively on the aspects of foreign
direct investment and Multi-lateral enterprises (MNEs). During last three decades
globalization has been the key to almost all countries’ economic policies. An important
aspect of globalization is FDI inflows from home countries to host countries.

Though there is no general rule of developed and developing countries as home and host
countries respectively, however, mostly it is seen that FDI flows from developed countries to
developing and emerging countries. There has been growing competition among
developing and emerging countries to attract FDI. India is not left behind in this regard.

FDI is believed to play many important roles in the host countries. It has different effects on
different countries based on the host country policies, investment climate and
other domestic macroeconomic conditions.
The first and foremost is, it acts as a capital supplement to the domestic capital for
investment demand. Apart from capital it brings new, innovative technology to the host
countries. In many countries it also promotes competition among the domestic firms to
improve their level of technology adoption.

Effectively, they invest more in research and development (R & D) to upgrade their
technology. With increased investment as supplement to domestic capital, it also generates
more employment opportunities. With keen interest in the investee firms through FDI, the
foreign firms improve their managerial competence, which also improves managerial skills
in the country through competition and dissemination of the new ideas and skills.

The firms with improved technology and competition produce quality products, which are
exportable, thus it improves the level of export and degree of openness of the host
countries. With foreign partners, there are better tie ups with the importing firms abroad for
potential exportable domestic products. With improvement in exports the foreign exchange
earnings of the host countries gets boosted. Capital flow through FDI and improved export
earnings can also increase the level of foreign exchange reserve in the host countries.

With higher foreign exchange reserve, the demand for domestic currency will go up. Hence
the domestic currency of the host country is expected to appreciate as against the basket of
foreign currencies mostly of trade partners.

FDI is also believed to improve the Gross domestic product (GDP) of the host country
through improved production and competition among the domestic firms. With improved
production and more employment, it also can improve gross domestic capital formation
(GDCF) which cater to the increasing requirement of domestic investment in the country.
Further, with competition, improvement in technology, the performance of the investee firms
as well as other domestic firms can improve. Thus it can have a positive impact on return on
capital and thereby on the stock prices.

Keeping in view the above mentioned relationships between inward FDI and other
macroeconomic variables, which has already been found by some of the earlier
researchers, this study tries to empirically establish the relationship between FDI and other
macroeconomic variables in Indian context after undergoing some of the existing work in
this area across economies.

Foreign portfolio investment (FPI)

 THESTREAK20 FEB 2019 1 COMMENT

Foreign portfolio investment (FPI) consists of securities and other financial assets passively
held by foreign investors. It does not provide the investor with direct ownership of financial
assets and is relatively liquid depending on the volatility of the market. Foreign portfolio
investment differs from foreign direct investment (FDI), in which a domestic company runs a
foreign firm, because although FDI allows a company to maintain better control over the firm
held abroad, it may face more difficulty selling the firm at a premium price in the future.

Foreign portfolio investment is part of a country’s capital account and shown on its balance of
payments (BOP). The BOP measures the amount of money flowing from one country to other
countries over one monetary year. It includes the country’s capital investments, monetary
transfers, and the number of exports and imports of goods and services.

Differences Between FPI and FDI

FPI lets an investor purchase stocks, bonds or other financial assets in a foreign country. Because
the investor does not actively manage the investments or the companies that issue the
investments, he does not have control over the securities or the business. However, since the
investor’s goal is to create a quick return on his money, FPI is more liquid and less risky than
FDI.

In contrast, FDI lets an investor purchase a direct business interest in a foreign country. For
example, an investor living in New York purchases a warehouse in Berlin so a German company
can expand its operations. The investor’s goal is to create a long-term income stream while
helping the company increase its profits.

The investor controls his monetary investments and actively manages the company into which he
puts money. He helps build the business and waits to see his return on investment (ROI).
However, because the investor’s money is tied up in a company, he faces less liquidity and more
risk when trying to sell his interest.

The investor also faces currency exchange risk, which may decrease the value of his investment
when converted from the country’s currency to U.S. dollars, and political risk, which may make
the foreign economy and his investment amount volatile.

Example of Foreign Portfolio Investment

In 2016, the United States received approximately 84% of total remittances, which was the
majority of outflows for FPI. The United Kingdom, Singapore, Hong Kong and Luxembourg
rounded out the top five countries receiving FPI, with approximately 81% of the combined share.
Net inflows from all countries were $451 million. Outflows were approximately $1.3 billion.
Approximately 84% of investments were in Philippine Stock Exchange-listed securities
pertaining to property companies, holding firms, banks, telecommunication companies, food,
beverage and tobacco companies.

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