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
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
Access to customers in new countries
Learning about customers in new
markets
Access to new, cheaper sources of
finance
Government incentives to relocate
Access to regional trading
agreements/avoidance of trade barriers
Economies of scale
Access to new resources (e.g. cheap of
skilled labour, natural resources)
Challenges
New competition for existing customers in
domestic markets
Adjusting products to local tastes and cultural
peculiarities
Global financial contagion
Costs of meeting a multitude of local/national laws
and regulations
Exchange rate fluctuations
Managing long supply chains
New competition for local resources (e.g. more
demand for labour pushing up local wage 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
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
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 Center9, 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
advantages10. 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 Extent to which basic,
Macroeconomic enterprises are
government policies technological, scientific
evaluation of the performing in an
are conductive to and human resources
domestic economy innovative, profitable
competitiveness (5 meet the needs of
(5 sub-factors) and responsible
sub-factors) business (5 sub-factors)
manner (5 sub-factors)
Domestic,
Public finance Productivity Basic infrastructure
economy,
Technological
International trade Fiscal policy Labour market
infrastructure
International Institutional
Finance Scientific infrastructure
investment framework
Employment Business legislation Management practices Health and environment
Societal framework Attitudes and values
Prices (78 criteria) Educations (96 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.

Innovation and
Basic requirements Efficiency enhancers
sophistication
Institutions Higher education and training Business sophistication
Infrastructure Goods market efficiency Innovation
Macroeconomic environment Labor market development
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 be policy and can be
quickly
changed changed easily
(Geography, (The quality of institutions, industrial (Tax code, international
topography, natural structure, ownership, public attitudes, relations and
resource endowment, composition of economic output, level and agreements, laws,
culture, history, quality of human and physical capital regulating frameworks,
climate, etc.) stocks, etc.) 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

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

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
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.

IFC, IDA

The International Finance Corporation (IFC) is an organization dedicated to helping the

private sector within developing countries. It provides investment and asset management
services to encourage the development of private enterprise in nations that might be lacking
the the necessary infrastructure or liquidity for businesses to secure financing.

The IFC was established in 1956 as a sector of the World Bank Group, focused on alleviating
poverty and creating jobs through the development of private enterprise. To that end, IFC
also ensures that private enterprises in developing nations have access to markets and
financing. Its most recent goals include the development of sustainable agriculture,
expanding small businesses’ access to microfinance, infrastructure improvements, as well as
climate, health, and education policies. The IFC is governed by its 184 member countries and
is headquartered in Washington, D.C.

The IFC views itself as a partner to its clients, delivering not only support with financing but
also technical expertise, global experience, and innovative thinking to help developing
nations overcome a range of problems, including financial, operational, and even at times
political.
The IFC also aims to mobilize third-party resources for its projects, often engaging in
difficult environments and leading crowding-in private finance, with the notion of extending
its impact beyond its direct resources.

International Development Association (IDA)

IDA is the largest source of concessional finance for the world’s 75 poorest countries, 39 of
which are in Africa. Resources from IDA bring positive change to the 1.3 billion people who
live in IDA countries.

With the ratification of the Sustainable Development Goals (SDGs) in 2015, along with a
historic agreement in Addis Ababa on ways to mobilize financing needed for the SDGs, the
world has a new roadmap for ending poverty by 2030. The International Development
Association (IDA) is poised to play a key role in this mission, by catalyzing trillions of
dollars in needed investment – public and private, national and global—and translating the
SDGs into country-led action.

As the largest source of concessional finance, IDA is recognized as a global institution with a
transformative effect that individual national donors cannot match. Here’s why:

 IDA provides leadership on global challenges. From its support for climate resilience
to the creation of jobs to get former combatants back into society, IDA rallies others
on tough issues for the common good and helps make the world more secure.
 IDA is transformational. IDA helps countries develop solutions that have literally
reshaped the development landscape—from its history-changing agriculture solutions
for millions of South Asians who faced starvation in the 1970s to its pioneering work
in the areas of debt relief and the phase-out of leaded gasoline.
 IDA is there for the long haul. IDA stays in a country after the cameras leave,
emphasizing long-term growth and capability to make sure results are sustained.
 When the poorest are ignored because they’re not profitable, IDA delivers. IDA
provides dignity and quality of life, bringing clean water, electricity, and toilets to
hundreds of millions of poor people.
 IDA makes the world a better place for girls and women. IDA works to reverse
gender discrimination by getting girls to school, helping women access financing to
start small businesses, and ultimately helping to improve the prospects of families and
communities.
 Working with the World Bank Group, IDA brings an integrated approach to
development. IDA helps create environments where change can flourish and where
the private sector can jumpstart investment.
 IDA is also a global leader in transparency and undergoes the toughest independent
evaluations of any international organization. For example, IDA placed in the highest
category in the 2018 Aid Transparency Index every year since the index was first
published in 2010—ranking highest among multilateral development banks.
 Equally, a 2018 assessment by the Center for Global Development and the Brookings
Institution named IDA one of the international community’s top performing providers
of development assistance, citing IDA’s low administrative costs, more predictable
aid flows, and large project size relative to other donors.
 And a 2017 survey of policymakers from 126 low- and middle-income countries by
AidData ranked the World Bank 2nd out of 56 bilateral donors and multilateral
 institutions on its agenda-setting influence in developing countries. The report cites
the World Bank as “punching above its weight” on value for money.

Foreign Direct Investment and Foreign

Institutional Investment
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

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) 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.