CHAPTER ONE

INTRODUCTION TO INTERNATIONAL FINANCE

Introduction
International finance as a subject is not new in the area of financial management, it has been
widely covered earlier in international economics and it is only the fast growth of international
business in the post-world war II and the associated complexities in the international transactions
that made the subject as an independent area of study.

The internationalization of finance and commerce has been brought about by the great advances
in transportation, communications, and information-processing technology. This development
introduces a dramatic new commercial reality—the global market for standardized consumer and
industrial products on a previously unimagined scale. It places primary emphasis on the one great
thing all markets have in common—the overwhelming desire for dependable, world-class
products at aggressively low prices. The international integration of markets also introduces the
global competitor, making firms insecure even in their home markets.

The transformation of the world economy has dramatic implications for business. Campuses have
students from many different countries. The chips in your laptop computer may have come from
Korea, the other hardware from China and its software could have been developed by Indian
engineers for a US branded computer. The concept of globalization refers to the increasing
connectivity and integration of countries and corporations and the people within them in terms of
their economic, political, and social activities. Because of globalization, multinational
corporations dominate the corporate landscape. A multinational corporation (MNC) produces and
sells goods or services in more than one nation. A prototypical example is the Coca-Cola
Company, which operates in more than 200 countries.

The doctrine of comparative advantage made an initial assumption that although the products of
economic activities could move internationally; the factors of production were relatively fixed in
a geographical sense. Land, labor and capital were assumed internationally immobile.

The fast growing of the cross-border business transactions in the second half of the last twentieth
century triggered the birth of multinational corporations, which is considered the most important
phenomena in the economic development in that century.

With growing operation of multinational corporations, a number of complexities arose in the area
of their financial decisions. Apart from the considerations of where, when and how to invest, the
decision concerning the management of working capital among their different subsidiaries and the
parent units became more complex, especially because the basic policies varied from one MNC
to another. Those MNCs that were more interested in maximizing the value of global wealth
adopted a centralized approach while those not interfering much with their subsidiaries believed
in a decentralized approach. Normally there is a mix of the two approaches in varying proportions,
for which the study of international finance has come to be more relevant.
Evolution of multinational corporations
Despite its increasing importance today, international business activity is not new. The transfer of
goods and services across national borders has been taking place for thousands of years, antedating
even Joseph’s advice to the rulers of Egypt to establish that nation as the granary of the Middle
East. Since the end of World War II, however, international business has undergone a revolution
out of which has emerged one of the most important economic phenomena of the latter half of the
twentieth century: the multinational corporation

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The term multinational, or global, corporation (MNC) is used to describe a firm that operates
in an integrated fashion in a number of countries. During the past 20 years, a new and
fundamentally different form of international commercial activity has developed, and this has
greatly increased worldwide economic and political interdependence. Rather than merely buying
resources from and selling goods to foreign nations, multinational firms now make direct
investments in fully integrated operations, from extraction of raw materials, through the
manufacturing process, to distribution to consumers throughout the world. Today, multinational
corporate networks control a large and growing share of the world’s technological, marketing, and
productive resources.

MEANING OF INTERNATIONAL FINANCE.

International finance activities help organizations to engage in cross-border transactions with
foreign business partners, such as customers, suppliers and lenders. Government agencies and
Non-profit institutions also use international finance tools to meet operating needs.

The term international finance is defined on the basis of various parameters:

 It is a discipline of financing the international economic and commercial relations between
countries.
 It includes international markets (such as international banking, euro currency market,
eurobond, international stock exchanges)
 It is related to management, economic, commercial and accounting activities of MNCs,
governments and private individuals.
 It involves conversion of one currency into another.
 It coordinates all financial and non-financial operations with the objectives of
maximization of the shareholders’ wealth.

International finance is the branch of economics that studies the dynamics of foreign exchange,
foreign direct investment and how these affect international trade. Also studies the international
projects, international investment and the international capital flow.

International Finance can be broadly defined, as the study of the financial decisions taken by a
multinational corporation in the area of international business i.e. global corporate finance.

International finance draws much of its background from the preliminary studies in the topics of
corporate finance such as capital budgeting, portfolio theory and cost of capital but now viewed
in the international dimension.

International finance is branch of economics that studies the dynamics of exchanges rates,
foreign investment and how these affect international trade. International finance covers all
procedures, techniques and tools that financial institutions, such as banks and insurance companies
provide to clients. These tools may include financing agreements and transaction strategies on
securities exchange. International finance is the study of the institutions, policies, and practices
that govern global financial management and/or financial aspects of global business.

Reasons for studying international finance

1. To understand a global economy
Three recent changes have had a profound effect on the international finance environment. These
are the end of the Cold War. The emergence of growing markets among the developing countries
East Asia and Latin America, and the increasing globalization of the international economy.
Understanding these changes should help one to see where the international economy is headed
in the future so that you can effectively respond to these challenges, fulfill your responsibilities,
and take advantage of those opportunities.

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 2. To understand the effects of global finance on business
There are many examples of the growing importance of international operations for individual
companies. Companies like coca cola earn more than half of their total operating profits through
international operations. Also companies like General motors, Sony, do business in more than 150
countries around the world. Philips electronics, Ford and IBM have more workers overseas than
in their home countries. Global finance has also become increasingly important as it serves world
trade and foreign investment. Simply stated, each nation is economically related to other nations
through a complex network of international trade, foreign investment, and international loans.
Companies have advantage in moving their operations forward if they understand the basic
elements of international finance. Apart from career interests, persons who want to improve their
knowledge of the world would be seriously handicapped if they do not understand the economic
dynamics and policy issues of finance, and investment flows among nations.
3. To make intelligent personal decisions
For example, when looking for a job, you may have the advantage of comparing two job offers,
one from a company in home country and another from a company in foreign country. When
deciding to buy a car, your choice between the latest modes offered by various companies (general
motors $ volks wagen) may well depends on the exchange rate between the home currency and
foreign currencies of those country where the car is coming from. All these decisions require
significant knowledge of international finance to make intelligent decisions in all these cases, the
important point is that you will participate not just in the domestic economy but in economies
around the world.

Features of MNCs:
1. MNCs have managerial headquarters in home countries, while they carry out operations
in a number of other (host) countries.
2. A large part of capital assets of the parent company is owned by the citizens of the
company's home country.
3. The absolute majority of the members of the Board of Directors are citizens of the home
country.
4. Decisions on new investment and the local objectives are taken by the parent company.
5. MNCs are predominantly large-sized and exercise a great degree of economic dominance.
6. MNCs control production activity with large foreign direct investment in more than one
developed and developing countries.
7. MNCs are not just participants in export trade without foreign investments.

Main Drivers of Globalization [International Business]

1. Cost driver companies consider the various lifestyle of the country before considering the
price of the product and services to rendered
2. Technology driver: increasing technology system, transportation, advancing in the level
of world trade system
3. Government driver: reducing trade tariffs and non-trade tariffs, reducing the role of
political policies
4. Competition driver: organization becoming a global center, shift in open market system,
Privatization, Liberalization

Approaches in International Business

1. Ethnocentric Orientation:
The ethnocentric orientation of a firm considers that the products, marketing strategies and
techniques applicable in the home market are equally so in the overseas market as well. In such a
firm, all foreign marketing operations are planned and carried out from home base, with little or
no difference in product formulation and specifications, pricing strategy, distribution and

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promotion measures between home and overseas markets. The firm generally depends on its
foreign agents and export-import merchants for its export sales.
2. Regiocentric Orientation:
In regiocentric approach, the firm accepts a regional marketing policy covering a group of
countries which have comparable market characteristics. The operational strategies are formulated
on the basis of the entire region rather than individual countries. The production and distribution
facilities are created to serve the whole region with effective economy on operation, close control
and coordination.
3. Geocentric Orientation:
In geocentric orientation, the firms accept a worldwide approach to marketing and its operations
become global. In global enterprise, the management establishes manufacturing and processing
facilities around the world in order to serve the various regional and national markets through a
complicated but well co-ordinate system of distribution network. There are similarities between
geocentric and regiocentric approaches in the international market except that the geocentric
approach calls for a much greater scale of operation.
4. Polycentric Operation:
When a firm adopts polycentric approach to overseas markets, it attempts to organize its
international marketing activities on a country to country basis. Each country is treated as a
separate entity and individual strategies are worked out accordingly. Local assembly or production
facilities and marketing organisations are created for serving market needs in each country.
Polycentric orientation could be most suitable for firms seriously committed to international
marketing and have its resources for investing abroad for fuller and long-term penetration into
chosen markets. Polycentric approach works better among countries which have significant
economic, political and cultural differences and performance of these tasks are free from the
problems created primarily by the environmental factors.

Evolution of multinational corporations

Despite its increasing importance today, international business activity is not new. The transfer of
goods and services across national borders has been taking place for thousands of years, antedating
even Joseph’s advice to the rulers of Egypt to establish that nation as the granary of the Middle
East. Since the end of World War II, however, international business has undergone a revolution
out of which has emerged one of the most important economic phenomena of the latter half of the
twentieth century: the multinational corporation.

A multinational corporation (MNC) is a company engaged in producing and selling goods or

services in more than one country. It ordinarily consists of a parent company located in the home
country and at least five or six foreign subsidiaries, typically with a high degree of strategic
interaction among the units. Some MNCs have upward of 100 foreign subsidiaries scattered
around the world.

Based in part on the development of modern communications and transportation technologies, the
rise of the multinational corporation was unanticipated by the classical theory of international
trade as first developed by Adam Smith and David Ricardo. According to this theory, which rests
on the doctrine of comparative advantage, each nation should specialize in the production and
export of those goods that it can produce with highest relative efficiency and import those goods
that other nations can produce relatively more efficiently. Underlying this theory is the assumption
that goods and services can move internationally but factors of production, such as capital, labour,
and land, are relatively immobile. Furthermore, the theory deals only with trade in commodities
that is, undifferentiated products; it ignores the roles of uncertainty, economies of scale,
transportation costs, and technology in international trade; and it is static rather than dynamic. For

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all these defects, however, it is a valuable theory, and it still provides a well-reasoned theoretical
foundation for free-trade arguments. But the growth of the MNC can be understood only by
relaxing the traditional assumptions of classical trade theory.

Classical trade theory implicitly assumes that countries differ enough in terms of resource
endowments and economic skills for those differences to be at the centre of any analysis of
corporate competitiveness. Differences among individual corporate strategies are considered to be
of only secondary importance; a company’s citizenship is the key determinant of international
success in the world of Adam Smith and David Ricardo.

Against this background, the ability of corporations of all sizes to use these globally available
factors of production is a far bigger factor in international competitiveness than broad
macroeconomic differences among countries. Contrary to the postulates of Smith and Ricardo, the
very existence of the multinational enterprise is based on the international mobility of certain
factors of production. Capital raised in London on the Eurodollar market may be used by a Swiss-
based pharmaceutical firm to finance the acquisition of German equipment by a subsidiary in
Brazil. A single Barbie doll is made in 10 countries—designed in California; with parts and
clothing from Japan, China, Hong Kong, Malaysia, Indonesia, Korea, Italy, and Taiwan; and
assembled in Mexico and sold in 144 countries.

The value added in a particular country product development, design, production, assembly, or
marketing depends on differences in labour costs and unique national attributes or skills. Although
trade in goods, capital, and services and the ability to shift production act to limit these differences
in costs and skills among nations, differences nonetheless remain based on cultural predilections,
historical accidents, and government policies. Each of these factors can affect the nature of the
competitive advantages enjoyed by different nations and their companies. For example, at the
moment, the United States has some significant competitive advantages. For one thing,
individualism and entrepreneurship characteristics that are deeply ingrained in the American spirit
are increasingly a source of competitive advantage as the creation of value becomes more
knowledge intensive. When inventiveness and entrepreneurship, along with a culture of openness
and innovation, are combined with abundant risk capital, superior graduate education, better
infrastructure, and an inflow of foreign brainpower, it is not surprising that U.S. companies from
Boston to Austin, from Silicon Alley to Silicon Valley dominate world markets in software,
biotechnology, Internet-related business, microprocessors, aerospace, and entertainment. Also,
U.S. firms are moving rapidly forward to construct an information superhighway and related
multimedia technology, whereas their European and Japanese rivals face continued regulatory and
bureaucratic roadblocks. Recent experiences also have given the United States a significant
competitive advantage. During the 1980s and 1990s, fundamental political, technological,
regulatory, and economic forces radically changed the global competitive environment. A brief
listing of some of these forces includes the following:
- Massive deregulation
- The collapse of communism
- The sale of hundreds of billions of dollars of state-owned firms around the world in
massive privatizations designed to shrink the public sector
- The revolution in information technologies
- The rise in the market for corporate control with its waves of takeovers, mergers, and
leveraged buyouts

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 - The jettisoning of statist policies and their replacement by free-market policies in Third
World nations
- The unprecedented number of nations submitting themselves to the exacting rigors and
standards of the global marketplace

These forces have combined to usher in an era of brutal price and service competition. The United
States is further along than other nations in adapting to this new world economic order, largely
because its more open economy has forced its firms to confront rather than hide from competitors.

Perhaps the most dramatic change in the international economy over the past three decades has
been the rise of China as a global competitor. From 1978, when Deng Xiaoping launched his
country’s economic reform program, to 2010, China’s gross domestic product rose by more than
3200%, an annual rate of 11%, the most rapid growth rate by far of any country in the world during
this 33-year period. Since 1991, China has attracted the largest amount of foreign investment
(FDI) among developing countries each year, with annual foreign investment by the late 1990s
exceeding $50 billion. Since 2002, China has been the world’s number-two destination (the United
States is number one) for foreign direct investment (FDI), which is the acquisition abroad of
companies, property, or physical assets such as plant and equipment, attracting over $105 billion
in FDI flows in 2010. About 400 out of the world’s 500 largest companies, employing 16 million
workers in 2008, have now invested in China.

Worldwide, the stock of FDI reached an estimated $18.9 trillion in 2010. Moreover, these
investments have grown steadily over time, facilitated by a combination of factors: falling
regulatory barriers to overseas investment; rapidly declining telecommunications and transport
costs; and freer domestic and international capital markets in which vast sums of money can be
raised, companies can be bought, and currency and other risks can be hedged. These factors have
made it easier for companies to invest abroad, to do so more cheaply, and to experience less risk
than ever before.

Reasons why Companies go global

1. To broaden their markets.
After a company has saturated its home market, growth opportunities are often better in foreign
markets. Thus, such home-grown firms as Coca-Cola are aggressively expanding into overseas
markets, and foreign firms such as Sony and Toshiba now dominate the U.S. consumer electronics
market. Also, as products become more complex, and development becomes more expensive, it
is necessary to sell more units to cover overhead costs, so larger markets are critical. Thus, movie
companies have “gone global” to get the volume necessary to support pictures such as Titanic.
2. To seek raw materials.
Many U.S. oil companies, such as Exxon Mobil, have major subsidiaries around the world to
ensure access to the basic resources needed to sustain the companies’ primary business line.
3. To seek new technology.
No single nation holds a commanding advantage in all technologies, so companies are scouring
the globe for leading scientific and design ideas. For example, Xerox has introduced more than 80
different office copiers in the United States that were engineered and built by its Japanese joint
venture, Fuji Xerox.
4. To seek production efficiency.
Companies in high-cost countries are shifting production to low-cost regions. For example, BMW,
in response to high production costs in Germany, has built assembly plants in the United States.
The ability to shift production from country to country has important implications for labor costs
in all countries. Some multinational companies make decisions almost daily on where to shift

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production. When Dow Chemical saw European demand for a certain solvent declining, the
company scaled back production at a German plant and shifted its production to another chemical
that had previously been imported from the United States. Relying on complex computer models
for making such decisions, Dow runs its plants at peak capacity and thus keeps capital costs down.
5. To avoid political and regulatory hurdles.
The primary reason Japanese auto companies moved production to the United States was to get
around U.S. import quotas. Now Honda, Nissan, Toyota, Mazda, and Mitsubishi are all
assembling vehicles in the United States. One of the factors that prompted U.S. pharmaceutical
maker SmithKline and Britain’s Beecham to merge was that they wanted to avoid licensing and
regulatory delays in their largest markets, Western Europe and the United States. Now SmithKline
Beecham can identify itself as an inside player in both Europe and the United States.
6. To diversify.
By establishing worldwide production facilities and markets, firms can cushion the impact of
adverse economic trends in any single country. For example, General Motors softened the blow
of poor sales in the United States during the 1990–1991 recessions with strong sales by its
European subsidiaries. In general, geographic diversification works because the economic ups and
downs of different countries are not perfectly
7. Cost Minimization.
Cost minimiser is a fairly recent category of firms doing business internationally. These firms
seek out and invest in lower cost production sites overseas (e.g.Hong Kong, Taiwan, and Ireland)
to remain cost competitive both at home and abroad. Many of these firms are in the electronics
industry. Examples include Texas Instruments, Intel, and Seagate Technology. Increasingly,
companies are shifting services overseas, not just manufacturing work. As of June 2007, GE had
about 13,000 employees in India to handle accounting, claims processing, customer service,
software operations, and credit evaluation and research. Similarly, companies such as AOL
(customer service), American Express (finance and customer service), and British Airways
(accounting) are shifting work to India, Jamaica, Hungary, Morocco, and the Philippines for
savings of up to 60%, while Chrysler has announced plans to expand its engineering canters in
China and Mexico and to open others in India and Russia to cut its engineering costs and to build
business ties in those big, developing markets. The off shoring of services can be done in two
ways: internally, through the establishment of wholly owned foreign affiliates, or externally, by
outsourcing a service to a third-party provider.
8. Knowledge Seeking
Some firms enter foreign markets in order to gain information and experience that is expected to
prove useful elsewhere. Beecham, an English firm (now part of GlaxoSmithKline), deliberately
set out to learn from its U.S. operations how to be more competitive, first in the area of consumer
products and later in pharmaceuticals. This knowledge proved highly valuable in competing with
American and other firms in its European markets. The flow of ideas is not all one way, however.
As Americans have demanded better-built, better-handling, and more fuel-efficient small cars,
Ford of Europe has become an important source of design and engineering ideas and management
talent for its U.S. parent, notably with the hugely successful Taurus.
9. Keeping Domestic Customers
Suppliers of goods or services to multinationals often will follow their customers abroad in order
to guarantee them a continuing product flow. Otherwise, the threat of a potential disruption to an
overseas supply line for example, a dock strike or the imposition of trade barriers can lead the
customer to select a local supplier, which may be a domestic competitor with international
operations. Hence, comes the dilemma: Follow your customers abroad or face the loss of not only
their foreign but also their domestic business. A similar threat to domestic market share has led
many banks; advertising agencies; and accounting, law, and consulting firms to set up foreign
practices in the wake of their multinational clients’ overseas expansion.
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 10. Exploiting Financial Market Imperfections
An alternative explanation for foreign direct investment relies on the existence of financial market
imperfections. The ability to reduce taxes and circumvent currency controls may lead to greater
project cash flows and a lower cost of funds for the MNC than for a purely domestic firm. An
even more important financial motivation for foreign direct investment is likely to be the desire
to reduce risks through international diversification. This motivation may be some-what surprising
because the inherent riskiness of the multinational corporation is usually taken for granted.
Exchange rate changes, currency controls, expropriation, and other forms of government
intervention are some of the risks that purely domestic firms rarely, if ever, encounter.

Thus, the greater a firm’s international investment, the riskier its operations should be. Yet, there
is good reason to believe that being multinational may actually reduce the riskiness of a firm.
Much of the systematic or general market risk affecting a company is related to the cyclical nature
of the national economy in which the company is domiciled. Hence, the diversification effect
resulting from operating in a number of countries whose economic cycles are not perfectly in
phase should reduce the variability of MNC earnings.

International Business Methods by MNCs

International financial management is related to managing finance of MNCs. There are six
methods by which firms conduct international business activities.
 Licensing:
A firm in one country licenses the use of some or all of its intellectual property (patents,
trademarks, copyrights, brand names) to a firm of some other country in exchange for fees or some
royalty payment. Licensing enables a firm to use its technology in foreign markets without a
substantial investment in foreign countries.
 Franchising:
A firm in one country authorising a firm in another country to utilise its brand names, logos etc.
in return for royalty payment.
 Joint ventures:
A corporate entity or partnership that is jointly owned and operated by two or more firms is known
as a joint venture. Joint ventures allow two firms to apply their respective comparative advantage
in a given project.
 Establishing new foreign subsidiaries:
A firm can also penetrate foreign markets by establishing new operations in foreign countries to
produce and sell their products. The advantage here is that the working and operation of the firm
can be tailored exactly to the firm’s needs. However, a large amount of investment is required in
this method.
 Management contracts:
A firms in one country agrees to operate facilities or provide other management services to a firm
in another country for an agreed upon fee.
 Acquisitions of Existing Operations:
Firms frequently acquire other firms in foreign countries as a means of penetrating foreign
markets. For example, American Express recently acquired offices in London, while Procter &
Gamble purchased a bleach company in Panama. Acquisitions allow firms to have full control
over their foreign businesses and to quickly obtain a large portion of foreign market share.

MULTINATIONAL VERSUS DOMESTIC FINANCIAL MANAGEMENT

Six major factors distinguish financial management in firms operating entirely within a single
country from firms that operate globally:
1. Different currency denominations.

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Cash flows in various parts of a multinational corporate system will be denominated in different
currencies. Hence, an analysis of exchange rates must be included in all financial analyses.
2. Economic and legal regulations.
Each country has its own unique economic and legal systems, and these differences can cause
significant problems when a corporation tries to coordinate and control its worldwide operations.
For example, differences in tax laws among countries can cause a given economic transaction to
have strikingly different after-tax consequences, depending on where the transaction occurs. Such
differences can restrict multinational corporations’ flexibility in deploying resources, and can even
make procedures that are required in one part of the company illegal in another part. These
differences also make it difficult for executives trained in one country to move easily to another.
3. Language differences.
The ability to communicate is critical in all business transactions, and here U.S. citizens are often
at a disadvantage because we are generally fluent only in English, while European and Japanese
businesspeople are usually fluent in several languages, including English. Thus, they can invade
our markets more easily than we can penetrate theirs.
4. Cultural differences.
Even within geographic regions that are considered relatively homogeneous, different countries
have unique cultural heritages that shape values and influence the conduct of business.
Multinational corporations find that matters such as defining the appropriate goals of the firm,
attitudes toward risk, dealings with employees, and the ability to curtail unprofitable operations
vary dramatically from one country to the next.
5. Role of governments.
Most financial models assume the existence of a competitive marketplace in which the terms of
trade are determined by the participants. The government, through its power to establish basic
ground rules, is involved in the process, but its role is minimal. Thus, the market provides the
primary barometer of success, and it gives the best clues about what must be done to remain
competitive. This view of the process is reasonably correct for the United States and Western
Europe, but it does not accurately describe the situation in most of the world. Frequently, the terms
under which companies compete, the actions that must be taken or avoided, and the terms of trade
on various transactions are determined not in the marketplace but by direct negotiation between
the host government and the multinational corporation. This is essentially a political process, and
it must be treated as such. Thus, our traditional financial models have to be recast to include
political and other noneconomic aspects of the decision.
6. Political risk.
A nation is free to place constraints on the transfer of corporate resources and even to expropriate
without compensation assets within their boundaries. This is political risk, and it tends to be
largely a given rather than a variable that can be changed by negotiation. Political risk varies from
country to country, and it must be addressed explicitly in any financial analysis. Another aspect
of political risk is terrorism against U.S. firms or executives. For example, U.S. and Japanese
executives have been kidnapped and held for ransom in several South American countries.

GOALS OF INTERNATIONAL FINANCE

There are various goals of international finance. These are:
1. To achieve higher rate of profits:
International companies search for foreign markets that hold promise for higher rate of profits.
Thus, the objective of profit affects and motivates the business to expand its operations to foreign
countries. For example, Hewlett Packard in US earned 86.2% of its profits from the foreign
markets, compared to that of domestic markets, in 2007. Apple earned, US $ 730 million as net
profit from the foreign markets and only US $ 620m. as net profit, from its domestic market, in
2007.
2. Expansion of production capacities:

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Some of the domestic companies expanded their production capacities more than the demand for
the product in the domestic countries. These companies in such cases, are forced to sell their
excess production in foreign developed countries. Toyota of Japan is an example.
3. Severe competition in the home country:
The weak companies which could not meet the competition of the strong companies in the
domestic country started entering the markets of the developing countries.
4. Limited home market:
When the size of the home market is limited due to the smaller size of the population or due to
lower purchasing power of the people or both, the companies internalise their operations. For
example, most of the Japanese automobile and electronic firms entered the U.S., Europe and even
African markets due to the smaller size of the home market. I.T.C. entered the European market
due to the lower purchasing power of Indians with regard to high quality cigarettes. Similarly, the
mere six million population of Switzerland, is the reason for Ciba-Geigy to internationalise its
operations. In fact, this company was forced to concentrate on global market and establish
manufacturing facilities in foreign countries.
5. Political stability vs. political instability:
Political stability does not simply mean that continuation of the same party in power, but it does
not mean that continuation of the same policies of the Government for a quieter longer period. It
is viewed that the U.S.A. is a politically stable country. Similarly, UK, France, Germany, Italy
and Japan are also politically stable countries. International companies prefer, to enter the
politically stable countries and are restrained from locating their business operations in politically
instable countries. In fact, business companies shift their operations from politically instable
countries to politically stable countries.
6. Availability of technology and skilled human resources:
Availability of advanced technology and competent human resources, in some countries act as
PULLING FACTORS for international companies. The developed countries due to these reasons
attract companies from the developing world American and European companies, depended on
Indian companies for software products and services through their BPOs. The cost of professionals
in India is 10 to 15 times less compared to US and European markets. These factors helped Indian
software industry to grow at a faster rate with world class standards. Added to this, satellite
communications help Indian companies to serve the global business without going globally.
7. High cost of transportation:
The major factor in lower profit margins to international companies, is the cost of transportation
of the products. Under such conditions, the foreign companies are inclined to increase their profit
margin by locating their manufacturing facilities in foreign countries, where there is enough
demand either in one country or in a group of neighboring countries. For example, Mobil, which
was supplying the petroleum products to Ethiopia, Kenya, Eritrea, Sudan, etc. from its refineries,
in Saudi Arabia, established its refinery facility in Eritrea, in order to reduce the cost of
transportation.
8. Nearness to raw materials:
The source of highly qualitative raw materials and bulk raw materials is a major factor for
attracting the companies from various foreign countries. Most of the US based and European based
companies located their manufacturing facilities in Saudi Arabia, Bahrain, Qatar, Iran etc. due to
availability of petroleum.
9. Availability of quality human resources:
This is a major factor for software, high technology and telecommunication companies to locate
their operations in India. India is a major source for high quality and low cost human resources.
10. Liberalisation and globalisation:
Most of the countries in the world, liberalised their economies and opened their countries to the
rest of the world.
11. Increased market share:

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Some of the large scale international companies like to enhance their market share in the world
market by expanding and intensifying their operations in various foreign countries. For example,
Ball Corporation, the third largest beverage cans manufacturer in the USA, bought the European
Packaging operations of continental can company. Then it expanded its operations in Europe and
met the Europe demand, which is 200 per cent more than that of USA. Thus, it increased its global
market share of soft drink cans.
12. To achieve higher rate of economic development:
International companies help the governments to achieve higher growth rate of the economy,
increase the total and per capita GDP, industrial growth, employment and income levels.
13. Tariffs and import quotas:
It was quite common before globalisation that governments imposed tariffs or duty on imports to
protect the domestic companies. Sometimes government also fixes import quotas to reduce the
competition to the domestic companies from competent foreign companies. To avoid high tariffs
and quotas companies prefer direct investments to go globally. For example, companies like Sony,
Honda and Toyota preferred direct foreign investment in various countries by establishing
subsidiaries or through joint ventures.

Theories of International Business

1. Theory of Absolute Advantage
The Scottish economist Adam Smith developed the trade theory of absolute advantage in 1776. A
country that has an absolute advantage produces greater output of a good or service than other
countries using the same amount of resources. Smith stated that tariffs and quotas should not
restrict international trade; it should be allowed to flow according to market forces. Contrary to
mercantilism Smith argued that a country should concentrate on production of goods in which it
holds an absolute advantage. No country would then need to produce all the goods it consumed.

The theory of absolute advantage destroys the mercantilistic idea that international trade is a zero-
sum game. According to the absolute advantage theory, international trade is a positive-sum game,
because there are gains for both countries to an exchange. Unlike mercantilism this theory
measures the nation's wealth by the living standards of its people and not by gold and silver. There
is a potential problem with absolute advantage. If there is one country that does not have an
absolute advantage in the production of any product, will there still be benefit to trade, and will
trade even occur? The answer may be found in the extension of absolute advantage, the theory of
comparative advantage.
2. Theory of Comparative Advantage
The most basic concept in the whole of international trade theory is the principle of comparative
advantage, first introduced by David Ricardo in 1817. It remains a major influence on much
international trade policy and is therefore important in understanding the modern global economy.
The principle of comparative advantage states that a country should specialize in producing and
exporting those products in which is has a comparative, or relative cost, advantage compared with
other countries and should import those goods in which it has a comparative disadvantage. Out of
such specialisation, it is argued, will accrue greater benefit for all.

In this theory there are several assumptions that limit the real-world application. The assumption
that countries are driven only by the maximization of production and consumption, and not by
issues out of concern for workers or consumers is a mistake.
3. Heckscher-Ohlin Theory
In the early 1900s an international trade theory called factor proportions theory emerged by two
Swedish economists, Eli Heckscher and Bertil Ohlin. This theory is also called the Heckscher
Ohlin theory. The Heckscher-Ohlin theory stresses that countries should produce and export goods
that require resources (factors) that are abundant and import goods that require resources in short
supply.

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This theory differs from the theories of comparative advantage and absolute advantage since these
theory focuses on the productivity of the production process for a particular good. On the contrary,
the Heckscher-Ohlin theory states that a country should specialise production and export using
the factors that are most abundant, and thus the cheapest. Not produce, as earlier theories stated,
the goods it produces most efficiently.

The Heckscher-Ohlin theory is preferred to the Ricardo theory by many economists, because it
makes fewer simplifying assumptions. In 1953, Wassily Leontief published a study, where he
tested the validity of the Heckscher-Ohlin theory. The study showed that the U.S was more
abundant in capital compared to other countries, therefore the U.S would export capital- intensive
goods and import labour-intensive goods. Leontief found out that the U.S's export was less capital
intensive than import.
4. Product Life Cycle Theory
Raymond Vernon developed the international product life cycle theory in the 1960s. The
international product life cycle theory stresses that a company will begin to export its product and
later take on foreign direct investment as the product moves through its life cycle. Eventually a
country's export becomes its import. Although the model is developed around the U.S, it can be
generalised and applied to any of the developed and innovative markets of the world.

The product life cycle theory was developed during the 1960s and focused on the U.S since most
innovations came from that market. This was an applicable theory at that time since the U.S
dominated the world trade. Today, the U.S is no longer the only innovator of products in the world.
Today companies design new products and modify them much quicker than before. Companies
are forced to introduce the products in many different markets at the same time to gain cost
benefits before its sales declines. The theory does not explain trade patterns of today.
5. Theory of Mercantilism
According to Wild, 2000, the trade theory that states that nations should accumulate financial
wealth, usually in the form of gold, by encouraging exports and discouraging imports is called
mercantilism. According to this theory other measures of countries' well being, such as living
standards or human development, are irrelevant. Mainly Great Britain, France, the Netherlands,
Portugal and Spain used mercantilism during the 1500s to the late 1700s.

Mercantilistic countries practiced the so-called zero-sum game, (situation in which one
participant's gains result only from another participant's equivalent losses. The net change in total
wealth among participants is zero; the wealth is just shifted from one to another.) which meant
that world wealth was limited and that countries only could increase their share at expense of their
neighbors. The economic development was prevented when the mercantilistic countries paid the
colonies little for export and charged them high price for import. The main problem with
mercantilism is that all countries engaged in export but was restricted from import, prevention
from development of international trade

EMERGING CHALLENGES IN INTERNATIONAL FINANCE

The players in international business, who are multinational companies are beset with many
number of difficulties and road blocks. These challenges have hampered international companies’
business considerably. The following are the important challenges in international finance:
1. Varied Economic Systems:
Economic system refers to the kind of governance of a country. It may be on the basis of the
principles of communism, capitalism, socialism and mixed economy, rules and ideologies. The
international companies have to navigate with country specific economic systems. American
companies are looked with scepticism by Japan, European and gulf countries and vice versa. The
economic system issue is not possible to address but MNCs may harness for their economic gains.

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 2. Tariff and non-tariff trade barriers:
The progress of the world trade is dependent on FREE TRADE POLICY. Many countries
distorted the free trade among themselves and this trade restriction is called trade barrier. The
opposite of free trade is trade barrier. These barriers are of two kinds:
 Tariff and
 Non-tariff
By imposing a high tariff (a kind of duty or customs imposed on imports or exports) rates, foreign
trade is scuttled. The other reason to restrain the imports is rejecting the goods for the reasons of
environmental safety, health hazards, labour standards, subsidy and so on. This is called
protectionism or non-tariff barriers World Trade Organisation provides a more powerful
organisation, with 159 member countries, its members at the end of 31st March 2014, to solve
disputes over trade among the member countries.
3. Political Risks:
The instability in the governance by political system in different countries is a major setback for
international companies. The draconian rules and policies of some countries restrict market access.
4. Environmental safeguards:
One of the major challenges today in the world is global warming. The carbon dioxide emissions
by different countries and the green house effect therein resulted in depletion of ozone layer. The
relentless use of natural resources is the route cause for environmental delay. The international
trade and environmental protection should go hand in hand in the interest of the future generation.
5. Dumping:
It refers to selling a product at a high price in the home currency and relatively at a LOW PRICE
in the host country by an international company. This practice ruins industries and employment
opportunities in the host country especially micro and small scale industries. For example, the
Chinese goods like goods sold in Dipawali, Holi and other festivals are sold, at very low prices in
India.
6. Cultural differences:
Every country has unique cultural heritage that shape values and influence the conduct of business.
Even within geographic regions that are considered relatively homogeneous, different sub-
cultures are prevailing. International companies have to cope with these differences and adopt to
the culture and sub-culture of the countries, where they operate. MNCs find that matters such as
defining the appropriate goals of the company, attitudes toward risk, dealing with employees and
the ability to curtail and profitable operations vary dramatically from one country to the next.
7. Language differences:
The ability to communicate is critical in all business, including
international transactions. The Indian and US. citizens are often at a disadvantage because they
are generally fluent in English, while European and German people are usually fluent in several
languages including English.
8. Intellectual property rights:
The trinity of intellectual properties are patents (for inventions) trade marks (for brand name,
image etc.) and copyright (for author, musicians, lyrics, filmmakers). The invention of the new
things require world class Research and Development set up by foreign firms. The problem of
privacy is haunting several leading companies and brands. India, after a great fight with USA has
registered the patent protection for Basmati rice, turmeric and tomato. In case of pharma products,
a large number of patent infringements is happening around the world especially the life savings
drugs. This is a vital issue in international business and finance.
9. Cyber-crimes:
Cyber-crime is a crime committed with the use of computer and internet. Today, all around the
world e-commerce and e-business, e-governance, are flourishing. The flip side of the e-commerce,
is cyber-crimes tantalizing the international finance. The privacy is interrupted, money in some
others accounts are withdrawn, manipulated and transferred. The cyber-crimes if unabated will
pose a great danger to the world business. The WTO has asked all the member countries to have

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in place a proper and comprehensive cyber law in place to check the maladies and anomalies of
cyber-crimes. We in India, have the first cyber law, styled Information Technology Act, 2000.
10. Transfer Pricing:
In any international business there are normally a large number of transfers of goods, services,
technology and other resources between the parent company and foreign subsidiaries. The price
at which goods, services and others are transferred between affiliates within the company is called
transfer price. Transfer price also affects an international company’s ability to monitor the
performance of individual corporate subsidiaries and to reward or punish managers responsible
for their performance. Further, transfer price affects the taxes an international company pays both
its home country and to various host countries in which it operates. Transfer price is also used to
avoid exchange controls, to increase the international company’s share of profits from a joint-
venture and to distinguish an affiliate’s true profitability.

Nevertheless, there are problems associated with Transfer Pricing. Many governments do not like
transfer pricing strategy. When transfer prices are used to reduce a firm’s tax liabilities or import
duties, most governments feel they are being cheated of their legitimate income. Several
governments limit the ability of an international business to manipulate transfer prices.
11. International Taxation:
Taxes have a significant impact on areas, as diverse as making foreign investment decisions,
managing exchange risks, planning capital structures, determining financing costs and managing
inter affiliate funds flows. For the international business with activities in many countries, the
various treaties have important implications for how the international company should structure
its internal payments system among the foreign subsidiaries and the parent company.
12. Economic and Currency Crisis:
The Asian crisis, Malaysian crisis, Pacific-Rim country crisis are in relation to economic crisis
wherein they have experienced. RECESSION and ADVERSE, BALANCE OF PAYMENTS
position. The same countries along with Japan experienced currency crisis in that the value of
currencies were either depreciated or devalued and further they were exposed to shortage of
foreign exchange reserves.
13. Interest Rates Charging:
The rate of interest charged by World Bank on its loans disbursed is 7.5 per cent p.a. and Asian
Development Bank’s concessional interest rate is 4 per cent p.a. The equity cost of capital is less
when compared to debt funds in the global capital market. The increasing interest rate raises cost
of capital and profitability of the company is lessened interest rate is a parameter in global finance
which plays a dominant role in production and operational risks of global corporates.
14. Foreign Exchange Risk:
Exchange Rate refers to the price of one currency against another currency. The exchange of
currency happens in two ways ie fixed exchange rate and floating exchange rate. The exchange
rate risk is more pronounced under flexible or floating exchange rate. This is because floating
exchange rate is based on market forces of DEMAND for and SUPPLY of foreign currencies, at
a particular time Trade surplus/deficit vis-a-vis the currencies of the countries, a host of economic
factors like GNP, Fiscal Deficit, balance of payments position. Industrial production data, and
employment data, inflation rate differentials and interest rate differentials.
15. Cold war between countries:
The enmity, animosity, difference of opinion between and among countries be routed out at the
surface level. Hatred is external while jealousy is internal. The cold war among nations is because
of the twin pests — hatred and jealousy between the countries in the world.
16. Operational risks:
The operational risk encompasses commercial risks, foreign exchange risk, political risks and
country specific risks. Different currencies, payments and receipts socioeconomic systems, laws,
habits, tasks preferences, and environmental aspects lead to higher risks in the form of credit,
market access, currency and exchange risks.

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 17. International terrorism:
The growing menace of international terrorism is ruining international business. Terrorism
obstructs the smooth flow of economic activities. It pushes the economy into bankruptcy and
insolvency. It worsens import and export trade. The countries which want to have cordial business
relations with other countries will rethink and hesitate to have relationship with terror hit
countries. The free flow of foreign investment is affected due to terrorism.
18. Creditworthiness:
International business and finance stands on and runs through the credibility, trustworthy and
credentials of the borrowers of goods, services technology or information. As the risks are high in
the international finance, creditworthiness is an essential part of entering into any trade or payment
agreement.
19. Foreign Exchange Markets:
It is the market where foreign currencies are bought and sold against each other. Foreign Exchange
(FEX) market is an organised one and banks are the important players. Bulk of trade is accounted
for small number of currencies, viz. US Dollar, Euro, Japanese Yens, Pound Sterling, Swiss
Francs, Canadian Dollar and Australian Dollar. It is an over the counter market. This means that
there is no single physical or electronic market place. The market itself is actually a worldwide
network of interbank traders consisting of authorized dealers, i.e., banks, connected by telephonic
lines and computers. The currency appreciation and depreciation of a particular currency will
affect international corporates business considerably. In advanced countries, the capital account
convertibility as in existence conversely in Indian, capital account convertibility of currency is
restricted for the fear of foreign capital exodus.

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