GLOBAL BUSINESS TODAY FIFTH EDITION ASIA–PACIFIC PERSPECTIVE hiL23674_fm_i-xxx.indd i 08/06/19 05:52 PM Copyright © 2019 McGraw-Hill Education (Australia) Pty Ltd Additional owners of copyright are acknowledged in on-page credits Every effort has been made to trace and acknowledge copyrighted material. The authors and publishers tender their apologies should any infringement have occurred. Reproduction and communication for educational purposes The Australian Copyright Act 1968 (the Act) allows a maximum of one chapter or 10% of the pages of this work, whichever is the greater, to be reproduced and/or communicated by any educational institution for its educational purposes provided that the institution (or the body that administers it) has sent a Statutory Educational notice to Copyright Agency (CA) and been granted a licence. For details of statutory educational and other copyright licences contact: Copyright Agency, 66 Goulburn Street, Sydney NSW 2000. Telephone: (02) 9394 7600. 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Hult, Rumintha Wickramasekera, Kim MacKenzie, Cameron Gordon Title: Global Business Today: Asia–Pacific Perspective Edition: 5th edition ISBN: 9781760423674 (paperback) Published in Australia by McGraw-Hill Education (Australia) Pty Ltd Level 33, 680 George Street, Sydney NSW 2000 Portfolio managers: Matthew Coxhill and Jillian Gibbs Content developer: Anne Harmer Production editor: Lara McMurray Proofreader: Annabel Adair Indexer: SPi, India Cover and internal design: Seymour Design Typeset in That 10/13 by SPi, India Printed in Singapore on 70 gsm matt art by Markono Print Media Pte Ltd hiL23674_fm_i-xxx.indd ii 08/06/19 05:52 PM GLOBAL BUSINESS TODAY FIFTH EDITION ASIA-PACIFIC PERSPECTIVE HILL HULT WICKRAMASEKERA MACKENZIE GORDON hiL23674_fm_i-xxx.indd iii 08/06/19 05:52 PM hiL23674_fm_i-xxx.indd iv 08/06/19 05:52 PM v hiL23674_fm_i-xxx.indd v 08/06/19 05:52 PM CONTENTS IN BRIEF 1 2 3 1 CHAPTER 1 GLOBALISATION 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE CHAPTER 2 THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION vi 55 56 CHAPTER 3 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 101 CHAPTER 4 FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 159 COUNTRY DIFFERENCES 207 CHAPTER 5 DIFFERENCES IN CULTURE 208 CHAPTER 6 POLITICAL AND LEGAL ENVIRONMENTS 255 CHAPTER 7 ECONOMIC ENVIRONMENT 301 CHAPTER 8 ETHICS AND CORPORATE RESPONSIBILITY 351 CHAPTER 9 COUNTRY MARKET RESEARCH 391 COMPETING IN THE GLOBAL MARKETPLACE 4 hiL23674_fm_i-xxx.indd GLOBALISATION 427 CHAPTER 10 THE STRATEGY OF INTERNATIONAL BUSINESS 428 CHAPTER 11 ENTERING FOREIGN MARKETS 473 CHAPTER 12 INTERNATIONAL MARKETING/BUSINESS ANALYTICS 509 CHAPTER 13 INTERNATIONAL PRODUCTION, OUTSOURCING AND LOGISTICS 557 CHAPTER 14 INTERNATIONAL HUMAN RESOURCE MANAGEMENT 599 08/06/19 05:52 PM CONTENTS IN FULL Prefacexiii Organisation/contentxx About the authors Text at a glance xxii Acknowledgmentsxvi Case and vignette matrix xxiv What’s new in the fifth edition International Business Graduate Attributes xiv xix xxviii 1 GLOBALISATION 1 CHAPTER 1 GLOBALISATION2 International Business Graduate Attributes (IBGAs) 3 Learning Objectives (LOs) 3 Opening Case: Kaihara: Globalisation of a shinise, a long-lived company 4 Introduction6 What is globalisation? 10 The globalisation of markets The globalisation of production 12 13 The emergence of global institutions 16 Drivers of globalisation 18 Declining trade and investment barriers The role of technological change Implications for the globalisation of production and markets The changing shape of the global economy The changing world output and world trade picture The changing foreign direct investment picture 19 20 21 23 23 24 The changing nature of the multinational enterprise The changing world order The global economy of the 21st century: The emerging markets century? The globalisation debate 27 28 30 32 Anti-globalisation protests Globalisation, jobs and income inequality Globalisation, labour policies and the environment Globalisation and national sovereignty Globalisation and the world’s poor 32 33 37 41 42 Managing in the global marketplace: What’s the difference? 44 Key terms 46 Summary46 International Business Graduate Attributes (IBGAs): Learning and assessment tasks 48 Closing Case: Global innovation through the mobility of ideas and talent 49 Endnotes53 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE 55 CHAPTER 2 THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 56 International Business Graduate Attributes (IBGAs) 57 Learning Objectives (LOs) 57 Opening Case: Bangladesh’s textile trade 58 Introduction59 Mercantilism61 Absolute advantage 61 Comparative advantage 62 Ricardo’s theory The Samuelson critique 62 67 Evidence for the link between trade and growth67 Heckscher-Ohlin theory 69 The Leontief paradox 70 The product life-cycle theory 71 Evaluating the product life-cycle theory 73 New trade theory 73 Increasing product variety and reducing costs Economies of scale, first-mover advantages and the pattern of trade Implications of new trade theory 74 74 75 CONTENTS IN FULL vii hiL23674_fm_i-xxx.indd vii 08/06/19 05:52 PM National competitive advantage: Porter’s diamond Factor endowments Demand conditions Related and supporting industries Firm strategy, structure and rivalry Evaluating Porter’s model Foreign direct investment in the world economy Why foreign direct investment? The pattern of foreign direct investment The eclectic paradigm Internationalisation of the company 77 78 79 79 79 80 82 83 86 86 88 The Uppsala models (U-models) The Innovation-related models (I-models) 89 90 ‘Born global’ companies 90 Key terms 94 Summary94 International Business Graduate Attributes (IBGAs): Learning and assessment tasks 96 Closing Case: Logitech’s global approach 97 Endnotes99 CHAPTER 3 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT International Business Graduate Attributes (IBGAs) 102 Learning Objectives (LOs) 102 Opening Case: Unease over China’s rare earth trade policies 103 Introduction104 Instruments of trade policy 106 Tariffs106 Subsidies107 Import quotas and voluntary export restraints 110 Local content requirements 110 Administrative policies 112 Anti-dumping policies 112 Why governments intervene in trade Political arguments for intervention Economic arguments for intervention Why governments intervene in FDI Host-country benefits and costs Home-country benefits and costs 113 101 Government policy instruments and FDI 126 Home-country policies Host-country policies 126 127 Trade and FDI liberalisation 131 Trade and FDI liberalisation and the WTO 133 Regional economic integration 140 The move towards regional economic integration Levels of economic integration The case for regional economic integration The case against regional economic integration 140 143 145 147 Key terms 150 Summary150 113 117 International Business Graduate Attributes (IBGAs): Learning and assessment tasks 152 122 Closing Case: Make it Australian? Free trade versus national identity 153 123 126 Endnotes157 CHAPTER 4 FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM International Business Graduate Attributes (IBGAs) 160 Learning Objectives (LOs) 160 Opening Case: The Mexican peso, the Japanese yen and Pokémon Go161 Introduction162 The foreign exchange market The nature of the foreign exchange market The functions of the foreign exchange market Determination of the exchange rate Prices and exchange rates Interest rates and exchange rates Investor psychology and the bandwagon effect The international monetary system Exchange rate regimes in practice Motives and means for managing the foreign exchange rate Functions of an international monetary system The rise and fall of the Bretton Woods system A role for the IMF 159 178 180 184 185 187 164 Key terms 164 166 Summary200 172 172 174 176 177 200 International Business Graduate Attributes (IBGAs): Learning and assessment tasks 202 Closing Case: The fluctuating value of the yuan gives Chinese business a lesson in foreign exchange risk 203 Endnotes205 viii GLOBAL BUSINESS TODAY hiL23674_fm_i-xxx.indd viii 08/06/19 05:52 PM 3 COUNTRY DIFFERENCES 207 CHAPTER 5 DIFFERENCES IN CULTURE 208 International Business Graduate Attributes (IBGAs) 209 Superstitions231 Learning Objectives (LOs) 209 Language233 Opening Case: Evolving culture at Panasonic 210 Introduction211 What is culture? Values and norms The determinants of culture Social structure Individuals and groups Social stratification Religious and ethical systems 212 213 215 216 216 218 221 Christianity222 Islam223 Hinduism227 Buddhism229 Confucianism230 Spoken language Unspoken language 233 234 Education235 Culture and the workplace 236 Cultural context 236 Cultural change 243 Key terms 248 Summary248 International Business Graduate Attributes (IBGAs): Learning and assessment tasks 249 Closing Case: Cognition Consulting: Exporting New Zealand’s educational expertise and culture 250 Endnotes253 CHAPTER 6 POLITICAL AND LEGAL ENVIRONMENTS International Business Graduate Attributes (IBGAs) 256 Learning Objectives (LOs) 256 Opening Case: Transformation in Saudi Arabia 257 Introduction258 Political systems Collectivism, socialism and individualism Shifting ideology and FDI Democracy and totalitarianism The spread of democracy The new world order and global terrorism Legal systems Different legal systems 258 260 264 268 272 274 275 276 255 Differences in contract law Property rights and corruption The protection of intellectual property Product safety and product liability Competition law Taxation law 277 278 282 284 286 287 Key terms 292 Summary292 International Business Graduate Attributes (IGBAs): Learning and assessment tasks 294 Closing Case: The elusive Elena Egorova 295 Endnotes299 CHAPTER 7 ECONOMIC ENVIRONMENT International Business Graduate Attributes (IBGAs) 302 Learning Objectives (LOs) 302 Opening Case: Brazil’s struggling economy 303 Introduction304 Economic endowments—natural and created 305 Size305 Geography305 People306 Infrastructure and institutions 310 Productivity and competitiveness 312 301 Economic performance: Macroeconomic stability 314 Economic stability 314 Economic growth and employment fluctuations 316 Inflation318 External viability and the balance of payments 319 Economic performance: Economic development 322 Measures of economic development Broader conceptions and measures of development Economic systems Market economy Command economy 323 327 329 330 330 CONTENTS IN FULL ix hiL23674_fm_i-xxx.indd ix 08/06/19 05:52 PM Mixed economy Economic systems and economic development 331 332 Summary345 Economies in transition 336 International Business Graduate Attributes (IBGAs): Learning and assessment tasks 346 336 336 Closing Case: Economic development in Bangladesh347 345 Endnotes349 The spread of the market The nature of economic transition Key terms CHAPTER 8 ETHICS AND CORPORATE RESPONSIBILITY International Business Graduate Attributes (IBGAs) 352 Learning Objectives (LOs) 352 Opening Case: Sustainability initiatives at Natura Cosmetics, The Body Shop and Aesop 353 Introduction354 Ethical issues in international business 356 Employment practices 356 Human rights 357 Environmental pollution 358 Bribery and corruption 359 Corporate social responsibility 361 Sustainability363 351 Philosophical approaches to ethics 372 The Friedman doctrine Cultural relativism Righteous moralism Naive immoralism Utilitarian and Kantian ethics Rights theories Justice theories 372 373 373 374 375 376 377 Ethical decision making in international business 379 Organisation culture and leadership Decision-making processes Ethics officers Moral courage Social enterprises Summary of managerial actions 380 381 383 383 384 384 Ethical dilemmas 364 Child labour 365 Key terms 367 Summary385 The roots of unethical behaviour Personal ethics Decision-making processes Organisation culture Unrealistic performance expectations Corporate governance and leadership 367 368 368 368 368 385 International Business Graduate Attributes (IBGAs): Learning and assessment tasks 386 Closing Case: Woolworths’ corporate responsibility strategy 387 Endnotes389 CHAPTER 9 COUNTRY MARKET RESEARCH391 International Business Graduate Attributes (IBGAs) 392 Learning Objectives (LOs) 392 Opening Case: Spotify and Soundcloud 393 Introduction394 The promise and pitfalls of exporting Improving export performance An international comparison Export promotion agencies Using export management companies Export strategy Basic entry decisions 395 397 397 397 398 399 400 Which foreign markets? 400 Gross fixed capital formation 405 The CAGE framework for distance analysis405 Cost–risk trade-off 408 Timing of entry Scale of entry and strategic commitments Financing trade 409 410 413 Lack of trust 414 Letter of credit 415 Draft416 Bill of lading 417 A typical international trade transaction 418 Export credit insurance 419 Conclusion419 Key terms 422 Summary422 International Business Graduate Attributes (IBGAs): Learning and assessment tasks 423 Closing Case: Jollibee: A multinational company from the Philippines 424 Endnotes426 x GLOBAL BUSINESS TODAY hiL23674_fm_i-xxx.indd x 08/06/19 05:52 PM 4 COMPETING IN THE GLOBAL MARKETPLACE 427 CHAPTER 10 THE STRATEGY OF INTERNATIONAL BUSINESS 428 International Business Graduate Attributes (IBGAs) 429 Learning Objectives (LOs) 429 Opening Case: Red Bull’s global strategy 430 Introduction431 Strategy and the company 432 Value creation 433 Strategic positioning 435 Operations: The company as a value chain 436 Organisation: The implementation of strategy 438 In sum: Strategic fit 441 Global expansion, profitability and profit growth 441 Expanding the market: Leveraging products and competencies 442 Location economies 443 Experience effects 445 Leveraging subsidiary skills 448 Summation449 Cost pressures and pressures for local responsiveness Pressures for cost reductions Pressures for local responsiveness 450 450 451 Differences in distribution channels Host government demands 452 454 Choosing a strategy 454 Global standardisation strategy Localisation strategy Transnational strategy International strategy 455 455 456 457 The evolution of strategy 458 Strategic alliances 460 The advantages of strategic alliances The disadvantages of strategic alliances Making alliances work 460 461 462 Key terms 466 Summary466 International Business Graduate Attributes (IBGAs): Learning and assessment tasks 467 Closing Case: The growth strategy of Haier 468 Endnotes470 CHAPTER 11 ENTERING FOREIGN MARKETS International Business Graduate Attributes (IBGAs) 474 Learning Objectives (LOs) 474 Opening Case: International market entry at Starbucks 475 Introduction476 Entry modes 476 Exporting476 Importing480 Turnkey projects 481 Licensing482 Franchising484 Joint ventures 486 Wholly owned subsidiaries 489 Selecting an entry mode Core competencies and entry mode Pressures for cost reductions and entry mode 490 491 493 473 Greenfield venture versus acquisition Pros and cons of acquisitions Pros and cons of greenfield ventures Making a choice: Greenfield or acquisition? Countertrade498 The incidence of countertrade 498 Types of countertrade 499 The pros and cons of countertrade 501 Key terms 510 Learning Objectives (LOs) 510 Opening Case: Burberry’s social media marketing 511 Introduction512 The globalisation of markets and brands 513 Market segmentation 514 502 Summary502 International Business Graduate Attributes (IBGAs): Learning and assessment tasks 503 Closing Case: The Happy Snack Company: This happy, healthy message is too good not to share 504 Endnotes507 CHAPTER 12 INTERNATIONAL MARKETING/BUSINESS ANALYTICS International Business Graduate Attributes (IBGAs) 493 494 496 497 Product attributes 509 518 Cultural differences Economic development Product and technical standards 518 519 519 Distribution strategy Differences between countries Choosing a distribution strategy 521 522 524 CONTENTS IN FULL xi hiL23674_fm_i-xxx.indd xi 08/06/19 05:52 PM Communication strategy Barriers to international communication Push versus pull strategies Global advertising 525 525 528 530 New product development 544 The location of R&D Integrating R&D, marketing and production Cross-functional teams Building global R&D capabilities 545 546 547 547 Pricing strategy Price discrimination Strategic pricing Regulatory influences on prices 533 533 534 536 Configuring the marketing mix 537 International Business Graduate Attributes (IBGAs): Learning and assessment tasks 551 International market research 538 Closing Case: Youi: Selling the you 552 Business analytics 541 Endnotes555 Key terms 549 Summary549 CHAPTER 13 INTERNATIONAL PRODUCTION, OUTSOURCING AND LOGISTICS International Business Graduate Attributes (IBGAs) 558 Learning Objectives (LOs) 558 Opening Case: Li & Fung Ltd: A factory of sorts, now out of sorts 559 Introduction561 Strategy, production and logistics 563 Where to produce Country factors Technological factors Product factors Locating production facilities 566 566 567 574 574 The strategic role of foreign factories Outsourcing production: Make-or-buy decisions 557 The advantages of ‘make’ decisions 580 The advantages of ‘buy’ decisions 583 Trade-offs585 Strategic alliances with suppliers 585 Managing a global supply chain The role of just-in-time inventory The role of information technology and the internet 586 588 Key terms 592 589 Summary592 International Business Graduate Attributes (IBGAs): Learning and assessment tasks 593 575 Closing Case: FMCG, soft dollars and lean supply chains 595 579 Endnotes597 CHAPTER 14 INTERNATIONAL HUMAN RESOURCE MANAGEMENT International Business Graduate Attributes (IBGAs) 600 Learning Objectives (LOs) 600 Opening Case: Global mobility at Shell 601 Introduction602 599 Performance appraisal problems Guidelines for performance appraisal 623 624 Compensation policy National differences in compensation Expatriate pay 624 624 625 International labour relations The concerns of organised labour Strategy of organised labour Approaches to labour relations The role of corporate social responsibility 628 629 629 631 632 Key terms 633 The strategic role of HRM 605 Staffing policy Types of staffing policy Expatriate management 606 607 611 Training and management development Training for expatriate managers Management development and strategy 617 618 619 Female participation in senior international management Equal opportunity Work–life balance Mentorship and networking 619 621 622 622 International Business Graduate Attributes (IBGAs): Learning and assessment tasks 635 Closing Case: Sodexo: Building a diverse global workforce 636 Performance appraisal 623 Endnotes638 Summary633 Glossary641 Acronyms 651 Countries/Capitals 653 Index 657 xii GLOBAL BUSINESS TODAY hiL23674_fm_i-xxx.indd xii 08/06/19 05:52 PM PREFACE Global Business Today is intended primarily as an introductory textbook for international/global business courses at tertiary institutions at both the undergraduate and postgraduate level. The authors have attempted to write a book that: • presents a balanced global view • goes beyond an uncritical presentation and shallow explanation of the body of knowledge • is well structured and well written, with tight integration and flow between chapters • focuses on managerial implications • uses up-to-date examples and case studies • examines international business in contexts relevant to the students’ experiences with an Asia–Pacific focus • makes important theories accessible and interesting • incorporates ancillary resources that enliven the text and make it easier to teach. In order to be comprehensive, a textbook on international/global business must: • explain how and why the world’s countries differ • present a thorough review of the economics and politics of international trade and investment • explain the functions and form of the international monetary system • examine the strategies and structures of international businesses, for both multinational corporations and small to medium-sized enterprises • examine the need for a sustainable long-lived approach to internationalisation • examine the need for ethical and legal behaviour in international business • assess the specific characteristics of international business’s various functions. As the authors of this book, we have endeavoured to do all of these things. We have thoroughly examined the structures and strategies of international firms, as well as the functional implications of international business for a variety of firms. Many students will soon be working in fields that require an understanding of the effects of international business on an organisation’s strategy, structure and function. This book pays close attention to these issues. Comprehensiveness and relevance also require coverage of the major current theories. The following insights have therefore been included: • the new trade theory and strategic trade policy • theories of internationalisation, including ‘born globals’ and international new ventures • the ‘emerging markets’ • concepts of global inequality • the work of Nobel Prize-winning economist Amartya Sen on economic development • the work of Hernando de Soto on the link between property rights and economic development • Samuel Huntington’s influential thesis on the ‘clash of civilisations’ • the new growth theory of economic development championed by Paul Romer and Gene Grossman • empirical work by Jeffery Sachs and others on the relationship between international trade and economic growth • Michael Porter’s theory on the competitive advantage of nations • Robert Reich’s work on national competitive advantage • the work of Nobel Prize-winner Douglas North and others on national institutional structures and the protection of property rights • Walden Bello’s call for deglobalisation, the failure of globalisation to deliver universal benefits • the ‘market imperfections’ approach to foreign direct investment that has grown out of Ronald Coase’s and Oliver Williamson’s work on transaction cost economics • Christopher Bartlett’s and Sumantra Ghoshal’s research on the transnational corporation • the writings of C.K. Prahalad and Gary Hamel on core competencies, global competition and global strategic alliances • Pankaj Ghemawat’s concept of semiglobalisation, and his work on how cross-border expansion is affected by differences in the various dimensions of distance • Makoto Kanda’s work on long-lived firms • insights into international business strategy that can be derived from the resource-based view of the firm. In light of the fast-changing nature of the international business environment, the leading-edge theory and up-to-date material included in this book make it a valuable resource in this field. PREFACE xiii hiL23674_fm_i-xxx.indd xiii 08/06/19 05:52 PM ABOUT THE AUTHORS ABOUT THE INTERNATIONAL AUTHORS CHARLES W.L. HILL is the Hughes M. Blake Professor of International Business at the School of Business, University of Washington. Professor Hill received his PhD in industrial organisation economics in 1983 from the University of Manchester’s Institute of Science and Technology (UMIST) in Great Britain. In addition to his position at the University of Washington, he has served on the faculties of UMIST, Texas A&M University and Michigan State University. Professor Hill teaches in the MBA and executive MBA programs at the University of Washington and has received awards for teaching excellence in both programs. He has also taught on several customised executive programs. Professor Hill has published more than 50 articles in peer-reviewed academic journals, as well as four university textbooks—one on strategic management, one on principles of management, and the other two on international business (one of which you are now holding). He serves on the editorial boards of several academic journals and previously served as consulting editor at the Academy of Management Review. TOMAS M. HULT is the John W. Byington Endowed Chair, Professor of Marketing and International Business, and Director of the International Business Center in the Eli Broad College of Business at Michigan State University. Several studies have ranked Professor Hult as one of the most cited scholars in the world in business and management (e.g. Thomson Reuters’ Essential Science Indicators). He has served as editor of Journal of the Academy of Marketing Science and has published 50 articles in premier business journals—Journal of International Business Studies, Academy of Management Journal, Strategic Management Journal, Journal of Management, Journal of Marketing, Journal of the Academy of Marketing Science, Journal of Retailing, Journal of Operations Management and Decision Sciences. Dr Hult has also published several books, including Global Supply Chain Management (2014), Total Global Strategy (2012) and Extending the Supply Chain (2005). Professor Hult is a well-known keynote speaker on global supply chain management, global strategy, and marketing strategy. He teaches in doctoral, master and undergraduate programs at Michigan State University, and is a visiting professor at Leeds University (United Kingdom) and Uppsala University (Sweden). He also teaches frequently in executive development programs and has developed a large clientele of the world’s top multinational corporations. xiv GLOBAL BUSINESS TODAY hiL23674_fm_i-xxx.indd xiv 08/06/19 05:52 PM ABOUT THE LOCAL AUTHORS RUMINTHA WICKRAMASEKERA is a Senior Fellow of the Higher Education Academy, UK. He is Associate Professor in International Business and the coordinator of one of the largest International Business programs in Australia—Global Business at Queensland University of Technology (QUT). He has nearly 20 years’ experience in teaching, developing and coordinating international business subjects at a number of Australian universities. Rumintha has also been involved in several major projects focusing on identifying the dynamics of the internationalisation process of small to medium-sized enterprises, including his PhD research, which examined the internationalisation of the Australian wine industry. He is the recipient of several teaching awards including the QUT Vice-Chancellor’s Award for Excellence in Learning and Teaching, and the Australian Government Office for Learning and Teaching Citation for Outstanding Contributions to Student Learning. KIM S. MACKENZIE has been a teaching and research member of the Queensland University of Technology (QUT) Business School for over 10 years and has assisted with the teaching, learning and curriculum development of many International Business and Business Technology–related units. Kim’s research interests focus on the innovative use of internet-based technologies and their global business implications. Her PhD (2011) explored the social, technical and macro societal pressures influencing the business adoption of social networking services (social media), which identified the enormous impact that social technologies were having at the global business level. Her explorative research has been published in the Journal of Developing Areas (2015), Journal of Accounting & Organizational Change (2013), Accounting, Auditing & Accountability Journal (2013), The International Journal of Digital Accounting Research (2013), Pacific Accounting Review (2013) and Electronic Commerce Research (2009). CAMERON GORDON is currently an Adjunct Associate Professor at the Research School of Management at the Australian National University (ANU). He also holds concurrent appointments with the Research School of Economics at the ANU; the Social Policy Simulation Center at the City University of New York; and the Faculty of Health (Centre for Research and Action in Public Health) at the University of Canberra. Prior to that, Dr. Gordon held permanent faculty appointments in Finance at the City University of New York and Public Policy at the University of Southern California. He has taught graduate and undergraduate International Business courses for over 10 years. Dr. Gordon’s research focuses on organisational governance, public–private partnerships, transport and logistics management, and the economics and ethics of offshoring. He has published over 50 peer-reviewed journal articles and a 2016 book Behavioural Approaches to Corporate Governance, published by Routledge Press. Before entering academia, he had a long public service career focusing on economic and policy research at the US National Academy of Sciences (Board of Infrastructure and Constructed Environment); US Congress Joint Committee on Taxation; and the US Army Corps of Engineers, Institute for Water Resources. ABOUT THE AUTHORS xv hiL23674_fm_i-xxx.indd xv 08/06/19 05:52 PM ACKNOWLEDGMENTS As with any endeavour of this type, this edition has been the result of a team effort. We would like to acknowledge the contribution of Cameron Gordon (Australian National University), whose ‘Country Focus’ vignettes and discussion questions appear in each chapter of the book. We would like to thank Maralyn McDowell (Queensland University of Technology), Áron Perényi (Swinburne University of Technology) and Jeremy Seward (La Trobe University) for their detailed reviews of the material during development. We would like to thank our case contributors. They have added the touch of colour that comes with presenting real-life situations: • Makoto Kanda, Meiji Gakuin University—Kaihara: Globalisation of a shinise, a long-lived company (Chapter 1) • Áron Perényi, Swinburne University of Technology—Global innovation through the mobility of ideas and talent (Chapter 1) • Brent Burmester, University of Auckland—Make it Australian? Free trade versus national identity (Chapter 3) & The elusive Elena Egorova (Chapter 6) • Professor Songhua Hu, Sun Yat-sen University—The growth strategy of Haier (Chapter 10) • Saskia de Klerk, University of the Sunshine Coast—The Happy Snack Company: This happy, healthy message is too good not to share (Chapter 11) & Youi: Selling the you (Chapter 12). Thanks to Peter Liesch for his contributing authorship for the fourth edition. We are also indebted to our ancillary authors who have worked hard to ensure that we have a strong ancillary package. Numerous people deserve to be thanked for their assistance in preparing this book. First, we want to extend our sincere thanks to all the people at McGraw-Hill who have worked with us on this project: Portfolio managers Matthew Coxhill and Jillian Gibbs, Content developer Anne Harmer and Production editor Lara McMurray. Rumintha is grateful to all of those who assisted him in his early work as well as his doctoral studies, and who have fostered his fascination with and enthusiasm for learning and teaching global/international business. He is especially indebted to Professors Norman Philp, Geoff Bamberry, Eddie Oczkowski and Gordon Boyce for their support and encouragement. To Thomas Cronk, co-author of the first three editions, Rumintha extends his sincere thanks for his generous support and innovative ideas in continually improving the book. He would also like to pass on his sincere thanks to the many students and colleagues who made a major contribution to the book by providing valuable feedback. Finally, he would like to send a very special thanks to his family for their continued support and encouragement. xvi GLOBAL BUSINESS TODAY hiL23674_fm_i-xxx.indd xvi 08/06/19 05:52 PM LearnSmart Advantage is a series of adaptive learning products fuelled by LearnSmart—the most widely used and adaptive learning resource proven to strengthen memory recall, increase retention and boost grades. Adaptive learning No two students are the same, so why should their learning experience be? Adaptive technology uses continual assessment and artificial intelligence to personalise the learning experience for each individual student. As the global leader in adaptive and personalised learning technologies, McGraw-Hill Education is pioneering ways to improve results and retention across all disciplines. SmartBook Fuelled by LearnSmart, SmartBook is the first and only adaptive reading experience available today. Starting with an initial preview of each chapter and key learning objectives, students read material and are guided to the topics they most need to practise at that time, based on their responses to a continuously adapting diagnostic. To ensure concept mastery and retention, reading and practice continue until SmartBook directs students to recharge and review important material they are most likely to forget. LearnSmart LearnSmart maximises learning productivity and efficiency by identifying the most important learning objectives for each student to master at a given point in time. It knows when students are likely to forget specific information and revisits that content to advance knowledge from their short-term to long-term memory. LearnSmart is proven to improve academic performance, ensuring higher retention rates and better grades. To find out more about SmartBook visit www.mheducation.com.au/student-smartbook hiL23674_fm_i-xxx.indd xvii 08/06/19 05:52 PM McGraw-Hill Connect® is the only learning platform that continually adapts to you, delivering precisely what you need, when you need it. Proven effective With Connect, you can complete your coursework anytime, anywhere. Millions of students have used Connect and the results are in: research shows that studying with McGraw-Hill Connect will increase the likelihood that you’ll pass your course and get a better grade. Connect support Connect includes animated tutorials, videos and additional embedded hints within specific questions to help you succeed. The Connect Success Academy for Students is where you’ll find tutorials on getting started, your study resources and completing assignments in Connect. Everything you need to know about Connect is here! Visual progress Connect provides you with reports to help you identify what you should study and when your next assignment is due, and tracks your performance. Connect’s Overall Performance report allows you to see all of your assignment attempts, your score on each attempt, the date you started and submitted the assignment, and the date the assignment was scored. To learn more about McGraw-Hill Connect®, visit www.mheducation.com.au/student-connect xviii GLOBAL BUSINESS TODAY hiL23674_fm_i-xxx.indd xviii 08/06/19 05:52 PM WHAT’S NEW IN THE FIFTH EDITION The success of the first four editions of Global Business Today: Asia–Pacific Perspective was based in part upon the incorporation of leading-edge research into the text, the discussion of current events within the context of the appropriate theory, and the use of examples, cases and statistics that were not only up-to-date but also relevant to our students to illustrate global trends and enterprise strategy. Building on these strengths, our goals for this revised edition have been five-fold: 1. Incorporate new insights from recent scholarly research wherever appropriate. 2. Ensure the content of the text covers all appropriate issues. 3. Ensure the text is as up-to-date and as relevant to the student cohort as possible with regard to current events, statistics, examples and case studies. 4. Make the link between principle and practice by drawing out the implications of concepts and ideas for international business management and operations. 5. Provide the opportunity for the students and their instructors to identify and attain the learning goals of their international business education. As part of the revision process, changes have been made to every chapter in the book and we have taken into account the reviews by our peers and our students. All material and statistics are as up-to-date as possible as of late 2018. We have added discussion on current events wherever appropriate. Examples include Brexit, the growth of sovereign wealth funds, climate change, the rise of emerging markets, growing nationalism and the changing power balance in international economic institutions and the increasing prevalence of regional economic integration, in particular free trade agreements. In Chapter 5, the discussion of culture has been broadened by the inclusion of Ed Shein’s definition of culture as well as the GLOBE and WVS frameworks. All opening and closing cases are either new or have been significantly revised with updates and, in some cases, a new focus. The ‘Country Focus’ features have all been replaced with new vignettes focusing on Australia’s top trading partners and they come with questions to assist with class discussion. The ‘Management Focus’ features have been updated and new ones added. Graphs and tables have been updated and provide useful visual snapshots of important statistics throughout all chapters. Strategically commissioned cases by those who are experts in their fields give detailed coverage of topics within a chapter. Our case mix includes American, Middle-Eastern, European and South-East Asian examples. A continued feature of this edition is the inclusion of International Business Graduate Attributes (IBGAs) in each chapter, accompanied by applicable learning and assessment tasks. The specification of the IBGAs and tasks in each chapter informs the students on what learning outcomes are expected and how they can demonstrate the attainment of these outcomes. The scope of the IBGAs makes clear that what is expected from a study of international business, and tertiary education more generally, is more than the ability to recall the correct answer to ‘what’, ‘how’ and ‘why’ questions. For the instructor and course designer, the specification of the IBGAs and assessment tasks enables them to demonstrate where and how the IBGAs are developed and assessed. This transparency is inherently an accountability measure, but it is also a necessary requirement for attaining external accreditation for a course of study. IBGA matters are outlined in more detail on pages xxviii–xxx. RUMINTHA WICKRAMASEKERA May 2019 WHAT’S NEW IN THE FIFTH EDITION xix hiL23674_fm_i-xxx.indd xix 08/06/19 05:52 PM ORGANISATION/CONTENT PART ONE GLOBALISATION CHAPTER 1 GLOBALISATION PART TWO CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE CHAPTER 2 THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION CHAPTER 3 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT CHAPTER 4 FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM HOME COUNTRY FOREIGN COUNTRY PART THREE COUNTRY DIFFERENCES CHAPTER 6 CHAPTER 7 ECONOMIC POLITICAL AND LEGAL ENVIRONMENT ENVIRONMENTS CHAPTER 5 DIFFERENCES IN CULTURE CHAPTER 8 ETHICS AND CORPORATE RESPONSIBILITY CHAPTER 9 COUNTRY MARKET RESEARCH PART FOUR COMPETING IN THE GLOBAL MARKETPLACE CHAPTER 10 THE STRATEGY OF INTERNATIONAL BUSINESS CHAPTER 11 ENTERING FOREIGN MARKETS CHAPTER 12 INTERNATIONAL MARKETING/ BUSINESS ANALYTICS CHAPTER 13 INTERNATIONAL PRODUCTION, OUTSOURCING AND LOGISTICS CHAPTER 14 INTERNATIONAL HUMAN RESOURCE MANAGEMENT xx GLOBAL BUSINESS TODAY hiL23674_fm_i-xxx.indd xx 08/06/19 05:52 PM A weakness of many texts is that they lack a tight, integrated flow of topics from chapter to chapter. Another is that they fail to give an overview of the scope and sequence of the content. An overview helps by clarifying expectations of what will be explored, to identify what is already known and to develop links between the two. It establishes an overall framework for the distinction and the links between the major ideas before delving into the specifics. The figure on the opposite page provides an overview of the scope and sequence of material in this book. variables, especially foreign exchange rates. There have been a number of internationally negotiated monetary agreements in an effort to provide greater stability to exchange rates and the international monetary system. Chapter 4 describes and explains the international monetary system, laying out the monetary framework in which international business transactions are conducted, and describes how the exposures to financial risks are managed. PART ONE GLOBALISATION Once a business goes international it may move into a vastly different operating environment. Many of the central issues of international business strategy and structure and international business operations arise out of country differences. In order to examine the strategies that firms adopt to compete in the different operational environments, it is vital to discuss these country differences first. Chapters 5–8 examine in detail four dimensions of countries’ environments: cultural, political–legal, economic and ethical. A systematic analysis of a country’s business environment is one requirement for deciding whether to choose that country as a potentially rewarding place to conduct business and as the basis for formulating appropriate international business strategies. Based on the understandings of the previous four chapters, and as a precursor to the discussion on strategic choices in the following chapters, Chapter 9 details financing trade and the framework and information sources necessary to undertake a comprehensive country market research. Chapter 1 examines the process of globalisation. ‘Globalisation’ refers to the growing interdependencies among people and institutions in different countries. While business is itself a force of globalisation, it also needs to respond to globalisation. In the study of international business, we need to understand what drives the process of globalisation, appreciate how it is changing the face of international business and understand why it has become a source of conflict and debate. Chapter 1 provides an overview of the key issues of the globalisation of business to be addressed in future chapters, and explains the overall plan of the book. PART TWO CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE Globalisation is evidenced by increasing links between countries, particularly via trade, investment and financial flows. Chapter 2 provides explanations of trade and investment, and the internationalisation of business. No country permits the free flow of trade and investment across its borders. Governments seek to influence trade and investment in order to achieve economic, social and political objectives. Chapter 3 investigates the political economy of trade and investment. The theories introduced in Chapter 2 are used in Chapter 3 as a basis for assessing government interventions and moves to reduce restrictions through international negotiations, as occur under the auspices of the World Trade Organization and regional trade agreements. The world financial markets are truly global phenomena, with actions by one country often affecting financial variables in another. A challenge for international business is managing exposures to often volatile changes in these PART THREE COUNTRY DIFFERENCES PART FOUR COMPETING IN THE GLOBAL MARKETPLACE In Chapters 10–14, attention shifts from the environment to the firm. Here we examine the strategies that firms adopt to compete effectively in the international business environment, including international market entry strategies, and explain how firms can perform key functions—marketing and R&D; production and logistics; and human resource management—in order to compete and succeed in the international business environment. Throughout the book, the relationship of new material to topics discussed in earlier chapters is pointed out to reinforce students’ understanding of how the material comprises an integrated whole. ORGANISATION/CONTENT xxi hiL23674_fm_i-xxx.indd xxi 08/06/19 05:52 PM TEXT AT A GLANCE This fifth edition of Global Business Today is a pedagogically rich learning resource. The features laid out on these pages are specially designed to encourage and enhance an understanding of the text content and the attainment of a broad scope of learning outcomes. Some of the unique features of this text include: OPENING CASE OPENING CASE KAIHARA: GLOBALISATION OF A SHINISE, A LONG-LIVED COMPANY Fukuyama city in Hiroshima Prefecture, Japan, used to be known as Bingo. The name was synonymous with its ‘Bingo kasuri’, a Japanese cotton kimono cloth with a splashed pattern. In 1893, Kaihara, a family business manufacturing kasuri, was established by Sukejiro Kaihara in Bingo. It remained a comparatively small operation until its transformation into Kaihara Textile Mills Ltd in 1951. Since then, the company has grown to become a world-renowned supplier of high-quality denim for leading jeans manufacturers/brands such as Levi’s, fastfashion retailers like GAP and premium brands like Hugo Boss. The company has more than a 50 per cent share of the blue denim market in Japan and exports more than 70 per cent of its products. The company’s successful internationalisation is illustrative of a traditional Japanese company that has used its core domestic technology as a stepping stone to become globally competitive. CLOSING CASE Each chapter begins with an Opening Case that sets the stage for the chapter content and details the real challenges in the conducting of international business. presented Kaihara with an opportunity to expand overseas. In 1951, a trading company from Aden, Yemen, was seeking a manufacturer able to supply sarong cloth blended with the Japanese kasuri. After a failed attempt to source from a company in Nishiwaki, Hyogo Prefecture (due to manufacturing limitations), the company approached Kaihara. Sarongs for children needed 36-inch wide cloth, while for adults 48-inch cloth was required, necessitating the stitching of two 24-inch cloths. In order to improve the quality of the end product and limit the stitching needed, Kaihara developed a machine capable of producing 48-inch wide cloth. This innovation resulted in a worker being able to operate four machines at a time, resulting in a ten-fold efficiency gain in comparison with producers in Indonesia. MOVE TO DENIM CLOSING CASE GLOBAL INNOVATION THROUGH THE MOBILITY OF IDEAS AND TALENT Kaihara grew rapidly due to the cost-effective production of sarongs and a newly developed wool kasuri fabric that satisfied customer demand for softer kasuri in the At the time the company was established there were Japanese market. However, a crisis hit the company: numerous kasuri makers in Japan. Therefore, from its inception the company’s founder decided to focus on political instability in the Middle East and devaluation Zinemath cPlc is a born global technology starta Hungarian engineer designed andofbuilt the high-end market, with higher quality products of and the British poundmilitary led to overstocked inventory up. Ita has investors from Italy and talent the first cannon the emperor of Byzantium in the kasuri sarong cloth for equivalent to a year’s production. The garnering 20–50 per cent price premium overacquired from Australia and targets the US market. Its 15th century, warfare. This later company had to revolutionising find a way to overcome the crisis. competitors’ products. revolutionary approach to developing virtual reality enabled the Ottoman Empire to conquer large parts Sadaharu Kaihara, the president, informed by one After World War II, Kaihara,reality like other companies, (VR) and augmented (AR)Japanese technology for of Europe (including Hungary).was Porcelain (originally of called his friends, ‘Jeans have become for the rebuiltuse its in business. The company focused on production cinematography, real-time broadcasting and ‘china’) production sprungfashionable up in Meissen, youngsters Since they are imported from innovations, as developing and patenting medicalsuch visualisation is opening up newan business Germany,ininJapan. the 18th century after engineers were automatic dyeing machine. In addition, it developed new abroad, why don’t you try to manufacture themfind using opportunities and potentially revolutionising able to re-create the production process and your company’s Traditionally, kasuri was products for the domestic market.industries Other innovations operations across multiple from local resources.technology?’ These are examples of how ideas dyed using the Japanese indigo plant,oflater substituted followed; for example, Kaiharacare produced the first 36-inch broadcasting to health and education. travel around the world by means trade and the wide kasuri fabric using an electric loom. However, due with indigo made from oil. The oil-based was also movement of people. Nowadays, in the indigo modern to changing market demand used for denim, and Kaihara had expertise in using trade, with exceptions grantedfrom onlyWesternisation under extreme and pressure, may not be the optimal policy global innovation system, international education,the Global innovation a significant decrease themay wearing kimonos, artificial dye. In addition, denim had synergy according to the theoryinbut be theof best policythe that the country is likely to recruitment get.41 collaboration, and production entrepreneurship drive company hadmovement limited sales Instead, innovation with weaving technology. Therefore, Sadaharu Global of success. ideas is as old as this global trade thekasuri exchange and sharing of ideas and other resources provided theand company with production capacity to Kaihara wenttotodevise Tokyonew to observe the uptake of jeans by itself, the two are the definitely related. A good necessary technologies and products, serviceexample larger markets, international markets. younger of this isincluding the technology transfer facilitated theand access generation. markets. He saw a significant market for denim and decided to diversify into denim production. the Silk Road. In ancient times,inChinese silk was Whileby kimono wearing was in decline Japan, ikat Systems of innovation are described by the transported to Egypt. Duringtextiles) the Middle (a dyeing method used to pattern used Ages, in this In concept 1969, theofcompany cheese-dyed indigo the rippleintroduced helix, which identifies the intercontinental tradecountries route was for the denim to of thecomplex Japanesetechnological market. However, the denim Indonesia, India and other forresponsible saris and sarongs source innovation as an transfer of technologies and ideas between Asia outcome of collaboration between universities and Europe. In the absence of long-haul flights, and (research institutes), governments and industry with tools of navigation and propulsion for 4 PART 1 limited GLOBALISATION (businesses). These ‘interactions’ manifest by seafaring, the American side of the Pacific was not transferring intangible and tangible resources, such accessible. (Although Maori reached all the way to the knowledge, people, time on money. to Magnesium allow the mass production ofasthe industry, ideas, the then chairman of task AMCand admitted islandsalloys of Aotearoa, andeconomic Chinese explorers may have Forreality example, governments provide grant funding to of strong, thin-walled, lightweight shapes and objects. the of the time that the persistent low magnesium arrived at the hiL23674_ch01_001-054.indd 4 shores of Australia much earlier, these 07/27/19 03:02 PM universities, on value the condition of workingdollar together Similargreat aluminium objects wouldpermanent be 50 pertrade cent routes.) heavier. prices, the high of the Australian and to cheap efforts did not yield help them innovate. Businesses directly contract When it is used with aluminium it improves the strength, metal imports from China wouldmay most likely preclude By means of thisweld-ability trade route,and people travelled, universities to conduct research for them, or help corrosive resistance, tear-ability of learned any new investment in magnesium smelting in Australia. and transferred across different parts themprophetic to collectthose ideas and recruit talent aluminium. In the lateknowledge 1990s, magnesium was hailed How sentiments were. through the world. envoy of the the demand Byzantine emperor, collaboration with students (class projects, internships, as theofmetal of the An future, with from the Inevents). the meantime, AMC looked to provide move on. By 2006, it Justinian, smuggled silkexpected worm eggs of China, And finally, governments funding world’s automotive industry to out be immense. had changed business model as a reflection hidden inspawned bamboo a sticks, to start silk production in for the higherits education sector andand, for research This optimism number of mineral-processing ofinstitutes the newto direction, it changed name to Advanced the Middle East in the 6th century. Marco Polo, the provide research andits development proposals in Australia, a process that turns raw Magnesium Limited public (AML).good, The Brisbane-based AML’s Italian merchant born in Venice, travelled to China services supporting and to train the next magnesite into finished magnesium. The largest proposal principal activities were researching, developing, back many things like noodles in the generation of experts andnow professionals to enable them at the and timebrought was that of the Australian Magnesium manufacturing newand proprietary magnesium 13th/14th centuries. The Ottoman acquired to contribute toand theselling economic social development Corporation (AMC). It proposed buildingEmpire a $1.7 billion, alloys and technologies to die casters for end use in thetonnes secretsper of year, gunpowder around the at 14th century, of the country. 90 000 processing plant Stanwell, the automotive, electronics and hardware industries. near Rockhampton, Queensland. As it was unable to AML no longer sought to manufacture magnesium purchase an existing technology in what was now a very or its proprietary alloys itself. Instead, it outsourced competitive global market, AMC with the assistance the manufacture of its alloys under licence to alloy of the CSIRO developed its own low-cost process producers in China, Japan and Europe—AML’s main technology. It built and operated a demonstration plant regional markets. to prove the technology to potential investors. To the CHAPTER 1 GLOBALISATION 49 regional and national economies, the project promised In 2008–09, AML made another change to its business 2000 jobs and $500 million in revenue per year. model. It identified a number of weaknesses with the licensing agreements with manufacturers. AML During 2000–03, AMC set about raising capital and realised that it lacked control over its supply 07/27/19 chain 03:02 PM hiL23674_ch01_001-054.indd 49 commenced construction. However, signs of trouble and as a consequence, the quality of the product soon began to appear. Construction costs rose and the quality of service provided to its customers above expectations and there was a shortfall in the protectionist right-wing politicians such asreturned Donald Trump. For over half a century, the US and other developed was falling. Consequently, in 2009, AML to capital raising. The state government of Queensland Will their mercantilist views (see Chapter an countries championed free trade and globalisation. It manufacturing its magnesium alloys itself.2)It bring entered provided $100 million to guarantee dividend payments endato globalisation? Is globalisation theakey reason for brought unprecedented growth and prosperity to millions into joint venture to build and operate greenfield to investors for three years. It provided another the loss of manufacturing in the developed countries, as of people around the world. However, it hollowed out magnesium facility in China, Henan Keweier Alloy $50 for infrastructure assistance. The national suggested protectionist politicians? themillion manufacturing sector and increased income Materials Co.byLtd (HNKWE), of which AML owned 53 per government provided $100 million leading to guarantee loans inequality in developed countries, to the rise of cent. HNKWE supplied AML’s alloys to all its customers and another $50 million for CSIRO to develop the new in China, Europe, the United States and Japan. China processing technology. is the world’s biggest producer of both primary SOURCE: T. Meyer and G. Sitaraman ‘A Trade Policy for All: Market Liberalization Should Be a Means, Not an End’, Foreign Affairs, 26 June 2018, magnesium ingot (90 per cent of the global supply) and After four years, with the plant in the very early phases accessed via www.foreignaffairs.com/articles/2018-06-26/trade-policy-all, on 3 July 2019. magnesium alloys. AML’s executive chairman at the time of construction, in June 2003 the project collapsed and of establishing the joint venture declared, ‘[T]he ideal was mothballed. Shareholders lost $500 million and location in Henan province, the availability of skilled taxpayers lost $240 million after salvaging some assets. labour and the support of both local and provincial The blowout in the construction costs was widely governments should ensure that the company makes broadcast as the cause of the collapse, but perhaps Many of the former Communist nations of Europe and Asia seem to have shown a significant market inroads over the next 12 months’. there were more fundamental causes. In an assessment ACCUMULATION OF TECHNOLOGIES Each chapter ends with a Closing Case that is designed to illustrate the relevance of the chapter material to the practice of international business, as well as to provide continued insight into how real companies handle those issues. MANAGEMENT FOCUS TRYING TO PICK A WINNER: GOVERNMENT SUPPORT OF THE MAGNESIUM INDUSTRY There is at least one Management Focus box in every chapter. Like the Opening Cases, the purpose of these is to illustrate the relevance of chapter material to the practice of international business. ANOTHER PERSPECTIVE RISE OF PROTECTIONISM commitment to democratic politics and free market economies. If this continues, the opportunities for international businesses will continue to be enormous. For half a century, these countries were essentially closed to Western international businesses. Now they present a host of export and investment opportunities. Just how this will play out over the CHAPTER 3 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT next decade or two is difficult to say. The economies of many of the former Communist states are still relatively undeveloped, and their continued commitment to democracy and free market economies cannot be taken for granted. Disturbing signs of growing unrest and totalitarian tendencies continue to be seen in several Eastern European and hiL23674_ch03_101-158.indd 121 07/27/19 Central Asian states, including Russia, which under the presidencies of Vladimir Putin and Dmitry Medvedev have shown signs of shifting back towards greater state involvement in economic activity. Findings from Freedom in the World 2015, Freedom House’s annual report on the state of global freedom, reveal that democracy declined worldwide for the tenth year in 2015, particularly in the Middle East.36 Thus, the risks involved in doing business in such countries are high, but so may be the returns. The 2007–09 GFC caused a reassessment of the extent to which governments should intervene in Western industrialised economies. To this point in time, the dominant ideology was one of free markets, private ownership and reduced government regulation. The events of the GFC, however, brought into question the efficacy of such a model. For fear of systemic collapse, governments became convinced that they had to usurp the market and intervene. The US and the UK governments bought controlling interests in private businesses—in effect, for a country such as the United Kingdom, this meant reversing the privatisation trend by renationalising parts of industry. In the United States, for example, the government bought 61 per cent of General Motors (GM), once one of the largest, private non-financial multinationals in the world, and in addition provided loans from taxpayer funds to assist GM through bankruptcy. The UK government took control of three financial institutions—the Royal Bank of Scotland, Lloyd’s Banking Group MANAGEMENT FOCUS ANOTHER PERSPECTIVE 121 Learning is easier and clearer if the subject matter is communicated in an interesting, informative and accessible manner. The Another Perspective boxes allow interesting anecdotes and alternative perspectives to be woven into the narrative of the text. They also provide additional context to the chapter topics. 03:41 PM xxii GLOBAL BUSINESS TODAY hiL23674_fm_i-xxx.indd xxii 08/06/19 05:52 PM EMERGING MARKETS INDIA’S IT SOFTWARE SECTOR Some 25 years ago, a number of small software enterprises was established in Bangalore, India. Typical of these enterprises was Infosys Technologies, which was started by seven Indian entrepreneurs with about $1000 among them. Infosys now has annual revenues of $7.4 billion and some 155 600 employees, but it is just one of more than a hundred software companies clustered around Bangalore, which has become the epicentre of India’s fast-growing information technology sector. From a standing start in the mid-1980s, by 2012 this sector was generating export sales of $68 billion. The growth of the Indian software sector has been based on four factors. First, the country has an abundant supply of engineering talent. Every year, Indian universities graduate some 400 000 engineers. Second, labour costs in India have historically been low. As recently as 2008, the cost to hire an Indian graduate was roughly 12 per cent of the cost of hiring an American or Australian graduate (this is now changing, with salaries increasing in India). Third, many Indians are fluent in English, which makes coordination between Western companies and India easier. Fourth, due to time differences, Indians can work while many other advanced English-speaking countries are asleep. EMERGING MARKETS Initially, Indian software enterprises focused on the low end of the software industry, supplying basic software development and testing services to Western companies. But as the industry has grown in size and sophistication, Indian companies have moved up the market. Today, the leading Indian companies compete directly with the likes of IBM and EDS for large software development projects, business process outsourcing contracts, and information technology consulting services. Over the past 15 years, these markets have boomed, with Indian enterprises capturing a large slice of the pie. One response of Western companies to this emerging competitive threat has been to invest in India to garner the same kind of economic advantages that Indian companies enjoy. IBM, for example, has invested $2 billion in its Indian operations and now has 150 000 employees located there, more than in any other country. Microsoft, too, has made major investments in India, including a research and development (R&D) centre in Hyderabad that employs 4000 people and was located there specifically to tap into talented Indian engineers who did not want to move overseas. FOCUS ON MANAGERIAL IMPLICATIONS INTERNATIONAL BUSINESS GRADUATE ATTRIBUTES (IBGAs) SOURCES: ‘America’s pain, India’s gain: outsourcing’, The Economist, 11 January 2003, p. 59; ‘The world is our oyster’, The Economist, 7 October 2006, Throughout we have now the2007, Australian appreciates towards pp. 9–10; ‘IBM and globalization: hungrythis tiger,chapter dancing elephant’, The Economist, 7 April pp. 67–69;dollar P. Mishra, ‘New billing model may hitparity, India’s LO 4.4 alluded on several occasions to the illustrated moving19down left-hand column of software exports’, Live Mint, 14 February 2013; ‘India’s outsourcing business: on the turn’, Theby Economist, Januarythe 2013. potential impact on international Tables 4.3A and 4.3B. If the manufacturer passes business of changes in foreign exchange rates. It is through 100 per cent of the impact of the exchange This chapter’s content, learning resources and case studies provide you with the critical that international companies understand the rate change, as in Table 4.3A, US prices rise. If the opportunity to develop a number of International Business (IBGAs), influence of exchange rates on the profitability of trade exchange rate went Graduate to parity, itAttributes would result in a including the following: share. Their share hascontracts. almost halved over in theexchange past decade as developing economies suchofas60 per cent. If the exchange and investment Changes rates significant price rise about changes the prices of traded goods rate went $1.40, the price increase would be the bring BRIC nations attract ainlarger share. As we shall see later in this book, thetosustained flow and services. Setting price to nations remain is competitive 14 perfor cent. With agrowth. price rise in the US, sales would of foreign investment into the developing an important stimulus economic IBGA1 Discipline Knowledge and Skills to fall and market share to decline. The maintain economy market share in foreign markets be expected Just and as Australia’s has relied on FDI to fuelisitsalso development, particularly via the complicated bymining exchange rateattracting changes, as adverse the fall, and the extent to which the exporter IBGA2 Criticalmore Analysis development of its sector, FDI bodes wellextent for theoffuture of countries put at riskand apparently profitable is willing to pass through the exchange suchchanges as Brazil,can Russia, India China, who are thedeals. leading beneficiaries of and theseable trends. IBGA5 Communication In this section, we look at the impact of exchange rate change, depends on a number Onesystem such inequalities benefit everyone. Rawls accepts that inequalities canofbefactors. just if the IBGA7 that Global Perspective rate changes on international business operations in factor is the sensitivity of More customers to price changes. produces inequalities is to the advantage of everyone. precisely, he formulates more detail, and how companies may manage these principle, If USwhich customers farm machinery for non-price IBGA9 Citizenship what hemultinational calls the difference is that buy inequalities are justified if they benefit The changing nature of the enterprise impacts. We begin by looking at the relationship reasons, such as unique capability, the fall in sales the position of the least advantaged person. So, for example, wide variations in income between exchange rates and the pricing of goods has in productive will notactivities be as great when prices rise. Another factor A multinational enterprise (MNE) any business MULTINATIONAL andis wealth can bethat considered just if the market-based system that produces this unequal foreign markets. We follow discussion of the trends in is the ofofcompetition. IfENTERPRISE other American and (MNE) in two or more countries. Sincewith the a1960s, two notable the amount character distribution also benefits least-advantaged members ofmanufacturers society. can argue that a well AnyOne business that has productive risks to which business canbeen be exposed as aof result ofthe foreign farm machinery offer similar multinational enterprises have (1) the rise non-US multinationals; (2)by the market-based and free and trade, promoting growth, benefit activities two or more countries exchange rate changes andregulated, the strategies they mayeconomy machines, a price rise is likelyeconomic to see ain marked fall growth of mini-multinationals. 1.1 the process and driversInof globalisation and the theExplain least-advantaged members ofinsociety. principle, at least, the inherent employ to mitigate these risks. market share. A third factor is inequalities the impact of the opportunities and challenges it creates for‘rising business. in such systems are therefore just (in other words, the tide’ of wealth created by exchange rate change on the costs of production. If a market-based economy and free trade ‘lifts all boats’, even those of the most disadvantaged). a large proportion of inputs to the production of 1.2 how the global economy has changed over 1theGLOBALISATION past the 27 EXCHANGE RATES ANDIllustrate SETTING CHAPTER farm machines in Australia are imported, costs InPRICE the context of international business ethics, Rawls’ theory creates anthe interesting 50 years. imported inputs will decrease as a result perspective. could askofthemselves whether the policies they adopt of in the foreign With dramatic swings in exchange rates,Managers particularly appreciation of theveil Australian dollar. a result, the Justify the labelling of the century as the Emerging in a freely floating1.3 exchangeoperations rate regime, setting would be considered just21st under Rawls’ of ignorance. Is As it just, for example, can be lowered andRawls’ the foreign prices for internationally traded goods is aCentury. challenge to pay foreign workers less thanex-factory workers inprice the firm’s home country? theoryprice would Markets hiL23674_ch01_001-054.indd 27 07/27/19 03:02 PM rise can be reduced. for international business management. extent suggest it is, The as long as the inequality benefits the least-advantaged members of the global 1.4 business Debate the impact of globalisation on issues such as job security, to which an international adjusts prices in society (which is what economicIf theory suggests). Alternatively, it is difficult to imagine all the price-sensitivity factors align adversely against a income foreign market as the and the inequality environment. the exporter may be forced to accept veilexporter, of ignorance would design a system where foreign EXCHANGE RATE PASS-THROUGH that managers operating under athe result of an exchange The extent to which an international lower mark-ups. This illustrated in Tablediffers 4.3B. If in employees werehow paid the subsistence wages to of work longishours inbusiness sweatshop conditions 1.5 Compare management international rate change is called business adjusts prices in a foreign the materials. US market for this type of farm machinery is very which they were exposed to toxic working conditions are clearly unjust from the management of domesticSuch business. rate passmarket as the result of an exchange exchange price-sensitive, as to illustrated here,Similarly, the exporter may in Rawls’ framework and, therefore, it is unethical adopt them. operating rate change through. be forced to price to what the market determines—in Most chapters include an Emerging Markets box that examines the nature of these markets and economies, their evolving role in the global economy and the implications for international business management. FOCUS ON MANAGERIAL IMPLICATIONS Showing how the material covered in the text is relevant to the actual practice of international business is important. This is done explicitly in Chapters 2–7, which focus on the practice of managing international business rather than just the environmental issues. LEARNING OBJECTIVES (LOs) under a veil of ignorance, most people would probably design a system that imparts this case, US$21 875. In other words, the exporter has We can illustrate the type ofsome pricing dilemmafrom environmental protection degradation to important global commons, such no market power to adjust prices upwards and must confronted by exporters and the pass-through concept as the oceans, atmosphere and tropical rainforests. To the extent that this is the case, it take the US dollar price as a given. In this situation, with the numerical examples in Tables 4.3A and 4.3B. follows that it is unjust, and by extension unethical, for companies to pursue actions that when the Australian dollar appreciates, the impact Suppose the ex-factory price of the Australian contribute towards extensive degradation of these commons. Thus, Rawls’ veil of the ignorance of the exchange rate change is on mark-ups and produced farm machinery is A$35 000 and the current is a conceptual toolinthat contributes to theprice. moralThe compass that managers can useas to help ex-factory pass-through is 0 per cent, exchange rate is A$1.60 = US$1.00. The price themrate navigate through ethical dilemmas. exports are priced to the market motor-vehicle the US market at this exchange is US$21 875, difficult the conditions. If the impact of exchange rate appreciation ignoring all transaction costs and assuming the is such that it causes substantial cuts to ex-factory manufacturer and all agents through the supply chain prices, a scenario arises that the export venture is no are satisfied that the existing mark-ups at these longer a sound business proposition. Of course, if the prices give acceptable sales and profits. Suppose 196 PART 2 On 1 December 2018, Meng Wanzhou, the chief Chinese tech company Huawei, was detained in Vancouver, Canada, at the request of US authorities. US prosecutors accused Wanzhou of helping Huawei to cover up violations of economic sanctions on Iran. In response, the Chinese government arrested and detained a number of Canadians in China. The underlying controversy motivating this tit-for-tat was US distrust of Huawei as a technology company and its decision, soon followed by other close US allies, to limit the company’s ability hiL23674_ch01_001-054.indd 3 to participate as a provider of the roll-out of nextgeneration 5G mobile networks. PART 3 INTERNATIONAL BUSINESS GRADUATE ATTRIBUTES (IBGAs): LEARNING AND ASSESSMENT TASKS 378 IBGA1: DISCIPLINE KNOWLEDGE AND SKILLS 1. ‘Japan is a neo-mercantilist nation. It protects industries where it has no competitive advantage in the world economy, such as domestic agriculture, while demanding that other countries open those markets where Japanese producers have a competitive advantage, such as cars.’ Discuss this statement. 2. Unions in developed nations often oppose imports from low-wage countries such as Bangladesh and advocate trade barriers to protect jobs from what they often characterise as ‘unfair’ import competition. Is such competition ‘unfair’? Do you think that this argument is in the best interests of: (a) the unions; (b) the people they represent; and/or (c) the country as a whole? 3. Drawing upon the new trade theory and Porter’s model of national competitive advantage, outline the case for government policies that would build national competitive advantage in a particular industry. What kinds of policies would you recommend that the government adopt? Are these policies at variance with the basic free trade philosophy? IBGA3: PROBLEM SOLVING 4. One of the most significant factor endowments is education, with important measures being the literacy rate and the literacy rate gap between the genders. Which of the following countries do you think has the highest literacy rate and which country has the largest literacy gap between males and females: (a) Iraq (b) Rwanda (c) Chile (d) India? IBGA4: ETHICAL DECISION MAKING 5. ‘The world’s poorest countries are at a competitive disadvantage in every sector of their economies. They have little to export. They have no capital, their land is of poor quality, they often have too many people given the available work opportunities and they are poorly educated. Free trade cannot possibly be in the interests of such nations!’ Discuss. IBGA5: COMMUNICATION 6. You are the international manager of an Australian or a New Zealand business that has just developed a PART 2 COUNTRY FOCUS Politics obscured the question of whether Huawei had in 07/26/19 fact subverted sanctions against Iran. These had been09:04 PM imposed under United Nations Security Council (UNSC) resolutions 1696 (2006), 1737 (2006), 1747 (2007), 1803 (2008) and 1929 (2010) and were designed to stop Iran from conducting its uranium enrichment program. The Iranian government said that activities were for3 CHAPTER 1 itsGLOBALISATION civilian nuclear power, but the international community claimed that it was in fact for the development of atomic weapons. Individual nations such as the US imposed their own additional sanctions. International companies 07/27/19 03:02 PM were thus forbidden from providing a whole range of goods and services to Iran, especially sensitive Every chapter has a Country Focus box that provides students with the background on the political, economic, cultural and ethical aspects of Australia’s top 14 trading partners as they deal with global business issues. COUNTRY DIFFERENCES hiL23674_ch08_351-390.indd 96 Each chapter starts with a list of the chapter’s learning objectives and they flag what you should know when you have worked through the chapter. The text within the chapter that is related to a learning objective has the globe symbol beside it. COUNTRY FOCUS IRAN: VIOLATING SANCTIONS CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd financial officer196of 378 LEARNING OBJECTIVES 07/29/19 08:54 PM revolutionary new personal computer that can perform the same functions as PCs but costs only half as much to manufacture. Your CEO has asked you to formulate a recommendation for how to expand into the European Union market. Your options are: (a) to export from your home market; (b) to license a European company to manufacture and market the computer in Europe; and (c) to set up a wholly owned subsidiary in Europe. Evaluate the pros and cons of each alternative and write a brief report suggesting a course of action to your CEO. 7. The UNCTAD World Investment Report and its World Investment Directory provide quick electronic access to comprehensive statistics on foreign direct investment and the operations of transnational corporations. Compile a list of the largest transnational corporations in terms of their FDI and identify their home country (i.e. headquarters country). Then provide a 15-minute commentary about the characteristics of countries that have the greatest number of transnational companies. IBGA6: SOCIAL INTERACTION 8. Your company is considering opening a new factory in an Asian country, and management is evaluating the specific country locations for this direct investment. The pool of candidate countries has been narrowed to China, India and Thailand. Form a small group of four or five peers and prepare a short report comparing the FDI environment and location advantage of these three countries. IBGA2: CRITICAL ANALYSIS 9. CASE ANALYSIS Read the Opening Case, ‘Bangladesh’s textile trade’ again, and answer the following questions. a. How has Bangladesh benefited from free trade and globalisation? INTERNATIONAL BUSINESS GRADUATE ATTRIBUTES: LEARNING AND ASSESSMENT TASKS Graduate attributes are the qualities, skills and understandings a student is expected to develop throughout their course of study. It is a part of sound teaching and learning practice to spell out to students in advance an aligned set of learning goals, learning tasks and assessment tasks. Educational institutions also are being asked to demonstrate explicitly to both students and external agencies where and how in their curriculum they are developing specified graduate attributes and assessing their attainment. This text sets out a framework for developing and assessing graduate attributes for international business studies. This framework is discussed in more detail in the following section. b. What did the end of the quota system mean for that country? c. Using Porter’s diamond of competitive advantage, explain Bangladesh’s competitive advantage in the production of textiles. d. How important are Bangladesh’s supporting industries to its textile trade? 10. CASE ANALYSIS Read the following Closing Case and answer the questions that follow. TEXT AT A GLANCE xxiii CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd hiL23674_fm_i-xxx.indd xxiii 96 07/29/19 08:49 PM 08/08/19 11:30 AM CASE AND VIGNETTE MATRIX PART ONE GLOBALISATION CHAPTER 1 GLOBALISATION OPENING CASE KAIHARA: GLOBALISATION OF A SHINISE, A LONG-LIVED COMPANY ANOTHER PERSPECTIVE RISE OF PROTECTIONISM EMERGING MARKETS INDIA’S IT SOFTWARE SECTOR MANAGEMENT FOCUS THE GLOBALISATION OF PRODUCTION AT BOEING WHO MAKES THE APPLE IPHONE? COUNTRY FOCUS CHINA: BELT AND ROAD INITIATIVE CLOSING CASE GLOBAL INNOVATION THROUGH THE MOBILITY OF IDEAS AND TALENT PART TWO CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE CHAPTER 2 THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION OPENING CASE BANGLADESH’S TEXTILE TRADE EMERGING MARKETS BRAZIL’S EMBRAER MANAGEMENT FOCUS HOLLOWING OUT THE MANUFACTURING-BASED ECONOMY COUNTRY FOCUS INDIA: LONG-TERM OPPORTUNITIES FOR BILATERAL TRADE AND INVESTMENT CLOSING CASE LOGITECH’S GLOBAL APPROACH CHAPTER 3 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT OPENING CASE UNEASE OVER CHINA’S RARE EARTH TRADE POLICIES ANOTHER PERSPECTIVE FREE TRADE AND EFFICIENCY VS FAIR TRADE AND JUSTICE A LICENCE TO PROFIT PATENTS VERSUS PATIENTS EMERGING MARKETS THE BRICS: ELECTRICAL APPLIANCES AND CONTRARY ENERGY-EFFICIENCY POLICIES MANAGEMENT FOCUS TRYING TO PICK A WINNER: GOVERNMENT SUPPORT OF THE MAGNESIUM INDUSTRY SANCTIONS, U-TURNS AND ACCUSATIONS OF MONEY LAUNDERING AT STANDARD CHARTERED COUNTRY FOCUS USA: THE NEW PROTECTIONISM CLOSING CASE MAKE IT AUSTRALIAN? FREE TRADE VERSUS NATIONAL IDENTITY CHAPTER 4 FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM OPENING CASE THE MEXICAN PESO, THE JAPANESE YEN AND POKÉMON GO ANOTHER PERSPECTIVE THE RISE OF CRYPTOCURRENCIES GROWING PAINS WITH THE EURO WHAT ABOUT THE STARBUCKS INDEX: A GOOD IDEA? SHOULD COUNTRIES BE FREE TO SET CURRENCY POLICY? CAN DOLLARISATION SAVE VENEZUELA? EMERGING MARKETS CHINA’S EXCHANGE RATE REGIME MANAGEMENT FOCUS EMBRAER AND THE GYRATIONS OF THE BRAZILIAN REAL COUNTRY FOCUS EGYPT AND THE IMF IMF AND ICELAND’S ECONOMIC RECOVERY CLOSING CASE THE FLUCTUATING VALUE OF THE YUAN GIVES CHINESE BUSINESS A LESSON IN FOREIGN EXCHANGE RISK xxiv GLOBAL BUSINESS TODAY hiL23674_fm_i-xxx.indd xxiv 08/06/19 05:52 PM PART THREE COUNTRY DIFFERENCES CHAPTER 5 DIFFERENCES IN CULTURE OPENING CASE EVOLVING CULTURE AT PANASONIC ANOTHER PERSPECTIVE ONLINE VIEW OF OTHER CULTURES RELIGIOUS FUNDAMENTALISM ADAPTING TO SUIT THE LOCAL PALATE STICKY PROBLEMS IN CULTURE RESEARCH EMERGING MARKETS ISLAMIC BANKING IN MALAYSIA A TALE OF TWO COUNTRIES MANAGEMENT FOCUS DMG ENTERTAINMENT COUNTRY FOCUS BREAKING INDIA’S CASTE SYSTEM AND GENDER DISCRIMINATION INDONESIA: CROSS-CULTURAL AND GEOPOLITICAL CLOSING CASE COGNITION CONSULTING: EXPORTING NEW ZEALAND’S EDUCATIONAL EXPERTISE AND CULTURE CHAPTER 6 POLITICAL AND LEGAL ENVIRONMENTS OPENING CASE TRANSFORMATION IN SAUDI ARABIA ANOTHER PERSPECTIVE DO YOU AGREE WITH THE UNIQUE SYSTEM OF ISLAMIC BANKING? HOW IMPORTANT ARE INTELLECTUAL PROPERTY RIGHTS? EMERGING MARKETS THE DECLINE OF ZIMBABWE INDIVIDUAL RIGHTS AND FREEDOMS IN THE BRICS MANAGEMENT FOCUS DID WALMART VIOLATE THE FOREIGN CORRUPT PRACTICES ACT? STARBUCKS WINS KEY TRADEMARK CASE IN CHINA COUNTRY FOCUS RUSSIA: EASING BUSINESS ENVIRONMENT OR UNCERTAIN FUTURE? CLOSING CASE THE ELUSIVE ELENA EGOROVA CHAPTER 7 ECONOMIC ENVIRONMENT OPENING CASE BRAZIL’S STRUGGLING ECONOMY ANOTHER PERSPECTIVE DISCONNECT OF THE VIRTUAL AND THE PHYSICAL WORLDS IF WE ON EARTH WERE A COMMUNITY OF 100 PEOPLE . . . EMERGING MARKETS THE DEVELOPMENT PERFORMANCE OF EMERGING MARKET ECONOMIES MANAGEMENT FOCUS FONTERRA AND THE CHANGING DEMAND FOR DAIRY PRODUCTS IN THE EMERGING MARKETS OF ASIA COUNTRY FOCUS CANADA AND AUSTRALIA: SIMILAR YET DIFFERENT? CLOSING CASE ECONOMIC DEVELOPMENT IN BANGLADESH CHAPTER 8 ETHICS AND CORPORATE RESPONSIBILITY OPENING CASE SUSTAINABILITY INITIATIVES AT NATURA COSMETICS, THE BODY SHOP AND AESOP ANOTHER PERSPECTIVE SUSTAINABILITY REPORTING MODERN SLAVERY ACT (AUSTRALIA) ARE HUMAN RIGHTS A MORAL COMPASS? TACKLING TAX AVOIDANCE MANAGEMENT FOCUS CORPORATE SOCIAL RESPONSIBILITY AT STORA ENSO PRESSURE ON NIKE CONTINUES ‘EMISSIONSGATE’ AT VOLKSWAGEN CASE AND VIGNETTE MATRIX xxv hiL23674_fm_i-xxx.indd xxv 08/06/19 05:52 PM COUNTRY FOCUS IRAN: VIOLATING SANCTIONS CLOSING CASE WOOLWORTHS’ CORPORATE RESPONSIBILITY STRATEGY CHAPTER 9 COUNTRY MARKET RESEARCH OPENING CASE SPOTIFY AND SOUNDCLOUD ANOTHER PERSPECTIVE ARE FIRST-MOVER ADVANTAGES ALWAYS A GOOD THING? EMERGING MARKETS TATA MOTORS AND EXPORTING MANAGEMENT FOCUS EXPORTING OR LICENSING? EMBRAER AND BRAZILIAN IMPORTING TWO MEN AND A TRUCK COUNTRY FOCUS PAKISTAN: THE COSTS OF CORRUPTION CLOSING CASE JOLLIBEE: A MULTINATIONAL COMPANY FROM THE PHILIPPINES PART FOUR COMPETING IN THE GLOBAL MARKETPLACE CHAPTER 10 THE STRATEGY OF INTERNATIONAL BUSINESS OPENING CASE RED BULL’S GLOBAL STRATEGY ANOTHER PERSPECTIVE EDUCATION AS A PART OF YOUR VALUE CHAIN LONG-LIVED COMPANIES EMERGING MARKETS PEARL RIVER PIANO COMPANY MANAGEMENT FOCUS IKEA: EVOLUTION OF STRATEGY CISCO SYSTEMS AND FUJITSU COUNTRY FOCUS NEW ZEALAND: AN ADJACENCY PLAY CLOSING CASE THE GROWTH STRATEGY OF HAIER CHAPTER 11 ENTERING FOREIGN MARKETS OPENING CASE INTERNATIONAL MARKET ENTRY AT STARBUCKS ANOTHER PERSPECTIVE EXPORTING OR LICENSING? SO, YOU THINK YOU WANT TO OWN A FRANCHISE? ALDI IN AUSTRALIA IS COUNTERTRADE AN APPROPRIATE WAY OF TRADING TODAY? EMERGING MARKETS JCB IN INDIA COUNTRY FOCUS MALAYSIA OPENS UP SOME TRADE MANAGEMENT FOCUS THE NEED TO GO INTERNATIONAL AUSTRALIAN TURNTABLE COMPANY TESCO’S INTERNATIONAL GROWTH STRATEGY CLOSING CASE THE HAPPY SNACK COMPANY: THIS HAPPY, HEALTHY MESSAGE IS TOO GOOD NOT TO SHARE CHAPTER 12 INTERNATIONAL MARKETING/BUSINESS ANALYTICS OPENING CASE BURBERRY’S SOCIAL MEDIA MARKETING ANOTHER PERSPECTIVE MARKETING FAILURES—VEGEMITE’S ISNACK 2.0 LOST IN TRANSLATION IS THE KIWIFRUIT A KIWI FRUIT? DESTINATION AND COUNTRY BRANDING FAKE NEWS AND ALTERNATIVE FACTS EMERGING MARKETS UNILEVER: SELLING TO INDIA’S POOR MANAGEMENT FOCUS GLOBAL BRANDING, MARVEL STUDIOS AND WALT DISNEY IS THE GOOGLE ADVERTISING MODEL VIABLE IN THE LONG TERM? COUNTRY FOCUS SPAIN: BUILDING AUSTRALIA’S INFRASTRUCTURE CLOSING CASE YOUI: SELLING THE YOU xxvi GLOBAL BUSINESS TODAY hiL23674_fm_i-xxx.indd xxvi 08/06/19 05:52 PM CHAPTER 13 INTERNATIONAL PRODUCTION, OUTSOURCING AND LOGISTICS OPENING CASE LI & FUNG LIMITED: A FACTORY OF SORTS, NOW OUT OF SORTS ANOTHER PERSPECTIVE CHANGING CAREER ROLES AND OPPORTUNITIES DIFFERENT STAGE, DIFFERENT SCALE THE GREENING OF CAR MANUFACTURING OFFSHORING LEGAL SERVICES REVERSE LOGISTICS RFID AND LIVESTOCK EMERGING MARKETS THE ‘CHINA-PLUS-ONE’ STRATEGY MANAGEMENT FOCUS HP SINGAPORE’S EVOLVING ROLE COUNTRY FOCUS THE PACIFIC ISLANDS: A KEY PARTNER IN AUSTRALIAN AGRICULTURE CLOSING CASE FMCG, SOFT DOLLARS AND LEAN SUPPLY CHAINS CHAPTER 14 INTERNATIONAL HUMAN RESOURCE MANAGEMENT OPENING CASE GLOBAL MOBILITY AT SHELL ANOTHER PERSPECTIVE LINKING HR ACROSS THE GLOBE THE FUTURE OF HR MOBILITY MANAGEMENT SENDING WOMEN ON INTERNATIONAL ASSIGNMENTS WHICH COUNTRY DO YOU WANT TO GO TO? EMERGING MARKETS THE COST OF WORKING IN CHINA MANAGEMENT FOCUS MCDONALD’S GLOBAL COMPENSATION PRACTICES COUNTRY FOCUS SOUTH AFRICA: THE APARTHEID LEGACY CLOSING CASE SODEXO: BUILDING A DIVERSE GLOBAL WORKFORCE CASE AND VIGNETTE MATRIX xxvii hiL23674_fm_i-xxx.indd xxvii 08/06/19 05:52 PM INTERNATIONAL BUSINESS GRADUATE ATTRIBUTES While individual educational institutions and courses of study will seek to develop attributes peculiar to their own situation, there are many generic attributes expressed in the institutional statements of learning goals. The following concepts are common in these statements: • • • • • • • • • Discipline Knowledge and Skill Critical Analysis Problem Solving Ethical Decision Making Communication Social Interaction Global Perspective Life-long Learning Citizenship. It is evident that a study of international business, by its very nature, can make a significant contribution to the development of these generic attributes. For teaching and learning purposes (including the assessment of learning), a more operational expression of the concepts is needed. The International Business Graduate Attributes (IBGAs) as defined below provide the operational expression of these concepts as they apply to an international business education. The concepts listed above have been selected as the basis of the development of the IBGAs used throughout this textbook and its accompanying teaching and learning resources. IBGAs need to be aligned with the learning objectives, and the learning and assessment activities of a specific unit of study, to ensure the development of the generic attributes. Learning objectives, alone or in combination, provide indicators of the attainment of the graduate attributes. A sample of such indicators is provided below for each IBGA. Alignment occurs in this textbook according to the IBGA chapter matrix below. While each chapter by way of its subject matter, learning objectives, suggested learning tasks and stimulus material potentially provides a vehicle for developing all IBGAs, the alignment matrix recognises that certain subject matter lends itself to the development of specific IBGAs. The matrix also acknowledges that two of the IBGAS are so generic that they can be assigned to all chapters. These IBGAs are IBGA1: Discipline Knowledge and Skills and IBGA5: Communication. Case analysis is used in each chapter, so IBGA2 Critical Analysis is also assigned to each chapter. IBGA1 DISCIPLINE KNOWLEDGE AND SKILLS Apply a coherent body of theoretical and practical knowledge and skills to understand international business. Indicator: You can: • e xplain the various methods used by governments to restrict imports • describe the circumstances under which a firm may choose to enter a foreign market using licensing rather than FDI • using the table of data provided, calculate the export price in the foreign currency if the firm adopts a 100 per cent pass-through pricing strategy. IBGA2 CRITICAL ANALYSIS Using a combination of insight, reason and practised skills, formulate a considered judgement on the value of data, experiences, arguments and proposals relating to international business issues. Indicator: You can: • s ummarise the data collected from returning expatriate staff on the adequacy of their overseas allowances • compare and contrast the public interest arguments underpinning the national government’s decision to prohibit one but permit another foreign takeover in the Australian mining industry • assess the viability of a business opportunity for the sale of kangaroo meat to South Korea. IBGA3 PROBLEM SOLVING Define problems and their causes confronting international business managers, and use a range of abilities, approaches and resources to reach decisions and make recommendations. Indicator: You can: • find sources of data on foreign competitors • outline how you would prepare yourself for a short-term work assignment to a subsidiary in a foreign country about which you know very little • develop strategies that enhance the opportunities and limit the threats for your business as a consequence of Australia becoming a part of an expanded ASEAN Free Trade Area. xxviii GLOBAL BUSINESS TODAY hiL23674_fm_i-xxx.indd xxviii 08/06/19 05:52 PM IBGA4 ETHICAL DECISION MAKING IBGA7 GLOBAL PERSPECTIVE Be aware of the different value systems, including one’s own, under which an international business may operate. Recognise and value the moral dimensions of international business decisions and actions. Indicator: You can: Understand and respect the economic, cultural and biological diversity and interdependence of global life. Indicator: You can: • r ecognise instances when the accepted rules of conduct regarding facility payments are broken • accept responsibility for the consequences of your actions • defend a code of practice for foreign suppliers that takes account of company profits, fairness, sustainability and Indigenous perspectives. IBGA5 COMMUNICATION Make connections that create meaning for others, including cross-cultural connections. Choose language, media and formats suitable for the message and the audience. Indicator: You can: • d ebate in a public forum the effectiveness of trade sanctions to bring about changes to the policies of a foreign government • conduct online a job interview with a candidate who is from a non-English-speaking background and is located offshore • write a report for management that explains the impact on the supply chain of your company of increasing global terrorism. IBGA6 SOCIAL INTERACTION Know how to get things done in groups. Indicator: You can: • elicit the views of others and help reach conclusions • recognise the strength of others and build positive relations • provide leadership within a team context by taking responsibility for organisation, planning, influencing and negotiating. • e xplain the concept of decoupling in the context of the Global Financial Crisis • compare world economic and political systems • assess the use of ‘food miles’ as a measure of the carbon footprint of a dairy food processor that exports to distant foreign markets. IBGA8 LIFE-LONG LEARNING Maintain an intellectual interest and a critical perspective on international business issues. Indicator: You can: • identify what you need to learn about international business • manage time and prioritise activities to achieve your goals • initiate ways and means of attaining and evaluating your learning outcomes. IBGA9 CITIZENSHIP Engage actively with communities in ways that are sensitive to their culture and responsive to their needs. Indicator: You can: • o rganise a program of speakers for a conference for international business graduates with the theme ‘Competing with Integrity in International Business’ • represent on their behalf the point of view and interests of Indigenous landholders who are seeking to form a strategic alliance with a foreign company to develop a tourist resort and golf course on their communal land • identify opportunities for collaboration between suitable NGOs and mine management on projects to improve the general and vocational education of miners and their families at a remote offshore mining site. INTERNATIONAL BUSINESS GRADUATE ATTRIBUTES xxix hiL23674_fm_i-xxx.indd xxix 08/06/19 05:52 PM IBGA–CHAPTER ALIGNMENT CHAPTER 1 2 3 4 5 6 7 8 9 10 11 12 13 14 1: Discipline Knowledge and Skills ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ 2: Critical Analysis ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ 3: Problem Solving ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ 4: Ethical Decision Making ✓ ✓ ✓ ✓ IBGA 5: Communication ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ 8: Life-long Learning 9: Citizenship ✓ ✓ 6: Social Interaction 7: Global Perspective ✓ ✓ ✓ ✓ xxx GLOBAL BUSINESS TODAY hiL23674_fm_i-xxx.indd xxx 08/06/19 05:52 PM 1 © aapsky/Shutterstock GLOBALISATION CHAPTER 1 hiL23674_ch01_001-054.indd 1 GLOBALISATION 08/06/19 07:40 PM © RODRIGO A TORRES/Glow Images CHAPTER 1 GLOBALISATION 2 PART 1 GLOBALISATION hiL23674_ch01_001-054.indd 2 08/06/19 07:40 PM INTERNATIONAL BUSINESS GRADUATE ATTRIBUTES (IBGAs) This chapter’s content, learning resources and case studies provide you with the opportunity to develop a number of International Business Graduate Attributes (IBGAs), including the following: IBGA1 IBGA2 IBGA5 IBGA7 IBGA9 Discipline Knowledge and Skills Critical Analysis Communication Global Perspective Citizenship LEARNING OBJECTIVES (LOs) 1.1 1.2 1.3 1.4 1.5 Explain the process and drivers of globalisation and the opportunities and challenges it creates for business. Illustrate how the global economy has changed over the past 50 years. Justify the labelling of the 21st century as the Emerging Markets Century. Debate the impact of globalisation on issues such as job security, income inequality and the environment. Compare how the management of international business differs from the management of domestic business. CHAPTER 1 hiL23674_ch01_001-054.indd 3 GLOBALISATION 3 08/06/19 07:40 PM OPENING CASE KAIHARA: GLOBALISATION OF A SHINISE, A LONG-LIVED COMPANY Fukuyama city in Hiroshima Prefecture, Japan, used to be known as Bingo. The name was synonymous with its ‘Bingo kasuri’, a Japanese cotton kimono cloth with a splashed pattern. In 1893, Kaihara, a family business manufacturing kasuri, was established by Sukejiro Kaihara in Bingo. It remained a comparatively small operation until its transformation into Kaihara Textile Mills Ltd in 1951. Since then, the company has grown to become a world-renowned supplier of high-quality denim for leading jeans manufacturers/brands such as Levi’s, fastfashion retailers like GAP and premium brands like Hugo Boss. The company has more than a 50 per cent share of the blue denim market in Japan and exports more than 70 per cent of its products. The company’s successful internationalisation is illustrative of a traditional Japanese company that has used its core domestic technology as a stepping stone to become globally competitive. presented Kaihara with an opportunity to expand overseas. In 1951, a trading company from Aden, Yemen, was seeking a manufacturer able to supply sarong cloth blended with the Japanese kasuri. After a failed attempt to source from a company in Nishiwaki, Hyogo Prefecture (due to manufacturing limitations), the company approached Kaihara. Sarongs for children needed 36-inch wide cloth, while for adults 48-inch cloth was required, necessitating the stitching of two 24-inch cloths. In order to improve the quality of the end product and limit the stitching needed, Kaihara developed a machine capable of producing 48-inch wide cloth. This innovation resulted in a worker being able to operate four machines at a time, resulting in a ten-fold efficiency gain in comparison with producers in Indonesia. ACCUMULATION OF TECHNOLOGIES Kaihara grew rapidly due to the cost-effective production of sarongs and a newly developed wool kasuri fabric that satisfied customer demand for softer kasuri in the Japanese market. However, a crisis hit the company: political instability in the Middle East and devaluation of the British pound led to overstocked inventory of kasuri sarong cloth equivalent to a year’s production. The company had to find a way to overcome the crisis. At the time the company was established there were numerous kasuri makers in Japan. Therefore, from its inception the company’s founder decided to focus on the high-end market, with higher quality products garnering a 20–50 per cent price premium over competitors’ products. After World War II, Kaihara, like other Japanese companies, rebuilt its business. The company focused on production innovations, such as developing and patenting an automatic dyeing machine. In addition, it developed new products for the domestic market. Other innovations followed; for example, Kaihara produced the first 36-inch wide kasuri fabric using an electric loom. However, due to changing market demand from Westernisation and a significant decrease in the wearing of kimonos, the company had limited sales success. Instead, this innovation provided the company with the production capacity to service larger markets, including international markets. While kimono wearing was in decline in Japan, ikat (a dyeing method used to pattern textiles) used in Indonesia, India and other countries for saris and sarongs 4 PART 1 MOVE TO DENIM Sadaharu Kaihara, the president, was informed by one of his friends, ‘Jeans have become fashionable for the youngsters in Japan. Since they are imported from abroad, why don’t you try to manufacture them using your company’s technology?’ Traditionally, kasuri was dyed using the Japanese indigo plant, later substituted with indigo made from oil. The oil-based indigo was also used for denim, and Kaihara had expertise in using the artificial dye. In addition, denim production had synergy with kasuri weaving technology. Therefore, Sadaharu Kaihara went to Tokyo to observe the uptake of jeans by the younger generation. He saw a significant market for denim and decided to diversify into denim production. In 1969, the company introduced cheese-dyed indigo denim to the Japanese market. However, the denim GLOBALISATION hiL23674_ch01_001-054.indd 4 08/06/19 07:40 PM was dyed on both sides while the American-made product was dyed only on the outer surface. The company quickly adapted. In 1979 it developed the first Japanese consecutive indigo-dyeing machine or ropedyeing machine. The machine increased production rates by a hundred-fold. The company named the machine ‘endurance’, symbolising the company’s enduring commitment to innovation. The machine was built using the company’s expertise accumulated in kasuri manufacturing. It reinforced the company’s commitment to high-quality products, including denim, and strengthened its core competency by developing its own technology, building on its historical roots as a kasuri manufacturer. In addition, geographical considerations necessitated the development of the company’s own technology. Kaihara is located deep in the mountains far away from the city centre. If a machine breaks down, it takes a long time for a repair person to attend to the fault. Yoshiharu Kaihara, the fourth president of the company, stated that it took a few days to rectify a fault if they asked others to fix it. Therefore, the company’s staff needed to fix things themselves to save time and minimise production downtime. Thus it was imperative for Kaihara to accumulate knowledge within the company. Copyright © 2019. McGraw-Hill Education (Australia) Pty Limited. All rights reserved. LEARNING FROM LEVI STRAUSS Because of the high quality of its denim and large production capacity, Kaihara was able to expand its business in Japan. To keep up with demand, it had to increase its production capacity by introducing new machines. In 1974 it installed 68 Toyota Gu8 weaving machines, followed by 120 Sulzer weaving machines in 1978. The company also installed finishing machines in the 1980s, making it possible to integrate many stages of denim production. This investment in machinery enabled the company to produce large volumes of high-quality denim with consistent quality. Integrated production processes enabled higher quality control. High-quality threads are required to produce high-quality denim. High-quality threads also facilitate improved production efficiency, by limiting downtime for weaving machines due to broken threads. Denim uses thicker cotton-based threads. Efficient production of threads can contribute to increased denim productivity, so in 1991 Kaihara built a spinning factory. With this factory it achieved a fully integrated denim production process from spinning to dyeing, weaving and finishing. Kaihara procures cotton from Australia, Syria and the United States among other countries. Due to varying growing conditions the quality of the cotton is inconsistent. The company thus mixes cottons from various countries to minimise variations in quality and to ensure consistently higher quality denim. The skill behind the blending process is another core competency of the company. The opportunity to expand its business into major international markets came from Levi Strauss, the US jeans company. In 1972, the company explored Hong Kong as a potential site for sewing jeans. In addition, it was exploring new suppliers. Levi’s purchased denim from a relatively unknown Japanese company and recognised the quality of Kaihara’s product. Specifications from Levi’s were stricter than expected, providing a steep learning curve to meet world standards for quality and new methods of quality control. Levi’s procured its denim from many suppliers and standardised the quality by using multidimensional standards such as colour, thickness and elasticity. To meet Levi’s specifications, Kaihara collected data during every step of the production process, leading to a data-driven scientific method of quality control. MADE IN JAPAN Kaihara has maintained its factories in Fukuyama with employees recruited from the local area. ‘Made in Japan’ is comparatively expensive compared with competitors with factories in emerging countries. Yoshiharu Kaihara explored the possibility of building a factory in China, but realised that it would result in higher costs due to the cost of logistics, rejected products and limited flexibility in production. As the company focused on the premium end of the market, it required a higher level of quality, and with frequent changes to production as fashion trends emerged, producing locally in Japan had greater advantages. The company educates and trains its employees as multiskilled workers. There are no exceptions—even office staff can operate the machines. The workforce is nimble and quick to respond to urgent orders from customers. Workers are expected to continuously improve the production process so that rejected products known as B or C class cloth are minimised. In addition, workers have a high work ethic. In turn, the company recognises workers’ contributions and rewards them by giving bonuses at the end of the financial year when targeted production volumes and revenue have been achieved. CHAPTER 1 hiL23674_ch01_001-054.indd 5 GLOBALISATION 5 08/06/19 07:40 PM ‘PROPOSALS’-BASED SALES Based on accumulated knowledge, Kaihara proactively develops and introduces new types of denim to jeans and apparel manufacturers. New products must meet the three Fs: fabric-materials, fit-silhouette or style, and finish-after-washing product quality. The company thinks that a good ‘proposal’ has a story behind it, including the three Fs. Kaihara produces 700–800 samples a year for the ‘proposals’ and on average around one-quarter are accepted. Some samples are developed in-house, others are made due to requests from customers. According to the company president, the company has many failures, since three-quarters of the ‘proposals’ are unsellable, but it is a necessary investment to ensure continued success. Corporation was established. There were two major reasons to expand production overseas: to supply global customers; and to internationalise to maintain production capacity in the future, as the company is located in rural Japan where there are significant issues of depopulation and an ageing population. The company chose Thailand not only because it was a suitable place for production, but also as it was seen as a good place for targeting emerging Asian markets that would demand higher quality jeans in the future. Kaihara did not compromise on quality in setting up its Thai factory, installing the most advanced machines and training local workers to meet Japanese standards. Professor Makoto Kanda Meiji Gakuin University © The Asahi Shimbun/Contributor/Getty Images According to the company president, the company invests in people and facilities, taking a long-term perspective, not short-term financial performance. The company is family owned and does not need to respond to shareholders with short-term interests. GLOBAL SUPPLY AND PRODUCTION In 1998 the company started business with UNIQLO, a Japanese SPA, or specialty store retailer of private label apparel, a subsidiary of Fast Retailing Corporation. As UNIQLO expanded globally, Kaihara was required to establish a global supply chain. Initially, it supplied from its Japanese factories, but found it necessary to build another factory abroad and in 2014 Kaihara (Thailand) SOURCES: Kaihara, Company History: Onko Soushin (Creating the New With Knowing the Old) (in Japanese), 2000, www.kaihara-denim.com/english/company/ history.html; T. Takai, ‘Innovation of shinise, the long-lived company: Kaihara 1-3’ (in Japanese), Seisansei Shinbun (Productivity Newspaper), No. 2550-2552, 2018; www.kaihara-denim.com/english/company/history.html accessed on 25 January 2018. INTRODUCTION Over the past three decades, a fundamental shift has been occurring in the world economy. We have moved away from a world in which national economies were relatively self-contained entities, isolated from each other by barriers to cross-border trade and investment; by distance, time zones and language; and by national differences in government regulation, culture and business systems. In addition, countries have moved towards a world where barriers to cross-border trade and investment have declined; perceived distance has shrunk due to advances in transportation and telecommunications technology; material culture is starting to look similar; and national economies have merged into an interdependent, integrated global economic system. The process by which 6 PART 1 GLOBALISATION hiL23674_ch01_001-054.indd 6 08/06/19 07:40 PM this occurred is commonly referred to as globalisation, and international business is the main facilitator of this process. However, recently we have seen a rise in anti-globalisation and a more protectionist/nationalistic approach to trade, a return to mercantilism? The Opening and Closing Cases (‘Kaihara: Globalisation of a shinise, a long-lived company’ and ‘Global innovation through the mobility of ideas and talent’) and the global dispersal of production for Boeing’s 787 Dreamliner, outlined in the Management Focus, are examples of the trend towards globalisation. In 1970, independent suppliers produced only 5 per cent of the value of a Boeing commercial jet. With the advent of the 787 Dreamliner, this figure reached 65 per cent, and many of those suppliers were scattered around the globe. Part of Boeing’s rationale was that 80 per cent of its sales went to foreign airlines, and winning orders in this global marketplace required that it outsource some production to other nations. Boeing also believed that it made sense to outsource production of component parts to independent suppliers if they were the best in the world at performing that particular activity, no matter where they were located. In Boeing’s view, the result of such a strategy would be greater efficiency and lower costs, which would help Boeing compete on price against its global rival in the commercial aircraft business, Airbus. As the case makes clear, however, there are risks involved in embracing globalisation to the extent that Boeing did. Coordinating a globally dispersed supply chain turned out to be a logistical nightmare, and was partly responsible for delaying the launch of the 787 by more than four years, which cost Boeing dearly. The Boeing example illustrates, therefore, that managers need to carefully think through their strategy for competing in the global marketplace of the 21st century, balancing the benefits of embracing globalisation against the associated risks. This is a theme that we shall return to repeatedly throughout this text. More generally, globalisation now has an impact upon almost everything we do. In this interdependent global economy, an Australian is driving home from work in a Ford ute—the brand of a US multinational, designed in Japan and manufactured in Thailand by a joint venture of Ford and Mazda, using a Mazda design. Components come from the United States and Japan using Korean steel and Malaysian rubber, and from sheet metal produced by an Australian company’s subsidiary in Thailand. On the way to work, the Australian driver fills the car with fuel at a BP service station owned by a British multinational company. The fuel could have been made from oil pumped out of a well off the coast of Africa by a French oil company that transported it to refineries in Singapore in a ship owned by a Greek shipping line. While driving home, the Australian rings her stockbroker on a hands-free mobile phone that was assembled in China using chip sets produced in Taiwan. She tells her stockbroker to purchase shares in CSL, an Australian biopharmaceutical company transformed from a government-owned enterprise to a privately owned global company, now with 14 000 employees operating in 30 countries.1 Playing on the car radio (made in Malaysia by a Japanese company) is a popular hip-hop song composed by a Swede and sung in English by a group of Danes who signed a recording contract with a French music company to promote their record worldwide. The driver pulls into a fast-food restaurant to buy a meal of Portuguese-style, flame-grilled periperi chicken from a South African Nando’s franchise owned and run by a Vietnamese immigrant. On the way home, a news announcer on the car radio informs the driver that anti-globalisation protests at a meeting of the World Economic Forum in Davos, Switzerland, have turned violent. One protester has been killed. The announcer then turns to the next item, a story about how interest rates in the United States have been increased by the US Federal Reserve, which overnight sparked a decline in the value of the Australian dollar on the foreign exchange markets. The driver muses that now might be the time to replace her old ute with a new imported one if the dollar looks likely to continue to depreciate in value. CHAPTER 1 hiL23674_ch01_001-054.indd 7 GLOBALISATION 7 08/06/19 07:40 PM This is the world in which we live. It is a world where the volume of goods, services and investments crossing national borders has expanded faster than world output consistently for more than half a century. It is a world where US$16 trillion of goods and US$4.8 trillion of services are sold annually across national borders.2 (As no global currency exists, when aggregating and comparing international monetary values, there is a need to adopt a single national currency as the unit of measurement. The most widely used unit of MANAGEMENT FOCUS THE GLOBALISATION OF PRODUCTION AT BOEING © WESTEND61 GmbH/Alamy Stock Photo Messier–Dowty makes the aircraft’s landing gear; German manufacturer Diehl Luftfahrt Elektronik supplies the main cabin lighting; Sweden’s Saab Aerostructures makes the access doors; Japanese company Jamco makes parts for the lavatories, flight decks interiors and galleys; Mitsubishi Heavy Industries of Japan makes the wings; KAA of Korea makes the wing tips; Boeing Aerostructures Australia (BAA) makes the movable trailing edges and inboard flaps; and so on. Executives at Boeing Corporation, America’s largest exporter, like to say that building a large commercial jet aircraft such as the 747 or 787 involves bringing together more than a million parts in flying formation. Fifty years ago, when the early models of Boeing’s venerable 737 and 747 jets were rolling off the company’s Seattle area production lines, foreign suppliers accounted for only 5 per cent of the aircraft parts, on average. Boeing was vertically integrated and manufactured many of the major components that went into its planes. The largest parts produced by outside suppliers were the jet engines; two of the three suppliers were US companies and the lone foreign manufacturer was the British company Rolls Royce. Fast-forward to the modern era and things look very different. For its latest aircraft, the super-efficient 787 Dreamliner, 50 outside suppliers spread around the world account for 65 per cent of the value of the aircraft: Italian company Alenia Aeronautica makes the centre fuselage and horizontal stabiliser; Kawasaki of Japan makes part of the forward fuselage and the fixed trailing edge of the wing; French company 8 PART 1 Why the change? One reason is that 80 per cent of Boeing’s customers are foreign airlines, and to sell into those nations it often helps to be giving business to those nations. The trend started in 1974 when Mitsubishi of Japan was given contracts to produce inboard wing flaps for the 747. The Japanese reciprocated by placing big orders for Boeing jets. A second rationale was to disperse component part production to those suppliers that are the best in the world at their particular activity. Over the years, for example, Mitsubishi has acquired considerable expertise in the manufacture of wings, so it was logical for Boeing to use Mitsubishi to make the wings for the 787. Similarly, the 787 is the first commercial jet aircraft to be made almost entirely out of carbon fibre, so Boeing tapped Japan’s Toray industries, a world-class expert in sturdy but light carbon-fibre composites, to supply materials for the fuselage. A third reason for the extensive outsourcing on the 787 was that Boeing wanted to unburden itself of some of the risks and costs associated with developing production facilities for the 787. By outsourcing, it pushed some of those risks and costs onto suppliers, which had to undertake major investments in capacity to ramp up to produce parts for the 787. So what did Boeing retain for itself? Engineering design, marketing and sales, and final assembly at GLOBALISATION hiL23674_ch01_001-054.indd 8 08/06/19 07:40 PM its Everett plant north of Seattle—all activities where Boeing maintains it is the best in the world. Of the major component parts, Boeing makes only the tail fin and wing to body fairing (which attaches the wings to the fuselage of the plane). Everything else is outsourced. As the 787 moved through development in the 2000s, however, it became clear that Boeing had pushed the outsourcing paradigm too far. Coordinating a globally dispersed production system this extensive turned out to be very challenging. Parts turned up late, some parts didn’t ‘snap together’ the way Boeing had envisioned and several suppliers ran into engineering problems that slowed down the entire production process. As a consequence, the delivery date for the first jet was pushed back more than four years and Boeing had to pay millions of dollars in penalties for late deliveries. In fact the problems at one supplier, Vought Aircraft in North Carolina, were so severe that Boeing ultimately agreed to acquire the company and bring its production in-house. Vought was co-owned by Alenia of Italy and made part of the main fuselage. Boeing has overcome these issues and the 787 Dreamliner is now being used by airlines such as Qantas for their long-haul routes due to its fuel efficiency and passenger comfort. measurement is the US dollar. The US dollar is used extensively as a medium of exchange, a foreign currency reserve and a unit of account in international transactions.) It is a world requiring more effective collaboration and action at a global level among national governments on issues such as climate change, terrorism, flu pandemics and financial crises. Today’s world is a world of integration and interdependence. The symbols of material and popular culture are increasingly global: from Coca-Cola and Toyota to Sony PlayStations, Samsung mobile phones, reality TV shows, Google, IKEA stores and Apple iPhones and iPads. In this world, products are made from inputs that come from all over the world. It is a world where an economic crisis in the tiny Greek economy causes uncertainty about the economic stability of the world’s largest economy, the United States; where a mortgage crisis in the housing sector in the US economy can lead to the bankruptcy of the economy of Iceland and a change of Iceland’s government; where a major flood in Thailand closes Thai factories which in turn disrupts global supply chains in the automotive industry and causes factories in other parts of the world to close. As the internet penetrates more regions of the world and information flows become mostly instantaneous and almost costless, global integration is becoming more individualised, rather than being just institution to institution or B2B.3 It is a world where we can share music files internationally with our peers, buy an item from overseas on an online auction site, coordinate the activities of suppressed political dissidents in a foreign country, and Fears of a slowdown in the Chinese economy and the fall in have our identity stolen by a foreign criminal gang. It is the value of Chinese shares saw the ASX lose a staggering $60 billion in a day. also a world in which vigorous and vocal groups protest CHAPTER 1 hiL23674_ch01_001-054.indd 9 GLOBALISATION 9 08/06/19 07:40 PM © IDEALINK PHOTOGRAPHY/Alamy Stock Photo SOURCES: K. Epstein and J. Crown, ‘Globalization bites Boeing’, Bloomberg Businessweek, 12 March 2008; H. Mallick, ‘Out of control outsourcing ruined Boeing’s beautiful Dreamliner’, The Star, 25 February 2013; P. Kavilanz, ‘Dreamliner: where in the world its parts come from’, CNN Money, 18 January 2013; S. Dubois, ‘Boeing’s Dreamliner mess: simply inevitable?’, CNN Money, 22 January 2013; A. Scott and T. Kelly, ‘Boeing’s loss of a $9.5 billion deal could bring jobs back to the US’, Business Insider, 14 October 2013; ‘Boeing talks up 787’s Australian link’, accessed via www.news.com.au/finance/ business/boeing-talks-up-787s-australian-link/story-e6frfkur-1226217631114 on 12 September 2015; ‘Boeing 787 Dreamliner’ accessed via www.boeing.com/commercial/787/ on 1 April 2019. OUTSOURCING The tasks that were previously performed in-house are now purchased from another firm OFFSHORING A form of outsourcing; it means that a task previously performed in one country is now being undertaken abroad LO 1.1 GLOBALISATION The shift towards a more integrated and interdependent world economy PART 1 against globalisation, which they blame for a list of ills, from job losses and unemployment in developed nations, and poverty in developing economies, to environmental degradation, climate change and the Americanisation of popular culture. There is no clearer evidence that we live in one economic world than the advent and fallout of the 2007–09 Global Financial Crisis (GFC) or the stock market volatility caused by events in Greece and China. As globalisation unfolds, it transforms industries and creates anxiety among those who believed their jobs were once protected from foreign competition. Historically, while many workers in manufacturing industries worried about the impact that foreign competition might have on their jobs, workers in service industries felt more secure. Now, this too, is changing. Advances in information and communications technology, lower transportation costs and the rise of skilled workers in emerging and developing countries mean that many services no longer need to be performed where they are delivered. Offshoring is an increasing trend. Offshoring is a particular form of outsourcing. Outsourcing means that tasks that were previously performed in-house are now purchased from another company. Offshoring means that a task previously performed in one country is now being undertaken abroad. The offshoring trend can be seen in many service industries such as data entry, customer service calls, software development and the preparation of legal briefs and tax returns. For example, Indian accountants, trained in the tax rules and processes of other countries, perform work for foreign accounting companies.4 They access individual tax returns stored on computers in the foreign country, perform routine calculations and save their work so that it can be inspected by a local accountant, who then bills clients. As the best-selling author Thomas Friedman argued, the world is becoming flat.5 People living in developed nations no longer have the playing field tilted in their favour. Increasingly, enterprising individuals based in India, China, Brazil or Eastern Europe have the same opportunities to better themselves as those living in Western Europe, Japan, North America, Australia or New Zealand. In this book, we take a close look at the issues introduced here, and at many more. We explore how changes in regulations governing international trade and investment, when coupled with changes in political and economic systems and technology, have dramatically altered the competitive playing field confronting many businesses. We discuss the resulting opportunities and threats, and review the different strategies that managers can pursue to exploit the opportunities and counter the threats. The Opening Case identified the choices that Kaihara management has made over time as it engaged with internationalisation and the impact of globalisation; for example, choices over what product it should produce to sustain international competitiveness. We consider whether globalisation benefits or harms national economies, and we look at what economic theory has to say about the outsourcing or offshoring of manufacturing and service jobs to places such as India and China, and at the benefits and costs of outsourcing—not just to entire economies but also to businesses and their employees. First, though, we need to get a better overview of the nature and process of globalisation, and that is the function of the current chapter. WHAT IS GLOBALISATION? As used in this book, the term globalisation refers to the shift towards a more integrated and interdependent world economy. Globalisation in general has several facets ranging over political, cultural, economic and ecological issues; but in the business world the focus is on the globalisation of markets and of production. GLOBALISATION hiL23674_ch01_001-054.indd 10 08/06/19 07:40 PM COUNTRY FOCUS CHINA: BELT AND ROAD INITIATIVE © tcly/Shutterstock Africa, and on to Europe. Six other economic corridors have been identified to link other countries to the Belt and the Road.’ The project’s name evokes the famous Silk Road of the Middle Ages, a network of informal but significant trading routes between Europe and Asia whereby silk, spices and other goods were moved from east to west, and famously chronicled by the European explorer and trader Marco Polo. When one thinks of globalisation it is often in terms of the developed world, especially the United States and Western Europe. There is a good reason for this since most current international institutions (such as the United Nations, the International Monetary Fund and the World Bank) were founded at the behest of the United States after World War II and the United States remains the largest economy in the world, with a major portion of the world’s wealth and income concentrated in Western countries. However, this economic predominance has been slowly shifting. China is now the second-largest world economy, with current projections indicating a continuing increase in the developing world’s share of world GDP over the next 50 years. A similar shift can be seen in international institutions, such as China’s Belt and Road Initiative (BRI). As the World Bank states: ‘The initiative aims to strengthen infrastructure, trade, and investment links between China and some 65 other countries that account collectively for over 30 per cent of global GDP, 62 per cent of population, and 75 per cent of known energy reserves. The BRI consists primarily of the Silk Road Economic Belt, linking China to Central and South Asia and onward to Europe, and the new Maritime Silk Road, linking China to the nations of South-East Asia, the Gulf Countries, North The Chinese government has been approaching countries throughout Asia and Africa offering foreign aid, loans and investments to develop ports, roads and other infrastructure to facilitate the movement of goods along the trading routes, and encouraging cooperation and broader exchange between participating nations. However, the initiative has engendered some controversy for a number of reasons. China has been accused of exploiting economically and politically weak nations through the use of loans and other means that might appear to offer beneficial investment but that may saddle recipient nations with heavy debt burdens later on (and, by extension, political dependence on the Beijing government). Many loans are being extended by China’s policy banks, with much of the money going not to local contractors but to Chinese enterprises that will actually do the work locally. Additionally, there is some question as to whether the BRI will end up mainly funnelling trade and investment flows to the benefit of China rather than the other participating countries. BRI funding will also be provided through another Chinese initiative, the Asian Infrastructure Investment Bank (AIIB), which was started by China but is funded by countries globally. The AIIB is China’s supplement to the World Bank. Many Western nations, especially the United States (which refused to participate in the AIIB, although invited to by China), view the BRI and AIIB with suspicion, seeing them as ways for Beijing to assert its geopolitical will through economic means. These critiques have merit and the debate continues. However, it must be remembered that the BRI is just CHAPTER 1 hiL23674_ch01_001-054.indd 11 GLOBALISATION 11 08/06/19 07:40 PM another example of a rising nation (China in this case) seeking to influence international economic and political order. Powerful nations will always seek to advance their own particular interests but hopefully they will also try to offer gains to other countries, ending in a ‘win–win’ outcome for all. Cameron Gordon Australian National University SOURCES: ‘Belt and Road Initiative’, The World Bank, 29 March 2018 accessed via www.worldbank.org/en/topic/regional-integration/brief/belt-androad-initiative on 30 April 2019; G. Wade, ‘China’s “One Belt, One Road” initiative’ accessed via www.aph.gov.au/About_Parliament/Parliamentary_ Departments/Parliamentary_Library/pubs/BriefingBook45p/ChinasRoad on 30 April 2019; ‘China’s belt and road initiative’ accessed via www.lowyinstitute. org/sites/default/files/documents/Understanding%20 China%E2%80%99s%20Belt%20and%20Road%20Initiative_WEB_1.pdf on 30 April 2019. The globalisation of markets GLOBALISATION OF MARKETS The merging of historically distinct and separate national markets into one huge global marketplace TEST PREP Preparing for a test? Use LearnSmart to help you remember what you’ve learned. 12 PART 1 The globalisation of markets refers to the merging of historically distinct and separate national markets into one huge global marketplace. Falling barriers to cross-border trade have made it easier to sell internationally. It has been argued for some time that the tastes and preferences of consumers in different nations are beginning to converge on some global norm, thereby helping to create a global market.6 The global acceptance of consumer products such as Prada fashions (home country: Italy), Coca-Cola soft drinks (United States), Sony PlayStation games (Japan), McDonald’s hamburgers (United States), Nescafé coffee (Switzerland) and IKEA furniture (Sweden) are frequently held up as prototypical examples of this trend. It is estimated that the best 10 ‘global’ brands by value are, in descending order, Apple, Google, Amazon, Microsoft, Coca-Cola, Samsung, Toyota, Mercedes-Benz, Facebook and McDonald’s.7 As consumers, we readily recognise these brands, but there are also many ‘global’ brands and companies in the industrial and business-to-business markets that are not as well known. Examples include the Taiwan Semiconductor Manufacturing Company (one of the world’s largest dedicated independent semiconductor manufacturers), ZPMC (formerly Shanghai Port Machinery Company, China, one of the world’s largest container-port equipment manufacturers—it is so large that it has 26 specially converted bulk cargo ships to transport its heavy cranes and equipment around the globe),8 and the diversified resources company BHP (Australia). In fact, the most global of markets currently are not the markets for consumer products, where national differences in tastes and preferences and other factors are still often important enough to act as a brake on globalisation, but markets for industrial goods and materials that serve a universal need. These include the markets for commodities such as iron ore, oil and wheat; for industrial products such as microprocessors, computer memory chips and software; for commercial jet aircraft; and for financial assets such as foreign currency, US Treasury bills, Eurobonds and futures. The companies in these industries, both consumer and industrial, are more than just beneficiaries of the globalisation of markets: they are also facilitators of it. By offering the same basic product worldwide, they enjoy cost advantages but they also help to create a global market. In many global markets, the same companies frequently confront each other as competitors in nation after nation. Coca-Cola’s rivalry with PepsiCo is a global one, as are the rivalries between Ford and Toyota, Boeing and Airbus, Nike and Adidas in sporting goods, Caterpillar and Komatsu in earth-moving equipment, and Samsung and Apple. If a company moves into a nation not currently served by its rivals, many of those rivals are sure to follow to prevent their competitor from gaining an advantage.9 As companies follow each other around the world, they bring with them what they have learned in other national markets. They bring many of the assets that served them well in these markets, GLOBALISATION hiL23674_ch01_001-054.indd 12 08/06/19 07:40 PM including their products, operating strategies, marketing strategies and brand names. This creates some homogeneity across markets. Thus, greater uniformity replaces diversity. In an increasing number of industries, it is no longer meaningful to talk about ‘the German market’, ‘the Australian market’, ‘the Brazilian market’ or ‘the Japanese market’ because for many companies there is only the global market. A company does not have to be the size of the multinational giants whose brands are mentioned above to facilitate and benefit from the globalisation of markets. For some time, small Australian companies have been enjoying success in the global economy. Forty-four per cent of all goods exporters are small companies; that is, less than 20 employees.10 Typical of the growth of a small to medium-sized exporter is the story of the Victorianbased company Gekko Systems, an innovator in mining technology and mineral processing, particularly in gold mining. Its headquarters is located in Ballarat, Victoria. One companydeveloped innovation is a process for treating ore underground, which means that only the most valuable portion is brought to the surface. As a result of this technology, mining operating costs can be cut by 25 per cent. Within months of establishment, 30 per cent of Gekko’s products were exported. After 10 years, its workforce grew to 75, doubling in two years. In the area of the processing of gold alone, it now employs globally a staff of 30 technicians and professionals. It exports to 30 countries and has opened regional offices in South Africa, Canada and Chile where mining and mineral processing are major industries.11 The situation with respect to small companies is similar in several other nations. In the United States, 34 per cent of total US exports are initiated by small to medium-sized companies (less than 500 employees). Ninety-eight per cent of all US exporters are small to medium-sized companies.12 In Germany, a staggering 98 per cent of all of its small to medium-sized companies have exposure to international markets, via either exports or international production.13 Despite the global prevalence of Toyota motor vehicles, McDonald’s hamburgers, Samsung phones, Apple iPads and the like, it is important not to push too far the view that national markets are giving way entirely to the global market, particularly in relation to consumer goods and services. As we shall see in later chapters, significant differences still exist among national markets along many relevant dimensions including consumer tastes and preferences, distribution channels, culturally embedded value systems, political systems, economic development and legal regulations. These differences frequently require companies to customise marketing strategies, product features and operating practices to best match conditions in a particular country. For example, motor vehicle companies will design and promote different car models in different nations, depending on a range of factors, such as local fuel costs, design standards, income levels, road conditions, environmental concerns and cultural values. It should not have come as a complete surprise that the Tata Group, the Indian-based global conglomerate, brought to the market the Nano, touted as the world’s cheapest car. Average incomes in India are low, but as the economy is rapidly growing and standards of living rise, the local demand for an affordable car is expected to rise substantially. The globalisation of production Globalisation of production refers to the sourcing of goods and services from locations around the globe to take advantage of national differences in the cost and quality of factors of production (such as labour, technology, land and capital). By doing this, companies hope to lower their overall cost structure or improve the quality or functionality of their product offering, thereby allowing them to compete more effectively. Part of Boeing’s rationale for outsourcing so much production to foreign suppliers is that these suppliers are the best in the world at their particular activity. A global web of GLOBALISATION OF PRODUCTION Sourcing goods and services from locations around the globe to take advantage of national differences in the cost and quality of various factors of production FACTORS OF PRODUCTION Components of production such as labour, technology, land and capital CHAPTER 1 hiL23674_ch01_001-054.indd 13 GLOBALISATION 13 08/06/19 07:40 PM suppliers yields a better final product, which enhances the chances of Boeing winning a greater share of total orders for aircraft than its global rival Airbus Industries. Boeing also outsources some production to foreign countries to increase the chance that it will win significant orders from airlines based in that country. The Japanese airline ANA was the first customer for the 787 when the plane entered service in late 2011. ANA has ordered 66 planes to date.14 China is a huge potential market for aviation manufacturers. Boeing outsourced to Chinese companies the building of the rudder, wing-to-body fairing panels and leading edge of the vertical fin for the new 787 Dreamliner. Komatsu, the world’s second largest manufacturer of construction and mining equipment, does not outsource production to the extent that Boeing does. Instead, Komatsu employs a mother plant/ daughter plant strategy to exploit the endowments of different locations around the globe. MANAGEMENT FOCUS WHO MAKES THE APPLE IPHONE? In its early days, US-based Apple usually didn’t look beyond its own backyard to manufacture its devices. By 2004, however, Apple had largely turned to foreign manufacturing. The shift to offshore manufacturing reached its peak with the iconic iPhone, which Apple first introduced in 2007. All iPhones contain hundreds of parts, an estimated 90 per cent of which are manufactured abroad. Advanced semiconductors come from Germany and Taiwan, memory from Korea and Japan, display panels and circuitry from Korea and Taiwan, chip sets from Europe, and rare metals from Africa and Asia. Apple’s major subcontractor, the Taiwanese multinational Foxconn, performs final assembly in China. However, in the future Foxconn is likely to manufacture the LCD panels in Wisconsin. Apple still employs some 47 000 people in the United States, and it has kept important activities at home, including product design, software engineering and marketing. Furthermore, Apple claims that its business supports another 304 000 jobs in the United States in engineering, manufacturing and transport. For example, the glass for the iPhone is manufactured at Corning’s US plants in Kentucky and New York. But an additional 700 000 people are involved in the engineering, building and final assembly of its products outside the United States, and most of them work at subcontractors like Foxconn. When explaining its decision to assemble the iPhone in China, Apple cites a number of factors. While it is true that labour costs are much lower in China, Apple executives point out that labour costs only account for 14 PART 1 a very small proportion of the total value of its products and are not the main driver of location decisions. Far more important, according to Apple, is the ability of its Chinese subcontractors to respond very quickly to requests from Apple to scale production up and down. In a famous illustration of this capability, in 2007 Steve Jobs demanded that a glass screen replace the plastic screen on his prototype iPhone. Jobs didn’t like the look and feel of plastic screens, which at the time were standard in the industry, nor did he like the way they scratched easily. This last-minute change in the design of the iPhone put Apple’s market introduction date at risk. Apple had selected Corning to manufacture large panes of strengthened glass, but finding a manufacturer that could cut those panes into millions of iPhone screens wasn’t easy. Then a bid arrived from a Chinese factory. When the Apple team visited the factory, they found that the plant’s owners were already constructing a new wing to cut the glass and installing equipment. ‘This is in case you give us the contract’, the manager said. The plant also had a warehouse full of glass samples for Apple, and a team of engineers available to work with Apple. They had built onsite dormitories so that the factory could run three shifts seven days a week in order to meet Apple’s demanding production schedule. The Chinese company got the bid. Another critical advantage of China for Apple was that it was much easier to hire engineers there. Apple calculated that about 8700 industrial engineers were needed to oversee and guide the 200 000 assembly-line GLOBALISATION hiL23674_ch01_001-054.indd 14 08/06/19 07:40 PM nine months to find that many engineers in the United States. In China it took 15 days. © Denis Rozhnovsky/Alamy Stock Photo Also important is the clustering together of factories in China. Many of the factories providing components for the iPhone are located close to Foxconn’s assembly plant. As one executive noted, ‘The entire supply chain is in China. You need a thousand rubber gaskets? That’s the factory next door. You need a million screws? That factory is a block away. You need a screw made a little bit different? That will take three hours.’ workers involved in manufacturing the iPhone. The company had estimated that it would take as long as All this being said, there are drawbacks to outsourcing to China. Several of Apple’s subcontractors have been targeted for their poor working conditions. Criticisms include low pay of line workers, long hours, mandatory overtime for little or no additional pay, and poor safety records. SOURCES: C. Duhigg and D. Barboza, ‘In China, human costs that are built into an iPad’, The New York Times, 26 January 2012; C. Duhigg and K. Bradsher, ‘How US lost out on iPhone work’, The New York Times, 22 January 2012; ‘Apple takes credit for over half a million US jobs’, Apple Intelligence, 2 March 2012, http://9to5mac.com/2012/03/02/apple-takes-credit-for-514000-u-s-jobs/#more-142766; Forbes, www.forbes.com/sites/ connieguglielmo/2012/03/02/apple-touts-itself-as-big-job-creator-in-the-u-s/#7628e89a1a60 accessed on 2 April 2019; ‘Foxconn announces North American headquarters in Wisconsin’, 16 June 2018, www.reuters.com/article/us-usa-foxconn/foxconn-announces-north-american-headquarters-inwisconsin-idUSKBN1JC0FW accessed on 20 April 2019. Its nine mother plants undertake research and development and produce a specific range of the more technology-intensive and high value-added products. They are located in the more technologically endowed countries such as Japan, Germany, Sweden, Italy and the United States. The Japanese-based mother plants produce the most strategic and innovative component parts that give Komatsu market leadership in segments of the global market for construction and mining equipment. The 34 daughter plants are located around the world in locations closer to the customer. They undertake assembly tasks and the manufacture of low-technology, low value-added products using components and operational techniques developed in the mother plants. Early outsourcing and offshore production efforts were primarily confined to manufacturing enterprises, such as those undertaken by Boeing and Komatsu. Increasingly, however, companies are taking advantage of modern communications technology, particularly the internet, to outsource service activities to low-cost producers in other nations and to provide more timely services to customers—from data entry, call centres and architectural designs to software development, legal services and medical services. Radiologists in either Sydney or London diagnose and report on images sent to them from radiology departments in UK and Australian hospitals and clinics. With about a 10 to ­ 12-hour time difference, images can be read ‘overnight’ and reports made available the next day to the attending doctor. Telephone reports and typed reports can be made available within the hour, if requested. Being able to switch diagnosis and reporting between the United Kingdom and Australia means that a pool of radiologists is always available in their ‘awake’ hours, 24/7. Hospitals and clinics, such as those in regional areas, are spared the expense of employing or developing a roster of their own radiologists. One Australian company, Imaging Partners Online (IPO), provides such tele-radiology CHAPTER 1 hiL23674_ch01_001-054.indd 15 GLOBALISATION 15 08/06/19 07:40 PM services using UK and Australian–qualified radiologists.15 While there is a growing demand for tele-radiology services internationally, the ability to outsource medical services is heavily restricted by national and state licensing and accreditation rules. Currently in Australia and the United Kingdom, the only people authorised to read and diagnose scans in Australia for UK patients are radiologists who qualified in Britain, are registered in Britain and living in Australia. The only ones who can read and diagnose scans of Australian patients in the United Kingdom must live there but be accredited and licensed in Australia. Dispersing value-creation activities offshore can compress the time and lower the costs required to deliver many services. Many such activities are outsourced to emerging and developing nations, where skilled and unskilled labour is cheaper. However, cost considerations may not be a sufficient motive. In the case of tele-radiology, the timely delivery of quality service is the key to successful business in this area. A consequence of the trend exemplified by companies such as Boeing and IPO is that it is becoming irrelevant to talk about ‘Chinese products’, ‘Australian products’, ‘US products’ or ‘Korean products’. Increasingly, the outsourcing of productive activities to different international suppliers and locations results in the creation of products that are global in nature; that is, ‘global products’.16 But as with the globalisation of markets, companies must be careful not to push the globalisation of production too far. As we will see in later chapters, substantial impediments still make it difficult for companies to achieve the optimal dispersion of their productive activities to locations around the globe. These impediments include formal and informal barriers to trade between countries, barriers to foreign direct investment (FDI), transportation and supply chain management costs, and issues associated with economic and political risk. For example, government regulations and professional ethics can limit the ability of hospitals to outsource the process of interpreting medical images and of lawyers to outsource the preparation of legal briefs to emerging and developing nations where the skilled professionals are cheaper. Nevertheless, the globalisation of markets and production will continue. International companies are important actors in this trend, their very actions fostering increased globalisation. These companies, however, are merely responding in an efficient manner to changing conditions in their operating environment—as well they should. THE EMERGENCE OF GLOBAL INSTITUTIONS GENERAL AGREEMENT ON TARIFFS AND TRADE (GATT) An international treaty that committed signatories to lowering barriers to the free flow of goods across national borders; a predecessor to the WTO WORLD TRADE ORGANIZATION (WTO) The organisation that succeeded the General Agreement on Tariffs and Trade and now acts to police the world trading system 16 PART 1 As markets globalise and an increasing proportion of business activity transcends national borders, institutions are needed to help manage, regulate and police the global marketplace, and to promote the establishment of multinational treaties to govern the global business system. Over the past 60-plus years, a number of important global institutions have been created to help perform these functions, including the General Agreement on Tariffs and Trade (GATT) and its successor the World Trade Organization (WTO); the International Monetary Fund (IMF) and its sister institution the World Bank; the United Nations (UN); the Group of Twenty (G20); and, more recently, the China-backed Asian Infrastructure Investment Bank (AIIB). These institutions were created by a voluntary agreement between individual nation-states and, apart from the G20, their functions are enshrined in international treaties and agreements. The World Trade Organization (WTO) (like its predecessor GATT) is primarily responsible for policing the world trading system and making sure nation-states adhere to the rules laid down in trade treaties signed by WTO member states. As of 2015, 164 members and observers that collectively accounted for 97 per cent of world trade were WTO members, thereby giving the organisation enormous scope and influence. Over its entire history, as did GATT, the WTO has promoted the lowering of barriers to cross-border GLOBALISATION hiL23674_ch01_001-054.indd 16 08/06/19 07:40 PM trade and investment. In doing so, the WTO has been the instrument of its member states, which have sought to create a more open global business system unencumbered by barriers to trade and investment between countries. Without an instrument such as the WTO, the globalisation of markets and production is unlikely to have proceeded as far as it has. However, as we shall see in this chapter and in Chapter 3 when we look more closely at the WTO, critics charge that the organisation is usurping the national sovereignty of individual nation-states and that it is failing to respond to fundamental shifts in the global economy. The International Monetary Fund (IMF) and the World Bank were both created in 1944 by 44 nations that met at Bretton Woods, New Hampshire, in the United States. One of the strong motives for forming these institutions and GATT, was to prevent recurrence of the trade wars that had erupted during the 1920s and 1930s. During this period, international trade and investment were severely restricted by the unilateral, retaliatory imposition of tariffs and exchange rate devaluations as governments sought to protect their own economies from the ravages of the Great Depression. The IMF was established to maintain order in the international monetary system; the World Bank was set up to promote economic development. In the 75 years since their creation, both institutions have emerged as significant players in the global economy. The World Bank (or more formally the International Bank of Reconstruction and Development) is the less controversial of the two sister instruments. It has focused on providing financial and technical assistance to improve living standards and reduce poverty in developing countries. In 2018, it had 189 member countries across a diverse range of activities including providing an ebola recovery and reconstruction project in Liberia, supporting the education of girls in Bangladesh, improving health care delivery in Mexico, helping East Timor to rebuild upon independence and helping to improve the delivery of local infrastructure services in northeastern Sri Lanka.17 The IMF, now with 189 members, is often seen as the lender of last resort to nationstates whose economies are in turmoil and whose currencies are losing value against those of other nations. Repeatedly during the past decade, for example, the IMF has lent money to the governments of troubled states, including Argentina, Indonesia, Mexico, Russia, South Korea, Thailand, Turkey and Iceland. More recently the IMF has taken a very proactive role in helping countries to cope with the fallout of the eurozone. However, IMF loans come with strings attached: in return for loans, the IMF requires borrower nationstates to adopt specific economic policies aimed at returning their troubled economies to stability and growth. These requirements have sparked controversy. Some critics charge that the IMF’s policy recommendations are often inappropriate; others maintain that by telling governments what economic policies they must adopt, the IMF, like the WTO, is usurping the sovereignty of nation-states. Another criticism common to both the WTO and the IMF is that their decision-making structures have failed to reflect the shifting economic power in the global economy towards emerging economies, particularly the BRIC group of countries (Brazil, Russia, India and China). We shall look at the debate over the role of the IMF and the international monetary system in Chapter 4. The United Nations (UN) was established on 24 October 1945 by 51 countries committed to preserving peace through international cooperation and collective security. Today, nearly every nation in the world belongs to the United Nations and membership now totals 193 countries. When states become members of the United Nations, they agree to accept the obligations of the UN Charter, an international treaty that establishes basic principles of international relations. According to the Charter, the UN has four purposes: • to maintain international peace and security • to develop friendly relations among nations INTERNATIONAL MONETARY FUND (IMF) The international institution set up to maintain order in the international monetary system WORLD BANK The international organisation set up to promote economic development, primarily by offering low-interest loans to governments of poorer nations BRIC Brazil, Russia, India and China; a group of emerging economic powers in the global economy UNITED NATIONS (UN) An international organisation made up of 193 countries charged with keeping international peace, developing cooperation between nations and promoting human rights CHAPTER 1 hiL23674_ch01_001-054.indd 17 GLOBALISATION 17 08/06/19 07:40 PM © Eric Crama/Shutterstock UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT (UNCTAD) A UN body that promotes the integration of developing countries into the world economy as a means of attaining sustainable economic development • to cooperate in solving international problems and in promoting respect for human rights • to be a centre for harmonising the actions of nations. Although the UN is perhaps best known for its peacekeeping role, one of the organisation’s central mandates is the promotion of higher standards of living, full employment and the conditions for economic and social progress and development—all issues that are central to the creation of a vibrant global economy. As much as 70 per cent of the work of the UN system is devoted to accomplishing this mandate. This effort GROUP OF TWENTY (G20) is clearly evident in the work performed by the United Nations Conference on Trade An international forum comprising the government representatives and Development (UNCTAD). Established in 1964, UNCTAD promotes the integration of of the G8 and other economies, developing countries into the world economy as a means of attaining sustainable economic including the emerging economies development. The UN works closely with other international institutions such as the World such as Brazil, China and India, as a reflection of their rising global Bank. Guiding the work is the belief that eradicating poverty and improving the wellbeing economic and political power of people everywhere are necessary steps in creating conditions for lasting world peace.18 Established in 1999, the Group of Twenty (G20) comprises the finance ministers and ASIAN INFRASTRUCTURE INVESTMENT BANK (AIIB) central bank governors of the 19 largest economies in the world, plus representatives from the A new multilateral development European Union and the European Central Bank. Collectively, the G20 represents 90 per cent bank focusing on funding of global GDP and 80 per cent of international global trade. Originally established to formulate infrastructure in Asia a coordinated policy response to financial crises in developing nations, in 2008 and 2009 it became the forum through which major nations attempted to launch a coordinated policy response to the GFC that started in the United States and then rapidly spread around the world, ushering in the first serious global economic recession since 1981. The Asian Infrastructure Investment Bank (AIIB) is a multilateral development bank (MDB) backed by China. The bank was created to overcome an infrastructure gap in Asia that is estimated to be over US$8 trillion, and partly in response to the slow phase of reform and the lack of recognition given by the existing organisations such as the World Bank, IMF and ADB (Asian Development Bank) to the new economic realities of the rise of the emerging economies such as China. The United States opposed the setting up of the bank on the grounds of lack of clarity on corporate governance. However, 57 countries signed up to the Prospective Founding Members (PFMs) meeting in The G20 is not without controversy. Several anti-globalisation June 2015, including some of the United States’ closest allies demonstrations have been held in host cities. (Australia, Germany, Israel and the United Kingdom).19 LO 1.1 DRIVERS OF GLOBALISATION As outlined in the previous discussion on the globalisation of markets and production, the actions of consumers and international business facilitate globalisation—for example, the consumer’s willingness to accept and source products globally, the outsourcing of production by business to take advantage of national differences in resource endowments, and the increased pressure on business to compete globally and match the market moves of their rivals, These individual consumer and company actions or micro factors, however, are sustained by two macro factors that underlie the trend towards greater globalisation.20 The first is the decline in barriers to the free flow of goods, services and capital that has occurred since the end of World War II. The second factor is technological change, particularly the dramatic developments in recent years in information and communication technologies (ICT) and transportation technologies. 18 PART 1 GLOBALISATION hiL23674_ch01_001-054.indd 18 08/06/19 07:40 PM As noted earlier, during the 1920s and 1930s many of the world’s nation-states erected INTERNATIONAL TRADE formidable barriers to international trade and foreign direct investment (FDI). International When a company exports goods or trade occurs when a company exports goods or services to buyers in another country. services to buyers in another country Foreign direct investment (FDI) occurs when a company invests resources in business FOREIGN DIRECT activities outside its home country, giving it some control over those activities. Many of INVESTMENT (FDI) the barriers to international trade took the form of high tariffs on imports of manufactured When a firm invests resources in goods. The typical aim of such tariffs was to protect domestic industries from foreign business activities outside its home competition. One consequence, however, was ‘beggar-thy-neighbour’ retaliatory trade country, giving it some control over those activities policies, with countries progressively raising trade barriers against each other. (We look at the issue of ‘beggar-thy-neighbour’ policies further in Chapters 3 and 4.) Ultimately, this policy depressed world demand and contributed to the Great Depression of the 1930s. Having learned from this experience, the advanced industrial nations of the West committed themselves after World War II to removing barriers to the free flow of goods, services and capital between nations.21 This goal was enshrined in the General Agreement on Tariffs and Trade. Under the umbrella of GATT (now subsumed under the WTO), eight completed rounds of negotiations among member states have worked to lower barriers to the free flow of goods and services, the most notable to date being the Uruguay Round, signedoff in December 1993.22 Table 1.1 summarises the impact of GATT agreements on average tariff rates for non-agricultural goods (i.e. manufactured goods). As can be seen, the average rates have fallen significantly since 1950 and now stand at less than 4 per cent. This reduction in tariff rates achieved by the once dominant economic powers and exporters—the United States, Japan and countries of the European Union—has not been matched universally, however. For example, in 2018, Australia’s average tariff rate on manufacturing imports was 11.0 per cent, China’s was 9.1 per cent, Brazil’s 30.8 per cent, India’s 34.6 per cent and Indonesia’s 35.6 per cent.23 This discrepancy in tariffs between the old and the emerging economic powers such as the BRIC group has been a hindrance to achieving agreement in current trade negotiations at the WTO. In late 2001, the WTO launched the current round of talks, the Doha Round, aimed at further liberalising the global trade and investment framework. The talks were The United Nations has the important goal of improving the wellbeing of people around the world. scheduled initially to last three years, but they haltingly TABLE 1.1 Average tariff rates on manufactured products as percentage of value 1913 1950 1990 2017 France 21 18 5.9 1.9 Germany 20 26 5.9 1.9 Italy 18 25 5.9 1.9 Japan 30 — 5.3 2.1 5 11 5.9 1.9 20 9 4.4 1.9 — 23 5.9 1.9 44 14 4.8 3.0 The Netherlands Sweden United Kingdom United States SOURCE: The 1913–1990 data are from ‘Who Wants to Be a Giant?’, The Economist: A Survey of the Multinationals, 24 June 1995, pp. 3–4; the 2017 data is from the World Bank, World Development Indicators. CHAPTER 1 hiL23674_ch01_001-054.indd 19 GLOBALISATION 19 08/06/19 07:40 PM © blurAZ/Shutterstock Declining trade and investment barriers continue—as they have stalled on a number of occasions due to opposition from several key nations. (These issues are discussed further in Chapter 3.) The lowering of barriers to international trade enables companies to view the world, rather than a single country, as their market. The lowering of trade and investment barriers also allows companies to base production at the optimal location for that activity. Thus, a company might design a product in one country, produce component parts in two other countries, assemble the product in yet another country, and then export the finished product around the world. The role of technological change The lowering of trade barriers made globalisation of markets and production a theoretical possibility. Technological change has made it a tangible reality. Since the end of World War II, the world has seen major advances in communication, information processing and transportation technologies, including the explosive emergence of the internet and the world wide web. Microprocessors and telecommunications MOORE’S LAW The premise that the power of microprocessor technology doubles and its cost of production drops by half every 18 months Perhaps the single most important innovation has been the development of the microprocessor, which has enabled the explosive growth of high-power, low-cost computing, vastly increasing the amount of information that can be processed by individuals and companies. The microprocessor also underlies many recent advances in telecommunications technology. Over the past 30 years, global communications have been revolutionised by developments in satellite, optical fibre and wireless technologies, and the internet and the web. These technologies rely on the microprocessor to encode, transmit and decode the vast amount of information that flows along these electronic highways. The cost of microprocessors continues to fall, while their power increases (a phenomenon known as Moore’s Law, which predicts that the power of microprocessor technology doubles and its cost of production falls by half every 18 months).24 The internet and the world wide web The rapid growth of the web is the latest expression of communications development. In 1990, fewer than one million users were connected to the internet. By 1995, the figure had risen to 50 million. By 2019, this figure had reached 4.4 billion users, or about 56 per cent of the world’s population.25 China has the largest internet population in the world and the largest population of online shoppers. Included in the expanding volume of webbased traffic is a growing percentage of cross-border trade in both goods and services. Advances in ICT have enabled many small companies to sell into international markets as they can reach a wide audience without the expense of setting up ‘bricks-and-mortar’ shop fronts. ICT has facilitated an increase in the offshoring of production. It has provided the means to coordinate the flow of component parts along the networks that comprise the global supply chains of modern production systems. Viewed globally, the web is emerging as an equaliser. It rolls back some of the constraints of location, scale and time zones.26 The web makes it much easier for buyers and sellers to find each other, wherever they may be located and whatever their size. It allows businesses, both small and large, to expand their global presence at a lower cost than ever before. It makes a virtue out of different time zones, enabling teams located in different time zones around the world to continue to provide a service as if they were a 24/7 operation. Transport technology In addition to developments in communication technology, several major innovations in transport technology have occurred since World War II. In economic terms, the most important are probably the development of commercial jet aircraft and superfreighters, and the introduction of containerisation, which simplifies trans-shipment from one mode of 20 PART 1 GLOBALISATION hiL23674_ch01_001-054.indd 20 08/06/19 07:40 PM • the efficiency of the clearance process by border control agencies • the quality of trade and transport infrastructure (ports, roads, rail, ICT) • the ease of arranging competitively priced shipments • the competence and quality of transport operators and customs brokers • the ability to track consignments • timeliness of delivery.27 Implications for the globalisation of production and markets As transport costs associated with the globalisation of production declined, dispersal of production to geographically separate locations became more economical. As a result of the technological innovations discussed above, the real costs of information processing and communication have fallen dramatically in the past three decades. These developments make it possible for a company to create and then manage a globally dispersed and networked production system, further facilitating the globalisation of production. A worldwide communications network has become essential for many international businesses. For example, computer maker Dell revolutionised supply-chain management when it adopted a ‘direct make-to-order’ business model to computer manufacturing while its competitors were continuing to use ‘make-to-stock’ processes. The adoption of this new strategy was made possible by the technological advances in transport and ICT, and it promoted Dell for a time to the status of number one computer company globally. Dell uses the internet to coordinate and control a globally dispersed production system to such an extent that it is able to hold only three days of inventory at its assembly locations. Dell’s internet-based system records orders for computer equipment as they are submitted by CHAPTER 1 hiL23674_ch01_001-054.indd 21 GLOBALISATION 21 08/06/19 07:40 PM © hxdyl/Shutterstock transport to another. The advent of commercial jet travel, by reducing the time needed to get from one location to another, has effectively shrunk the globe. Australian and New Zealand producers of merchandise exports, geographically distant from the large northern-hemisphere markets, retain competitiveness as the time and costs to these markets are reduced. For example, with the advent of jet travel and ‘cold chain’ logistics technologies, Australian and New Zealand aquaculture producers can supply the high-margin live fish and crustacean markets of Asia. Reliable delivery of goods within narrow time windows is important to a firm’s ability to participate and compete not only in fresh food markets, but also in the just-in-time supply-chain regimes of global manufacturing. As a result Before the advent of containerisation, it could take several days and several hundred stevedores to unload a ship and of the efficiency gains associated with containerisation, reload goods on to trucks and trains. transport costs have plummeted. This makes it much more economical to ship goods around the globe by air and by sea, thereby helping to drive the globalisation of markets and production. Access to jet aircraft and container ships, however, is only part of the story in facilitating trade expansion and export diversification or attracting foreign direct investment to a particular location. The potential cost savings of these transport technologies are lost if, for example, the bureaucracy of customs checks or the poor quality of the port infrastructure causes a container to sit on a loading dock for an inordinate amount of time. The World Bank identifies factors that affect what it calls ‘logistics performance’, any one of which might explain a disruption to trade and add to trade costs: customers via the company’s website and then immediately transmits the resulting orders for components to various suppliers around the world, which have a real-time look at Dell’s order flow and can adjust their production schedules accordingly. Given the low cost of airfreight, Dell can use air transport to speed up the delivery of the critical components to meet unanticipated demand shifts without delaying the shipment of the final product to consumers. Dell also uses modern information and communication technologies as a marketing tool. In 2010, Dell launched its Social Media Listening Command Center (LCC). This centre monitors the questions and opinions about Dell and its products that people express on all forms of social media, from Facebook and Twitter to blogs, forums and news sites. Every day, Dell monitors and analyses nearly 25 000 conversations about Dell—and these are just the ones in English.28 Dell redesigned the keypad of one of its best selling laptops because the buzz on social media was that the apostrophe was positioned awkwardly and needed to be shifted. The buzz of social media, of course, crosses national borders, thus further promoting the globalisation of markets. We examine issues in international marketing and international supply chain management in more detail in Chapters 12 and 13. In addition to the globalisation of production, technological innovations have also facilitated the globalisation of markets. Low-cost global communications networks such as the world wide web, have helped create electronic global marketplaces. For example, an Indian legal company sells its services to a mining multinational, Rio Tinto, on a global basis. Since commencing in 1995, Amazon.com has become the world’s largest online retailer. Faster, low-cost transport has made it more economical to ship products around the world, thereby helping to create global markets. For example, due to the tumbling costs of transporting goods by air, roses grown in Ecuador can be cut and sold in cities of Europe and the United States two days later while they are still fresh. This has given rise to an industry in Ecuador that did not exist 20 years ago and now supplies a global market for roses. In addition, low-cost jet travel has resulted in the mass movement of people between countries. This has reduced the cultural distance between countries and is bringing about some convergence of consumer tastes and preferences. At the same time, global communication networks and global media such as CNN and the BBC are creating a worldwide culture. In any society, the media are primary conveyors of culture: as global media develops and social media becomes more popular, we must expect the evolution of something akin to a global culture. A logical result of this evolution is the emergence of global markets for consumer products. The first signs of this are already apparent. It is as easy to find a McDonald’s restaurant in Beijing as it is in New York, to buy an iPad in Rio de Janeiro as it is in Berlin, and to buy Prada accessories in Melbourne as it is in Milan. Despite these trends, we must be careful not to overemphasise their importance. While modern communication and transportation technologies are ushering in the ‘global village’, significant national differences remain in culture, consumer preferences and business practices. In competition with CNN and BBC for global viewers is the influential Arab news and public affairs broadcaster, Al Jazeera. Based in Qatar and owned by the Emirate of Qatar, it reaches an estimated audience of 40 million in the Arab world. It has uncensored independence, which is unusual for a broadcaster in the Arab world.29 The success of Al Jazeera suggests that the creation of a global culture still has some way to go. To accommodate two different cultural traditions, there are two news operations, Al Jazeera Arabic and Al Jazeera English; and Al Jazeera itself has had to confront national cultural difference. The Al Jazeera English network is virtually locked out of the United States. It can be accessed by the internet, but none of the major cable TV networks will carry its programs. It is thought of as ‘an anti-American network’. To gain a more significant foothold in the United States, Al Jazeera was forced to acquire its own, albeit small, cable network.30 A company that ignores differences between countries does so at its peril. We shall stress this point repeatedly throughout this book and elaborate on it in later chapters. 22 PART 1 GLOBALISATION hiL23674_ch01_001-054.indd 22 08/06/19 07:40 PM THE CHANGING SHAPE OF THE GLOBAL ECONOMY LO 1.2, 1.3 Hand in hand with the trend towards globalisation has been a fairly dramatic change in the shape of the global economy over the past 50 years. As late as the 1960s, four stylised characteristics described the global economy. The first was the United States, Western European and Japanese dominance in the world economy and world trade picture, particularly US dominance. The second was the dominance by these same countries in world foreign direct investment. Related to this, the third fact was the dominance of large, multinationals from these countries on the international business scene. The fourth was that roughly half the globe—the centrally planned economies of the Communist world—was off-limits to Western international businesses. As will be explained below, all four of these qualities either have changed or are now changing rapidly. The following will be examined: • the changing world output and world trade picture • the changing foreign direct investment picture • the changing nature of the multinational enterprise • the changing world order. The changing world output and world trade picture In the early 1960s, the United States was by far the world’s dominant industrial power. In 1963, the United States accounted for 40.3 per cent of world output. Since then, there has been a shift in the world’s economic centre of gravity. By 2015, the United States accounted for 16.1 per cent of world output, still by far the world’s largest industrial power but down significantly in relative size since the 1960s (see Table 1.2). Nor was the United States the only developed nation to see its relative standing slip. Germany, France and the United Kingdom—all nations that were among the first to industrialise—experienced significant declines. The change in the position of these countries was not an absolute decline, since these economies continued to grow. Rather, it was a relative decline, reflecting the faster economic growth of several other economies, particularly in China and India. In the 1970s, the world pattern of production and trade could be described as bipolar, dominated by the United States and the Western European countries. By the beginning of the 1990s, it was shifting to a more tripolar pattern with the rise of the Japanese economy. As can be seen from Table 1.2, Japan’s share of world production had leapfrogged that of individual European countries and remains dominant, despite Japan incurring periods of negative economic growth over the decade of the 2000s. By the end of the 2000s, however, the tripolar pattern is no longer clear. As can be seen in Table 1.2, the United States and the integrated economies of the European Union, as a single entity, still dominate, but China and India now each contribute more to global production than any one of the Western European countries. Their share of world output has also surpassed that of Japan. Brazil and Russia are also now contributing as much as the individual Western European economies. A new pattern of world production has emerged. As emerging economies such as China, India, Russia and Brazil continue to grow, a further relative decline in the share of world output and world exports accounted for by the United States and other long-established industrialised nations seems likely. By itself, this is not bad. The relative decline of the United States reflects the growing economic development and industrialisation of the world economy, as opposed to any absolute decline in the robustness of the US economy. A strong US economy and market remain necessary to support the growth and development of these emerging economies. Running parallel to the declining economic dominance of the world economy by nations such as the United States, the United Kingdom, Japan and Germany is a decline in CHAPTER 1 hiL23674_ch01_001-054.indd 23 GLOBALISATION 23 08/06/19 07:40 PM TABLE 1.2 The changing pattern of world output and trade SHARE OF WORLD COUNTRY United States GDP OUTPUT (%), 1963 GDP OUTPUT (%), 2014 EXPORTS (%), 2014 40.3 16.1 10.0 Germany 9.7 3.4 7.5 France 6.3 2.4 3.6 Italy 3.4 2.0 2.7 United Kingdom 6.5 2.4 3.6 Japan 5.5 4.4 3.7 China na 16.3 10.5 India na 6.8 2.1 Russia na 3.3 2.4 Brazil na 3.0 1.1 SOURCES: IMF, World Economic Outlook, October 2015, accessed via www.imf.org/external/pubs/f t/weo/2015/01/pdf/ text.pdf on 12 September 2015; data for 1963 derived from N. Hood and J. Young, The Economics of the Multinational Enterprise, New York, Longman, 1973; GDP output data based on purchasing power parity figures, which adjust the value of GDP to reflect the cost of living in various economies—exports comprise goods and services. GROUP OF EIGHT (G8) An international forum comprising the government representatives of eight Western industrial economies: Canada, France, Germany, Italy, Japan, the United Kingdom, the United States and a relatively new member, Russia the political power of these nations in the major global economic forums. One illustration is the rise to prominence of the G20 at the expense of the G8. Along with institutions such as the IMF, the G20 has become the premium forum when collective economic leadership and problem solving are called for to address such global issues as energy security, climate change and international financial regulation. The Group of Eight (G8) comprises representatives of the governments of Canada, France, Germany, Italy, Japan, Russia, the United Kingdom and the United States. It represents 900 million people. Where once the market-capitalist democracies of the G8 (that excludes Russia at the time) dominated global economic leadership, authoritarian states such as China, Russia and Saudi Arabia are now exerting more influence. There is also no certainty that the world’s democracies will naturally stick together. For example, on the matter of climate change, four of the most economically and politically strategic democracies—Brazil, South Africa, India and Turkey— sided with China over caps on greenhouse emissions. Their status as a developing economy was more important to them than their status as a democracy.31 While authoritarian governments and developing countries continue to harbour concerns about the inequities of US-led, Western-world global capitalism, and as their influence in economic forums increases, continuing globalisation and trade liberalisation are not guaranteed. The freedom to pursue international business opportunities may well be curbed by increased state intervention. Forecasts are not always correct, but there is a shift in the economic geography of the world. For international businesses, the implications of this changing economic geography are clear: many of tomorrow’s economic opportunities will be found in the developing nations of the world, despite their attendant risks, and many of tomorrow’s most capable competitors will also emerge from these regions. The changing foreign direct investment picture In the 1960s, US companies accounted for 66.3 per cent of worldwide FDI flows. British companies were second, accounting for 10.5 per cent. As a consequence, companies from the United States and the United Kingdom accumulated a considerable stock of productive assets abroad. Over time as the barriers to the free flow of goods, services and investment fell and as other countries began to prosper and increase their share of world output, nonUS companies increasingly began to invest across national borders. The motivation for 24 PART 1 GLOBALISATION hiL23674_ch01_001-054.indd 24 08/06/19 07:40 PM a ia Ind on om i De ve lop ing ec Ch in es n pa Ja es at St ed Un it Un it ed Ki ng do m much of this foreign direct investment by non-US companies was the desire to disperse production activities to optimal locations and to build a direct presence in major foreign markets. Thus, beginning in the 1970s, European and Japanese companies began to shift labour-intensive manufacturing operations from their home markets to developing nations where labour costs were lower. In addition, many Japanese companies invested in North America and Europe, often as a hedge against unfavourable currency movements and the possible 40% 35% imposition of trade barriers. For example, Toyota, the 30% Japanese motor vehicle company, rapidly increased its 25% investment in motor vehicle production facilities in 20% the United States and Europe during the late 1980s 15% 10% and early 1990s. Toyota executives believed that an 5% increasingly strong Japanese yen would price Japanese 0% motor vehicle exports out of foreign markets; therefore, production in the most important foreign markets, as opposed to exports from Japan, made sense. Toyota also undertook these investments to head off the growing political pressures about automotive industry job losses in the United States and Europe to restrict Japanese 2000 2010 2017 motor vehicle imports in those markets. The consequence of these developments is illustrated in Figure 1.1, which shows the changing share of FDI stock sourced from selected economies and regions over the period 2000 to 2017. Individual economies such as the United States, the United Kingdom and Japan are still the dominant sources of FDI, but this dominance has declined in the past two-anda-half decades. The stock of FDI accounted for by companies from developing countries has increased more than twofold. Companies from developing East Asia and South-East Asia account for most of this growth, particularly companies from Hong Kong, Singapore, mainland China, Taiwan and South Korea. Hong Kong ranks among one of the world’s largest sources of FDI as companies based there launch into neighbouring mainland China and East Asia. Not all FDI flows and stock are initiated and held by privately-owned, commercial businesses. A relatively new type of investor has appeared on the scene, the sovereign wealth fund (SWF). A sovereign wealth fund is a government-controlled fund that manages and invests government savings. The investment strategies and objectives tend to be different from those of the traditional, privately-owned multinational enterprise. Australia’s Future Fund and Singapore’s Temasek Holdings are examples. Although SWFs have been in existence since the 1950s, especially in oil-producing countries, they have grown considerably in number and size in the past decade. Sovereign wealth funds, including those managed by the governments of major oil-exporting developing countries and emerging economic powers such as China, had a total of some US$7.1 trillion in assets. (The largest SWF is the Norwegian government’s Pension Fund Global—worth $945 billion.32) Despite their very small contribution to FDI, SWFs have attracted what appears to be a disproportionate amount of scrutiny by authorities. There are several reasons for this close scrutiny.33 Much of the recent growth in SWFs has come from the large balance of payments surpluses run, in particular, by China and other East Asian economies. These economies have been accumulating foreign exchange reserves on an unprecedented scale as a result of intervention by their governments to maintain what are considered to be undervalued exchange rates for their currencies. Low exchange rates favour their exporters at the expense of foreign exporters. Exchange rates and balance of payments surpluses are discussed in more detail in Chapter 4. Figures 1.2 and 1.3 illustrate two other important trends in the global economy: the first is the strong growth in cross-border flows in FDI, albeit with volatile swings through FIGURE 1.1 Source of FDI stock; percentage of world total of FDI stock, 2000, 2014 and 2017, selected economies. SOURCE: Calculated by the author from data in UNCTAD, World Investment Report 2018, Annex Tables, accessed via https://unctad.org/en/PublicationsLibrary/ wir2018_en.pdf on 26 March 2019. SOVEREIGN WEALTH FUND (SWF) A government-controlled fund that manages and invests government savings CHAPTER 1 hiL23674_ch01_001-054.indd 25 GLOBALISATION 25 08/06/19 07:40 PM FIGURE 1.2 FDI inflows, 1991–2017, by economy type, annual, US$ million. 2 500 000 SOURCE: Calculated by the author from data in UNCTAD, World Investment Report 2018, Annex Tables, accessed via https:// unctad.org/en/PublicationsLibrary/ wir2018_en.pdf on 26 March 2019. 2 000 000 Transition economies Developed economies Developing economies 1 500 000 1 000 000 500 000 SOURCE: Calculated by the author from data in UNCTAD, World Investment Report 2018, Annex Tables, accessed via https:// unctad.org/en/PublicationsLibrary/ wir2018_en.pdf on 26 March 2019. 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 20 14 20 15 20 16 20 17 98 19 97 19 96 19 95 19 19 19 94 92 93 19 25 Percentage of total world FIGURE 1.3 FDI inflows, 2000, 2011 and 2017, selected countries, percentage of world total. 19 19 91 0 20 15 10 5 0 Australia 2000 Brazil China 2011 2017 India Russia UK US peaks and troughs. The second is the growing importance of developing and transition nations (the latter are the nations of Central and Eastern Europe, including Russia) as the destination of FDI. Throughout the 1990s, the amount of investment directed at both developed and developing nations increased dramatically, a trend that reflects the increasing internationalisation of business corporations. There was a dramatic slump during the global economic recession in 2001–03 and again during the GFC of 2007–09, but on both occasions FDI recovered and continued on its long-term growth trend. The second trend, shown in Figure 1.2, is the increasing amount of FDI since 1991 directed to developing economies; also, since the economic and political reforms in the former Communist countries of Central and Eastern Europe, post-1990 there has been an increase in FDI to these transition economies. This change in the destination of FDI is also shown in Figure 1.3. While the United States and the United Kingdom have tended to attract the largest share of FDI, it is a declining 26 PART 1 GLOBALISATION hiL23674_ch01_001-054.indd 26 08/06/19 07:40 PM EMERGING MARKETS INDIA’S IT SOFTWARE SECTOR Some 25 years ago, a number of small software enterprises was established in Bangalore, India. Typical of these enterprises was Infosys Technologies, which was started by seven Indian entrepreneurs with about $1000 among them. Infosys now has annual revenue of $7.4 billion and some 155 600 employees, but it is just one of more than a hundred software companies clustered around Bangalore, which has become the epicentre of India’s fast-growing information technology sector. From a standing start in the mid-1980s, by 2012 this sector was generating export sales of $68 billion. The growth of the Indian software sector has been based on four factors. First, the country has an abundant supply of engineering talent. Every year, Indian universities graduate some 400 000 engineers. Second, labour costs in India have historically been low. As recently as 2008, the cost to hire an Indian graduate was roughly 12 per cent of the cost of hiring an American or Australian graduate (this is now changing, with salaries increasing in India). Third, many Indians are fluent in English, which makes coordination between Western companies and India easier. Fourth, due to time differences, Indians can work while many other advanced English-speaking countries are asleep. Initially, Indian software enterprises focused on the low end of the software industry, supplying basic software development and testing services to Western companies. But as the industry has grown in size and sophistication, Indian companies have moved up the market. Today, the leading Indian companies compete directly with the likes of IBM and EDS for large software development projects, business process outsourcing contracts, and information technology consulting services. Over the past 15 years, these markets have boomed, with Indian enterprises capturing a large slice of the pie. One response of Western companies to this emerging competitive threat has been to invest in India to garner the same kind of economic advantages that Indian companies enjoy. IBM, for example, has invested $2 billion in its Indian operations and now has 150 000 employees located there, more than in any other country. Microsoft, too, has made major investments in India, including a research and development (R&D) centre in Hyderabad that employs 4000 people and was located there specifically to tap into talented Indian engineers who did not want to move overseas. SOURCES: ‘America’s pain, India’s gain: outsourcing’, The Economist, 11 January 2003, p. 59; ‘The world is our oyster’, The Economist, 7 October 2006, pp. 9–10; ‘IBM and globalization: hungry tiger, dancing elephant’, The Economist, 7 April 2007, pp. 67–69; P. Mishra, ‘New billing model may hit India’s software exports’, Live Mint, 14 February 2013; ‘India’s outsourcing business: on the turn’, The Economist, 19 January 2013. share. Their share has almost halved over the past decade as developing economies such as the BRIC nations attract a larger share. As we shall see later in this book, the sustained flow of foreign investment into developing nations is an important stimulus for economic growth. Just as Australia’s economy has relied on FDI to fuel its development, particularly via the development of its mining sector, attracting more FDI bodes well for the future of countries such as Brazil, Russia, India and China, who are the leading beneficiaries of these trends. The changing nature of the multinational enterprise A multinational enterprise (MNE) is any business that has productive activities in two or more countries. Since the 1960s, two notable trends in the character of multinational enterprises have been (1) the rise of non-US multinationals; and (2) the growth of m ­ ini-multinationals. MULTINATIONAL ENTERPRISE (MNE) Any business that has productive activities in two or more countries CHAPTER 1 hiL23674_ch01_001-054.indd 27 GLOBALISATION 27 08/06/19 07:40 PM Multinationals In the 1960s, global business activity was dominated by large US multinational corporations. With US firms accounting for about two-thirds of foreign direct investment during the 1960s, one would expect most multinationals to be US enterprises. In 1973, 48 per cent of the world’s 260 largest multinationals were US companies. Figure 1.1, however, implies that the dominance of US multinationals in terms of holdings of FDI assets has declined. In terms of the size of the multinationals, the ranks of the world’s largest multinationals are still dominated by US companies and companies from other developed nations. Names of such companies that are globally recognisable include General Electrics (US), Toyota Motor Corporation (Japan), Vodafone Group (UK), Siemens AG (Germany), Veolia (France) and BHP (Australia/United Kingdom). While most of the largest multinationals originate in the developed countries, multinationals from developing countries are beginning to make their presence felt in the global economy. Some of the names of multinationals may not be as recognisable universally as those from the developed countries but include Hutchinson Whampoa (Hong Kong), Vale SA (Brazil), Cemex (Mexico), Petronas (Malaysia), Citic Group (China), Tata Steel (India), Rusal (Russia) and Sappi (South Africa). Among the developing countries, Asia remains by far the major home-region for multinationals. As the number of multinational enterprises from the world’s developing countries grows, we can expect these enterprises to emerge as important competitors in global markets. There will be a further shift of the axis of the world economy away from North America and Western Europe and a threat to the long-term dominance of Western companies. The rise of mini-multinationals Another trend in international business has been the growth of small and medium-sized multinationals (mini-multinationals).34 When people think of international businesses, they tend to think of firms such as GE, Vodafone, Toyota, Rio Tinto and so on—large, complex multinational corporations with operations that span the globe. Although most international trade and investment is still conducted by such large companies, many small and medium-sized businesses are becoming increasingly involved in international trade and investment as highlighted by the Opening Case. As we noted previously, the rise of the internet has lowered the barriers that small companies face in providing products and services internationally and in building international sales. For example, Comvita, with its headquarters and original manufacturing base at Paengaroa, New Zealand, is a natural health and wellness company that manufactures therapeutic apicultural products, including the unique Manuka honey-based products with their exceptional antibacterial qualities. It began as a small two-person local operation in 1974, but is now a listed company. It is the world’s largest manufacturer and marketer of Manuka honey, and also produces a diversified range of products in health food, health care, beauty and personal care and medi-honey. In 2007, the company had a staff of 120 worldwide, which has now grown to 500 in eight countries. More than half of the staff is located outside New Zealand. Nearly 70 per cent of its NZ$153 million annual sales is generated in foreign markets.35 The changing world order Between 1989 and 1991, a series of remarkable democratic revolutions swept the Communist world. For reasons that are explored in more detail in Chapters 6 and 7, in country after country throughout Eastern Europe and eventually in the Soviet Union itself, Communist Party governments collapsed. The Soviet Union is now receding into history, having been replaced by 15 independent republics. Czechoslovakia has divided itself into two states, while Yugoslavia dissolved after a bloody civil war, thankfully now over, into five successor states. 28 PART 1 GLOBALISATION hiL23674_ch01_001-054.indd 28 08/06/19 07:40 PM ANOTHER PERSPECTIVE RISE OF PROTECTIONISM For over half a century, the US and other developed countries championed free trade and globalisation. It brought unprecedented growth and prosperity to millions of people around the world. However, it hollowed out the manufacturing sector and increased income inequality in developed countries, leading to the rise of protectionist right-wing politicians such as Donald Trump. Will their mercantilist views (see Chapter 2) bring an end to globalisation? Is globalisation the key reason for the loss of manufacturing in developed countries, as suggested by protectionist politicians? SOURCE: T. Meyer and G. Sitaraman, ‘A Trade Policy for All: Market Liberalization Should Be a Means, Not an End’, Foreign Affairs, 26 June 2018, accessed via www.foreignaffairs.com/articles/2018-06-26/trade-policy-all on 3 July 2019. Many of the former Communist nations of Europe and Asia seem to have shown a commitment to democratic politics and free market economies. If this continues, the opportunities for international businesses will continue to be enormous. For half a century, these countries were essentially closed to Western international businesses. Now they present a host of export and investment opportunities. Just how this will play out over the next decade or two is difficult to say. The economies of many of the former Communist states are still relatively undeveloped, and their continued commitment to democracy and free market economies cannot be taken for granted. Disturbing signs of growing unrest and totalitarian tendencies continue to be seen in several Eastern European and Central Asian states, including Russia, which under the presidencies of Vladimir Putin and Dmitry Medvedev have shown signs of shifting back towards greater state involvement in economic activity. Findings from Freedom in the World 2015, Freedom House’s annual report on the state of global freedom, reveal that democracy declined worldwide for the tenth year in 2015, particularly in the Middle East.36 Thus, the risks involved in doing business in such countries are high, but so may be the returns. The 2007–09 GFC caused a reassessment of the extent to which governments should intervene in Western industrialised economies. To this point in time, the dominant ideology was one of free markets, private ownership and reduced government regulation. The events of the GFC, however, brought into question the efficacy of such a model. For fear of systemic collapse, governments became convinced that they had to usurp the market and intervene. The US and the UK governments bought controlling interests in private businesses—in effect, for a country such as the United Kingdom, this meant reversing the privatisation trend by renationalising parts of industry. In the United States, for example, the government bought 61 per cent of General Motors (GM), once one of the largest, private non-financial multinationals in the world, and in addition provided loans from taxpayer funds to assist GM through bankruptcy. The UK government took control of three financial institutions—the Royal Bank of Scotland, Lloyd’s Banking Group and Northern Rock. In Australia, the government offered the major banks guaranteed access to capital to maintain public confidence in the financial sector. Again, a complete move to free market economies with declining state intervention cannot be taken for granted. CHAPTER 1 hiL23674_ch01_001-054.indd 29 GLOBALISATION 29 08/06/19 07:40 PM LO 1.3 The global economy of the 21st century: The emerging markets century? Opportunities and risks As discussed above, the past quarter of a century has seen rapid changes in the global economy. Barriers to the free flow of goods, services and foreign investment have been coming down. The volume of cross-border trade and investment has been growing more rapidly than global output, indicating that national economies are becoming more closely integrated into a single, interdependent, global economic system. As their economies advance, more nations are joining the ranks of the developed world. A generation ago, countries such as South Korea and Taiwan were viewed as second-tier developing nations. Now they boast large economies, and their companies are major players in many global industries. The move towards a global economy has been further strengthened by the widespread adoption of liberal economic policies by countries that had firmly opposed them for two generations or more. Thus, in keeping with the normative prescriptions of liberal economic ideology, in country after country, we have seen state-owned businesses privatised, widespread deregulation adopted, markets opened to more competition, and commitment increased to removing barriers to cross-border trade and investment. This suggests that over the next few decades, countries such as the Czech Republic (Czechia), Mexico, Poland, Brazil, China, India, Turkey and South Africa may build powerful marketoriented economies. In short, current trends indicate that the world is moving rapidly towards an economic system that is more favourable for international business. But it is always hazardous to use established trends to predict the future. The world may be moving towards a more global economic system, but globalisation is not inevitable. Countries may pull back from the recent commitment to liberal economic ideology if their experiences do not match their expectations. Also, greater globalisation brings with it risks of its own. The GFC of 2007–09 and the emergence of SWFs have spawned a rise in trade and investment protectionist sentiment. Clearly, such reversals make it a tougher world for international businesses. In addition, there are many powerful voices that are critical of globalisation. These critics blame globalisation for many of today’s ills, including job losses, growing income inequality, food insecurity and climate change. The responses to resolve these ills by the anti-globalisation forces tend to have two common threads. They are, one, to increase the level of oversight and regulation of cross-border trade and investment at a domestic or global level; and, two, to de-globalise—that is, to re-orient economies away from global markets and global production chains and towards local and regional markets and production.37 Should the anti-globalisation forces win the ears of the policymakers, the outcomes would be anathema to international business. Emerging market economies There is little doubt that if a business is intending to expand internationally, it would have in its sights the economies of the likes of China and India. Their large size in terms of population and national production, their above-average rates of economic growth, their rising living standards, their attraction to foreign investors and the increasing presence of their multinationals on the world stage should certainly grab the attention of any international business manager investigating business opportunities. (Concepts and measures of economic growth and development and the comparative economic performance of nations are examined in more detail in Chapter 7.) As noted above, the rapid growth of the developing and emerging economies is changing the shape of the global economy. This is clearly illustrated by the comparative growth rates of the world’s two largest economies, the United States and China. If China continues to grow at current rates, which average nearly double the rate of US economic growth, China’s economy will 30 PART 1 GLOBALISATION hiL23674_ch01_001-054.indd 30 08/06/19 07:40 PM be larger than the US economy. The US per capita income, however, is still expected to be four times larger than that of China.38 The economies like those of China and India are developing and a business that enters these markets could grow with them. Map 1.1 identifies 25 countries classified as emerging market economies. The vast majority of these countries are common to the lists developed by the official organisations such as the IMF and the equity-index vendors such as MSCI and FTSE according to their definition of emerging markets. The status of a country as a developed or developing/ emerging economy, however, can change over time. Lists will also differ because the assignment of the status relies on subjective judgement. The assignment of weights to each criterion is a subjective judgement. Many of the criteria listed above are qualitative. The debate over the status of South Korea is an example of the possibility of a change in status. The status of countries such as Greece must also be in some doubt as a consequence of the eurozone crisis. It is currently ranked as a developed country, but the eurozone crisis has exposed many structural weaknesses of the economy and its apparent incapacity to sustain any economic growth even with the substantial financial bailouts from the IMF and its fellow EU members. The Economist perhaps best sums up why there is no definitive list of emerging markets: Emerging markets is a useful term precisely because it is imprecise. Coined for the convenience of investors looking for somewhere exciting to put their money, it covers a bewildering range of economies with little in common, except that they are not too rich, not too poor and not too closed to foreign capital.39 The quote from The Economist contains a note of caution for the international business manager. While emerging markets do have common features and they are changing the shape of global markets, they are also different to each other in many ways. They are also different to developed markets. As they emerge, they are not simply a small clone of an advanced economy that shows economic potential and is growing up rapidly. Each market is a product of idiosyncratic historical, political, legal, economic and cultural forces within MAP 1.1 The 25 countries classified as emerging market economies SOURCE: Based on Grant Thornton International Ltd, ‘Emerging markets opportunity index: high growth economies’, International Business Report 2012, 2012. China India Russia Brazil Mexico Turkey Indonesia Poland Malaysia Thailand Argentina Chile Hungary South Africa Peru Emerging economies, BRIC Vietnam Nigeria Romania Colombia Venezuela Iran Egypt Philippines Bangladesh Taiwan Emerging economies, non-BRIC CHAPTER 1 hiL23674_ch01_001-054.indd 31 GLOBALISATION 31 08/06/19 07:40 PM the country. Operating conditions in each market will be different. Understanding these conditions and learning how to work with them in the specific market is the key to taking advantage of the growth opportunities that emerging markets offer in the 21st century. Chapters 5, 6, 7 and 8 explain in more detail the different political, legal, economic, cultural and ethical dimensions of markets that international business has to navigate and the strategies that international business adopts to deal with these differences. LO 1.4 THE GLOBALISATION DEBATE Is the shift towards a more integrated and interdependent global economy a good thing? Many influential economists, politicians and business leaders seem to think so.40 They argue that falling barriers to international trade and investment are the twin engines driving the global economy towards greater prosperity. They say that increased international trade and cross-border investment will result in lower prices for goods and services. They believe that globalisation stimulates economic growth, raises the incomes of consumers, and helps to create jobs in all countries that participate in the global trading system. The arguments of those who support globalisation are covered in detail in Chapters 2, 3, 6 and 7. As we shall see, there are good theoretical reasons for believing that declining barriers to international trade and investment do stimulate economic growth, create jobs and raise income levels. Nevertheless, despite the existence of a compelling body of theory and evidence, globalisation has its critics.41 Here, we look at the nature of protests against globalisation and briefly review the main themes of the debate concerning its merits. In later chapters, we elaborate on many of the points mentioned below. Anti-globalisation protests Street demonstrations against globalisation date back to December 1999, when more than 40 000 protesters blocked the streets of the US city of Seattle in an attempt to shut down a WTO meeting being held there. The protests were marred by a number of violent events which captured the attention of the international media. The demonstrators were protesting against a wide range of issues, including job losses in industries under attack from foreign competitors, downward pressure on the wage rates of unskilled workers, environmental degradation, and the cultural imperialism of the global media and multinational enterprises. Local cultures and values were seen as being dominated by what some protesters called the ‘culturally impoverished’ interests and values of the United States. All of these ills, the demonstrators claimed, could be laid at the feet of globalisation. The WTO was meeting to try to launch a new round of talks to cut barriers to crossborder trade and investment. As such, it was seen as a promoter of globalisation and a legitimate target for the anti-globalisation protesters. In subsequent years, in the Seattle tradition, most meetings of a global nature, be they the meetings of the World Economic Forum, the G20 or a Climate Change Conference, have attracted vehement anti-globalisation protests. There were many familiar protest messages: the corporate corruption of political systems and the takeover of democracy; the manipulation of globalisation for the benefit of corporations; the destruction of the environment and the exhaustion of natural resources by global capitalism; and the pursuit by governments of business-friendly policies post-GFC that have cut social services and resulted in huge job losses. While violent protests may give the anti-globalisation movement a bad name, it is clear from the scale of the demonstrations that support for the cause goes beyond a core of anarchists. Larger segments of the population in many countries now believe that globalisation does have detrimental effects on living standards 32 PART 1 GLOBALISATION hiL23674_ch01_001-054.indd 32 08/06/19 07:40 PM and the environment. Indeed, the support for US President Donald Trump was primarily based on his assertion that trade deals had exported US jobs overseas and created unemployment and low wages in the country. Both theory and evidence, however, suggest that many of these concerns may be exaggerated, but politicians and business have not been able to communicate this message clearly. There are significant gains that are real, although they may not be as easily identified or dramatised by the media as a story on local job losses. Witness to the gains are the opportunities that globalisation has afforded small firms such as Gekko, Comvita and Imaging Partners Online, and the income and jobs that have been created for the IT workers in India (see Emerging Markets: ‘India’s IT software sector’). Globalisation, jobs and income inequality Concerns over job losses, job insecurity, lower wages and growing income inequality are frequently voiced by globalisation opponents. The critics argue that falling trade and investment barriers allow companies to move manufacturing activities to countries where wage rates are much lower.42 This offshoring causes job losses and depresses wages. Indeed, due to the entry of China, India and the Eastern European states into the global trading system (along with population growth), estimates suggest that the pool of global labour may have quadrupled between 1985 and 2005, with most of the increase taking place after 1990.43 Other things being equal, critics argue that this enormous expansion in the global labour force, when coupled with expanding international trade, will depress wages in developed nations, particularly the wage rates of lower-paid, less-skilled manufacturing workers in developed countries. As noted above, over the last two decades, the same fears have been expressed about service jobs. Technological advances now mean that many services that were previously non-tradeable are now tradeable. More skilled, white-collar jobs increasingly have been outsourced to nations with lower labour costs. Evidence seems to support the critics. In most developed countries, the wages share of national income (in contrast to the profits share) has declined since 1980 and income inequality within developed nations has risen.44 What is hotly debated, however, is whether globalisation and offshoring are the main causes of these phenomena. Supporters of globalisation reply that critics miss the essential point about free trade— that is, the benefits outweigh the costs.45 Supporters argue that free trade will result in countries specialising in the production of those goods and services that they can produce most efficiently, while importing goods and services that they cannot produce as efficiently. When a country embraces free trade, there is always some dislocation at the sector level— for example, lost jobs in clothing manufacturing or lost call-centre jobs at banks—but the whole economy is better off as a result. According to this view, it makes little sense for Australia to produce low-wage, low-skilled textiles and clothing at home when they can be produced at a lower cost in China, Thailand or Indonesia. Importing textiles from China leads to lower prices for clothes in Australia, which enables consumers to spend more of their money on other items. At the same time, the increased income generated in China from textile exports increases income levels and—as the industrial sector and the middle class expand in that country—the Chinese are able to purchase more products from Australia, such as iron ore, food staples, elaborately transformed manufactures, professional services, educational services, tourism services and mining equipment. The same argument can be made to support the outsourcing of services to low-wage countries. By outsourcing customer service call centres and back-office jobs to India, China or the Philippines, financial institutions can reduce their cost structure and, thereby, their prices for financial services to their Australian customers. Australians can spend more of their money on other goods and services. Moreover, for every event of offshoring in a CHAPTER 1 hiL23674_ch01_001-054.indd 33 GLOBALISATION 33 08/06/19 07:40 PM developed country, there is a converse event of ‘onshoring’ in a developing country. The increase in income levels in India, China and the Philippines allows the growing middle class in these countries to purchase more Australian goods and services, which helps to create jobs at home. In this manner, supporters of globalisation argue that free trade benefits all countries that adhere to a free trade regime. There is another mechanism by which globalisation affects jobs other than via this income effect. While globalisation will put certain jobs at risk, it will create other jobs. In developed regions such as Australia, North America and Western Europe, supporters claim that most attention focuses on the jobs lost from offshoring and import competition but ignores the jobs created through increased productivity and increased exports. A study in the United States estimated that the number of jobs potentially at risk of being offshored from that country to low-wage, labour-abundant countries was about 15–20 million (about 40 per cent of these were in the manufacturing sector), but predicted that these job losses would be offset in aggregate terms by job gains from services exporting.46 The net effect on jobs from offshoring, therefore, is the result of two opposing effects—the ‘relocation effect’ and the ‘scale effect’.47 When jobs are offshored (e.g. the back-office jobs of banks), jobs are lost. This is the relocation effect. When offshoring these jobs results in the business being more productive and more efficient, enabling it to be more competitive and increase sales and employment, this job creation is the scale effect. A study of 17 OECD countries found that offshoring within the same industry has no overall effect on employment because the new jobs created by increased sales (the scale effect) offset jobs due to the loss of labour-intensive work, the relocation effect.48 Jobs to be offshored are relatively low-wage, low-skilled intensive jobs, whereas jobs to be gained are in relatively high-wage, high-skilled intensive services in which the developed countries have a comparative advantage—for example, finance, entertainment and higher education. An example of these high-end services which developed countries are onshoring or exporting is tertiary education. The OECD countries continue to attract the lion’s share of foreign students by a considerable margin with the United States and the United Kingdom dominating the market. Companies in OECD countries will also be retaining the high-skilled tasks in their home base for strategic reasons. Companies are unlikely to offshore the high-skilled jobs that underpin their ‘core competencies’ in areas such as marketing, finance, R&D and design. International trade figures appear to support the notion that there is both job loss and job creation in offshoring. The United States and other developed economies are net exporters of services and in many cases these net surpluses have been increasing rather than decreasing.49 In other words, developed countries may offshore certain jobs, but they are also able to create and onshore other jobs. There is a theory of trade that supports this way of thinking, embodied in the principle of comparative advantage as compared to absolute advantage, which is discussed in more detail in the next chapter. As noted above, the critics of globalisation argue that globalisation causes wages in developed countries to fall and the gap in incomes between the low-wage, low-skilled worker and the high-wage, high-skilled worker to rise. The result is rising income inequality. Rising income inequality will also occur in the developing countries. Supporters of globalisation concede the point with respect to the evidence of growing income inequality, but would debate whether globalisation is the culprit. Technological change also plays a major role.50 There are two channels through which globalisation may widen income inequality. • 34 PART 1 When jobs are offshored from developed to developing countries, they tend to be the low-skill-intensive jobs from the developed country’s point of view but high-skillintensive from the perspective of the developing country. Consequently, offshoring GLOBALISATION hiL23674_ch01_001-054.indd 34 08/06/19 07:40 PM • increases the demand for the relatively high-skilled labour in both developed and developing countries, thus increasing income inequality within both groups of countries. If low-income workers disproportionately work for low-productivity, low-profit companies, and these companies suffer most from import competition, trade will increase income inequality by reducing the employment opportunities and/or lowering the relative wages of the low-income workers.51 Technological advances can also affect income inequality if they benefit higher-skilled workers more than others. Technological advances have destroyed many low-skilled jobs within economies through automation thus reducing the demand for low-skilled, lowincome workers. Technological advances have also made many medium and high-skilled service jobs tradeable or ‘offshoreable’. (With current technologies at the moment, the tasks of skilled medical specialists reading X-rays, for example, are offshoreable but not yet the tasks of low-skilled gardeners and garbage collectors.) By the same token, as noted above, developed countries may well have a comparative advantage in many medium and highskilled tradeable services that are ‘onshoreable’. The evidence suggests that the increasing tradeability of services due to technological advances has not disproportionately impacted the demand for skilled workers. Offshoring has in fact increased the wages of skilled workers relative to those of unskilled workers. Technological advances, therefore, are more likely to impact negatively the wages and employment opportunities of medium-skilled workers (in services) and low-skilled, low-income workers (in manufacturing) than impact high-skilled workers, thus increasing income inequality.52 In addition, globalisation and technological change reinforce each other, further raising income inequality. Technology is a driving force for globalisation, but globalisation increases the competition on companies forcing them to introduce skill-based technological change. So while the critics argue that the decline in unskilled wage rates, job losses and growing inequality corresponds to the rise of globalisation, academics and the supporters of globalisation see a more complex picture. One complication is the entanglement of relocation and scale effects. Another is to disentangle globalisation effects from the effects of technological change. Supporters point out that many advanced economies report a shortage of highly skilled workers and an excess supply of unskilled workers. Thus, growing income inequality is a result of the wages for skilled workers being bid up by the labour market and the wages for unskilled workers being discounted. They point to evidence that suggests that technological change has had a bigger impact than globalisation on the declining share of the national income enjoyed by wage and salary earners and the increase in wage dispersion.53 Supporters would also contend that despite any rise in income inequality, the standards of living of the unskilled worker would continue to rise. They would share a larger economic pie due to the productivity-enhancing effects on economic growth of free trade, skill transfers, more intense international competition and specialisation. Yet another complication is the difficulty of attributing job loss to any one cause when there always exists a large churn in jobs, as to be expected in any dynamic economy. A study in the United Kingdom found that 51 000 jobs are destroyed and 53 000 jobs are created in the private sector in one week, representing nearly 16 per cent of the private sector workforce.54 It is also difficult to disentangle the impact of economic cycles of expansion and recession on employment and unemployment, which in turn increase income differentials and income inequality. Estimating the actual or potential number of jobs to be lost and gained by globalisation or offshoring and onshoring and whether or not forces other than globalisation are the source of rising income inequality are difficult tasks. The reality is that jobs are being CHAPTER 1 hiL23674_ch01_001-054.indd 35 GLOBALISATION 35 08/06/19 07:40 PM lost, wage growth has been restrained and income inequality has coincided with rising globalisation. The challenge facing international business into the future is that this coincidence may create the perception that globalisation is at fault and may be sufficient to undermine the public support for globalisation. The public might agree that globalisation has caused the national economy to grow and that there are benefits of globalisation but when they see the pay of senior executives rising while their incomes are stagnant, company profits rising while wages are stagnant and taxpayers being asked to bailout huge corporations and financial institutions who are ‘too big to fail’, the public understandably might conclude that the benefits of globalisation are not being evenly divided. Moreover, as offshoring extends to high-tech goods and higher skill services, the sense of economic vulnerability will spread across a wider range of skill and education groups—rather than falling entirely on low-skilled workers, as had been the case until recently. A growing number of people from all socioeconomic groups can more readily identify themselves as losers and have sympathy with movements such as Occupy Wall Street. They begin to question the merits of liberal free trade and foreign investment policies. When the public perceives that their incomes are stagnant and the benefits are unevenly divided, they become more protectionist.55 Rising protectionism is contrary to the interest of international business. Perceived increasing economic insecurity and the backlash of rising protectionism suggest an urgent need for policies that both liberalise trade and investment to foster globalisation while redistributing the benefits of globalisation (i.e. compensating the losers). Proponents of different ideological stances will have different views of the extent to which governments should intervene and redistribute income. In response to the growing protectionist sentiment supporters of globalisation, including international business, argue that the solution to the problem of declining income shares of low-income earners is to be found not in limiting free trade and globalisation but in increasing society’s investment in education and training to reduce the supply of unskilled workers.56 (We look at the different ideological stances and their implications for international business in Chapter 6.) Education policies that increase graduation rates in higher education and promote equal access have been shown to help reduce income inequality.57 The cautionary tale with education and training, however, is that it would be futile to target training to specific jobs. It is difficult to predict which tasks are likely to be ‘offshoreable’ or ‘onshoreable’. The education and training to assist workers who may be displaced by technological changes and globalisation would be more effective if it were more general and aimed at lifetime employment and a variety of industries.58 Others would argue for more interventionist policies to reduce income dispersion—for example, more progressive taxes, broader social welfare safety nets, minimum wage legislation and strengthening the role of trade unions. Interventionist redistribution policies may be necessary to build the political consensus that makes it feasible to liberalise international trade and investment and resist the call for more protection. International business would most likely prefer to see the longstanding debate about globalisation and jobs focus more on how best to compensate the losers of an open trading system and globalisation. Finally, there is the question of the pace of change. If the speed of the transition to offshoring and onshoring is slow, the impact of the disruption to labour markets in developed countries is likely to be less disruptive. The speed of transition will be governed by factors in the onshoring countries. Do the economies of China and India have the capacities to take on evermore sophisticated and complex tasks? These capacities are born of a complex of quality economic and social institutions—including the material infrastructure, education systems, property rights, intellectual property law, the rule of law, and governance. There is also the question of whether or how quickly other developing and emerging economies can replicate the achievements of China and India. It is also worth noting that 36 PART 1 GLOBALISATION hiL23674_ch01_001-054.indd 36 08/06/19 07:40 PM the wage gap between developing and developed nations is closing as developing countries experience rapid economic growth. We saw this in the case of India’s IT software industry (see Emerging Markets: ‘India’s IT software sector’). One estimate suggests that wages in China will approach Western economy levels in about 30 years.59 To the extent that this is the case, rising wages in China and India could well erode their cost advantages and limit the number of jobs that can be offshored. The migration of unskilled and medium-skilled jobs to low-wage countries may well be a temporary phenomenon, representing a structural adjustment on the way to a more tightly integrated global economy. Globalisation, labour policies and the environment A second source of concern is that free trade encourages companies from advanced nations to move manufacturing facilities to less developed countries or source products from countries that lack adequate regulations to protect labour and the environment from abuse by unscrupulous businesses.60 Globalisation critics often argue that adhering to labour and environmental regulations significantly increases the costs of manufacturing enterprises and puts them at a competitive disadvantage in the global marketplace vis-à-vis companies based in developing nations that do not have to comply with such regulations. Companies deal with this cost disadvantage, the argument goes, by moving their production facilities to nations that do not have such burdensome regulations or that fail to enforce the regulations they have. Multinationals are accused of putting downward pressure on wages, employment conditions and environmental controls, fostering a regulatory ‘race to the bottom’. This argument is used repeatedly by those who oppose any form of trade and investment liberalisation, particularly by those who face the consequences of more intense international competition. This was the situation in the case of the Ecuadorean rose industry. The industry came under fire from environmentalists and human rights activists in the United States and Europe. Growers were accused of misusing a toxic mixture of pesticides, fungicides and fumigants to grow and export unblemished pest-free flowers, in the process damaging the environment and endangering the health of workers. Those who have a vested interest in restricting the flow of Ecuadorean exports, namely the established growers in the Northern Hemisphere, are quick to lend voice to such criticisms. There also continues to be a stream of reports of worker exploitation emanating from China that does not help the cause of globalisation. The Taiwanese company Foxconn, manufactures in China more than 40 per cent of the world’s electronics for companies such as Apple, Dell, Amazon and others. In a recent report, Foxconn was accused of violating Chinese law and industry codes of conduct on numerous occasions, by having employees work more than 60 hours a week, and sometimes for 11 or more days in a row. The report prompted protests and petitions over conditions at overseas factories and several labour rights organisations called for greater scrutiny of suppliers like Foxconn. Foxconn has also been accused of employing child labour.61 (The issues in relation to ethics and corporate social responsibility are discussed in more detail in Chapter 8.) On the other hand, where FDI creates a foreign affiliate, these affiliates pay higher wages relative to domestic companies in both developed and developing countries. The wage differential between domestic and foreign-owned companies ranges from about 10 to 70 per cent depending on the country. Jobs created by FDI are good jobs because they are likely to pay higher wages and offer more training than local companies.62 Globalisation is also blamed for environmental degradation and global warming.63 Critics argue that the expansion of world trade and multinational activity results in increased carbon emissions as more goods are transported over greater distances all over the globe. They argue that many of the goods in question can be produced much closer to the point CHAPTER 1 hiL23674_ch01_001-054.indd 37 GLOBALISATION 37 08/06/19 07:40 PM of consumption. Another criticism of globalisation is that trade and globalisation have contributed to enormous global economic growth, which with current technologies is very carbon-intensive—global economic growth driven by the likes of China and India. A related problem is the changing composition of economic growth. Globalisation has changed consumption patterns throughout the world. The aspirational norms of consumption have become more akin to the materialistic, ostentatious consumption patterns of the Western world.64 Consequently, the impacts on environmental resources and systems of the economic growth attained throughout the world are magnified. For example, while global population doubled between 1950 and 2004, global wood use more than doubled, global water use trebled, and the consumption of coal, oil and natural gas increased nearly five times.65 It is estimated that car ownership in China will exceed 200 million in 2020, causing serious energy security and environmental issues.66 The critics conclude that globalisation is a force for rapid, carbon-fuelled development. If the critics are correct, one might expect trade to lead to an increase in pollution and result in companies from advanced nations exploiting the labour of less developed nations.67 Supporters of free trade and greater globalisation express doubts about this scenario. They argue that there is little evidence that globalisation fosters an environmental ‘race to the bottom’. Any costs associated with meeting the standards set by environmental regulations are not considered to be so burdensome as to sway a decision on location choice. Access to markets and labour costs are more important to location decisions. Supporters make the point that newly built foreign plants maintain higher standards than domestic plants even when not required to do so. Companies find it more efficient to have a single set of management practices, pollution control technologies and training programs geared to a common set of standards, rather than seeking out any cost advantage that might be obtained by scaling back on environmental standards in any particular foreign facility.68 Furthermore, the relationship between pollution, labour exploitation and production costs may not be that suggested by critics. In general, a well-treated labour force is productive, and it is productivity rather than base-wage rates that often has the greatest influence on costs. The vision of greedy managers who shift production to low-wage countries to exploit their labour force or the local environment may be misplaced. Supporters of globalisation argue more generally that tougher environmental regulations and stricter labour standards go hand in hand with economic progress.69 As countries get richer, they enact tougher environmental and labour regulations.70 Because free trade enables developing countries to increase their economic growth rates and become richer, this should lead to tougher environmental and labour laws. In this view, the critics of free trade have got it backwards—free trade does not lead to more pollution and labour exploitation; it leads to less. By creating wealth and incentives for enterprises to produce technological innovations, the free market system and free trade could make it easier for the world to cope with pollution and population growth. Indeed, while pollution levels (which includes the many forms of air, land and water pollution but excludes carbon dioxide emissions) are rising in the world’s poorer countries, they have been falling in developed nations. A number of econometric studies have found consistent evidence of a hump-shaped relationship between income levels and pollution levels (see Figure 1.4).71 As an economy grows and income levels rise, initially pollution levels also rise. However, past some point, rising income levels lead to demands for greater environmental protection, and pollution levels then fall. A seminal study by Grossman and Krueger found that the turning point generally occurred before per capita income levels reached US$8000.72 While the hump-shaped relationship depicted in Figure 1.4 seems to hold across a wide range of pollutants—from sulphur dioxide to lead concentrations and water quality—carbon 38 PART 1 GLOBALISATION hiL23674_ch01_001-054.indd 38 08/06/19 07:40 PM Carbon dioxide emissions Pollution levels dioxide emissions are an important exception, rising steadily with higher income levels. Given that increased atmospheric carbon dioxide concentrations are implicated in global warming, action to reduce carbon emissions is required. The solution to the problem, however, is probably not to roll back the trade liberalisation efforts that have fostered economic growth and globalisation, but to get the nations of the world to agree to tougher standards on limiting carbon emissions as agreed to under the Paris Agreement in 2015. The limitation of this agreement is that limits on carbon are nationally determined. As seen in Australia, reaching agreement can be very challenging, especially in an environment where the United States has decided to walk away from the agreement. Essentially, national governments are not prepared to commit to mandated emission targets on three grounds. Other pollutants US$8000 Income per capita FIGURE 1.4 Income levels and environmental pollution • They claim pursuit of such targets will undermine the international competitiveness of domestic industry and unreasonably retard national economic growth—that is, they need a level ‘carbon playing field’. • They are concerned about ‘carbon leakage’—that is, carbon emissions will simply shift from the parts of the planet that will undertake carbon reduction to other parts that will not.73 • They are concerned that to be subjected to the monitoring of their progress towards attaining such targets by an external body would impinge on their national sovereignty. Environmental issues are inherently global. Life-sustaining ecosystems and air pollution cross national boundaries. Climate change will eventually affect everyone but impacts such as rising sea levels and the degradation of agricultural land are likely to impact first and hardest on the poor.74 Climate change, therefore, is likely to increase the incidence of global poverty. It will cause population displacement and an increase in the domestic and international migration of economic refugees, and result in conflict over access to natural resources—all of which will pose new threats to the security of an already insecure world. These outcomes are not conducive to international business. The resulting political and economic instability raises the risks of doing business internationally. The lack of an international agreement on climate change may spell difficulties for international business in a second way. Without internationally agreed commitments, countries that do decide to act unilaterally to achieve environmental objectives will most likely resort to trade restrictions. Recourse to trade restrictions is typically sought on two grounds: (1) as a means of attaining a ‘level carbon playing field’; and (2) as a means of countering ‘carbon leakage’—that is, using the threat of trade sanctions as a means of forcing other countries to fall into line on carbon reduction. A type of ‘green’ tariff or countervailing duty, as will be discussed in Chapter 3, would likely be the instrument of choice. Unilateral action tends to provoke retaliatory trade restrictions and a spiral into a trade or investment war. Rapidly developing countries such as China and India that are emerging as the major polluters see themselves as the target of such trade sanctions. In their minds, however, it is the Western industrialised countries that are primarily responsible for the climate change problem. The threat of ‘green’ trade restrictions, therefore, is not conducive to international cooperation. In today’s global economy, no meaningful global regulatory regime to do with climate change, trade or finance can exist without the cooperation of China and India. International business would prefer to see CHAPTER 1 hiL23674_ch01_001-054.indd 39 GLOBALISATION 39 08/06/19 07:40 PM © Overflightstock Ltd/Alamy Stock Photo multilateral negotiation and cooperation on the governance of environmental issues, as this is less likely to provoke rising trade and investment protectionism. The WTO with its system of trade rules and sanctions may need to play a greater role in building global cooperation on the control of carbon emissions. (The role of the WTO is discussed in more detail in Chapter 3.) Sea-level rise due to global warming will make many small Pacific Island nations uninhabitable. Notwithstanding the difficulty of getting nations to agree on tougher standards to cut carbon emissions, supporters of free trade and globalisation argue that the solution to the problem is not to roll back the trade liberalisation that has fostered global economic growth and globalisation. They contend that free trade can benefit the environment in the following ways, contrary to the views of the critics:75 40 PART 1 • a more open trading system increases global access to products and services that can help improve energy efficiency, natural resource conservation, and the quality of air and other environmental systems • freer trade will lower the cost of environmentally friendly goods, services and advanced technologies as a result of the efficiency gains accruing from comparative advantage and specialisation. This will be important for countries that do not have the domestic industries to produce such products • additional exports opportunities will give businesses the incentives to develop new products to mitigate environmental problems • the increase in income that flows from trade and investment results in society demanding better environmental quality (as depicted in Figure 1.4) • trade’s role in generating greenhouse gas emissions through its link with transport may be exaggerated. Ninety per cent of world merchandise trade is transported by ship. Marine transport generates only about 9 per cent of the emissions of the transport sector. Road transport contributes nearly 74 per cent. International trade’s contribution to transport emissions is minor. GLOBALISATION hiL23674_ch01_001-054.indd 40 08/06/19 07:40 PM Globalisation and national sovereignty Another concern voiced by critics of globalisation is that today’s increasingly interdependent global economy shifts economic power away from national governments and towards supranational organisations such as the World Trade Organization, the European Union and the United Nations. As perceived by critics, unelected bureaucrats now impose policies on the democratically elected governments of nation-states, thereby undermining the sovereignty of those states and limiting their ability to control their own destiny.76 As noted above, sovereignty concerns have been a stumbling block to achieving international agreement on how to manage climate change. The World Trade Organization is a favourite target of those who attack the headlong rush towards a global economy. As noted earlier, the WTO was founded in 1994 to police the world trading system established by the General Agreement on Tariffs and Trade. The WTO arbitrates trade disputes between the 157 states that are signatories to GATT. The arbitration panel can issue a ruling instructing a member state to change trade policies that violate GATT regulations. If the violator refuses to comply with the ruling, the WTO allows other states to impose appropriate trade sanctions on the transgressor. As a result, according to one prominent critic, US environmentalist, consumer rights advocate and former presidential candidate Ralph Nader: Under the new system, many decisions that affect billions of people are no longer made by local or national governments but instead, if challenged by any WTO member nation, would be deferred to a group of unelected bureaucrats sitting behind closed doors in Geneva (which is where the headquarters of the WTO are located). The bureaucrats can decide whether or not people in California can prevent the destruction of the last virgin forests or determine if carcinogenic pesticides can be banned from their foods; or whether European countries have the right to ban dangerous biotech hormones in meat . . . At risk is the very basis of democracy and accountable decision making.77 This lack of democratic accountability and control of borders (loss of national sovereignty) was instrumental in the Brexit vote, whereby the United Kingdom chose to withdraw from the European Union. One UK national newspaper, the Daily Express, took up the cause as follows: After far too many years as the victims of Brussels’ larceny, bullying, over-regulation and all-round interference, the time has come for the British people to win back their country and restore legitimacy and accountability to their political process.78 In contrast to these views, many economists and politicians maintain that the power of supranational organisations such as the WTO is limited to what nation-states collectively agree to grant them. They argue that bodies such as the UN and the WTO exist to serve the collective interests of member states, not to subvert those interests. Supporters of supranational organisations point out that the power of these bodies rests largely on their ability to persuade member states to follow a certain action. If these bodies fail to serve the collective interests of member states, those states will withdraw their support and the supranational organisation will quickly collapse. In this view, real power still resides with individual nation-states, not supranational organisations. There are two other concerns in relation to the increasing liberalisation of foreign trade and investment, the rise of globalisation and the possible erosion of national sovereignty. They are the issues of the relatively small but growing role of SWFs in FDI; and the economic size and power of multinational corporations relative to the size of national CHAPTER 1 hiL23674_ch01_001-054.indd 41 GLOBALISATION 41 08/06/19 07:40 PM economies, particularly developing economies. Both of these issues are addressed elsewhere in this book. The concerns over SWFs and responses were raised earlier in this chapter, and they are also discussed in Chapter 3. The power of multinationals is discussed in Chapter 6 in the context of shifting ideologies and the control of FDI. The reality is that no government permits the free flow of trade and investment. They tend to take a pragmatic stance of attempting to maximise the benefits and minimise the costs of these flows in order to advance what they consider is the ‘national interest’. Concerns such as these frequently arise in Australia when iconic enterprises are taken over by foreign investors, for example, the foreign takeover of Cubbie Station, Australia’s largest cotton grower. The national sovereignty debate can become emotional, spurred by considerable economic xenophobia. Supporters of globalisation would concur with the view opined by one commentator on the Cubbie Station affair, ‘[A]s long as foreign investors obey Australian law, there’s no reason their dollars will pose a problem. Foreign money is as good as local money’.79 Where democratic institutions and the rule of law preside, real power resides with the state and its eminent domain powers. Globalisation and the world’s poor Critics of globalisation argue that despite the supposed benefits associated with free trade and investment, over the past 100 years or so the gap between the rich and poor nations of the world has widened. In 1870, the average income per capita in the world’s 17 richest nations was 2.4 times that of all other countries. In 1990, the same group was 4.5 times as rich as the rest. In 2019, the 34 member states of the Organisation for Economic Cooperation and Development (OECD), which includes most of the world’s rich economies, had an average gross national income (GNI) of more than $40 000 per capita, whereas the world’s 40 least developed countries had a GNI of under $1000 per capita—implying that income per capita in the world’s 34 richest nations was 40 times that in the world’s 40 poorest.80 While recent history has shown that some of the world’s poorer nations are capable of rapid periods of economic growth—witness the transformation that has occurred in some South-East Asian nations such as South Korea, Thailand and Malaysia—there appear to be strong forces for stagnation among the world’s poorest nations. A quarter of the countries with a GDP per capita of less than $1000 in 1960 had growth rates of less than zero, and a third had growth rates of less than 0.05 per cent.81 Critics argue that if globalisation is such a positive development, this divergence between rich and poor should not have occurred. Although the reasons for economic stagnation vary, several factors stand out, none of which has anything to do with free trade or globalisation.82 Many of the world’s poorest countries have suffered from totalitarian governments, economic policies that destroyed wealth rather than facilitated its creation, endemic corruption, scant protection for property rights and prolonged civil war. A combination of such factors helps explain why countries such as Afghanistan, Cuba, Haiti, Iraq, Libya, Nigeria, Sudan, Syria, North Korea and Zimbabwe have failed to improve the economic lot of their citizens during recent decades. A complicating factor is the rapidly expanding population in many of these countries. Without a major change in government, population growth may exacerbate their problems. Promoters of free trade argue that the best way for these countries to improve their lot is to lower their barriers to free trade and investment and to implement economic policies based on free market economics.83 Many of the world’s poorer nations are being held back by large debt burdens. Of particular concern are the 40 or so ‘highly indebted poorer countries’ (HIPCs), which are home to some 700 million people. Among these countries, the average government debt burden has been as high as 85 per cent of the value of the economy, as measured by GDP, and the annual costs of serving government debt have consumed 15 per cent of the 42 PART 1 GLOBALISATION hiL23674_ch01_001-054.indd 42 08/06/19 07:40 PM CHAPTER 1 hiL23674_ch01_001-054.indd 43 GLOBALISATION © John Wang/Getty Images country’s export earnings.84 Servicing such a heavy debt load leaves the governments of these countries with little left to invest in important public infrastructure projects such as education, health care, roads and power. The result is that HIPCs are trapped in a cycle of poverty and debt that inhibits economic development. Free trade alone, some argue, is a necessary but not sufficient prerequisite to help these countries to bootstrap themselves out of poverty. Instead, large-scale debt relief is needed for the world’s poorest nations to give them the opportunity to restructure their economies and start the long climb towards prosperity. Supporters of debt relief also argue that new democratic governments in poor nations should not be forced to honour debts that were incurred and mismanaged long ago by their corrupt and dictatorial predecessors. In the late 1990s, a debt relief movement began to gain ground among the political establishment in the world’s richer nations.85 Fuelled by high-profile endorsements from Irish rock star Bono (who has been a tireless and increasingly effective advocate for debt relief), the Dalai Lama and influential Harvard economist Jeffrey Sachs, the debt relief movement was instrumental in persuading the United States to enact legislation in 2000 that provided $435 million in debt relief for HIPCs. More importantly perhaps, the United States also backed an IMF plan to sell some of its gold reserves and use the proceeds to help with debt relief. The IMF and the World Bank have now picked up the banner and have embarked on a systematic debt relief program. For such a program to have a lasting effect, however, debt relief must be matched by wise investment in public projects that boost economic growth (such as education) and by the adoption of economic policies that facilitate investment and trade. Consistent with this, in June 2005 the finance ministers from several of the world’s richest economies (including the United States) agreed to provide enough funds to the World Bank and the IMF to allow them to cancel a further $55 billion in debt owed by HIPCs. The goal was to enable HIPCs to redirect resources from debt payments to health and education programs, and to alleviate poverty. The richest nations of the world can also help by reducing barriers to the importation of products from the world’s poorest nations, particularly tariffs on imports of agricultural products and textiles. High-tariff barriers and other impediments to trade make it difficult for poor countries to export more of their agricultural production. The WTO has estimated that if the developed nations of the world eradicated subsidies to their agricultural producers and removed tariff barriers to trade in agriculture, this would raise global economic welfare by $128 billion, with $30 billion of that going to poor nations, many of which are highly indebted. The faster growth associated with expanded trade in agriculture could significantly reduce the number of people living in poverty, according to the WTO.86 Despite the large gap between the rich and poor nations, there is some evidence that progress is being made. In 2015, the United Nations adopted what were known as the Sustainable Development Goals, 17 economic and human development goals for the world. We address these goals in Chapter 5. Overall, it is hard to escape the conclusion that globalisation and lower barriers to cross-border trade and investment are major factors in this remarkable prospect. While internal conditions in developing countries play a significant role, it does not excuse the developed nations from contributing to the reduction in inequality. Critics Many factors explain the plight of poor countries, ranging of the free trade strategy for development—such as the from domestic factors such as corrupt governments Cambridge University economist Ha-Joon Chang—argue that and economic mismanagement to external factors such the free trade rules of the world economy are designed not as the imbalance of economic power between rich and poor nations. to help poor nations develop but to lock in the advantages 43 08/06/19 07:40 PM of the present industrial developed countries. In other words, some of the main reasons for lack of economic development are not domestic or internal factors but factors external to the economy, factors over which developing countries have little control.87 LO 1.5 INTERNATIONAL BUSINESS Any firm that engages in international trade or investment 44 PART 1 MANAGING IN THE GLOBAL MARKETPLACE: WHAT’S THE DIFFERENCE? Much of this book is concerned with the challenges of managing an international business. An international business is any company that engages in international trade or investment. A company does not have to become a multinational enterprise, investing directly in operations in other countries, to engage in international business, although multinational enterprises are international businesses. All a company has to do is export or import products from other countries. As the world shifts towards a truly integrated global economy, more companies, both large and small, are becoming international businesses. What does this shift towards a global economy mean for managers within an international business? As their organisations increasingly engage in cross-border trade and investment, managers need to recognise that the task of managing an international business differs from that of managing a purely domestic business in many ways. At the most fundamental level, the differences arise from the simple fact that countries are different. Countries differ in their cultures, political systems, economic systems, legal systems and levels of economic development. Despite all the talk about the emerging global village, and despite the trend towards globalisation of markets and production, as we shall see in this book, many of these differences are profound and enduring. Differences between countries require that an international business vary its practices country by country. Marketing a product in Brazil may require a different approach from marketing the product in Germany; managing Australian workers might require different skills than managing Thai workers; maintaining close relations with a particular level of government may be very important in Indonesia but less relevant in New Zealand; the business strategy pursued in India might not work in South Korea; and so on. Managers in an international business must not only be sensitive to these differences, but they must also adopt the appropriate policies and strategies for coping with them. Much of this book is devoted to explaining the sources of these differences and the methods for successfully coping with them. A further way in which international business differs from domestic business is the greater complexity of managing an international business. In addition to the problems that arise from the differences between countries, a manager in an international business is confronted with a range of other issues that the manager in a domestic business never confronts. In global markets, the business will confront more intense competition from rivals—often the benchmark firms in the business—and often that competition will not be on a ‘level playing field’. To continue the sporting parlance, they will not have the home advantage. The manager needs to be informed across a greater number of variables in order to arrive at the best strategy to compete successfully. The managers of an international business must decide where in the world to site production activities to minimise costs and to maximise value added. They must decide whether it is ethical to adhere to the lower labour and environmental standards found in many less developed nations. Then they must decide how best to coordinate and control globally dispersed production activities (which, as we shall see later in the book, is not a trivial problem). The managers in an international business must also decide which foreign markets to enter and which to avoid. They must choose the appropriate mode for entering a particular foreign country. Is it best to export its product to the foreign country? Should the company allow a local company to produce its product under licence in that country? Should the company enter into a joint venture with a local firm to produce its product in that country? Or should the firm set up a wholly owned subsidiary to serve the market in that country? As we shall see, the choice of entry mode is GLOBALISATION hiL23674_ch01_001-054.indd 44 08/06/19 07:40 PM • countries are different—they have different political, legal, economic and cultural systems • the range of problems confronted by a manager in an international business is wider • the problems themselves are more complex and the knowledge demands much higher • the competition will be more intense • an international business must find ways to work within the limits imposed by government intervention in the international trade and investment system • international transactions involve converting money into different currencies. In this book, we examine all these issues in depth, paying close attention to the different strategies and policies that managers pursue to deal with the various challenges created when a company becomes an international business. Chapter 2 provides theoretical explanations for companies going international. Chapter 3 examines why and how national governments intervene in international trade and investment, and the role played by global and regional agreements in promoting international trade and investment. Chapter 4 focuses on the nature of the foreign exchange market and the international monetary system, and the risks of conducting business across different currencies and with foreign parties. Chapters 5, 6 and 7 explore how countries differ from each other with regard to their cultural, political, legal and economic systems and institutions. Chapter 8 takes a detailed look at the ethical issues and issues of social responsibility that arise in international business. Chapter 9 draws from the previous chapters and describes analytical tools and resources that managers use to decide on the best location for their business operations. Chapters 10 and 11 explore the strategies of international business to enter and compete in foreign markets. Chapters 12, 13 and 14 look at the management of various functional operations within an international business, including marketing, production and human relations. By the time you complete this book, you should have a good grasp of the issues that managers working within international business have to grapple with on a daily basis, and you should be familiar with the range of strategies and operating policies available to compete more effectively in today’s rapidly emerging global economy. CHAPTER 1 hiL23674_ch01_001-054.indd 45 GLOBALISATION 45 08/06/19 07:40 PM © Paul Springett/Alamy Stock Photo critical because it has major implications for the long-term health of the company. Conducting business transactions across national borders requires understanding the rules governing the international trade and monetary systems. Managers in an international business must deal with government restrictions on international trade and investment. They must find ways to work within the limits imposed by specific governmental interventions. As this book explains, even though many governments are nominally committed to free trade, they often intervene to regulate cross-border trade and investment. Managers within international businesses must develop strategies and policies for dealing with such interventions. Cross-border transactions also require that money be Despite the trend towards modernisation and the globalisation of markets and production, many differences converted from the company’s home currency into a foreign between countries are profound and enduring. currency, and vice versa. Because currency exchange rates vary in response to changing economic conditions, managers in an international business must develop policies for dealing with exchange rate movements. A company that adopts a wrong policy can lose large amounts of money, whereas one that adopts the right policy can increase the profitability of its international transactions. In sum, managing an international business is different from managing a purely domestic business, for at least six reasons: KEY TERMS PAGE 18Asian Infrastructure Investment Bank (AIIB) 17 BRIC 13 factors of production 19 foreign direct investment (FDI) 16General Agreement on Tariffs and Trade (GATT) 10 globalisation 12 13 24 18 44 17 19 20 27 globalisation of markets globalisation of production Group of Eight (G8) Group of Twenty (G20) international business International Monetary Fund (IMF) international trade Moore’s Law multinational enterprise (MNE) 10 offshoring 10 outsourcing 25 sovereign wealth fund (SWF) 17 United Nations (UN) 18United Nations Conference on Trade and Development (UNCTAD) 17 World Bank 16 World Trade Organization (WTO) SUMMARY This chapter sets the scene for the rest of the book. It shows how the world economy is becoming more global and it reviews the main drivers of globalisation, arguing that they seem to be thrusting nation-states towards a more tightly integrated global economy. We looked at how the nature of international business is changing in response to the changing global economy; we discussed some concerns raised by rapid globalisation; and we reviewed implications of rapid globalisation for individual managers. The chapter made the following points: 1. Over the past three decades, we have witnessed the globalisation of markets and production. There is greater integration and interdependence of economies. 2. The globalisation of markets implies that national markets are merging into one huge marketplace. However, it is important not to push this view too far, as significant differences in culture, politics and economies exist between countries and the adaptation of products and strategies to local conditions is often necessary for international business to succeed. 3. The globalisation of production implies that companies are basing individual productive activities at the optimal world locations for the particular activities, often resulting in the offshoring of activities that were once conducted at home. As a consequence, it is increasingly irrelevant to talk about ‘Australian products’, ‘Japanese products’ or ‘German products’, since these are being replaced by ‘global products’. 4. Two factors seem to underlie the trend towards globalisation: (a) declining trade barriers; and (b) changes in communication, information and transport technologies. These factors have facilitated the trend towards the globalisation of production and have enabled companies to view the world as a single market. 5. As a consequence of the globalisation of production and markets, world trade has grown faster than world output, foreign direct investment has surged, imports have penetrated more deeply into the world’s industrial nations, and competitive pressures on industry have increased. 6. It is noted throughout the chapter that events such as the GFC, the rise of sovereign wealth funds and climate 46 PART 1 change can provoke trade and investment protectionist sentiment and have the potential to stall trade and investment liberalisation and globalisation. 7. With the technological advances in transport and ICT, it is no longer necessary to produce goods close to where they are consumed resulting in a rapid increase in trade and FDI. These technological advances have facilitated an increasing level of offshoring both of manufactured goods and services. 8. The technological advances, especially those embodied in the internet, have helped companies to link their worldwide operations into sophisticated information networks. Companies are able to achieve tight coordination of their worldwide operations and to view the world as a single market. 9. The shape of the global economy has changed. Where once the economies of the United States, Japan and the European Union were dominant in global trade and production and the drivers of global economic growth, the poles of growth are now more dispersed among a number of countries, including the emerging economies such as the BRICs. 10. Evidence of a more multi-polar global economy is the changing source and destination of trade and FDI, the growth of non-US multinationals and the increasing representation and political power of the emerging economies in organisations as the IMF, AIIB and G20. 11. Among the most dramatic developments of the past 30 years have been the collapse of communism in Eastern Europe and the rise of China as an economic power. These developments have created enormous long-run GLOBALISATION hiL23674_ch01_001-054.indd 46 08/06/19 07:40 PM opportunities for international businesses. In addition, the free market reforms in Eastern Europe, East and South Asia, and Latin America have created opportunities (and competitive threats) for the once dominant Western international businesses. 12. The benefits and costs of globalisation are hotly debated. The debates focus on the impact of globalisation on jobs, wages and working conditions, poverty, income inequality both within and across nations, the environment and national sovereignty. Some critics have called for de-globalisation while supporters call for more openness and the liberalisation of trade and investment. 13. Managing an international business is different from managing a domestic business and is more challenging due to a variety of reasons including country differences; a wider range of more complex problems; the greater intensity of competition; increased likelihood of intervention by governments, home and host; and added complexity of conducting transactions in different currencies. CHAPTER 1 hiL23674_ch01_001-054.indd 47 GLOBALISATION 47 08/06/19 07:40 PM INTERNATIONAL BUSINESS GRADUATE ATTRIBUTES (IBGAs): LEARNING AND ASSESSMENT TASKS IBGA1: DISCIPLINE KNOWLEDGE AND SKILLS 1. Describe the shifts in the world economy over the past 30 years. Compare the implications of these shifts for international businesses based in a country of your choice. 2. ‘The study of international business is fine if you are going to work in a large multinational enterprise, but it has no relevance for individuals who are going to work in small domestic firms.’ Evaluate this statement. IBGA5: COMMUNICATION 3. As a group, develop a two-sentence maximum definition of ‘globalisation’. As a starting point to your discussion, consider the following notions. Does globalisation simply mean internationalisation—that is, the increase in cross-border trade, investment and migration? Does it mean liberalisation—that is, the gradual removal of government-imposed restrictions on cross-border exchange? Or universalisation—that is, as ideas spread around the world, people’s aspirations and experiences become harmonised? Or Westernisation—that is, the destruction of local identity and self-determination as capitalism, consumerism and industrialism spread over the world? Or de-territorialisation—that is, distance and territorial borders grow less significant and the world is conceived as a single place as exemplified in such aspects as communications over the world wide web, multinational organisations, global products, foreign currency exchanges, climate change and religious affiliations? These different concepts are drawn from J. Scholte, ‘Defining globalisation’, World Economy, 31(11) (November 2008). After the discussion and the task are completed, reflect on the behaviours in the group that facilitated the discussion and task completion. 4. Write a brief report, including suitable graphs and tables, that examines the rise of China and India in the global economy since 1970. Accessing data from organisations such as the OECD and the World Bank, particularly World Development Indicators, may prove a useful starting point. IBGA7: GLOBAL PERSPECTIVE 5. Identify a number of civil society groups or associations that are essentially global—for example, Oxfam. Many are concerned with issues of global justice and sustainable 48 PART 1 development. Outline their missions and goals. Assess the extent to which the issues they address and the actions they take transcend borders. Discuss the risks, if any, that these groups present to globalisation and international business. 6. Successful international business managers are often described as possessing a ‘global mindset’. Outline what you think characterises an individual with a global mindset. IBGA9: CITIZENSHIP 7. The internet is reaching further into all parts of the world, including developing countries. Outline how globalisation and international business have been affected by this increased connectivity, and speculate on the additional challenges and responsibilities confronting international business that are likely to arise from being an active participant in the one ‘global village’. 8. Read ‘Who makes the Apple iPhone?’. What are the potential ethical problems associated with outsourcing assembly jobs to Foxconn in China? How might Apple deal with these? IBGA1: DISCIPLINE KNOWLEDGE AND SKILLS IBGA2: CRITICAL ANALYSIS 9. CASE ANALYSIS Read again the Opening Case: ‘Kaihara: Globalisation of a shinise, a long-lived company’ and then answer the following questions. a. From its inception Kaihara has focused on the high-end market segment. Discuss the merits of this strategy. b. Kaihara is a Japanese long-lived company. What factors have contributed to its longevity? c. Kaihara originally produced kasuri, a product focused on the Japanese market. However, the company has been able to achieve international success. Discuss the strategies behind this international success. d. What were the reasons for the company establishing a Thai subsidiary? 10. CASE ANALYSIS Read the following Closing Case and answer the questions that follow. GLOBALISATION hiL23674_ch01_001-054.indd 48 08/06/19 07:40 PM CLOSING CASE GLOBAL INNOVATION THROUGH THE MOBILITY OF IDEAS AND TALENT Zinemath cPlc is a born global technology startup. It has investors from Italy and talent acquired from Australia and targets the US market. Its revolutionary approach to developing virtual reality (VR) and augmented reality (AR) technology for use in cinematography, real-time broadcasting and medical visualisation is opening up new business opportunities and potentially revolutionising operations across multiple industries from broadcasting to health care and education. Global innovation Global movement of ideas is as old as global trade itself, and the two are definitely related. A good example of this is the technology transfer facilitated by the Silk Road. In ancient times, Chinese silk was transported to Egypt. During the Middle Ages, this intercontinental trade route was responsible for the transfer of technologies and ideas between Asia and Europe. In the absence of long-haul flights, and with limited tools of navigation and propulsion for seafaring, the American side of the Pacific was not accessible. (Although Maori reached all the way to the islands of Aotearoa, and Chinese explorers may have arrived at the shores of Australia much earlier, these great efforts did not yield permanent trade routes.) By means of this trade route, people travelled, learned and transferred knowledge across different parts of the world. An envoy of the Byzantine emperor, Justinian, smuggled silk worm eggs out of China, hidden in bamboo sticks, to start silk production in the Middle East in the 6th century. Marco Polo, the Italian merchant born in Venice, travelled to China and brought back many things like noodles in the 13th/14th centuries. The Ottoman Empire acquired the secrets of gunpowder around the 14th century, and a Hungarian military engineer designed and built the first cannon for the emperor of Byzantium in the 15th century, revolutionising warfare. This later enabled the Ottoman Empire to conquer large parts of Europe (including Hungary). Porcelain (originally called ‘china’) production sprung up in Meissen, Germany, in the 18th century after engineers were able to re-create the production process and find local resources. These are examples of how ideas travel around the world by means of trade and the movement of people. Nowadays, in the modern global innovation system, international education, collaboration, recruitment and entrepreneurship drive the exchange and sharing of ideas and other resources necessary to devise new technologies and products, and access markets. Systems of innovation are described by the concept of the ripple helix, which identifies the source of complex technological innovation as an outcome of collaboration between universities (research institutes), governments and industry (businesses). These ‘interactions’ manifest by transferring intangible and tangible resources, such as knowledge, ideas, people, time on task and money. For example, governments provide grant funding to universities, on the condition of working together to help them innovate. Businesses may directly contract universities to conduct research for them, or help them to collect ideas and recruit talent through collaboration with students (class projects, internships, events). And finally, governments provide funding for the higher education sector and for research institutes to provide research and development services supporting public good, and to train the next generation of experts and professionals to enable them to contribute to the economic and social development of the country. CHAPTER 1 hiL23674_ch01_001-054.indd 49 GLOBALISATION 49 08/06/19 07:40 PM Global talent and mobility In the 21st century, innovation has become a global phenomenon, and with the global mobility of people, the global mobility of ideas has also emerged. Dr Ferenc Birloni, born in Hungary, completed a Masters in electrical engineering in Budapest, studied as an exchange student at UTS in Sydney and earned his PhD in mathematical engineering and information physics at the University of Tokyo. Ferenc moved to Australia in 2008 to work as a consultant for a rail, engineering and consultancy company, to grow the business unit for ICT and electrical engineering solutions. Throughout his career, beyond his technical skills in electrical engineering and IT, Ferenc developed his skills as a technology and business development manager, and has become a serial entrepreneur, participating in multiple start-ups. Zinemath cPlc In 2015, Ferenc was chief technology officer (CTO) of Zinemath cPlc, an already existing technology startup located in Budapest. Zinemath was established as a specialist provider of virtual production platforms to the film, production and broadcast industries. The company has developed zLense, a world-first depth-mapping camera that captures 3D data and scenery in real time and adds a depth layer to the footage. The zLense technology processes spatial information in real time, making new and real 3D compositing methods possible, enabling film production teams to create stunning 3D effects and use state-of-the-art computer-generated imagery (CGI) in live television or pre-recorded formats. The zLense technology enables live broadcast of unique simulated and AR environments, generating and combining dynamic VR and AR effects in live broadcast of studio production. The company was founded in 2012 by three Hungarian film and media entrepreneurs: Norbert Komenczi, a producer, and Botond Csizi and Gergo" Soós, developers. The founders actively sought collaboration opportunities with other businesses in the industry, attracting funding from CenTech Hungarian 50 PART 1 Venture Capital Fund, as well as some minor capital investments (Colabs Plc, Seed Co-Investment Ltd, StreamNovation Ltd and Solid Ltd), and a major enabler of capital injection by specialist investor, Docler Holding. European venture capital investments are growing (though only half the average size of those in the United States) and Brussels is preparing legislation that will further increase small to medium-sized enterprise (SME) access to venture capital, cutting red tape and fees and expanding assets in which venture capital funds can invest to include even smaller companies. In 2016, €2.5 billion was invested in seed and early-stage investments across Europe, a major increase since 2012 according to Invest Europe, the association representing Europe’s private equity, venture capital and infrastructure sectors and investors. Zinemath grew quickly between 2012 and 2015, doubling its research staff. After the arrival of Ferenc in mid-2015, the product portfolio of zLense was diversified into zStudio (3D AR visual plug-in for integration with studio systems, providing real-time AR composite), zTrack (a state-of-the-art cameratracking solution vital to create VR content rendering) and zKey (a depth-based image segmentation solution). Collaboration with SZTAKI (the Hungarian Academy of Sciences Institute for Computer Science and Control), Budapest University of Technology and international partners was also developed. Ferenc’s appointment brought clarity to the company’s strategic direction. The diversification and collaboration efforts of 2015–17 were aimed at developing marketable products through prototyping and linking with potential high-profile end users to generate new revenue streams. This expectation was driven by the new investor, Docler Holding, and its owner György Gattyán. András Somkuti, the chairman of Gattyán Group, had his eyes on the global film and television industries, with a total annual market of €1600 billion, and actively encouraged Zinemath’s participation in international events and trade shows, in Europe and beyond. The additional research capacity and efforts to find new collaborations led management to venture GLOBALISATION hiL23674_ch01_001-054.indd 50 08/06/19 07:40 PM into the health and medical industries. This was a milestone, and enabled Zinemath to win one of the largest technology development grants provided by the EU, with a total value of HUF1799 million (approximately €6 million), in July 2017. The project was granted EU funding (in the Hungarian Economic Development and Innovation Operational Programme) from the Structural and Cohesion Funds (European Regional Development Funding and European Social Fund) in order to contribute to support the Research, Technology Development and Innovation (RTDI) projects of Hungarian SMEs. The grant is funding the development of the zMed product line, aiming to use AR technologies in medical imaging and rehabilitation, and improving doctor–patient relationships and medical practitioner education, in collaboration with the Medical School of the University of Pécs and SZTAKI. As a result, Zinemath’s research and development capacity has significantly increased. April 2018: Dr Ferenc Birloni left company September 2018: technology development operations for the grant program in full swing The role of international exhibitions and global networking in the social media age Trade shows and exhibitions have historically been an opportunity for organisations to showcase their new products and technologies, to meet representatives from other organisations, and for the formal and informal exchange of ideas and talent. Of course, in the age of the internet, email, VoIP, chat and social media, this may seem like an expensive and redundant way of networking. And yet, trade shows and exhibitions are as popular as ever, demonstrating the importance of creating personal connections and networks. April 2017: received Best of Show innovation award at National Association of Broadcasters (NAB), Las Vegas The NAB show is an annual event, started in 2008 in Las Vegas, bringing together businesses and people from a wide range of related industries including broadcast television, radio, production, post production, news gathering, streaming, cable television, satellite television, film restoration, data storage, data management, weather forecasting, computer-generated imagery, connected media and cybersecurity. Zinemath’s research and development team received the Best of Show innovation award for its ground-breaking development of the zLense at the 2017 NAB show. The award gave Ferenc an opportunity to showcase the progress his team had made in terms of technology development, producing a working prototype for the exhibition and providing assurance to investors that their money was being put to good use. This was a strong basis for continuing the work, and facilitated investors’ commitment to apply for grant funding, which the organisation received in the same year. April 2017: showcased at the NAB exhibition in Las Vegas Technology development: initial stage and opportunities created for new ideas July 2017: received major EU-funded National Development Plan grant with a total value of HUF1799 million (€6 million) to develop collaborative interdisciplinary research solutions with the health and medical industries Zinemath’s original scope was to develop VR and AR applications for real-time live studio broadcasting. In a commercial entertainment context, this enabled a streamlining of requirements for shooting live media broadcasts without excessive studio equipment. Zinemath milestones/timeline February 2012: founded by three Hungarian entrepreneurs, with registered capital of HUF5 million (€17 000) 2012–13: registered capital increased to HUF16 million (€55 000), investors: CenTech Hungarian Venture Capital Fund, Colabs Plc, Seed Co-Investment Ltd, StreamNovation Ltd and Solid Ltd February 2014: major capital investment provided by Docler Holding, acquiring majority control of Zinemath June 2015: appointment of new CTO, Dr Ferenc Birloni CHAPTER 1 hiL23674_ch01_001-054.indd 51 GLOBALISATION 51 08/06/19 07:40 PM The technology development grant funding received in 2017 opened several new opportunities for the technology development team in the area of application of AR for medical technology. Applications can be used in medical education, by means of simulations, and further opportunities may also emerge. Dr Áron Perényi Swinburne University of Technology SOURCES: Docler Holding history, accessed via www.doclerholding.com/en/about/companies/43/; Docler Holding history, accessed via www. doclerholding.hu/en/about/companies/41/; LinkedIn, www.linkedin.com/company/zinemath/; ‘Company overview of Zinemath Zrt’, accessed via www. bloomberg.com/research/stocks/private/snapshot.asp?privcapid=228274724; ‘You can’t just take our business away’, Forbes, accessed via www. doclerholding.com/static/press/Forbes-Hungary-2017-Gattyan-Gyorgy.pdf; YouTube, www.youtube.com/user/zinemath; H. Winbladh, ‘Time to think big in European VC’, 11 September 2017, accessed via www.investeurope.eu/news-opinion/opinion/blog/2017/time-to-think-big-in-european-vc/; LinkedIn, www.linkedin.com/in/ferenc-birloni-dr-b85b396/?originalSubdomain=au; ‘Access to finance’, accessed via https://europa.eu/youreurope/business/ funding-grants/access-to-finance/; Zinemath, http://zinemath.com/; zLense, http://zlense.com/; NABSHOW, http://www.nabshow.com/; S. Varga, ‘It’s going to sound as big as a color film back then’, accessed via http://hvg.hu/gazdasag/20140306_Ez_akkorat_fog_szolni_mint_annak_idejen; ‘Hungarian Zinemath Zrt. can simplify film production in the world’, Business online, 13 February 2017, accessed via http://businessonline.prim.hu/ cikk/123615/; http://nkfih.gov.hu/palyazatok/europai-unios-forrasbol/versenykepessegi-kivalosagi-egyuttmukodesek; ‘Docler has invested in Zinemath Zrt’, Computer world, 10 February 2014, accessed via https://computerworld.hu/uzlet/a-zinemath-zrt-be-fektetett-a-docler-144539.html. CLOSING CASE DISCUSSION QUESTIONS a. Dr Ferenc Birloni, CTO of Zinemath, successfully drove the company’s diversification and technology development efforts. It is now time to generate revenue. How would you recommend expanding into the global market to the new management of Zinemath? How would you suggest they identify and realise the potential revenue streams globally? b. The owner and chairman of the largest investor in Zinemath have a portfolio of online content provider businesses. How would you recommend linking the newly developed medical product line, zMed, with their strategic investment portfolio in online content provision, globally? What opportunities do you think the Asia–Pacific region holds for them? c. Zinemath has grown substantially since its foundation in 2012, and with EU funding might have a shot at conquering global markets. How would you recommend the founders seek further investment to build their capabilities using their global networks? d. How would you recommend the new CTO goes about technology development, with the opportunities opening up in the Asia–Pacific region, in terms of talent, markets and collaboration opportunities? 52 PART 1 GLOBALISATION hiL23674_ch01_001-054.indd 52 08/06/19 07:40 PM ENDNOTES 1. www.csl.com.au/businesses accessed on 8 September 2015. 2. For trade statistics, see the databases of the World Trade Organization at www.wto.org, accessed on 2 April 2019. 3. M. Naim, ‘Globalization’, Foreign Policy, 171 (March/April 2009). 4. T. Friedman, The World Is Flat, New York: Farrar, Straus and Giroux, 2005. 5. Ibid. 6. T. Levitt, ‘The globalization of markets’, Harvard Business Review, May–June, 1983. 7. Interbrand, ‘Rankings, 2018’, accessed via www.interbrand.com/bestbrands/best-global-brands/2018/ranking on 24 May 2018. 8. A. Inkpen and K. Ramaswamy, ‘End of the multinational: the emerging markets redraw the picture’, The Journal of Business Strategy, 28(5) (2007); ZPMC, Company Information, accessed via www.zpmc.com/about.php on 15 January 2013. 9. See F.T. Knickerbocker, Oligopolistic Reaction and Multinational Enterprise, Boston: Harvard Business School Press, 1973; and R.E. Caves, ‘Japanese investment in the US: Lessons for the economic analysis of foreign investment’, The World Economy 16 (1993), pp. 279–300. 10. Australian Bureau of Statistics, Characteristics of Australian Exporters, 2013-14, Cat. No. 5368.0, accessed via www.abs.gov.au/ausstats/abs@.nsf/ PrimaryMainFeatures/5368.0.55.006 on 10 September 2015. 11. AusIndustry, ‘Success Stories—Gekko Systems’, Australian Government, accessed via www.ausindustry.gov.au on 31 March 2007; ‘Gekko Footprint’, Gekko Systems, News Releases, accessed via www.gekkos.com/pages. php?page=2 on 15 January 2013. 12. US Department of Commerce, A Profile of U.S. Exporting and Importing Companies, 2009–2010, 12 April 2012, accessed via www.census.gov/ foreign-trade/Press-Release/edb/2010/edbrel.pdf on 15 January 2013. 13. B. Benoit and R. Milne, ‘Germany’s best kept secret, how its exporters are beating the world’, Financial Times, 19 May 2006, p. 11. 14. All Nippon Airlines, Press Release, 1 November 2012, accessed via www .ana.co.jp/wws/us/e/local/about_ana/corp_info/pr2012/120619.html on 16 October 2012. 15. 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Williams, ‘Trade round like this may never be seen again’, Financial Times, 15 April 1994, p. 8. 23. World Trade Organization, World Tariff Profiles, 2014, accessed via https:// www.wto.org/english/res_e/booksp_e/tariff_profiles17_e.pdf accessed on 02/04/2018. 24. Moore’s Law is named after Intel founder Gordon Moore. 25. www.internetworldstats.com/stats.htm accessed on 2 April 2019. 26. For a counterpoint, see ‘Geography and the Net: putting it in its place’, The Economist, 11 August 2001, pp. 18–20. 27. World Bank, Connecting to Compete, Trade Logistics in the Global Economy, 2012, accessed via http://siteresources.worldbank.org/TRADE/ Resources/239070-1336654966193/LPI_2012_final.pdf#page=11 on 18 January 2013. 28. ‘Dell in social media’, accessed via http://content.dell.com/au/en/corp/aboutdell-social-media on 18 January 2013. 29. ‘Al Jazeera, Times topics’, The New York Times, 8 February 2010. 30. N. McDonald, ‘Al Jazeera America, a test case for an open society’, CBC News, 11 January 2013, accessed via www.cbc.ca/m/touch/news/ story/2013/01/10/f-rfa-macdonald-al-jazeera.html on 18 January 2013. 31. J. Sachs, ‘America has passed on the baton. Collective action needs to succeed’, Financial Times, 30 September 2009; G. Rachman, ‘America is losing the free world’, Financial Times, 5 January 2010. 32. P. Pielichata, ‘Norway’s sovereign wealth fund returns –6.1% in 2018’, Pensions & Investments, 27 February 2019, accessed via www.pionline. com/article/20190227/ONLINE/190229866/norways-sovereign-wealthfund-returns-61-in-2018. 33. UNCTAD World Investment Report 2009; World Investment Report 2008. 34. S. Chetty, ‘Explosive international growth and problems of success among small- and medium-sized firms’, International Small Business Journal, February 2003, pp. 5–28. 35. Comvita, Annual Reports 2006, 2008, 2012, 2015; New Zealand Trade and Enterprise, ‘Comvita’, New Zealand Export Awards accessed via www.nzte. govt.nz/section/14606/16255.aspx on 18 March 2007; Comvita Investor Centre, accessed via www.comvita.co.nz/_assets/Investors/FinancialNews/31%20March%202015%20CVT%20Annual%20Report%206MB.pdf on 16 September 2015. 36. N. Buckley and A. Ostrovsky, ‘Back to business—How Putin’s allies are turning Russia into a corporate state’, Financial Times, 19 June 2006; Freedom House, accessed via https://freedomhouse.org/report/freedomworld/freedom-world-2015#.VfjfkJMep_U on 16 September 2015. 37. For examples of this way of thinking, see ‘People first economics’, New Internationalist, 19 November 2008; W. Bello, ‘The virtues of deglobalization’, Foreign Policy in Focus, Institute of Policy Studies, 3 September 2009, accessed via www.fpif.org/articles on 20 February 2010; ‘Turning their backs on the world’, The Economist, 19 February 2009. 38. G. Thornton, Emerging Markets Opportunity Index, International Business Report 2012, accessed via www.internationalbusinessreport.com/ Reports/2012 on 21 January 2013. 39. The Economist, ‘To have and have not. It may no longer be wise to group these disparate countries together’, 21 April 2012, accessed via www.economist .com/node/21552995?zid=295&ah=0bca374e65f2354d553956ea65f756e0 on 21 January 2013. 40. J. Stiglitz, Globalization and Its Discontents, New York: W.W. Norton, 2003; J. Bhagwati, In Defense of Globalization, New York: Oxford University Press, 2004; and Friedman, The World Is Flat, op. cit. 41. Ravi Batra, The Myth of Free Trade, New York: Touchstone Books, 1993; William Greider, One World, Ready or Not: The Manic Logic of Global Capitalism, New York: Simon & Schuster, 1997; D. Radrik, Has Globalization Gone Too Far?, Washington, DC: Institution for International Economics, 1997; J. Stiglitz, Making Globalization Work, New York: W.W. Norton, 2006; N. Kleins, The Shock Doctrine: The Rise of Disaster Capitalism, New York: Metropolitan Books, 2007; see also ‘Clean start—creating a fair economy’, New Internationalist, 19 November 2008. 42. James Goldsmith, ‘The winners and the losers’, in J. Mander and E. Goldsmith (eds.), The Case Against the Global Economy, San Francisco: Sierra Club, 1996; and Lou Dobbs, Exporting America, New York: Time Warner Books, 2004; see also the concerns expressed by interest groups such as trade unions—for example, The Australian Workers Union (www .awu.net.au) and NGOs such as Oxfam (www.oxfam.org). 43. For an excellent summary, see ‘The globalization of labor’, IMF World Economic Outlook 2007 (April 2007), Ch. 5; and R. Freeman, ‘Labor Market Imbalances’, Harvard University Working Paper, accessed via www.bos.frb .org/economic/conf/conf51 on 14 June 2007. 44. D. Coe, ‘Globalisation and labour markets: policy issues arising from the emergence of China and India’, OECD Social, Employment and Migration Working Papers, No. 63, 12 November 2007; W. Milberg and D. Winkler, ‘Globalization, Offshoring and Economic Insecurity in Industrialized Countries’, DESA Working Paper No. 87, ST/ESA/2009/DWP/87, November 2009, accessed via www.un.org/esa/desa/papers/2009/wp87_2009.pdf on 29 January 2013. 45. For example, see P. Krugman, Pop Internationalism, Cambridge, MA: MIT Press, 1996; T. Harcourt, Beyond Our Shores: Essays on Australia and the World Economy, Second Edition, Australian Trade Commission, Austrade: Australian Government, 2005. 46. J. Bradford Jensen and Lori G. Kletzer, ‘Fear’ and Offshoring: The Scope and Potential Impact of Imports and Exports of Services, No. PB08-1, Washington, DC: Peterson Institute for International Economics, 2008. 47. Described in H. Görg, Globalization, offshoring and jobs, International Labour Organization and World Trade Organization 2011, accessed via www.wto.org/english/res_e/booksp_e/glob_soc_sus_e_chap1_e.pdf on 30 January 2013. 48. Ibid. 49. Quoted in D. Coe, ‘Globalisation and labour markets: policy issues arising from the emergence of China and India’, 2007, op. cit. CHAPTER 1 hiL23674_ch01_001-054.indd 53 GLOBALISATION 53 08/06/19 07:40 PM 50. P. Gottschalk and T. Smeeding, ‘Cross-national comparisons of earnings and income inequality’, Journal of Economic Literature, 35 (June 1997), pp. 633–87; and S. Collins, Exports, Imports, and the American Worker, Washington, DC: Brookings Institution, 1998. 51. OECD, ‘Reducing income inequality while boosting economic growth: Can it be done?’ Economic Policy Reforms, 2012, Going for Growth, OECD, 2012, Ch.5, accessed via www.oecd.org/dataoecd/44/26/49421421.pdf on 21 February 2012. 52. D. Coe, ‘Globalisation and labour markets: policy issues arising from the emergence of China and India’, op. cit. 53. IMF, ‘The globalization of labor’, 2007, op. cit.; D. Coe, ‘Globalisation and labour markets: policy issues arising from the emergence of China and India’, 2007, op. cit. 54. Quoted in H. Görg, Globalization, offshoring and jobs, 2011, op. cit. 55. D. Coe, ‘Globalisation and labour markets: policy issues arising from the emergence of China and India’, op. cit.; W. Milberg and D. Winkler, ‘Globalization, offshoring and economic insecurity in industrialized countries’, 2009, op. cit. 56. See Krugman, Pop Internationalism, op. cit.; and D. Belman and T.M. Lee, ‘International trade and the performance of US labor markets’, in R.A. Blecker (ed.), U.S. Trade Policy and Global Growth, New York: Economic Policy Institute, 1996. 57. OECD, ‘Reducing income inequality while boosting economic growth: Can it be done?’, op. cit. 58. A. Blinder, ‘Offshoring: big deal or business as usual?’ CEPS Working Paper No.149, June 2007, accessed via www.princeton.edu/~ceps/ workingpapers/149blinder.pdf on 25 January 2013. 59. Freeman, ‘Labor Market Imbalances’, op. cit. 60. E. Goldsmith, ‘Global trade and the environment’, in J. Mander and E. Goldsmith (eds.), The Case Against the Global Economy, San Francisco: Sierra Club, 1996. 61. China Labor Watch, ‘Foxconn employs interns between 14 to 16’, 15 October 2012, accessed via www.chinalaborwatch.org/news/new-438.html on 30 January 2013. 62. B. Javorcik, Does FDI Bring Good Jobs to Host Countries?, Background Paper for the World Development Report 2013. 63. L. Leopold, ‘Globalization is fueling global warming’, AlterNet, 28 December 2007, accessed via www.alternet.org on 16 February 2010; A. Najam, D. Runnalls and M. Halle, ‘Environment and globalization: five propositions’, International Institute for Sustainable Development, Environment and Governance Project, 2007. 64. Ibid., p. 21. 65. Ibid. 66. Bao Chang, ‘Automobile ownership to exceed 100m by year’s end: CMIF’, China Daily, 23 July 2011, accessed via www.chinadaily.com.cn/ business/2011-07/23/content_12967089.htm on 30 January 2013. 67. C. Mooney and B. Dennis, ‘WHO: Global air pollution is worsening, and poor countries are being hit the hardest’, The Washington Post, 12 May 2016, accessed via www.washingtonpost.com/news/energy-environment/ wp/2016/05/12/who-global-air-pollution-is-worsening-and-poor-countriesare-being-hit-the-hardest/?noredirect=on&utm_term=.83a2351d0335 on 3 July 2019. O. Omoju, ‘Environmental Pollution is Inevitable in Developing Countries’, Breaking Energy, 23 September 2014, accessed via https:// breakingenergy.com/2014/09/23/environmental-pollution-is-inevitable-indeveloping-countries/ on 3 July 2019. 54 PART 1 68. F. Mann, ‘The environmental benefits of globalization’, Global Envision, July 2004, accessed via www.globalenvision.org on 18 February 2010. 69. B. Lomborg, The Skeptical Environmentalist, Cambridge: Cambridge University Press, 2001. 70. H. Nordstrom and S. Vaughan, Trade and the Environment, World Trade Organization Special Studies No. 4, Geneva: WTO, 1999. 71. For an exhaustive review of the empirical literature, see B.R. Copeland and M. Scott Taylor, ‘Trade, growth and the environment’, Journal of Economic Literature, March 2004, pp. 7–77. 72. G. Grossman and A. Krueger, ‘Economic growth and the environment’, Quarterly Journal of Economics, 110 (1995), pp. 353–78. 73. P. Lamy, ‘Lamy underscores the urgency of responding to the climate crisis’, WTO News: Speeches, 2 November 2009, accessed via www.wto.org/ english/news on 17 February 2010. 74. See, for example, E. Gertz, ‘Pacific Island youth comes to Copenhagen, seeking climate change justice’, Oxfam America, 7 December 2009; http:// blogs.oxfamamerica.org, accessed on 17 February 2010; and E. Gertz, ‘Indigenous peoples affected by climate change, climate talks’, Oxfam America, 9 December 2009. 75. See World Trade Organization, ‘The impact of trade opening on climate change’, Trade Topics, WTO, 2013, accessed via www.wto.org/english/ tratop_e/envir_e/climate_impact_e.htm on 31 January 2013. 76. R. Kuttner, ‘Managed trade and economic sovereignty’, in R. Blecker (ed.), U.S. Trade Policy and Global Growth, New York: Economic Policy Institute, 1996. 77. R. Nader and L. Wallach, ‘GATT, NAFTA, and the subversion of the democratic process’, in R. Blecker (ed.), U.S. Trade Policy and Global Growth, New York: Economic Policy Institute, 1996, pp. 93–4. 78. ‘Get Britain out of Europe’, Daily Express, 31 January 2013, accessed via www.express.co.uk/web/europecrusade on 31 January 2013. 79. C. Berg, ‘Australia’s unfounded foreign investment fear’, The Drum, ABC, accessed via www.abc.net.au/unleashed/4242062.html on 31 January 2013. 80. L. Pritchett, ‘Divergence, big time’, Journal of Economic Perspectives 11(3) (Summer 1997), pp. 3–18. The data are from the World Bank’s World Development Indicators, 2015. 81. Ibid. 82. W. Easterly, ‘How did heavily indebted poor countries become heavily indebted?’ World Development, October 2002, pp. 1677–96; J. Sachs, The End of Poverty New York: Penguin Books, 2006. 83. D. Ben-David, H. Nordstrom and L. A. Winters, Trade, Income Disparity and Poverty, World Trade Organization Special Studies No. 5, Geneva: WTO, 1999. 84. W. Easterly, ‘Debt relief’, Foreign Policy, November–December 2001, pp. 20–6. 85. J. Sachs, ‘Sachs on development: helping the world’s poorest’, The Economist, 14 August 1999, pp. 17–20. 86. World Trade Organization, Annual Report 2003, Geneva: WTO, 2004. 87. See also M. Lind, ‘Do as we say, not as we did’, The Weekend Australian Financial Review, 24–25 January 2004, p. 10, for a review of Chang’s arguments; M. Hart-Landsberg, ‘Neoliberalism: Myths and reality’, Monthly Review, 27(11) (1 April 2006); and Oxfam, ‘Signing away the future: how trade and investment agreements between rich and poor countries undermine development’, Briefing Paper 101, Oxfam, March 2007, accessed via www.oxfam.org.uk/what_we_do/issues/trade/downloads/ bp101_ftas.pdf on 3 April 2007. GLOBALISATION hiL23674_ch01_001-054.indd 54 08/06/19 07:40 PM 2 © Songquan Deng/Shutterstock CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE CHAPTER 2 THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION CHAPTER 3 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT CHAPTER 4 FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM hiL23674_ch02_055-100.indd 55 08/06/19 07:41 PM © Miki Studio/Shutterstock CHAPTER 2 THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 56 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 56 08/06/19 07:41 PM INTERNATIONAL BUSINESS GRADUATE ATTRIBUTES (IBGAs) This chapter’s content, learning resources and case studies provide you with the opportunity to develop a number of International Business Graduate Attributes (IBGAs), including the following: IBGA1 IBGA2 IBGA3 IBGA4 IBGA5 IBGA6 Discipline Knowledge and Skills Critical Analysis Problem Solving Ethical Decision Making Communication Social Interaction LEARNING OBJECTIVES (LOs) 2.1 2.2 2.3 2.4 2.5 2.6 Understand why countries trade with each other—the benefits of trade. Understand the theories explaining trade between countries. Understand why companies invest in other countries. Understand explanations of the internationalisation of the company. Understand the arguments for why governments might play a role in promoting national competitive advantage in particular industries. Examine implications that international trade, investment and internationalisation hold for international business practice. CHAPTER 2 hiL23674_ch02_055-100.indd 57 THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 57 08/06/19 07:41 PM OPENING CASE BANGLADESH’S TEXTILE TRADE © NurPhoto/Sony Ramany/Getty Images Bangladesh has a comparative advantage in the production of textiles: it is one of the world’s low-cost producers—and this is allowing the country to grow its share of world markets. Obviously, this benefits producers in Bangladesh, but it also benefits consumers in developed nations who can use money saved on garment purchases to buy other goods and services. Garment workers working inside a factory in Gazipur, Bangladesh, on 14 May 2017. Bangladesh is the secondlargest apparel exporter in the world after China. Bangladesh, one of the world’s poorest countries, has long depended heavily upon exports of textile products to generate income, employment and economic growth. Most of these exports are low-cost, finished garments sold to Western mass-market retailers, such as Walmart in the United States, and Rivers, Coles and Kmart in Australia. For decades, Bangladesh was able to take advantage of a quota system for textile exports that gave it, and other poor countries, preferential access to rich markets such as the United States and the European Union. However, on 1 January 2005 that system was scrapped in favour of one that was based on free trade principles. From that point on, exporters in Bangladesh would have to compete for business against producers from other nations such as China and Indonesia. Many analysts predicted the quick collapse of Bangladesh’s textile industry. They predicted a sharp jump in unemployment, a decline in the country’s balance of payments accounts and a negative impact upon economic growth. The collapse didn’t happen. On the contrary, Bangladesh’s exports of textiles continued to grow. For example, Bangladesh’s exports of apparel amounted to US$8.9 billion in 2006 but in December 2015, apparel exports amounted to roughly $2.6 billion for that month alone. Apparently, Bangladesh’s advantage is based on a number of factors. First, labour costs are low, in part due to low hourly wage rates, and in part due to textile manufacturers’ investments in productivity-boosting technology during the previous decade. Today, minimum wage rates in Bangladesh’s textile industry are about US$95 a month, a 51 per cent increase, mandated by government in September 2018, over the prior minimum. This new pay rate seems dismally low by Western standards (and some ethical issues have arisen within the sector—see Chapter 8), but in a country where the gross national income per capita is only $1470 a year, the textile industry provided a source of employment for some 4.5 million people in 2018—more than 60 per cent of whom are women with few alternative employment opportunities. Another source of advantage for Bangladesh is that it has a vibrant network of supporting industries that supply inputs to its garment manufacturers. Some threequarters of all inputs are made locally. This saves garment manufacturers transport and storage costs, import duties and the long lead times that come with the imported woven fabrics used to make shirts and trousers. In other words, the local supporting industries help boost the productivity of Bangladesh’s garment manufacturers, giving them a cost advantage that goes beyond low wage rates. A third advantage for Bangladesh is that it has benefited from the trend by Western importers to diversify their supply sources. Many importers in the West have grown cautious about becoming too dependent upon China for imports of specific goods, for fear that an economic or other disruption would decimate their supply chains unless they had an alternative source. SOURCES: E. Matsangou, ‘Bangladesh textile industry sets export record’, World Finance, 26 January 2016; R. Paul, ‘Bangladesh raises wages for garment workers’, Reuters, 14 September 2018; ‘Australian retailers Rivers, Coles, Target, Kmart linked to Bangladesh factory worker abuse’, ABC Four Corners, 24 June 2013; A. Akhar, ‘Employment trends in 2018 in Bangladesh textile and apparel industry’, Textile Today, 2 January 2019; ‘Knitting pretty’, The Economist, 18 July 2008, p. 54; World Bank data on Bangladesh accessed via http://data.worldbank.org/country/bangladesh on 19 February 2019. 58 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 58 08/06/19 07:41 PM INTRODUCTION LO 2.1 The benefits of free trade and globalisation are well illustrated by the growth of the garment industry in Bangladesh. Low barriers to trade have enabled Bangladesh, one of the world’s poorest nations, to exploit its comparative advantage in the production of garments and enabled growth of its exports, even during a global economic downturn. Strong garment exports help support over 4.5 million jobs in Bangladesh, and may help the country to sustain economic growth. Bangladesh’s garment exports also benefit consumers in developed nations who can save on garment purchases and, consequently, have more money available for other goods and services, thereby improving their living standards. The losers in this process are higher-cost garment producers in more developed nations, who have lost business to enterprises from Bangladesh, and the employees in these highercost enterprises. Local workers (in this case, those in Bangladesh) do gain employment that they otherwise would not have. But the process that generated offshoring in the first place, namely global competition and international pressure for cost containment, will tend to contain wage growth and potentially keep the local employment base insecure and with low employment standards. After all, if Bangladesh becomes too expensive, in either wages or production-cost terms (e.g. better occupational health and safety), the tendency will be to seek out a new cheaper country to relocate production to. This process, when it occurs, is often referred to as a ‘race to the bottom’. In the world of international trade and investment, there are always winners and losers, but as economists have long argued, the benefits to the winners generally outweigh the costs borne by the losers. Economists argue that in the long run, free trade leads to optimal resource allocation, which stimulates economic growth and raises living standards—although there are, as noted above, distributional impacts in more immediate periods as some sectors and individuals lose while others gain. The economic arguments on the benefits and costs of free trade in goods and services are not solely abstract and the results are there for all to see. The formation of the World Trade Organization (WTO) (and its predecessor, the GATT, the General Agreement on Tariffs and Trade) and regional trade blocs have changed the international trade landscape in recent times. Free trade has enabled the economic rise of the large emerging markets—Brazil, Russia, India and China— and it is enabling continued growth and rising living standards across the globe. But it has arguably also led to growing social and political conflict. We open this chapter with a discussion on mercantilism. Mercantilism was advocated in the 16th to 18th centuries by the Englishmen Gerard de Malynes and Thomas Mun, and developed further by Josiah Child and Frenchman Jean-Baptiste Colbert. Mercantilist theory holds that countries should encourage and promote exports while discouraging imports, as the goal is to amass trade surpluses—accumulation of wealth as an end in itself. Although mercantilism is an old and largely discredited doctrine, its echoes remain in modern political debate and in the trade policies of many countries. We often hear pronouncements on neo-mercantilism in our modern economies. Mercantilism cannot work in our modern economies, particularly those with floating exchange rates, which is most countries. When trade surpluses persist, as advocated by mercantilists, the value of the currency in the exporting country will rise as a result because countries importing from the surplus country will have to buy more of the exporter’s currency to pay for those imports. With an increasing exchange rate (relative to the importing country), exports from the exporting country will become more expensive to the importing country. As exports become more expensive, the importing country will demand fewer exports, and hence the exporting country will export less, ultimately having its surplus eliminated. CHAPTER 2 hiL23674_ch02_055-100.indd 59 FREE TRADE The absence of barriers to the free flow of goods and services between countries MERCANTILISM An economic philosophy advocating that countries should simultaneously encourage exports and dissuade imports to accumulate surpluses THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 59 08/06/19 07:41 PM COMPARATIVE ADVANTAGE The theory that countries should specialise in the production of goods and services they can produce relatively more efficiently 60 PART 2 Mercantilism treats trade as an exercise in wealth accumulation—at the extreme one country would accumulate all wealth—and as a zero-sum game. However, trade is not a zero-sum game, as Adam Smith maintained in his 1776 book, An Inquiry into the Nature and Causes of the Wealth of Nations. Smith argued that there are mutual gains from trade when country differences (naturally occurring) render some countries more able to produce particular products, and thus have an ‘absolute advantage’ in the production of a product when it is more efficient than any other country in producing that good. A country with an absolute advantage should specialise and trade with other countries for goods in which they have an absolute advantage, and as such, trade is a positive-sum game in that both countries gain and increase their standard of living. It would seem that when one country might have an absolute advantage in producing all goods, mutual gains from trade exhaust themselves. However, David Ricardo (1772–1823) postulated that there are still gains to be had in a country specialising in the production of goods for which it has a ‘comparative advantage’, even if it has an absolute advantage in its ability to produce all goods more efficiently than some other country. Comparative advantage is the ability of a country to produce a particular good or service at a lower marginal and opportunity cost relative to another country. Ricardian comparative advantage theory has become the major argument for free trade, with productivity differentials between countries driving trade gains. Much later, Heckscher and Ohlin (1933) emphasised the association between comparative advantage and factor endowments (i.e. inputs such as labour and capital)—the more abundant the factor, the lower its cost. Hence, a country will export those goods that make intensive use of its relatively abundant factors, and it will import those goods that make intensive use of its relatively scarce factors (known as Heckscher–Ohlin theory). In the 1950s, the economist Wassily Leontief empirically tested the Heckscher–Ohlin theory in a study of the goods imported and exported by the United States. The results were surprising in that they didn’t support the Heckscher–Ohlin theory. This became known as the Leontief paradox. Leontief (1953) demonstrated that US exports were less capital-intensive than were its imports. Why is a capital-rich economy exporting products that are less capital-intensive than are its imports? Various explanations have been advanced, but one possible explanation is that US exports may be skilled labour-intensive (including large shares of innovation and entrepreneurship), while its imports are physicalcapital-intensive (being more mass produced). An early response to the failure of the Heckscher–Ohlin theory to explain the observed pattern of international trade in the United States was the product life-cycle (PLC) theory proposed by Raymond Vernon in the early 1960s. Then, during the 1980s, the economist Paul Krugman of the Massachusetts Institute of Technology developed the new trade theory. New trade theory stresses that, in some cases, countries specialise in the production and export of particular products not because of underlying differences in factor endowments, but because in certain industries the world market can support only a limited number of companies. Michael Porter of the Harvard Business School carried this idea further in his theory of national competitive advantage, which attempts to explain why particular nations achieve international success in particular industries. In addition to factor endowments, Porter points out the importance of country factors such as domestic demand and vigorous domestic competition in explaining a nation’s dominance in the production and export of particular products. While international trade theories explain the patterns of trade between countries, and why particular countries specialise in particular goods and services, they do not explain why particular companies engage in business exchange in foreign markets. In recent decades, a new stream of research has emerged to explain individual company behaviours in foreign markets. In the later sections of this chapter, we will discuss foreign CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 60 08/06/19 07:41 PM direct investment theories, company internationalisation models, and a particular cadre of companies that have recently become prominent in international markets, the so-called international new ventures and born globals. MERCANTILISM LO 2.2 We now take for granted the notion that there are ‘mutual gains from trade’ (to use economics phraseology). In other words, if two parties each have something the other wants, and they can negotiate the terms and price each finds satisfactory, then both parties will be better off conducting such an exchange. However, the history of trade theory shows that this idea was not always so obvious. The first theory of international trade emerged in the era of the large European empires of the 15th and 16th centuries. Referred to as mercantilism, its principal assertion was that gold and silver were the portents of national wealth and were essential to commerce. At that time, gold and silver were the currencies of trade between countries. The main tenet of mercantilism was that it is in a country’s best interest to maintain a trade surplus—to export more than it imports. By doing so, a country would accumulate gold and silver and, consequently, increase its national wealth, prestige and power. As the English mercantilist writer Thomas Mun put it in 1630: ‘The ordinary means therefore to increase our wealth and treasure is by foreign trade, wherein we must ever observe this rule: to sell more to strangers yearly than we consume of theirs in value’.1 Consistent with this belief, the mercantilist doctrine advocated government intervention to achieve a trade surplus. They recommended policies to maximise exports, through subsidies, and to minimise imports, through tariffs and quotas. Then, in 1752, the economist David Hume pointed out an inconsistency in mercantilist doctrine. According to Hume, if England had a trade surplus with France (it exported more than it imported), the resulting inflow of gold and silver would expand the domestic money supply and generate inflation in England. In France, however, the outflow of gold and silver would have the opposite effect: France’s money supply would contract and its prices would fall. This change in relative prices between France and England would encourage the French to buy fewer English goods (because they were becoming more expensive) and the English to buy more French goods (because they were becoming cheaper). The result would be a deterioration in the English balance of trade and an improvement in France’s trade balance, until the English surplus was eliminated. The flaw with mercantilism was that it viewed trade as a zero-sum game, one in which a gain by one country results in a loss by the other. Adam Smith and David Ricardo showed the shortsightedness of this approach and demonstrated that trade is a positive-sum game as both countries will benefit. ABSOLUTE ADVANTAGE POSITIVE-SUM GAME A situation in which all countries can benefit even if some benefit more than others from trade LO 2.2 In The Wealth of Nations, Adam Smith refuted the mercantilist assumption that trade is a zero-sum game. Smith argued that countries differ in their ability to produce goods efficiently. In Smith’s time, the English, by virtue of their superior manufacturing processes, were the world’s most efficient textile manufacturers. Due to the combination of favourable climate, good soils and accumulated expertise, the French had the world’s most efficient wine industry. The English had an absolute advantage in the production of textiles, while the French had an absolute advantage in the production of wine. Thus, Smith postulated that a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it. CHAPTER 2 hiL23674_ch02_055-100.indd 61 ZERO-SUM GAME A situation in which an economic gain by one country results in an economic loss by another ABSOLUTE ADVANTAGE A country has an absolute advantage in the production of a product when it is more efficient than any other country at producing it THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 61 08/06/19 07:41 PM According to Smith, countries should specialise in the production of goods for which they have an absolute advantage and then trade these goods for goods produced by other countries. At the time, England should specialise in textiles, while France should specialise in wine. England could get all the wine it needed by selling its textiles to France, and France could get all the textiles it needed by selling wine to England. Smith’s basic argument, therefore, is that a country should not produce goods at home that it can buy at a lower cost from other countries. By specialising in the production of goods in which each has an absolute advantage, both countries gain by engaging in trade. LO 2.2 COMPARATIVE ADVANTAGE Ricardo’s theory PRODUCTION POSSIBILITY FRONTIER (PPF) The boundary between those combinations of goods and services that can be produced and those that cannot David Ricardo developed Smith’s absolute comparative advantage theory further by asking what would happen when one country has an absolute advantage in the production of all goods.2 According to Ricardo’s theory of comparative advantage, a country should specialise in the production of those goods that it produces relatively most efficiently and buy the goods that it produces relatively less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itself.3 This may seem counterintuitive, so let’s take a traditional illustration. Assume that Ghana is more efficient than South Korea in producing both cocoa and rice; that is, Ghana has an absolute advantage over South Korea in the production of both products. Each country has a resources base of 200 units. In Ghana it takes 10 units of resource to produce 1 tonne of cocoa and 13⅓ units to produce 1 tonne of rice. Thus, given its 200 units of resources, Ghana can produce 20 tonnes of cocoa and no rice, 15 tonnes of rice and no cocoa, or any combination in between on its production possibility frontier (PPF) (the line GG′ in Figure 2.1). (The production possibility frontier is the boundary between those combinations of goods and services that can be produced and those that cannot.) In South Korea, it takes 40 units of resources to produce 1 tonne of cocoa and 20 units of resources to produce 1 tonne of rice. Thus, South Korea can produce 5 tonnes of cocoa and no rice, 10 tonnes of rice and no cocoa, or any combination on its PPF (the line KK′ in Figure 2.1). Assume that without trade, each country uses half of FIGURE 2.1 Theory of comparative advantage 20 G C Cocoa 15 A 10 5 K B 2.5 0 3.75 5 7.5 K' G' 10 15 20 Rice PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 62 08/06/19 07:41 PM its resources to produce rice and half to produce cocoa. Thus, without trade, Ghana will produce 10 tonnes of cocoa and 7.5 tonnes of rice (point A in Figure 2.1), while South Korea will produce 2.5 tonnes of cocoa and 5 tonnes of rice (point B in Figure 2.1). In the light of Ghana’s absolute advantage in the production of both goods, why should it trade with South Korea? Although Ghana has an absolute advantage in the production of both cocoa and rice, it has a comparative advantage only in the production of cocoa: Ghana can produce four times as much cocoa as South Korea, but only 1.5 times as much rice. Ghana is comparatively more efficient at producing cocoa than it is at producing rice. Without trade, the combined production of cocoa will be 12.5 tonnes (10 tonnes in Ghana and 2.5 tonnes in South Korea) and the combined production of rice will also be 12.5 tonnes (7.5 tonnes in Ghana and 5 tonnes in South Korea). Without trade, each country must consume what it produces. By engaging in trade, the two countries can increase their combined production of rice and cocoa, and consumers in both nations can consume more of both goods. The gains from trade Imagine that Ghana exploits its comparative advantage in the production of cocoa to increase its output from 10 tonnes to 15 tonnes. This uses up 150 units of resources, leaving the remaining 50 units of resources to be used in producing 3.75 tonnes of rice (point C in Figure 2.1). Meanwhile, South Korea specialises in the production of rice, producing 10 tonnes. The combined output of both cocoa and rice has now increased. Before specialisation, the combined output was 12.5 tonnes of cocoa and 12.5 tonnes of rice. Now it is 15 tonnes of cocoa and 13.75 tonnes of rice (3.75 tonnes in Ghana and 10 tonnes in South Korea). The source of the increase in production is summarised in Table 2.1. Not only is output higher, but both countries also can benefit from trade. If Ghana and South Korea exchange cocoa and rice on a one-to-one basis, with both countries choosing RESOURCES REQUIRED TO PRODUCE 1 TONNE OF COCOA AND RICE Cocoa Ghana 10.0 South Korea 40.0 PRODUCTION AND CONSUMPTION WITHOUT TRADE Cocoa Ghana 10.0 South Korea 2.5 Total production 12.5 PRODUCTION WITH SPECIALISATION Cocoa Ghana 15.0 South Korea 0.0 Total production 15.0 CONSUMPTION AFTER GHANA TRADES 4 TONNES OF COCOA FOR 4 TONNES OF SOUTH KOREAN RICE Cocoa Ghana 11.0 South Korea 4.0 INCREASE IN CONSUMPTION AS A RESULT OF SPECIALISATION AND TRADE Cocoa Ghana 1.0 South Korea 1.5 CHAPTER 2 hiL23674_ch02_055-100.indd 63 Rice 13.33 20.00 LO 2.1 TABLE 2.1 Comparative advantage and the gains from trade Rice 7.50 5.00 12.50 Rice 3.75 10.00 13.75 Rice 7.75 6.00 Rice 0.25 1.00 THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 63 08/06/19 07:41 PM to exchange 4 tonnes of their export for 4 tonnes of the import, both countries are able to consume more cocoa and rice than they could before specialisation and trade (see Table 2.1). Thus, if Ghana exchanges 4 tonnes of cocoa with South Korea for 4 tonnes of rice, it is still left with 11 tonnes of cocoa, which is 1 tonne more than it had before trade. The 4 tonnes of rice it gets from South Korea in exchange for its 4 tonnes of cocoa, when added to the 3.75 tonnes it now produces domestically, leaves it with a total of 7.75 tonnes of rice, which is 0.25 of a tonne more than it had before specialisation. Similarly, after exchanging 4 tonnes of rice with Ghana, South Korea still ends up with 6 tonnes of rice, which is more than it had before specialisation. In addition, the 4 tonnes of cocoa it receives in exchange is 1.5 tonnes more than it produced before trade. Thus, consumption of cocoa and rice can increase in both countries as a result of specialisation and trade. Importantly, the message from comparative advantage theory is that potential total world production is greater with unrestricted free trade than it is with restricting trade. Ricardo’s comparative advantage theory predicts that consumers in all nations can consume more if there are no restrictions on trade. This occurs even in countries that lack an absolute advantage in the production of any good. In other words, to an even greater degree than the theory of absolute advantage, the theory of comparative advantage suggests that trade is a positive-sum game in which all countries that participate ultimately realise economic gains. As such, this theory provides a powerful argument for encouraging free trade. Qualifications and assumptions The conclusion that free trade is universally beneficial is a rather bold one to draw from such a simple model. Our simple model includes many assumptions: 1. A simple world in which there are only two countries and two goods. In the real world, there are many countries and many goods. 2. No transport costs between countries. This is clearly an over-simplification. 3. No differences in the prices of resources in different countries. Exchange rates are assumed away—cocoa and rice are bartered on a one-to-one basis. 4. Resources can move freely from the production of one good to another within a country. This is not always the case. 5. Constant returns to scale. That is, specialisation by one country has no effect on the amount of resources required to produce one tonne of cocoa or rice. In reality, both diminishing and increasing returns to specialisation exist. The amount of resources required to produce a good might decrease or increase as a nation specialises in production of that good. 6. Each country has a fixed stock of resources and that free trade does not change the efficiency with which a country uses its resources. This assumption makes no allowances for the dynamic changes in a country’s stock of resources and in the efficiency with which the country uses its resources that might result from free trade. 7. Trade has no effect on income distribution within a country. Given these assumptions, can the conclusion that free trade is mutually beneficial be extended to a world of many countries, many goods, positive transportation costs, volatile exchange rates, immobile domestic resources, non-constant returns to specialisation and dynamic changes? It has been shown that the basic result derived from our simple model can be generalised to a world composed of many countries producing many different goods.4,5 However, once all the assumptions are relaxed, the case for unrestricted free trade has been argued by some economists associated with the new trade theory to be less than optimal.6 We return to this issue later in this chapter when we discuss new trade theory. 64 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 64 08/06/19 07:41 PM Also, the Nobel Prize-winning economist Paul Samuelson argued (contrary to the standard interpretation) that in certain circumstances the theory of comparative advantage predicts that a rich country might actually be worse off by switching to a free trade regime with a poor nation.7 We will consider Samuelson’s critique in the next section. Extensions of the Ricardian model We’ll now explore the effect of relaxing three of the assumptions identified earlier in the simple comparative advantage model. We relax the assumptions that resources move freely from the production of one good to another within a country, that there are constant returns to scale and that trade does not change a country’s stock of resources or the efficiency with which those resources are used. Immobile resources In our simple comparative model of Ghana and South Korea, we assumed that producers could easily convert land from the production of cocoa to rice, and vice versa. While this assumption may hold for some agricultural products, resources do not always shift quite so easily from producing one good to another. For example, embracing a free trade regime for an advanced economy such as Australia, New Zealand, Japan or the United States often implies that the country will produce less of some labour-intensive goods, such as textiles, and more of some knowledge-intensive goods, such as computer software or biotechnology products. Although the country as a whole will gain from such a shift, textile producers will lose. A textile worker in Sydney, Auckland or Tokyo is probably not qualified to write software. Thus, the shift to free trade may mean that he or she becomes unemployed, must be retrained or has to accept another less attractive job. Resources do not always move easily from one economic activity into another. While the theory predicts that the benefits of free trade outweigh the costs, this is of little comfort to those who bear the costs. Additionally, it takes time, sometimes years, to replace an outmoded industry and its employment with a new one. Accordingly, political opposition to the adoption of a free trade regime typically comes from those whose jobs are most at risk. In Australia, for example, workers and companies in the car industry generally resisted the move towards free trade precisely because this group had much to lose from free trade. Indeed, the last car plant in Australia closed in 2017 after remaining government subsidies were removed. Diminishing returns The simple comparative advantage model developed earlier assumes constant returns to specialisation. Constant returns to specialisation means that the units of resources required to produce a good (cocoa or rice) are assumed to remain constant no matter where one sits on a country’s production possibility frontier. Thus, we assumed that it always took Ghana 10 units of resources to produce 1 tonne of cocoa. However, it is more realistic to assume diminishing returns to specialisation. Diminishing returns to specialisation occurs when more units of resources are required to produce each additional unit. While 10 units of resources may be sufficient to increase Ghana’s output of cocoa from 12 tonnes to 13 tonnes, 11 units of resources may be needed to increase output from 13 tonnes to 14 tonnes, 12 units of resources to increase output from 14 tonnes to 15 tonnes, and so on. Diminishing returns implies a convex PPF for Ghana (see Figure 2.2), rather than the straight line depicted in Figure 2.1. It is more realistic to assume diminishing returns for two reasons. First, not all resources are of the same quality. As a country tries to increase its output of a certain good, it is increasingly likely to draw on more marginal resources whose productivity is not as great as those initially employed. The result is that it requires ever more resources to produce an equal increase in output. For example, some land is more productive than other land. As Ghana tries to expand its output of cocoa, it might have to use increasingly marginal CHAPTER 2 hiL23674_ch02_055-100.indd 65 THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 65 08/06/19 07:41 PM FIGURE 2.2 Ghana’s PPF under diminishing returns Cocoa G 0 Rice LO 2.1 FIGURE 2.3 The influence of free trade on the PPF PPF2 Cocoa PPF1 0 66 Rice PART 2 land that is less fertile than the land it originally used. As yields per hectare decline, Ghana must use more land to produce each additional tonne of cocoa. A second reason for diminishing returns is that different goods use resources in different proportions. For example, imagine that growing cocoa uses more land and less labour than growing rice, and that Ghana tries to transfer resources from rice production to cocoa production. The rice industry will release proportionately too much labour and too little land for efficient cocoa production. To absorb the additional resources of labour and land, the cocoa industry will have to shift towards more labour-intensive methods of production. The effect is that the efficiency with which the cocoa industry uses labour will decline, and returns will diminish. Diminishing returns shows that it is not feasible for a country to specialise to the degree suggested by the simple Ricardian model outlined earlier. Diminishing returns to specialisation suggests that the gains from G' specialisation are likely to be exhausted before specialisation is complete. In reality, most countries do not specialise, but instead, produce a range of goods. However, the theory predicts that it is worthwhile to specialise until the point where the resulting gains from trade are outweighed by diminishing returns. Thus, the basic conclusion that unrestricted free trade is beneficial still holds, although, because of diminishing returns, the gains may not be as great as suggested in the constant returns case. Dynamic effects and economic growth The simple comparative advantage model assumes that trade does not change a country’s stock of resources or the efficiency with which it utilises those resources. This assumption is static, referring to conditions at a single point in time, and makes no allowances for the dynamic changes over time that might result from trade. If we relax this assumption, it becomes apparent that opening an economy to trade is likely to generate dynamic gains of two types.8 First, free trade might increase a country’s stock of resources, as increased supplies of labour and capital from abroad become available for use within the country. For example, this occurred when foreign companies first invested in China as that economy opened up in the 1990s and early 2000s and it is now occurring again as China is investing in nearby South-East Asia as its own production costs have risen. Second, free trade might also increase the efficiency with which a country uses its resources. Gains in the efficiency of resource utilisation could arise from a number of factors. For example, economies of large-scale production might become available as trade expands the size of the total market available to domestic companies. Trade might make better technology from abroad available to domestic companies. Better technology can increase labour productivity or the productivity of land. The so-called green revolution had this effect on agricultural outputs in developing countries such as India. Also, opening an economy to foreign competition might stimulate domestic producers to look for ways to increase their efficiency. Again, this phenomenon has arguably been occurring in the once-protected markets of Eastern Europe and China, where many former state monopolies have had to increase the efficiency of their operations to survive in the competitive world market. Dynamic gains in both the stock of a country’s resources and the efficiency with which resources are utilised will cause a country’s PPF to shift outward. This is illustrated in Figure 2.3, where the shift from PPF1 to PPF2 results from the dynamic gains that arise from free trade. As a consequence of this outward shift, the country in Figure 2.3 can produce more of both goods than it did before the introduction of free trade. The theory suggests that opening an economy to free trade results not only in CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 66 08/06/19 07:41 PM static gains of the type discussed earlier, but also in dynamic gains that stimulate economic growth. If this is so, the case for free trade becomes stronger still. However, these effects do take time and there can be losses during the transition period. Moreover, as noted earlier, one of the leading economic theorists of the 20th century, Paul Samuelson, argued that in some circumstances, dynamic gains can lead to an outcome that is not so beneficial. The Samuelson critique Samuelson’s critique considers what happens when a rich country such as Singapore, New Zealand or Australia enters into a free trade agreement with an emerging market—such as China—that rapidly improves its productivity after the introduction of a free trade regime. That is, there is a dynamic gain in the efficiency with which resources are used in the poorer country. Samuelson’s model suggests that in such cases, the lower prices that Australian consumers pay for goods imported from China following the introduction of a free trade regime may not be enough to produce a net gain for the Australian economy if the dynamic effect of free trade is to lower real wage rates in Australia.9 Samuelson goes on to note that his concern is also about the ability to move offshore service jobs that traditionally were not internationally mobile, such as software debugging, call centre jobs, accounting jobs and even medical diagnosis of CT scans. Recent advances in communications technology have made this possible, effectively expanding the labour market for these jobs to include educated people in places such as India, the Philippines and China. When coupled with rapid advances in the productivity of foreign labour due to better education, the effect on middle-class wages in developed countries such as the United States, New Zealand and Australia may be similar to mass inward migration into those countries. It will lower the market clearing wage rate, perhaps by enough to outweigh the positive benefits of international trade. However, Samuelson concedes that free trade has historically benefited rich countries (as data discussed later confirm). Also, he notes that introducing protectionist measures (e.g. trade barriers) to guard against the theoretical possibility that free trade may harm developed countries in the future may produce a situation that is worse than the disease they are trying to prevent. To quote Samuelson: ‘Free trade may turn out pragmatically to be still best for each region in comparison to lobbyist-induced tariffs and quotas which involve both a perversion of democracy and non subtle deadweight distortion losses’.10 Evidence for the link between trade and growth LO 2.1 Many economic studies have looked at the relationship between trade and economic growth.11 In general, these studies suggest that, as predicted by comparative advantage theory, countries that adopt a more open stance towards international trade enjoy higher growth rates than those that close their economies to trade. (The Opening Case provides evidence of the link between trade and growth.) Jeffrey Sachs and Andrew Warner created a measure of how ‘open’ to international trade an economy was, and then looked at the relationship between openness and economic growth for a sample of more than 100 countries from 1970 to 1990.12 Among other findings, they reported: We find a strong association between openness and growth, both within the group of developing and the group of developed countries. Within the group of developing countries, the open economies grew at 4.49 per cent per year, and the closed economies grew at 0.69 per cent per year. Within the group of developed economies, the open economies grew at 2.29 per cent per year, and the closed economies grew at 0.74 per cent per year.13 CHAPTER 2 hiL23674_ch02_055-100.indd 67 THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 67 08/06/19 07:41 PM A study by Romain Wacziarg and Karen Horn Welch updated the Sachs and Warner data through the late 1990s. They found that from 1950 to 1998, countries that liberalised their trade regimes experienced, on average, increases in their annual growth rates of 1.5 per cent compared to pre-liberalisation times.14 However, there is also evidence that further trade liberalisation, at least in the developed world, may be yielding diminishing returns. A survey of economic studies of the gains to the US economy from concluding the Trans-Pacific Partnership (TPP) trade agreement found estimated annual gains to US GDP of between 0.15 per cent and 0.5 per cent—not negligible but not as large as prior agreements, which may have already picked most of the ‘low-hanging fruit’ so to speak. This is not an argument per se against further liberalisation, but an indication that the substantial disruption that can occur during transition periods is now often proportionately greater relative to the potential gains than used to be the case.15 This may be one reason why new large trade agreements have not been as easy to reach as they used to be. © Purestock/Superstock MANAGEMENT FOCUS HOLLOWING OUT THE MANUFACTURINGBASED ECONOMY Major banks in Australia and other countries have outsourced or relocated skilled jobs overseas to lowcost countries such as India and the Philippines. Classical economists have long argued that free trade produces gains for all countries that participate in a free trading system; however, as the Global Financial Crisis (GFC) of 2007–09 swept through the Australian and New Zealand economies, many people—particularly those who lost their jobs as a result—wondered if this were true. In the past quarter 68 PART 2 of a century, free trade has been associated with the movement of low-skill, blue-collar manufacturing jobs out of rich developed countries (such as Australia and New Zealand) towards low-wage countries—for example, textiles and shoes to China, and information technology to India. Developments such as the shifting of manufacturing to Asia by Pacific Brands (the owner of brands such as Bonds, KingGee and Holeproof) at the height of the financial downturn with a loss of over 1800 jobs were indicative of this trend. Earlier, the iconic Australian boot-maker Blundstone shifted its manufacturing overseas, with the loss of 350 jobs in Tasmania and New Zealand, when it was unable to compete with cheaper imports because of the relatively high wages in Australia and New Zealand. Blundstone decided not to seek government assistance or protection against cheaper imports; instead, it addressed the low-cost competition issue on a permanent basis by choosing to manufacture overseas while retaining Australian ownership. For the workers being made redundant as a result of such developments, the future is often bleak—they may find it difficult to gain employment locally with a similar company where their skills will be useful. While many observers bemoan the ‘hollowing out’ of Australian and New Zealand manufacturing, economists have traditionally argued that high-skilled CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 68 08/06/19 07:41 PM and high-wage white-collar jobs associated with the service and knowledge-based economy will stay in these countries. For example, garments might be made in China or Indonesia, but they will continue to be designed in Australia and New Zealand, they say. However, automation and artificial intelligence (AI) are making many skilled jobs either redundant or more ‘tradeable’ in the sense that they can be done remotely anywhere. These recent developments have some people questioning the assumption about continued growth in the knowledge-based sector. Even during the long economic boom in the 1990s, Bank of America had to compete with other organisations for the scarce talents of information technology (IT) specialists, driving annual salaries to more than US$100 000. But with business under pressure, the bank cut nearly 5000 jobs from its 25 000-strong, US-based IT workforce. Some of these jobs were transferred to India, where work that costs $100 an hour in the United States could be done for $20 an hour. In Australia, a number of banks such as ANZ have outsourced jobs to India and the Philippines. Filipino employees earn around $6000 per year, while their Australian counterparts may earn 10 times that amount. Shifting work to the Philippines gives the banks a costbased competitive advantage in the very competitive global banking sector. The companies that outsource or relocate skilled jobs clearly benefit from lower costs, enhanced competitiveness in the global economy and greater profits. Developing nations such as India and the Philippines, which have a good supply of welleducated, skilled and (by global standards) low-cost labour, also benefit. However, some observers wonder whether developed countries such as Australia and New Zealand will suffer from the loss of highly skilled and high-paying jobs in addition to low-skilled jobs. Standard trade theory would argue that while there will be short-term losses to some workers, the overall economy will benefit, although with a changing structure. They point out that while some of the more routine skilled jobs are going overseas, most managerial, marketing and cutting-edge research and development jobs are staying in developed countries such as Australia or New Zealand, precisely because these countries have a comparative advantage in those areas. Second, economists argue that the lower price of services that results from such outsourcing means that the average Australian or New Zealand consumer can afford to consume more of these services, or can use any savings to consume more of other goods and services, thereby boosting economic growth and associated employment. Third, economists believe that any economic growth that occurs in China, India, the Philippines and so on, as a result of this trend will ultimately benefit Australia and New Zealand, since consumers in those countries will be able to purchase more Australian and New Zealand goods and services. In the end it comes down to the data, past and future. Research by the Boston Federal Reserve Bank in the United States indicates that past experience shows that offshoring of jobs has caused disruption but overall jobs eliminated onshore have been more than replaced with new jobs in new industries and activities. On the other hand, a working paper by the US International Trade Office notes: ‘Offshoring is a contentious political issue. Unfortunately, it is also a complex economic issue, with many subtle aspects in which a simple model may over-simplify and thus miss key mechanisms or outcomes.’ Time will tell. SOURCES: K. Barlow, ‘AM–Blundstone’s move offshore leaves 350 jobless’, ABC Online, 17 January 2007 accessed via www.abc.net.au/am/content/ 2007/s1828662.htm on 7 August 2009; ‘Bonds, King Gee owner slashes 1850 jobs’, ABC Online, accessed via www.abc.net.au/news/stories/2009/ 02/25/2500712.htm on 7 August 2009; C. Waters, ‘ANZ recruiting in Philippines as local jobs axed’, The Age, 19 February 2012, accessed via www. theage.com.au/national/anz-recruiting-in-philippines-as-local-jobs-axed-20120218-1tg3l.html#ixzz2Ak3EA13K on 30 October 2012; A. Barbe and D. Riker, ‘The Effects of Offshoring on Domestic Workers: A Review of the Literature’, Working Paper 2017-10-A, US International Trade Commission, October 2017; J. Little, ‘Perspective: outsourcing jobs overseas, a cause for concern?’, US Federal Reserve Bank of Boston Regional Review, Q2/Q3 2004, pp. 2–6. Heckscher–Ohlin theory LO 2.2 Ricardo argued that comparative advantage arises from differences in productivity. Thus, whether Ghana is more efficient than South Korea in the production of cocoa depends on how productively it uses its resources. Swedish economists Eli Heckscher (1919) and Bertil Ohlin (1933) (independently) put forward an explanation of comparative advantage CHAPTER 2 hiL23674_ch02_055-100.indd 69 THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 69 08/06/19 07:41 PM based on differences in national factor endowments,16 the extent to which a country is endowed with resources such as land, labour and capital. Nations have different factor endowments, and different factor endowments explain differences in factor costs. The more abundant a factor, the lower its cost will be. The Heckscher–Ohlin theory predicts that countries will export those goods that make intensive use of their relatively abundant factors and they will import goods that make intensive use of their relatively scarce factors. Like Ricardian theory, the Heckscher–Ohlin theory argues that free trade is beneficial, but unlike Ricardo’s theory, the Heckscher–Ohlin theory argues that the pattern of international trade is determined by differences in factor endowments, rather than gross differences in productivity. The theory has commonsense appeal. For example, Australia, New Zealand and the United States have long been exporters of agricultural goods, reflecting in part their abundance of arable land. In contrast, China exports goods produced in labour-intensive light manufacturing industries. This reflects China’s relative abundance of low-cost labour. Australia, New Zealand and the United States, which are high labour-cost economies, have been importers of these goods. Note that it is relative, not absolute, endowments that are important. A country may have larger absolute amounts of land and labour than another country, but be relatively abundant in one of them. © yousang/Shutterstock The Leontief paradox Heckscher–Ohlin theory has been influential in international economics. It is generally preferred to Ricardo’s theory because it makes fewer simplifying assumptions. Because of its influence, Heckscher–Ohlin theory has been subjected to many empirical tests. Beginning with a famous study published in 1953 by Wassily Leontief (winner of the Nobel Prize in economics in 1973), many of these tests have raised questions about the validity of Heckscher–Ohlin theory.17 Applying Heckscher–Ohlin theory, Leontief postulated that the United States would be an exporter of c­ apital-intensive goods and an importer of labourintensive goods because it was relatively abundant in capital. He found that US exports were less capital intensive than were US imports; hence, this result became known as the Leontief paradox. Tests of the theory using data for a large number of countries tend to confirm the existence of the Leontief paradox.18 One possible explanation for this paradox in the United States context is that the United States has a special advantage in producing new products or goods made with innovative technologies. These products may be less physical capital intensive than are products whose technology has had time to mature and become suitable for mass production. Thus, the United States may be exporting goods that heavily use skilled labour and innovative entrepreneurship, such as computer software, while importing heavy manufacturing products that use large amounts of physical capital. Empirical studies tend to confirm this explanation.19 This presents a dilemma though. Heckscher–Ohlin theory is preferred on theoretical grounds, but it is a relatively poor predictor of real-world international trade patterns. On American car manufacturing company Tesla Motors prides the other hand, Ricardo’s theory of comparative advantage itself on energy innovation. Its first plug-in electric car, the actually predicts trade patterns with greater accuracy. A Model S, is shown here being charged at a supercharger station in Beijing. solution to this dilemma may be to return to the Ricardian 70 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 70 08/06/19 07:41 PM idea that trade patterns are largely driven by international differences in productivity. Thus, one might argue that the United States exports commercial aircraft and imports textiles not because its factor endowments are especially suited to aircraft manufacture and not suited to textile manufacture, but because the United States is relatively more efficient at producing aircrafts than textiles. A key assumption in Heckscher–Ohlin theory is that technologies are the same across countries. This may not be the case. Differences in technology may lead to differences in productivity. These differences, in turn, drive international trade patterns.20 Thus, Japan’s success in exporting vehicles in the 1970s and 1980s was based not just on the relative abundance of capital, but also on its development of innovative manufacturing technology, coupled with a high standard of quality, which enabled it to achieve higher productivity levels in vehicle production than other countries that also had abundant capital. Recent empirical investigations strongly suggest that this explanation may be correct.21 The new research shows that once differences in technology across countries are controlled for, countries do export those goods that make intensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce. In other words, once the impact of differences of technology on productivity is controlled for, Heckscher–Ohlin theory seems to gain predictive power. THE PRODUCT LIFE-CYCLE THEORY LO 2.2 The theories considered thus far demonstrate that unfettered trade is generally beneficial to those who undertake it. They are also more based in pure economic theory than the business realities of the market in action. We will now turn to theories that focus more on explaining the patterns of trade that are actually observed in practice. Raymond Vernon initially proposed his product life-cycle theory in the mid-1960s.22 This theory was based on the observation that for most of the 20th century a large proportion of the world’s new products had been developed by US companies and sold first in the US market (e.g. mass-produced cars, televisions, instant cameras, photocopiers, personal computers and semiconductor chips). To explain this, Vernon argued that the disposable income and size of the US market gave US companies a strong incentive to develop new consumer products. In addition, the high cost of US labour gave US companies an incentive to develop cost-saving process innovations. One could say that while traditional trade theories focus on the nature of the supply side, Vernon’s theory incorporates elements of product demand into why countries specialise in particular ways and how that specialisation can change over time. Just because a new product (such as a microwave oven) is developed by a US company and first sold in the US market, it does not follow that all new products must be produced in the United States. It could be produced abroad at some low-cost location and then exported back into the United States. Nonetheless, Vernon argued that most new products were initially produced in America, which was an accurate observation in his time. Pioneering companies believed it was better to keep production facilities close to the market and to the company’s centre of decision making, given the uncertainty and risks inherent in introducing new products. Also, the demand for most new products tends to be based on non-price factors, such as quality. Consequently, companies can charge relatively high prices for new products, which obviates the need to look for low-cost production sites in other countries. Vernon went on to argue that early in the life-cycle of a typical new product, while demand was growing rapidly in the United States, demand in other advanced countries CHAPTER 2 hiL23674_ch02_055-100.indd 71 THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 71 08/06/19 07:41 PM 160 140 120 100 Production 80 60 40 20 0 160 140 120 100 80 60 40 Consumption 20 0 160 140 120 100 80 60 40 20 0 New product FIGURE 2.4 The product life-cycle theory 72 PART 2 was limited to high-income groups. This limited demand elsewhere does not make it worthwhile for companies in those countries to start producing the new product, but it does necessitate some exports from the United States to those countries. Over time, demand for the new product continues to grow in the other advanced countries, ultimately making it worthwhile for foreign producers to begin producing for their home A. United States markets. In addition, US companies might set up production facilities in those advanced countries where demand is growing, limiting the potential for exports from the United States. As the market in the United States and other Imports advanced nations matures, the product becomes Exports standardised, price becomes the main competitive weapon and cost considerations play a greater role in the competitive process. Producers based Consumption in advanced countries where labour costs are lower than in the United States might now be able to export to the United States. If cost pressures become intense, the process might not stop there and the locus of global production B. Other advanced countries initially switches from the United States to other advanced nations and then from those nations to developing countries. Over time, the s t r United States switches from being the inventor o Exp and exporter of the product to an importer as production becomes concentrated in lower-cost foreign locations. Figure 2.4 shows the growth of production and consumption over time in the United States, rts other advanced countries and developing countries. o Production p Im What this graph is positing is that in the early stages of a new product, the first units produced are made in the originating country (in this example, the United States). At first, domestic C. Developing countries production levels are small and domestically consumed, but as production expands domestic demand is satisfied and units are increasingly made to export to markets with similar characteristics (in this case, other advanced countries). These importing countries then start to follow a similar Exports cycle, developing their own production of the new product for their own consumption, and then shifting towards exporting. After a time, as the Consumption product market saturates and matures, and the s t r o product has become standardised and low cost to Imp Production produce, both the originating country (the United States) and the similarly situated export markets Maturing Standardised product product (other advanced countries) begin to offshore production of the product to ­low-cost developing Stages of product development economies, which now become the manufacturers and exporters to the rest of the world. CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 72 08/06/19 07:41 PM Evaluating the product life-cycle theory The product life-cycle theory appears to be an accurate explanation of international trade patterns for manufacturing-based economies. For example, photocopiers were first developed in the early 1960s by Xerox in the United States and sold initially in the United States. Xerox then exported photocopiers from the United States, primarily to Japan and the advanced countries of Western Europe. As demand began to grow in those countries, Xerox entered into joint ventures to produce in Japan (Fuji–Xerox) and the United Kingdom (Rank–Xerox). In addition, once Xerox’s patents on the photocopier process expired, other foreign competitors began to enter the market (e.g. Canon in Japan, Olivetti in Italy). As a consequence, exports from the United States declined, and US users began to buy some of their photocopiers from lower-cost foreign sources, particularly Japan. More recently, Japanese companies have found that manufacturing costs are too high in their country, so they have begun to switch production to developing countries such as Singapore and Thailand. Thus, the United States and other advanced countries (e.g. Japan and the United Kingdom) have switched from being exporters of photocopiers to importers. This evolution in the pattern of international trade in photocopiers is consistent with the predictions of the product life-cycle theory. Even China is, in many ways, following this pattern now. However, the product life-cycle theory is not without shortcomings. Vernon’s argument that most new products are developed and introduced in the United States is true during the period of US global dominance (from 1945 to 1975), when most new products were introduced in the United States, but even then there were important exceptions. These exceptions have become more common in recent years. Many new products are now introduced elsewhere (e.g. video-game consoles in Japan). In addition, with the increased globalisation and integration of the world economy (discussed in Chapter 1), many new products (e.g. laptop computers, compact discs, digital cameras, mobile devices) are introduced simultaneously in the United States, Japan, Australia, New Zealand, Singapore, the advanced European nations and elsewhere. This may be accompanied by globally dispersed production, with particular components of a new product produced in those locations around the globe where the mix of factor costs and skills is most favourable, as predicted by the theory of comparative advantage. Finally, economies have become more service-based and the notion of a product life-cycle may be more subtle. NEW TRADE THEORY LO 2.3 New trade theory emerged in the 1970s when a number of economists pointed out that relaxing the assumptions that were necessary in earlier trade theories highlighted outcomes and policy recommendations that were different from those earlier practised. The assumption of constant returns to scale (CRS) is particularly unrealistic, and while all theory requires simplifying assumptions, this one has been seen as too simplistic given that the ability of companies to attain economies of scale often has important implications for international trade. Economies of scale are unit cost reductions associated with a large scale of output. Economies of scale have a number of sources, including the ability to spread fixed costs over a large volume, and the ability of large-volume producers to use specialised employees and equipment that are more productive than less specialised employees and equipment. Economies of scale are a major source of cost reductions in many industries, including computer software, vehicles, pharmaceuticals and aerospace. For example, Google and Facebook realise economies of scale by spreading the fixed costs of developing new versions, and maintaining existing versions, of their online tools and platforms. Similarly, vehicle manufacturers realise economies of scale by producing high volumes from an assembly line where each employee has a specialised task, repeatedly undertaken. CHAPTER 2 hiL23674_ch02_055-100.indd 73 ECONOMIES OF SCALE Cost advantages associated with large-scale production THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 73 08/06/19 07:41 PM New trade theory makes two important points based on this. First, international trade can increase economies of scale by increasing the size of the market. Second, in those industries where the output required to attain economies of scale represents a significant proportion of total world demand, the global market will support only a small number of companies. Thus, world trade in certain products may be dominated by countries whose companies were first movers in their production. LO 2.1 Increasing product variety and reducing costs Imagine a world without trade. In industries where economies of scale are important, both the variety of goods that a country can produce and the scale of production are limited by the size of the home market. If the home market is small, there may not be demand to enable producers to realise economies of scale for certain products. Accordingly, those products may not be produced at all, thereby limiting consumer choice. Alternatively, they may be produced, but at such low volumes that unit costs and thus prices are much higher than they might be if economies of scale could be realised. Now enable countries to trade with each other. Individual home markets aggregate into a large world market. As the size of this market expands due to trade, individual companies may be able to better attain economies of scale. The implication, according to new trade theory, is that each nation may be able to specialise in producing a narrower range of products than it would in the absence of trade, yet by importing goods that it does not make from other countries, each nation can simultaneously increase the variety of goods available to its consumers. The costs of these goods are lowered; thus, trade offers an opportunity for mutual gain even when countries do not differ in their resource endowments or technology. Suppose two countries each have an annual home market for one million cars. By trading with each other, these countries can create a combined market for two million cars. In this combined market, due to the ability to realise economies of scale better, more varieties (models) of cars can be produced, and at a lower average cost, than in either market alone. For example, demand for a sports car may be limited to 55 000 units in each national market, while a total output of at least 100 000 per year may be required to realise significant scale economies. Similarly, demand for a minivan may be 80 000 units in each national market, and again a total output of at least 100 000 per year may be required to realise significant scale economies. Faced with limited domestic market demand, companies in each nation may decide not to produce a sports car, since the costs of doing so at such low volume are too great. Although they may produce minivans, the cost of doing so will be higher than if significant economies of scale had been attained. However, if these two countries trade, a company in one nation may specialise in producing sports cars, while a company in the other nation may produce minivans. The combined demand for 110 000 sports cars and 160 000 minivans allows each company to realise scale economies. Consumers benefit from having access to a product (sports cars) that was not available before international trade, and from the lower price for a product (minivans) that could not be produced at the most efficient scale before international trade. Trade is mutually beneficial because it allows for the specialisation of production, the realisation of scale economies, the production of a greater variety of products and at lower prices. LO 2.4 FIRST-MOVER ADVANTAGES Advantages accruing to firms that enter markets early 74 PART 2 Economies of scale, first-mover advantages and the pattern of trade A second theme in new trade theory is that the pattern of trade we observe worldwide may be the result of economies of scale and first-mover advantages. First-mover advantages CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 74 08/06/19 07:41 PM are the economic and strategic advantages that accrue to early entrants into an industry.23 The ability to capture scale economies ahead of later entrants, and thus benefit from a lower cost structure, is an important first-mover advantage. New trade theory argues that for those products where economies of scale are significant and represent a substantial proportion of world demand, the first movers in an industry can gain a scale-based cost advantage that later entrants find almost impossible to match. Countries may dominate in the export of certain goods because economies of scale are important in their production and because firms located in those countries were the first to capture scale economies, giving them a first-mover advantage. For example, consider the commercial aerospace industry. Substantial scale economies arise from the ability to spread the fixed costs of developing a new jet aircraft over a large number of sales. It cost Airbus some US$14 billion to develop its super-jumbo jet, the 550-seat A380. To recoup those costs and break even, Airbus had to sell at least 250 of the A380 planes. If it could sell more than 350 of the A380 planes, it would have been a profitable venture. However, demand for this class of aircraft has turned out to be well below this number and Airbus is closing production of the plane in 2021.24 Airbus was calculating that the global market could profitably support only one producer of jet aircraft in the super-jumbo category and was hoping to dominate in the export of very large jet aircraft, by being the first to produce a 550-seat jet aircraft and realise scale economies. Other potential producers, such as Boeing, might have been shut out of the market because they lacked the scale economies that Airbus enjoys in this category. In this case, however, the gamble failed, due to changes in the way airlines serve their customers, increasingly moving away from flying to ultimate destinations through major hubs (where carrying large numbers in a single plane makes sense) and returning to an older pattern of more direct flights (where smaller capacity planes, cheaper to operate, are better). What this case illustrates is that economies of scale, combined with first-mover advantage, can create a powerful competitive advantage for a company and, by extension, the nation or region that company is based in. Implications of new trade theory LO 2.1, 2.4 New trade theory has important implications. This theory suggests that nations may benefit from trade even when they do not differ in resource endowments or technology. Trade allows a nation to specialise in the production of certain products, attaining scale economies and lowering the costs of producing those products, while importing products that it does not produce from other nations that specialise in the production of those products. By this mechanism, the variety of products available to consumers in each nation is increased, while the average costs of those products should fall, as should their price, thus freeing resources to produce other goods and services. The theory also suggests that a country may predominate in the export of a good simply because it was lucky enough to have one or more companies among the first to produce that good. Because they are able to gain economies of scale, the first movers in an industry may dominate in the world market and discourage entry by other companies. In the commercial aircraft industry, that Boeing and Airbus are already in the industry and have the benefits of economies of scale discourages entry by new companies and reinforces the dominance of the United States and Europe in the trade of midsize and large jet aircraft (although China could possibly now challenge this dominance with its extensive state support for strategic industries). This dominance is further reinforced because global demand may not be sufficient to profitably support another producer of midsize and large jet aircraft in the industry. So, although Japanese companies might be able to compete CHAPTER 2 hiL23674_ch02_055-100.indd 75 THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 75 08/06/19 07:41 PM in the market, they have decided not to enter the industry but to position themselves as major subcontractors to primary producers (e.g. Mitsubishi Heavy Industries is a major subcontractor for Boeing on the 777 and 787 programs). New trade theory is at variance with Heckscher–Ohlin theory, which, as we have seen, suggests that a country will predominate in the export of a product when it is particularly well endowed with those factors used intensively in its manufacture. New trade theorists argue that the United States is a major exporter of commercial jet aircraft not because it is better endowed with the factors of production required to manufacture aircraft, but because one of the first movers in the industry, Boeing, was a US company. However, new trade theory is not at variance with the comparative advantage theory. Economies of scale increase productivity. Thus, the new trade theory identifies an important source of comparative advantage. This theory is especially useful in explaining trade patterns. Empirical studies support the predictions of the theory that trade increases the specialisation of production within an industry, increases the variety of products available to consumers and results in lower average prices.25 With regard to first-mover advantages and international trade, a study by Harvard business historian Alfred Chandler suggests that the existence of first-mover advantages is an important factor in explaining the dominance of companies from certain nations in specific industries.26 The number of companies is very limited in many global industries, including the chemical, heavy construction-equipment, heavy truck, tyre, consumer electronics, jet engine and computer software industries. EMERGING MARKETS BRAZIL’S EMBRAER If you have flown in a jet aircraft in regional Australia, it is likely you would have travelled in a Brazilian-built Embraer such as the E 190AR. The company (formerly known as Embraer-Empresa Brasileira de Aeronáutica S.A., changing its name to Embraer S.A. in November 2010) was launched by the Brazilian government in 1969 to give Brazil an independent capacity to produce aircraft—primarily military aircraft. In the early years, the company relied on financial support and orders from the Brazilian government to build EMB 326 Xavante, an advanced trainer and ground attack jet, under licence from an Italian company. This government backing gave Embraer the solid start it needed to compete with established players and to carve out a niche market in corporate jets, commercial regional jets, military trainers and agricultural aviation. In 2000, as part of the Brazilian government’s privatisation plans, the company was listed on the New York Stock Exchange. Since then the company has expanded globally with production, service or sales facilities in the United States, China, Portugal, France and Singapore. The head office and major design and production facilities are based at São José dos Campos in São Paulo, where a cluster of high-tech companies and educational institutions has developed, further enhancing Embraer’s ability to continue to innovate. As of early 2019, the company had a market capitalisation of US$3.8 billion and 18 434 full-time employees. SOURCE: Yahoo!7 Finance, https://finance.yahoo.com/quote/ERJ/profile?p=ERJ accessed on 20 February 2019. 76 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 76 08/06/19 07:41 PM Certainly the most contentious implication of new trade theory is its support for an argument for government intervention and strategic trade policy.27 New trade theorists stress the role of luck, entrepreneurship and innovation in giving a firm firstmover advantage. According to this argument, the reason Boeing was the first mover in commercial jet aircraft manufacture, rather than companies such as the United Kingdom’s DeHavilland and Hawker Siddeley or the Netherlands’ Fokker (all of which could have been), was that Boeing was both lucky and innovative. Boeing was lucky in that DeHavilland jeopardised its prospects when its Comet jet airliner, introduced two years earlier than Boeing’s first jet airliner, the 707, was found to be seriously technologically flawed. Had DeHavilland not made technological mistakes, the United Kingdom might have become the world’s leading exporter of commercial jet aircraft. Boeing’s innovativeness was demonstrated by its independent development of the technological know-how required to build a commercial jet airliner. Several new trade theorists have pointed out, however, that Boeing’s research and development was largely paid for by the US government; that is, the 707 was a spin-off from governmentfunded military programs. (The entry of Airbus into the industry was supported also by significant government subsidies.) Herein is a rationale for government intervention: by the sophisticated and judicious use of subsidies, could a government increase the chances of its domestic companies becoming first movers in newly emerging industries, as the US government did with Boeing, the European Union with Airbus and the Brazilians with Embraer (see Emerging Markets: ‘Brazil’s Embraer’)? This being possible, new trade theory suggests an economic rationale for a proactive trade policy exists that is at variance with the free trade prescriptions of the earlier trade theories we have introduced. Having said this, governments still need to tread with caution. The historical record suggests that the public sector’s ability to ‘pick winners’ is uneven and subject to political considerations. NATIONAL COMPETITIVE ADVANTAGE: PORTER’S DIAMOND LO 2.2 Economic theory uses a deductive method; that is, a theory is posited and its validity is then checked against the facts. This is generally a sound approach but in the complex world of international business a more inductive approach is also useful; that is, collecting facts and then building a theory suggested by those facts that can then be tested against additional data. In 1990, Michael Porter of the Harvard Business School published the results of an extensive research project that attempted to determine why some nations succeed and others fail in international competition.28 Porter looked at 100 industries in 10 nations. Like the new trade theorists, Porter’s work was driven by a belief that existing theories of international trade were at best partial. For Porter, the task was to explain why a nation achieves international success in a particular industry. Why, for example, does Japan do so well in the car industry? Why does Switzerland excel in the production and export of precision instruments and pharmaceuticals? Why do Germany and the United States do so well in the chemical industry? These questions cannot be answered by Heckscher– Ohlin theory (since all these countries have similar factor endowments), and the theory of comparative advantage offers only a partial explanation. The theory of comparative advantage would say that Switzerland excels in the production and export of precision instruments because it uses its resources very productively in these industries. Although this may be correct, this does not explain why Switzerland is more productive in this industry than the United Kingdom, Germany or Spain. Porter tries to solve this puzzle by positing that four broad attributes of a nation shape the environment in which local CHAPTER 2 hiL23674_ch02_055-100.indd 77 THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 77 08/06/19 07:41 PM companies compete, and these attributes promote or impede the creation of ‘competitive’ advantage (see Figure 2.5). These attributes are: Firm strategy, structure and rivalry Factor endowments Demand conditions Relating and supporting industries FIGURE 2.5 Determinants of national competitive advantage: Porter’s diamond SOURCE: Reprinted by permission of the Harvard Business Review. ‘The competitive advantage of nations’ by Michael E. Porter, March–April 1990, p. 77. © 1990 by The President and Fellows of Harvard College. All rights reserved. https://hbr.org/1990/03/ the-competitive-advantage-of-nations. • F actor endowments—a nation’s factors of production such as skilled labour or the infrastructure necessary to compete in a given industry • D emand conditions—the nature of home demand for the industry’s product or service • R elating and supporting industries—the presence or absence of supplier industries and related industries that are internationally competitive • F irm strategy, structure and rivalry—the conditions governing how companies are created, organised and managed, and the extent of domestic rivalry. These four attributes constitute Porter’s diamond. He argues that companies are most likely to succeed in industries or segments of an industry where the diamond is complete and favourable. He also argues that the diamond is a mutually reinforcing system. The effect of one attribute is contingent on the state of others. For example, Porter argues that favourable demand conditions will not result in competitive advantage unless the state of rivalry is sufficient to cause companies to respond to them. Porter maintains that two additional variables can influence the national diamond in important ways: chance and government. Chance events, such as major innovations, can reshape industry structure and provide the opportunity for the companies from one nation to displace those from another. Government, by its choice of policies, can impede or improve national competitive advantage. For example, regulation can alter home demand conditions, antitrust policies can influence the intensity of rivalry within an industry and government investments in education can change factor endowments. Factor endowments Factor endowments are at the centre of Heckscher–Ohlin theory. Porter embellishes on this theory by further analysing the characteristics of the factors of production. He recognises hierarchies among factors, distinguishing between basic factors (e.g. natural resources, climate, location and demographics) and advanced factors (communication infrastructure, sophisticated and skilled labour, research facilities and technological knowhow). He argues that advanced factors are the most significant for competitive advantage. Unlike the naturally endowed basic factors, advanced factors are a product of investment by individuals, firms and governments. Thus, government investment in basic and higher education, by improving the general skill and knowledge level of the population and by stimulating advanced research at higher education institutions, can upgrade a nation’s advanced factors. The relationship between advanced and basic factors is complex. Basic factors can provide an initial advantage that is subsequently reinforced and extended by investment in advanced factors. For example, in Australia and New Zealand the success of the wine industry has been attributed to the availability of natural resources—land, and appropriate climate—as well as skilled labour, research facilities and innovative wine-making processes. Disadvantages in basic factors can also create pressures to invest in advanced factors. An obvious example of this phenomenon is Japan, a country that lacks arable land and mineral 78 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 78 08/06/19 07:41 PM deposits and yet, through investment, has built a substantial endowment of advanced factors. Porter notes that Japan’s large pool of engineers (resulting from more engineering graduates per capita than almost any other nation) has been vital to Japan’s success in many manufacturing industries. Demand conditions Porter highlights the role home demand plays in upgrading competitive advantage. Companies are typically most sensitive to the needs of their closest customers. Thus, the characteristics of home demand are particularly important in shaping the attributes of domestically made products and in creating pressures for innovation and quality. Porter argues that a nation’s companies gain competitive advantage if their domestic consumers are sophisticated and demanding, creating pressure on local companies to meet high standards of product quality and to produce innovative products. Porter notes that Japan’s sophisticated and knowledgeable buyers of cameras helped stimulate the Japanese camera industry to improve product quality and to introduce innovative models. A similar example can be found in the wireless telephone equipment industry, where sophisticated and demanding local customers in Scandinavia helped push Nokia of Finland and Ericsson of Sweden to invest in mobile phone technology long before demand for mobile phones took off in other developed nations. Related and supporting industries The third attribute of national advantage in an industry is the presence of internationally competitive suppliers or related industries. The benefits of investments by related and supporting industries in advanced factors of production can spill over into an industry, thereby helping it achieve a strong competitive position internationally. Swedish expertise in fabricated steel products (e.g. ball bearings and cutting tools) has drawn on strengths in its specialty steel industry. Technological leadership in the US semiconductor industry provided the basis for US success in personal computers and several other technically advanced electronic products. Similarly, Switzerland’s success in pharmaceuticals is closely related to its previous international success in the technologically related dye industry. One consequence of this process is that successful industries within a country tend to be grouped into clusters of related industries—a pervasive finding of Porter’s study. One such cluster Porter identified was in the German textile and apparel sector, which included highquality cotton, wool, synthetic fibres, sewing machine needles and a wide range of textile machinery. Clusters are important because valuable knowledge can flow between companies within a geographic cluster, benefiting all within that cluster—what economists would call positive externalities. Knowledge spillovers (another economics term) occur when employees move between companies within a region and when national industry associations bring employees from different companies together for regular conferences or workshops.29 Firm strategy, structure and rivalry The fourth attribute of national competitive advantage in Porter’s model is the strategy, structure and rivalry of companies within a nation. Porter makes two important points here. First, different nations are characterised by different management ideologies, which are either helpful or unhelpful in building national competitive advantage. For example, Porter noted the predominance of engineers in top management at German and Japanese companies. He attributed this to these companies’ emphasis on improving manufacturing CHAPTER 2 hiL23674_ch02_055-100.indd 79 THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 79 08/06/19 07:41 PM © Maridav/Shutterstock processes and product design. In contrast, Porter noted a predominance of people with finance backgrounds leading many US companies. He linked this to US companies’ lack of attention to improving manufacturing processes and product design. He argued that the dominance of finance led to an overemphasis on maximising short-term financial returns. According to Porter, one consequence of these different management ideologies was a relative loss of US competitiveness in those engineering-based industries where manufacturing processes and product design issues are allimportant (e.g. the motor vehicle industry). Porter’s second point here is that there is a strong association between vigorous domestic rivalry and the creation and persistence of competitive advantage in an industry. Vigorous domestic rivalry induces companies to look for ways to improve efficiency, which makes them more internationally competitive. Domestic rivalry creates pressures to innovate, to improve quality, to reduce costs and to invest in upgrading advanced factors. This all helps to create world-class competitors. Porter cites the case of Japan: Nowhere is the role of domestic rivalry more evident than in Japan, where it is a­ llout warfare in which many companies fail to achieve profitability. With goals that stress market share, Japanese companies engage in a continuing struggle to outdo each other. Shares fluctuate markedly. The process is prominently covered in the business press. Elaborate rankings measure which companies are most popular with university graduates. The rate of new product and process development is breathtaking.30 LO 2.4 Evaluating Porter’s model Porter contends that the degree to which a nation is likely to achieve international success in a certain industry is a function of the combined impact of factor endowments, domestic demand conditions, related and supporting industries, and domestic rivalry—his diamond. He argues that the presence of all four components is usually required for this diamond to boost competitive performance. Porter also contends that government can influence each of the four components of the diamond positively or negatively. Factor endowments can be affected by subsidies, policies towards capital markets, policies towards education and the like. Government can shape domestic demand through local product standards or with regulations that mandate or influence buyer needs. Government policy can influence supporting and related industries through regulation, and can influence company rivalry through instruments such as capital market regulation, tax policy and competition laws. Porter’s model predicts that the pattern of international trade that we observe throughout the world consists of countries exporting products from those industries where all four components of the diamond are favourable, while importing in those sectors where the components are not favourable. Is he correct? We simply cannot say so definitively. Porter’s model has not been subjected to independent empirical testing. Much about his model rings true, but the same can be said for new trade theory, the theory of comparative advantage and Heckscher–Ohlin theory. It may be that each of these explanations, which complement each other, explains something about the patterns of international trade. 80 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 80 08/06/19 07:41 PM COUNTRY FOCUS INDIA: LONG-TERM OPPORTUNITIES FOR BILATERAL TRADE AND INVESTMENT © Image Source, All rights reserved Of course, India faces many challenges. A large population is a double-edged sword, providing, on the one hand, a large potential labour force and customer base, but on the other hand meaning many mouths to feed, so to speak. China limited its population growth with a controversial one-child policy. Democratic India cannot resort to such extreme measures and has tamed some of its population growth, but more needs to be done to lower the birth rate to sustainable levels. Poverty is still endemic in much of the country. There is a growing middle class, but many still live in urban slums or off subsistence village agriculture, and 22 per cent of the population (270 million people) are below the poverty line. China has long been the market that Australian businesses have focused on. The country is expected to become the world’s largest economy within the next 10–20 years, and it is by far Australia’s largest export and import trading partner. However, India may be the ultimate longer term source of growth. Even now India is Australia’s fifth largest export market valued at approximately $19.2 billion as of 2016–17; bilateral trade (including imports and exports) was valued at $25.7 billion over the same period. Australia also has significant foreign direct investment in India (around $10.3 billion in 2016–17), a little less than Indian foreign investment into Australia ($13.5 billion) over the same time. India’s growth rate remains at around 7 per cent per annum and is now greater than China’s growth rate which, if such a gap remains, means that India will at some point swap places with China in accession to the number one GDP spot. Currently, by 2030, India is projected to be the world’s third largest economy. Unlike China, India is a democracy—the world’s largest in fact—suggesting, potentially, greater longterm political stability. English is widely (though not universally) spoken in the country, a legacy of the British Empire heritage and an advantage as English remains the lingua franca of world business. India also has the second-largest population in the world, at 1.3 billion, still behind China, but only just. There is also much to be done in terms of lessening the bureaucratic obstacles to establishing and running businesses in the country and dealing with relatively high levels of public and private corruption. Since 1991 India has embarked on a program of economic liberalisation and deregulation that has made the nation more attractive to Australian and other international trade and investment. But such changes are not always easy to accomplish in a democracy where every economic group has its say, and where such changes can exacerbate social issues (such as economic inequality) if not implemented in the right way. Progress is being made, but it is not assured. Still, the prospects for Australian business in India are overall bullish. Demand for Australian minerals should grow as the country makes investments to close its significant infrastructure needs (perhaps just in time to make up for lowered demand from China as it closes its own gaps in that area). Education is currently Australia’s second-largest export to India and rising incomes should increase demand there as well, building on an already established base. India is now a major tourist destination for Australians (and vice versa) and should grow with rising development and income levels. If most Indians get lifted out of poverty, the demands of 1.3 billion consumers could be very attractive indeed. The next 20 years are almost certainly China’s, but India could well own the 20 years after that. Cameron Gordon Australian National University SOURCES: ‘Market profile’, Australian Government: Australian Trade and Investment Commission accessed via www.austrade.gov.au/Australian/Export/ Export-markets/Countries/India/Market-profile; ‘India country brief’, Australian Government: Department of Foreign Affairs and Trade accessed via https://dfat.gov.au/geo/india/Pages/india-country-brief.aspx; ‘India’, 2019 Index of Economic Freedom accessed via www.heritage.org/index/country/ india; ‘India’s poverty profile’, The World Bank, 25 May 2016 accessed via www.worldbank.org/en/news/infographic/2016/05/27/india-s-poverty-profile. CHAPTER 2 hiL23674_ch02_055-100.indd 81 THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 81 08/06/19 07:41 PM Thus far, we have not differentiated among different types of international trade. Implicit in our discussion is trade of one type—inter-industry trade—trade between industries across national borders. Australia exports resources-based commodities and agricultural products, while importing sophisticated manufactures. Japan exports sophisticated manufactures and imports resources-based commodities and agricultural products. There are other types of international trade, such as intra-industry trade, which is trade between countries in the same industry categories—European countries import cars from Japan while Japan imports cars from European countries. There is also intra-company trade—trade within the same company—such as trade between subsidiaries of a multinational corporation. Most manufacturing multinational corporations have subsidiaries in different countries that produce different components for final assembly elsewhere into final products. This is to say that there are several types of international trade, and when explaining patterns of international trade we need to be mindful that a particular type of international trade is better explained by one or another of the explanations introduced here. The trade theories and some of the newer theories, such as Vernon’s PLC theory, do contribute to some understanding of why individual companies engage in international trade into markets across national borders. However, in general, trade theories have limitations in explaining the motivations and behavioural patterns of individual companies that, after all, are the entities actually doing most of the trading. Patterns of international trade are attributed to countries. Companies engage in international business through various means of exchange across national borders. International trade is one such means, and if international trade is the only involvement, the company remains ‘at home’ and exports and/or imports from there. We will see later that this is a low-commitment mode of international business. If the company chooses to invest abroad, possibly by establishing a physical presence in another country, we label this foreign direct investment (FDI). This could be in the form of establishing a manufacturing operation in another country or by acquiring a foreign company. This is a high commitment mode of international business. We now introduce foreign direct investment. LO 2.3 FOREIGN DIRECT INVESTMENT IN THE WORLD ECONOMY In this section we introduce FDI and some explanations of FDI. At the outset, there are some fundamentals we need to understand. FDI must not be confused with foreign portfolio investment (FPI). FPI occurs when a local company takes up an interest in financial instruments abroad (e.g. foreign corporate shareholdings, government bonds). This is not our interest here. Our interest is exclusively with FDI, a local company investing in physical facilities abroad, either through establishing physical operations itself or by acquiring an enterprise abroad. In addition, to explain why companies invest in physical facilities abroad, it is important to establish some context to this activity. It is useful to conceive of FDI as companies operating in markets, and the two fundamental institutions in this system are the company and the market. Pure theory posits a perfect market with no physical space or time, no institutions and no imperfections, the result being that buyers and sellers only pay direct costs of making and/or purchasing the product. In other words, there are no additional transaction costs. Of course, real markets are not pure in the theoretical sense. Globalisation is all about transacting across physical space and there are transport costs to be borne on top of the costs of the product or service being traded. Trades between buyers and sellers often require contracts and there are thus contract costs arising from legal institutions and 82 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 82 08/06/19 07:41 PM requirements. There are also market imperfections such as government intervention via tariffs and subsidies, and asymmetries in information access (where all information relevant to the exchange is not readily available to buyers and sellers). There are always some transaction costs and market imperfections, even in markets that function well. The bottom line is that real markets will never be perfectly efficient (i.e. devoid of transaction costs). This is where FDI comes in. Companies can remain ‘at home’ and export into markets overseas, importing components and the like from other countries to assemble final products at home, which are then sold abroad. This is the international trade we discussed earlier. When companies choose to engage in actual investment abroad—for example, building an overseas plant to produce and sell to the local market there—different explanations are needed, and these explanations relate to the nature of markets and the extent of imperfections in these markets both at home and abroad. If markets were ‘perfect’, there would be no incentive for a company engaging in international business to do otherwise than to remain at home and export and/or import. This is the least costly and risky way for a company to do international business. But international business is complex, costly and risky, because of market imperfections and transaction costs. Hence, there must be compelling reasons for companies to engage in FDI. We now consider some of these reasons. We approach FDI from three complementary perspectives. One is to explain why a company will favour FDI as a means of entering a foreign market when alternatives are possible. Another is to explain why companies in the same industry often undertake FDI at the same time, and why certain locations are favoured over others as targets for FDI. Here the interest is to explain the observed pattern of FDI flows. A third perspective combines these other two perspectives into one holistic explanation, and this addresses important questions that all companies must consider when undertaking international business. Having decided to do international business, the company must ask itself which countries (markets) will it enter, and via what mode of operation will it enter these markets? Why foreign direct investment? As mentioned above, companies have various possibilities besides FDI available to them for exploiting the profit opportunities in a foreign market. Two of these possibilities are exporting and licensing. As we have seen, exporting involves producing goods at home and then transporting them to the receiving country for sale. Licensing, on the other hand, involves granting a foreign company (the licensee) the right to produce and sell our company’s product in return for a royalty fee on every unit the licensee sells. Clearly, FDI may be both expensive and risky when compared to exporting and licensing. FDI is expensive because the company must bear the costs of establishing facilities in a foreign country or of acquiring a foreign enterprise. FDI is risky because the company is putting its own capital at risk in a country where the ‘rules of the game’ may be very different. Relative to local companies, a foreign company undertaking FDI in another country incurs a ‘liability of foreignness’. When a company exports, it need not bear the costs associated with FDI, and the risks associated with selling abroad can be reduced by using a local sales agent. Similarly, when a licensor allows a licensee to produce its products under licence, it need not bear the costs or risks of FDI, since these are borne by the licensee. So, why do companies choose FDI over either exporting or licensing? There are a number of reasons for companies to invest abroad. These include direct access to new markets and to directly acquire resources not available at home. In addition, companies seek improved efficiency by relocating operations to countries that offer costrelated advantages, investment incentives, or science and industrial parks which encourage knowledge transfer among like-minded companies. Companies also invest abroad in order CHAPTER 2 hiL23674_ch02_055-100.indd 83 EXPORTING Sale of products produced in one country into another country LICENSING Occurs when a firm (the licensor) licenses the right to produce its product, use its production processes, or use its brand name or trademark to another firm (the licensee). In return for giving the licensee these rights, the licensor collects a royalty fee on every unit the licensee sells THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 83 08/06/19 07:41 PM to seek strategic assets by investing in local companies to gain access to distribution networks and local knowledge, and other ownership advantages.31 In all, companies investing abroad are market-seeking, resources-seeking, efficiency-seeking or strategic ­ asset-seeking in the real world where there are various barriers that exporting alone may not be able to overcome. Limitations of exporting Exporting can be constrained by transport costs (a natural market imperfection) and trade barriers (a human-made market imperfection). Clearly, costs of transporting production inputs or outputs generally accumulate as distances covered increase, and past a certain point the final cost to a buyer might make the sale unviable. This is particularly so for products that have a low value-to-weight ratio and can be produced in almost any location (e.g. cement, soft drinks and beer). For these products, relative to either FDI or licensing, exporting is unattractive. For products with a high value-to-weight ratio, however, transport costs might be a minor component of total landed cost (e.g. electronic components, personal computers, medical equipment, computer software and commercial aircraft) and have little impact on the relative attractiveness of exporting, licensing and FDI. Transport costs aside, some FDI is undertaken as a response to actual or threatened trade barriers such as import tariffs or quotas. By placing tariffs on imported goods, governments can increase the cost of exporting relative to FDI and licensing. Similarly, by limiting imports through quotas, governments increase the attractiveness of FDI and licensing. For example, the wave of FDI by Japanese car companies in the United States during the 1980s and 1990s was partly driven by protectionist threats from the US Congress and by quotas on the importation of Japanese cars. For Japanese car companies, these factors decreased the profitability of exporting and increased that of FDI. Trade barriers do not have to be physically in place for FDI to be favoured over exporting. Often, the desire to reduce the ‘threat’ that trade barriers might be imposed is enough to justify FDI as an alternative to exporting. The drama of Brexit is an example of how unforeseen events can suddenly alter business environments. In this case some companies are considering FDI within the EU to limit the business consequences of the United Kingdom suddenly losing its preferential trading arrangements with Europe. Limitations of licensing Licensing has three major drawbacks as a strategy for exploiting foreign market opportunities and these have mainly to do with another real-world factor not present in pure theory; namely, the fact that the knowledge and assets that a company owns often are not easily transferable from one use or party to another and/or not easily controlled if a transfer is made. Since such a transfer is what happens under licensing, it is useful to outline the three main ways these complications can interfere with its effectiveness. First, licensing may result in a company giving away valuable technological know-how to a potential foreign competitor. For example, in the 1960s, US company RCA licensed its leading-edge colour television technology to a number of Japanese companies, including Matsushita and Sony. At the time, RCA saw licensing as a way to earn a return from its technological know-how in the Japanese market without the costs and risks associated with FDI. However, Matsushita and Sony quickly assimilated RCA’s technology and used it to enter the US market to compete directly against RCA. In 1986, the company was disbanded; the RCA brand was acquired by the French company Thompson. In addition, many e­ x-RCA employees were hired by Sony.32 A second problem with licensing is loss of control over manufacturing, marketing and strategy in a foreign country. For both strategic and operational reasons, a company may want to retain control over these functions. The rationale for wanting control over the strategy of a foreign entity is that a company might want its foreign subsidiary to 84 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 84 08/06/19 07:41 PM price and market very aggressively as a way of keeping a foreign competitor in check. US company Kodak pursued this strategy in Japan a couple of decades ago. The competitive attacks launched by Kodak’s Japanese subsidiary kept its major global competitor, Fuji, busy defending its competitive position in Japan, causing it to pull back from its earlier strategy of confronting Kodak aggressively in the United States. (Changes in the way pictures are taken and distributed have since made Kodak a shell of its former self and have radically altered the nature of Fuji’s business as well. But such is life in the dynamic world of international business.) The use of FDI in the form of a wholly owned subsidiary allows the pursuit of aggressive and pre-emptive (if also high-risk) moves, if judged to be in the company’s best interest. A licensee would be unlikely to accept such an imposition, as such a strategy implies the licensee could be compelled to accept a lowered profit, or might even have to take a loss. In addition, the international company might wish to take advantage of differences in factor costs across countries, producing only part of its final product in a given country, while importing other parts from elsewhere where they can be produced at lower cost. The internationalisation of production is discussed later, but for the present, licensing may not be the best option when the companies can leverage factor cost differentials across countries. Again, a licensee would be unlikely to accept such an arrangement, since it would limit the licensee’s autonomy. Hence, for these reasons, when control over a foreign operation is desirable, FDI is preferable to licensing. A third problem with licensing arises when the company’s competitive advantage is based not so much on its products but on the management, marketing and manufacturing capabilities that produce those products. These capabilities often are not amenable to licensing; that is, they cannot be codified and contracts written to replicate them by a licensee overseas. While a foreign licensee physically may be able to reproduce the company’s product under licence, it often may not be able to do so as efficiently as the company could itself. As a result, the licensee may not be able to fully exploit the profit potential inherent in a foreign market. For example, consider Toyota, a company whose competitive advantage in the global car industry is acknowledged to be its superior ability to manage the overall value chain of designing, engineering, manufacturing and selling vehicles; that is, its management and organisational capabilities. Indeed, Toyota is credited with pioneering the development of a new production process, known as lean production, which enables it to produce higher quality cars at a lower cost than its global rivals.33 Although Toyota has certain products that could be licensed, its real competitive advantage comes from its management and process capabilities. These kinds of skills are difficult to codify. They cannot be written into a licensing contract. Within the particular company, these capabilities are organisation-wide and have been developed over a long time. They are not embodied in any one individual, but instead are widely dispersed throughout the organisation. Toyota’s skills are embedded in its organisational culture, and culture cannot be licensed. If Toyota were to allow a foreign entity to produce its cars under licence, the entity would be unlikely to do so as efficiently as does Toyota. In turn, this would limit the ability of the foreign entity to fully develop the market potential of that product. This reasoning underlies Toyota’s preference for FDI abroad as opposed to permitting foreign car manufacturers to produce its cars under licence. FDI is thus more profitable than licensing when one or more of the following conditions holds: (1) when the company has valuable know-how that cannot be adequately protected by a licensing contract; (2) when the company needs tight control over a foreign entity to maximise its market share and earnings in that country; and (3) when a company’s skills and know-how are not amenable to licensing. A company will favour FDI over exporting and licensing when market imperfections and transaction costs are higher rather than lower. CHAPTER 2 hiL23674_ch02_055-100.indd 85 THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 85 08/06/19 07:41 PM The pattern of foreign direct investment It is often observed in some sectors that companies in the same industry undertake FDI at about the same time as do their rivals. Retail banking is one such sector. In Australian retail banking, the four major banks seek to increase market share by entering foreign markets, and they consistently mimic one another’s behaviour in this respect. The announcement by one of the Australian banking majors that it is entering retail banking in a country overseas is generally followed in due course by another’s similar announcement. This is a pattern that goes back decades; for example, when Australian banks opened their first US branches over the course of a few short years in the late 1960s and early 1970s (and following a similar clustering of opening London branches in the late 1950s).34 There is also a clear tendency for companies to direct their investment activities towards particular locations. We offer two explanations now that explain these patterns observed in FDI flows. Strategic behaviour OLIGOPOLY An industry composed of a limited number of large firms all of whom recognise their mutual interdependence MULTIPOINT COMPETITION Arises when two or more firms encounter each other in different regional markets, national markets or industries LO 2.3 One explanation of this FDI pattern of imitative behaviour is based on the idea that FDI flows are a manifestation of strategic rivalry between international companies in the global marketplace. An early exponent was F.T. Knickerbocker, who studied the relationship between FDI and rivalry in oligopolistic industries.35 An oligopoly is an industry composed of a limited number of large companies all of which recognise their interdependence: what one company does has an immediate impact on major competitors, eliciting a retaliatory response. Thus, if one company in an oligopoly lowers prices, this can cut into rivals’ market share, forcing them to respond with similar price cuts to retain their market share. Such imitative behaviour can take many forms in an oligopoly. Building on this, Knickerbocker argued that the same kind of imitative behaviour characterises FDI. Studies of US companies during the 1950s and 1960s that investigated FDI show that companies based in oligopolistic industries tended to imitate each other’s FDI.36 The same phenomenon has been observed with regard to FDI undertaken by Japanese companies during the 1980s.37 For example, Toyota and Nissan responded to investments by Honda in the United States and Europe by undertaking their own FDI in the United States and Europe. More recently, research has shown that models of strategic behaviour in a global oligopoly can explain the pattern of FDI in the global tyre industry.38 Knickerbocker’s theory can be extended to embrace the concept of multipoint competition. Multipoint competition arises when two or more companies encounter each other in different regional markets, national markets or industries. Economic theory suggests that like chess players jockeying for advantage, companies will try to match the moves of each other in different markets to try to hold one another in check. The strategy is to ensure that a rival does not gain a commanding position in one market and then use the profits generated there to subsidise competitive attacks in other markets. The online retail business is a good example of this. A few large international and major regional players contest major markets one by one, hoping to establish a first-mover advantage and an unbeatable competitive position. For example, Amazon, Alibaba and Walmart are now competing for dominance in the Indian retail space, repeating earlier and ongoing battles in other national markets.39 The eclectic paradigm Internalisation theory Internalisation theory explains why companies often prefer FDI over licensing as a strategy for entering foreign markets.40 According to internalisation theory, when market imperfections make market-based transactions less efficient, a company is likely to undertake FDI. The company ‘internalises’ what otherwise would have been ‘externalised’ 86 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 86 08/06/19 07:41 PM market-based transactions. The transaction costs incurred in using the market are too costly and the company making the exchange will internalise these costly exchanges into the organisational form of the company—it brings the costly exchange into the company to minimise or avoid these costs. As such, and attributed to Ronald Coase in 1937, internalisation theory provides a cogent explanation of why companies exist, and in international business, it provides the strongest explanation of the nature and form of the multinational corporation. This theorising was pioneered in international business by Peter Buckley and Mark Casson (1976), Jean-Francois Hennart (1982) and Alan Rugman (1986). All of the explanations introduced above have made important but partial contributions to understanding the determinants of FDI. John Dunning, appointed to the Order of the British Empire (OBE) in 2008, championed his eclectic paradigm,41 arguing that in addition to ownership advantages that are company-specific and render some companies more competitive than others, there are internalisation and location-specific advantages. Internalisation advantages, the advantages of particular modes of operation in particular circumstances of market imperfections, and location-specific advantages, the attributes of one location over another, are also critical in explaining both the rationale for and the direction of FDI. By location-specific advantages, Dunning refers to advantages that arise from using resource endowments or assets that are tied to a particular foreign location and that a company finds valuable to combine with its own unique company-specific assets, such as the company’s technological, marketing or management capabilities. Dunning accepts the argument of internalisation theory that it can be difficult for a company to license its own unique capabilities and know-how; that is, its ownership advantages. Therefore, he argues that combining location-specific assets or resource endowments and the company’s own unique capabilities often requires FDI. This requires the company to establish production facilities where those foreign assets or resource endowments are located as they are location-bounded. This paradigm has been labelled Dunning’s O-L-I paradigm, and it addresses explicitly two core questions that all companies doing international business must consider. Having decided to do international business, for whatever reason, where will the company engage overseas, and by what mode of operation will the company engage overseas? The company will leverage on its O, its ownership advantage, in a particular L, location, which offers it advantage in deriving the highest returns to its O. It will choose a mode of operation which best permits efficiency given the nature and extent of market imperfections in this location. This latter, I, addresses the internalisation-specific attributes of the different modes of operation, which we have earlier briefly introduced. An obvious example of Dunning’s location arguments is natural resources, such as oil and other minerals, which are by their character specific to certain locations. However, Dunning’s framework has implications that go beyond basic resources such as minerals and labour. Incentive schemes to attract FDI including the establishment of free trade zones, or the existence of clusters such as Silicon Valley in the United States and Bangalore in India, provide locational advantages. Consider Silicon Valley, which is the world centre for the computer and semiconductor industry. Many of the world’s major computer and semiconductor companies, such as Apple Computer, Hewlett–Packard and Intel, are located close to each other in the Silicon Valley region. As a result, much of the cutting-edge research and product development in computers and semiconductors occurs here. (Note that this dynamic also mirrors an aspect of Porter’s diamond theory.) According to Dunning’s arguments, knowledge is being generated in Silicon Valley with regard to the design and manufacture of computers and semiconductors that is available nowhere else in the world. As it is commercialised, that knowledge diffuses throughout the world, but the leading edge of knowledge generation in the computer and semiconductor industries is to be found in Silicon Valley. In Dunning’s language, this CHAPTER 2 hiL23674_ch02_055-100.indd 87 INTERNALISATION THEORY Market imperfection approach to explaining foreign direct investment ECLECTIC PARADIGM A framework, also known as ownership, location, internalisation (OLI), developed by John Dunning to determine conditions suitable for a firm to pursue foreign direct investment (FDI) INTERNALISATION ADVANTAGES Factors associated with imperfections in the market, and the firm deciding to keep the production of a good or service within the firm rather than externalising it to other firms LOCATION-SPECIFIC ADVANTAGES Advantages that arise from using resource endowments or assets that are tied to a particular foreign location and that the firm finds valuable to combine with its own unique ownership-specific attributes OWNERSHIP ADVANTAGES Advantages that arise from the accumulation of intangible assets, technological capacities or innovations that are specific to the particular firm CLUSTERS Geographic concentrations of interconnected firms and institutions in a particular industry THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 87 08/06/19 07:41 PM © Phillip Bond/Alamy Stock Photo Silicon Valley, where Google is based (as well as other major US tech firms such as Facebook), has long been known as the epicentre of the computer and semiconductor industry. LO 2.3 EXTERNALITIES Spillovers which occur when a firm is impacted by an event and does not choose to incur that benefit or cost. The firm’s interests are not taken into account when the event occurs. They can be positive or negative 88 PART 2 means that Silicon Valley has a location-specific advantage in the generation of knowledge related to the computer and semiconductor industries. In part, this advantage comes from the sheer concentration of intellectual talent in this area, and in part it arises from a network of informal contacts that allows companies to benefit from each other’s knowledgegeneration activities. These knowledge spillovers generate externalities which enable interested companies that locate nearby to internalise where possible these positive spillovers.42 Companies learn from one another. It makes sense for foreign computer and semiconductor companies to invest in research and (perhaps) production facilities so they too can learn about and use valuable new knowledge before those based elsewhere can, thereby giving them a competitive advantage in the global marketplace.43 INTERNATIONALISATION OF THE COMPANY In the previous section, explanations of FDI were introduced. In general, FDI is undertaken by large multinational companies (MNCs), although this is not always the case as smaller companies can also invest abroad. Technico Pty Ltd, an innovative Australian small seedpotato company, chose to establish a complete manufacturing facility in Yanglin, Yunnan Province, China, early in the company’s life-cycle as part of its internationalisation strategy to take its seed potatoes to the world. Nonetheless, smaller companies more often use market-based modes of operating in international markets. That is, as we have seen, they can externalise their exchanges into companies in international markets, rather than internalising them within the organisational structure of their own company. They contract with other companies for some activities rather than undertaking these activities themselves. As such, they export or license, given the three possibilities we have thus far introduced. These are less risky and costly than is FDI, and hence are more attractive international possibilities. The majority of Australian and New Zealand companies are small to medium-sized enterprises (SMEs) and much business activity in these and other countries is conducted by small companies. While there is no universal definition of an SME, in Australia a small business is defined as a company employing between five and 20 people, and a medium business is one that employs more than 20 but fewer than 200 people.44 Over the last four decades, a number of models have emerged to explain how companies develop from operating in domestic markets exclusively to operating in international markets (referred to in the literature as the internationalisation process of the company). It has also been found that exporting is the most common form of initial international market entry mode,45 and these models have attempted to explain the process involved in beginning to export and progressing beyond export. In addition, exporting is a mode of internationalisation often favoured by governments, given the benefits that accrue to an economy from foreign currency earnings through export, and the employment benefits of keeping operations at home. SMEs are very significant employers and new SMEs particularly so. Since the 1960s, the internationalisation process of companies has been an attractive research domain. Scholars such as Jan Johanson and Finn Wiedersheim-Paul,46 S. Tamer Cavusgil47 and Michael Czinkota48 among others have conceptualised the internationalisation process of the company as an incremental process, with companies at a similar stage of development in their internationalisation exhibiting similar characteristics in their export behaviour.49 Unfortunately, like the FDI theories, at present there is no CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 88 08/06/19 07:41 PM single widely accepted internationalisation process model. However, two schools of thought have emerged in the literature to explain internationalisation processes. Otto Andersen has categorised these as the Uppsala internationalisation process models (U-models) and the Innovation-related internationalisation models (I-models).50 The Uppsala models (U-models) The U-models were pioneered by researchers in Sweden. Johanson and Wiedersheim-Paul,51 supported by evidence from a case study of just four Swedish manufacturing companies, identified four different stages of entering an international market, where each successive stage represents a greater degree of commitment to internationalisation: • Stage 1—no regular export activity • Stage 2—export via independent representatives (agents) • Stage 3—establishment of an overseas sales subsidiary • Stage 4—overseas production/manufacturing units. The framework was further developed by Jan Johanson and Jan-Erik Vahlne.52 To explain the incremental nature of internationalisation, they formulated a dynamic model in which the outcome of one cycle is the input to the next cycle. The model structure is given by the distinction between the state and change aspects of internationalisation. The basic PSYCHIC DISTANCE idea of this model is that internationalisation begins with increased knowledge of foreign Factors impeding the flow of markets which then triggers increased actual commitment of resources on the ground in information between the firm and an those markets, with a reinforcing feedback loop between knowledge and commitment international market ongoing after that (see Figure 2.6). The Uppsala models are explicitly staged in that companies incrementally increase progressive involvement in their international markets as they experientially learn by carrying out operations in foreign markets. Reducing risk through experiential learning, Uppsala-type companies expand their international operations by progressively increasing their commitment and by extending gradually into markets that are dissimilar to the home FIGURE 2.6 market. In the Uppsala models, their increasing commitment through higher involvement The theoretical and operational level modes is referred to as the ‘establishment chain postulate’ and the behaviour of gradually of the knowledge and foreign market extending in dissimilar markets is referred to as the commitment development U-model ‘psychic distance postulate’. According to Daniel Sullivan Operational level and Alan Bauerschmidt, ‘the internationalization of the firm is an incremental process owing to the progressive Overseas market location Operational steps for overseas reduction of psychic distance through managers’ gradual choices commitment levels accumulation of knowledge of foreign markets’.53 The Uppsala models are actually a conceptualisation Initial entry into low-distance that is represented by two underlying models, a theoretical 1. No/few exports markets (close geographical, model and an operational (empirical) model. Figure 2.6 cultural and/or ‘psychic’ distance provides a comparison of the theoretical and operational from home country) levels of the model. As can be seen, the relationship 2. Indirect exports (via third parties) between the concepts of the theoretical model and linkages between the theoretical and the operational level are somewhat vague, making it difficult to test the model. 3. FDI—overseas sales The tests that have been carried out have produced mixed operations results.54 Researchers such as Yung-Chul Kwon and Michael Hu55 have found support for the evolutionary path, but Expansion (if successful) Andrew Millington and Brian Bayliss56 have not. There 4. FDI–production into more distant markets have been other criticisms of the model, such as its inability CHAPTER 2 hiL23674_ch02_055-100.indd 89 THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 89 08/06/19 07:41 PM to explain the international behaviours of a cadre of companies that do not begin operations in their home market before internationalising. These companies have become known as ‘born globals’.57 (The ‘born global’ aspect of companies will be discussed in the next section.) Overall, U-model researchers have made a significant contribution towards our understanding of the internationalisation process and have influenced much of the subsequent empirical research. They have highlighted the importance of knowledge in export market development. In their revised model, Johanson and Vahlne58 also recognised the importance of networks to small companies and also to larger ones, and opportunity seeking in international markets. Even more recently, they have extended their internationalisation process model to become a globalisation model, and in 2017 Vahlne and Johanson published another version as an evolutionary model of their so-called modern multinational business enterprise.59 The Innovation-related models (I-models) The body of research referred to as I-models60 encompasses a number of studies61 that differ from the U-models in that they view exporting as an innovation in the company as it changes the company in a fundamental way. Proponents of this approach have relied on the application of Rogers’62 theory of innovation diffusion to explain the export behaviour of companies. Rogers’ theory is widely accepted in other fields of study such as consumer behaviour.63 The basic premise common to these models is that the internationalisation process is a series of innovations for the company, particularly managerial innovations.64 The focus of these models is primarily on the export development process of SMEs.65 When management decides that own export is too demanding, they might appoint a sales agent in a foreign market. As such, they implicitly give up some control of their international expansion aspirations, relying on this agent to undertake all of the company’s international marketing activities in this foreign market. This is viewed as a managerial innovation and if continued might foreshadow progressive and gradual foreign market expansion with deepening involvement of independent agents overseas. There are several limitations identified in the literature that are common to both the U-models and the I-models. Some researchers have criticised these models for being too deterministic and of limited value in accounting for the idiosyncratic behaviours of internationalising companies.66 This criticism has become centred on a number of studies that have found that the conventional internationalisation theories do not adequately explain the internationalisation of a cadre of companies, especially (but not exclusively) those small companies in the high-tech fields that appear to be ‘born global’. These companies internationalise very early in their life-cycles and they accelerate their subsequent international expansion.67 As such, early development in home markets before the first internationalisation step, and gradual expansion overseas as theorised by the Uppsala and Innovation-related models, is not observed. LO 2.5 BORN GLOBAL A firm that internationalises into global markets soon after it is formed 90 PART 2 ‘BORN GLOBAL’ COMPANIES Various terms have been used to describe companies that internationalise early in their life-cycles and accelerate subsequent international expansion activity. These include ‘early internationalisers’, ‘global start-ups’, ‘international new ventures’ (INVs)68 and ‘born globals’.69 In this chapter we will adopt the last term, ‘born globals’, as this label is becoming prevalent in the literature. Unfortunately, there is no consensus within the literature as to what constitutes a born global company. However, it is generally taken that INVs emerge from existing companies, whereas born globals are new companies that internationalise soon after the company is formed. We will focus on the so-called born globals. Researchers from around the world have reported that high-tech (mostly, but not exclusively) companies that have internationalised rapidly are becoming more common CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 90 08/06/19 07:41 PM and are emerging from many countries. This is now a worldwide phenomenon, and lowertech companies are also being born global. However, we need to be careful, as the term ‘born global’ is not an accurate descriptor, as few of these companies are actually born global. They do not generally enter global markets from inception. More accurately, these companies are born internationally. Nonetheless, there are many, many new companies from many countries that are entering markets overseas soon after the company is formed and they are continuing with entry in new markets more rapidly than predicted by the gradual internationalisation of the Uppsala and Innovation-related models. Gary Knight and S. Tamer Cavusgil70 conducted a number of case studies in Australia to develop profiles of some emerging exporters. Even back when they did the study a couple of decades ago, they found a breed of exporting companies that did not match the profile of traditional exporters. An example they cited was ANCA, a manufacturer of CNC tool grinders and controls, which exported 85 per cent of its products within five years of its founding. This business attributed its success to its leading-edge technology, unique product and international vision, backed up by resource commitment. Trends like this have continued. An Austrade survey in 2017, defining ‘born global’ as ‘firms that have earned international revenue within two years of starting operations’, found an increasing proportion of companies meeting this criteria between 2000 and 2017, with the proportion of companies considered to be born global between 2010 and 2017 a good deal larger compared with the previous three decades.71 Similar trends have been found in other regions too. Jim Bell conducted a comparative study into the export behaviour and internationalisation of small computer software companies in Finland, Ireland and Norway. The findings of this study challenged many of the underlying assumptions of conventional internationalisation ‘stage’ theories (namely, the incremental sequential process), leading to the conclusion that such theories do not adequately reflect the internationalisation process among small computer software companies. AMC/McKinsey72 in Australia examined exports by manufacturers in the areas of emerging high value-added and elaborately transformed manufactures. This study found a trend that companies in this sector tend to be born global. The study also found that these successful exporters are generally companies in which top management has a desire and commitment to export, compete on value, and also have a strong market orientation. Based on their own research and that of AMC/McKinsey,73 Knight and Cavusgil concluded that small companies have inherent advantages in terms of response time, flexibility and adaptability, all of which facilitate their internationalisation efforts. They also concluded that ‘gradual internationalization is dead’, at least for value-added exporters, and that rapid internationalisation is feasible and even desirable. However, we should not take this statement as a definitive conclusion, as many companies will remain gradual internationalisers. Nonetheless, in certain instances, some companies will ‘leapfrog’ into internationalisation rather than moving cautiously through a series of incremental steps, as suggested by the ‘stage’ theories.74 Another reason for rapid internationalisation includes shorter product lifecycles in some industries, especially in high-tech industries, the reduction in trade barriers and the ease of communicating and transacting across national borders. Some interesting companies in this cadre are reported in the publication Born to be Global: A Closer Look at the International Venturing of Australian Born Global Firms.75 The companies studied present a cross-section of early internationalising Australian companies from different industry sectors. Other more widely recognised companies include Logitech, a Switzerland-based producer of aids for personal computers (see the Closing Case), and Cochlear, an Australian company producing implants for people with deafness and deriving more than 95 per cent of its income from exports. The Department of Foreign Affairs and Trade identified a number of companies that have internationalised using the internet. Yahoo is another company that was born global, relying on the internet. CHAPTER 2 hiL23674_ch02_055-100.indd 91 TEST PREP Preparing for a test? Use LearnSmart to help you remember what you’ve learned. THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 91 08/06/19 07:41 PM FOCUS ON MANAGERIAL IMPLICATIONS Why does all this matter for international business? There are several implications for international businesses. These include: (1) international business as exchange across borders; (2) FDI as an option; (3) location as core to international business; (4) first-mover advantages; (5) internationalisation of the company; and (6) policy implications. LO 2.6 INTERNATIONAL BUSINESS AS EXCHANGE ACROSS BORDERS Companies can choose to remain ‘at home’ and cater to their domestic markets exclusively. This may be the best strategy for some companies that do not have something special to take to the world—Dunning’s O—an ownership-specific advantage. For a company to engage in international business, and to market goods or services in markets overseas, it must have something special as the competition in these markets will be intense, and the company will confront a liability of foreignness in overseas markets. Having taken a decision to do international business, there are choices to be made. First, where to go—which overseas market to enter? Second, how to enter that market—which mode of operation to choose? Here we have introduced just three modes—exporting, licensing and FDI. More will be said of these modes later in this book. At this point, we recognise that all markets have varying degrees of imperfections, human-made and natural, and the choice of mode will depend on the nature and extent of these market imperfections—the more imperfect the market, the more internalised will be the exchange. However, we also recognise that the more internalised the mode, the more costly will be the foreign operation, and the more risks the company will have to accommodate. FDI AS AN OPTION The implications of FDI theory for international business practice are several. First, it is worth noting that the location-specific advantages argument associated with John Dunning helps to explain the 92 PART 2 direction of FDI flows. However, the location-specific advantages argument does not explain why companies prefer FDI, an internalised mode of operation, to the market-based modes of licensing or exporting. In this regard, from both explanatory and international business perspectives, a useful explanation is that which focuses on the limitations of exporting and licensing. This explanation is useful because it identifies precisely how the relative attractiveness of FDI, exporting and licensing varies with different circumstances. Exporting is preferable to licensing and FDI when transport costs and trade barriers are few and low. As transport costs and trade barriers increase, exporting becomes less attractive, and the choice is between FDI and licensing. Because FDI is more costly and more risky than licensing, all other things being equal, licensing is preferable to FDI. Other things are seldom equal, however, and licensing is not an attractive option in the following conditions: (a) the company has valuable know-how that cannot be adequately protected by a licensing contract; (b) the company needs tight control over a foreign entity in order to maximise its market share and earnings in that country; and (c) the company’s skills and capabilities are not amenable to licensing. LOCATION AS CORE TO INTERNATIONAL BUSINESS Underlying most of the explanations we have discussed is the notion that different countries have particular advantages in different productive activities. That is, different countries have particular locationspecific advantages. It makes sense for a company to disperse its need for productive capabilities to those countries where particular activities can be performed most efficiently. If design can be performed most efficiently in Finland, then that is where design facilities should be located; if the manufacture of basic components can be performed most efficiently in China, then that is where they should be manufactured; and if final assembly can be performed most efficiently in Singapore, then that is where final assembly should be performed. The company might be headquartered CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 92 08/06/19 07:41 PM in New Zealand or Australia. The result is a global web of productive enterprise, with different activities being performed in different locations around the globe, depending on considerations of comparative advantage, factor endowments and other aspects of trade and investment. As such, international business for the company is an evolving mix of international trade, FDI, licensing and other modes of international business operations, yet to be discussed. As Dunning’s O-L-I paradigm outlines, location is fundamental to international business. FIRST-MOVER ADVANTAGES According to new trade theory, companies that establish a first-mover advantage in the production and marketing of a new product may dominate global trade in that product. This is particularly true in industries where the global market can profitably support only a limited number of companies, such as the aerospace market. Early commitments also seem to be important in less concentrated industries, such as the market for mobile telephone equipment. For the individual company, the message is that it pays to invest substantial financial resources in building either a firstmover or early-mover advantage, even if that means several years of losses before a new venture becomes profitable. The intent is to pre-empt demand, gain cost advantages related to volume, build an enduring brand ahead of rivals and, consequently, establish a longterm sustainable competitive advantage. Although the details of how to achieve this are beyond the scope of this chapter, many publications offer strategies for exploiting first-mover advantages, and for avoiding the traps associated with pioneering a market (first-mover disadvantages).76 INTERNATIONALISATION OF THE COMPANY There are several forms of international trade and no one theory explains all forms of trade. Regardless of the form of international trade, trade is initiated by companies and much trade occurs between companies or within companies across national borders. FDI is also an option for companies in international markets. While international trade is critical to a nation’s standard of living and wellbeing, and is well explained by longstanding existing theories, trade only occurs CHAPTER 2 hiL23674_ch02_055-100.indd 93 because companies choose to engage in international business through internationalisation activities. With modern technologies and forces interconnecting the world more and more, companies large and small are internationalising in ever-expanding numbers and from all corners of the globe. While there are some patterns to these internationalisation activities and processes, and the search is for explanations of these processes, there is much variation in companies’ internationalisation. Explanations of these processes require that management within these companies be understood, and as such, behavioural considerations are vitally important. No one explanation of the internationalisation process has achieved consensus. This domain of international business is an attractive research context. POLICY IMPLICATIONS International trade matters to international business because companies are major players on the international trade scene. International business companies produce exports, and they import the products of other countries either for final sale to consumers or as components into their own production processes. Because of their fundamental role in international trade, companies can exert a strong influence on government trade policy, lobbying to promote free trade or trade restrictions. The theories of international trade claim that promoting free trade is generally in the best interests of a country, although it may not always be in the best interests of an individual company. Many companies recognise this and lobby governments. Porter’s theory of national competitive advantage also contains policy implications. Porter suggests that it is in the best interests of an economy that companies invest in upgrading advanced factors of production; for example, to invest in better training for its employees and to increase its commitment to research and development. It is also in the best interests of the business community to lobby government to adopt policies that have a favourable impact on each component of the so-called national diamond. Thus, according to Porter, companies should urge government to increase investment in education, infrastructure and basic research (since all these enhance advanced factors), and to adopt policies that promote strong competition within domestic markets (since this makes companies stronger international competitors). THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 93 08/06/19 07:41 PM KEY TERMS PAGE 61 absolute advantage 90 born global 87 clusters 60 comparative advantage 87 eclectic paradigm 73 economies of scale 83 exporting 88 74 59 87 87 83 87 59 externalities first-mover advantages free trade internalisation advantages internalisation theory licensing location-specific advantages mercantilism 86 86 87 61 62 89 61 multipoint competition oligopoly ownership advantages positive-sum game production possibility frontier (PPF) psychic distance zero-sum game SUMMARY In this chapter, we recognise that international business involves international trade and foreign direct investment, and other modes of operating overseas such as licensing. Large MNCs with operations in many countries will have a complex mix of international trade and FDI strategically located so as to maximise their advantages to increase their revenue and profits overall. Smaller companies that internationalise successfully are likely to begin by exporting and importing but will likely deepen their internationalisation by moving to higher commitment modes of operation and extending into more overseas markets. These patterns of internationalisation will differ depending on the companies’ strategies, country differences and a host of other variables. We recognise that in our modern world economies today, increasing numbers of companies, large and small, are internationalising as globalising forces are making the business world more interconnected. While we understand that companies trade, a number of theories have been introduced that explain why it is beneficial for a country to engage in international trade. These theories have explained the patterns of international trade observed in the world economy. In addition, we have discussed some of the explanations of why companies undertake FDI, as well as some recent theoretical developments in explaining the internationalisation process of SMEs. In this chapter, the following points were made: 1. Mercantilists argued that it was in a country’s best interests to persistently run trade surpluses, and to persistently accumulate wealth acquired from other countries. This theory holds that trade is a zero-sum game, in which one country’s gains result in losses for other countries. This philosophy has been proven to be flawed, but neo-mercantilism remains a common view held by some within our modern economies. Trade has been proven to be a positive-sum game. 2. The theory of absolute advantage suggests that countries differ in their ability to produce goods efficiently. The theory suggests that a country should specialise in producing goods for which it has an absolute advantage in productivity over all other countries and import goods from other countries which have absolute advantages in their particular goods. 3. What happens if one country has an absolute advantage in producing all goods? The theory of comparative advantage suggests that it makes sense for a country to specialise in producing those goods that it can produce most efficiently relative to others it produces, while importing goods that it produces relatively less efficiently from other countries, even if that means importing goods it could have produced more efficiently itself. 4. The Heckscher–Ohlin theory argues that the pattern of international trade is determined by differences in 94 PART 2 factor endowments. It predicts that countries will export those goods that make intensive use of their relatively abundant factors and they will import goods that make intensive use of their relatively scarce factors. 5. Vernon’s product life-cycle theory suggests that trade patterns are influenced by where a new product is invented and first produced. In an increasingly integrated global economy, the product life-cycle theory seems to be less predictive than it once was. 6. New trade theory states that trade allows a country to specialise in the production of certain goods, attaining scale economies and lowering the costs of producing those goods, while buying goods that it does not produce from other countries that are similarly specialised. By this mechanism, the variety of goods available in each nation is increased, while the average costs of those goods should fall. 7. New trade theory also states that in those industries where substantial economies of scale imply that the world market will profitably support only a few firms (an oligopolistic industry), countries may predominate in the export of certain products simply because they had a company that was a first mover in that industry. 8. Some new trade theorists have promoted the idea of strategic trade policy. The argument is that government, CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 94 08/06/19 07:41 PM by the sophisticated and judicious use of subsidies, might be able to increase the chances of domestic companies becoming first movers in newly emerging industries. 9. Porter’s model of national competitive advantage suggests that patterns of trade are influenced by four attributes of a country: (a) factor endowments; (b) domestic demand conditions; (c) relating and supporting industries; and (d) company strategy, structure and rivalry. In addition, chance and government policy are vitally important. Specialisation in this construct should be in goods and services where the ‘diamond’ of attributes is strongest and most complete. 10. International markets have varying types and degrees of market imperfections and transactions costs. Some are human-made and others are natural. When markets are imperfect and transactions costs exist, there is an incentive to internalise the market for exchanges rather than to use market-based modes of exchange. Exporting is a market-based mode of exchange while FDI is an internalised mode. 11. High transport costs (a natural market imperfection) and tariffs imposed on imports (a human-made market imperfection) help to explain why many companies prefer FDI (an internalised mode) to licensing or exporting (market-based modes). 12. Companies often prefer FDI to licensing when: (a) the company has valuable know-how that cannot be protected by a licensing contract; (b) the company needs tight control over a foreign entity to maximise its market share and earnings in that country; or (c) the company’s skills and capabilities are not amenable to licensing. 13. Knickerbocker’s theory suggests that much FDI is explained by imitative behaviour by rival companies in an oligopolistic industry. 14. Vernon’s product life-cycle theory suggests that companies undertake FDI at particular stages in the lifecycle of products they have pioneered. However, Vernon’s theory does not address the issue of whether FDI is more efficient than exporting or licensing for expanding abroad. CHAPTER 2 hiL23674_ch02_055-100.indd 95 15. Dunning argued that location-specific advantages are important in explaining the nature and direction of FDI. According to Dunning, companies undertake FDI to exploit markets, resource endowments or assets that are location-specific. 16. Dunning’s O-L-I paradigm has become widely recognised in international business. A company considering international business must have something special to take overseas, an ownership-specific advantage, an O. After having taken a decision to internationalise, Dunning asks into which market overseas will the company go (different countries have different location-specific advantages, L). Having chosen a location overseas, which mode of entry and operation will the company select? (All modes have varying degrees of market internalisation and internalisation-specific advantages, I.) 17. The internationalisation pattern of SMEs has been described as an incremental, sequential process in some explanations, but in others, the first internationalisation activity occurs soon after the company is founded and is rapid, and its subsequent internationalisation activity can be accelerated. 18. Some internationalisation models suggest that companies initiating exports for the first time will target countries that are psychically close. As such, a company in Australia would start exporting to countries such as New Zealand or the United Kingdom, and only after accumulating experience in markets overseas would it enter a market such as Japan, which is psychically distant from Australia. 19. The so-called INVs and born globals internationalise rapidly due to many factors which include reduced trade barriers, shorter product life-cycles and communication technologies which facilitate that rapid internationalisation. In addition, often management in these companies has experience accumulated from previous work-lives and this can truncate the formative phases in the new company. These companies do not follow an incremental, sequential process to internationalisation. THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 95 08/06/19 07:41 PM INTERNATIONAL BUSINESS GRADUATE ATTRIBUTES (IBGAs): LEARNING AND ASSESSMENT TASKS IBGA1: DISCIPLINE KNOWLEDGE AND SKILLS 1. ‘Japan is a neo-mercantilist nation. It protects industries where it has no competitive advantage in the world economy, such as domestic agriculture, while demanding that other countries open those markets where Japanese producers have a competitive advantage, such as cars.’ Discuss this statement. 2. Unions in developed nations often oppose imports from low-wage countries such as Bangladesh and advocate trade barriers to protect jobs from what they often characterise as ‘unfair’ import competition. Is such competition ‘unfair’? Do you think that this argument is in the best interests of: (a) the unions; (b) the people they represent; and/or (c) the country as a whole? 3. Drawing upon the new trade theory and Porter’s model of national competitive advantage, outline the case for government policies that would build national competitive advantage in a particular industry. What kinds of policies would you recommend that the government adopt? Are these policies at variance with the basic free trade philosophy? IBGA3: PROBLEM SOLVING 4. One of the most significant factor endowments is education, with important measures being the literacy rate and the literacy rate gap between the genders. Which of the following countries do you think has the highest literacy rate and which country has the largest literacy gap between males and females: (a) Iraq (b) Rwanda (c) Chile (d) India? IBGA4: ETHICAL DECISION MAKING 5. ‘The world’s poorest countries are at a competitive disadvantage in every sector of their economies. They have little to export. They have no capital, their land is of poor quality, they often have too many people given the available work opportunities and they are poorly educated. Free trade cannot possibly be in the interests of such nations!’ Discuss. IBGA5: COMMUNICATION 6. You are the international manager of an Australian or a New Zealand business that has just developed a 96 PART 2 revolutionary new personal computer that can perform the same functions as PCs but costs only half as much to manufacture. Your CEO has asked you to formulate a recommendation for how to expand into the European Union market. Your options are: (a) to export from your home market; (b) to license a European company to manufacture and market the computer in Europe; and (c) to set up a wholly owned subsidiary in Europe. Evaluate the pros and cons of each alternative and write a brief report suggesting a course of action to your CEO. 7. The UNCTAD World Investment Report and its World Investment Directory provide quick electronic access to comprehensive statistics on foreign direct investment and the operations of transnational corporations. Compile a list of the largest transnational corporations in terms of their FDI and identify their home country (i.e. headquarters country). Then provide a 15-minute commentary about the characteristics of countries that have the greatest number of transnational companies. IBGA6: SOCIAL INTERACTION 8. Your company is considering opening a new factory in an Asian country, and management is evaluating the specific country locations for this direct investment. The pool of candidate countries has been narrowed to China, India and Thailand. Form a small group of four or five peers and prepare a short report comparing the FDI environment and location advantage of these three countries. IBGA2: CRITICAL ANALYSIS 9. CASE ANALYSIS Read the Opening Case, ‘Bangladesh’s textile trade’ again, and answer the following questions. a. How has Bangladesh benefited from free trade and globalisation? b. What did the end of the quota system mean for that country? c. Using Porter’s diamond of competitive advantage, explain Bangladesh’s competitive advantage in the production of textiles. d. How important are Bangladesh’s supporting industries to its textile trade? 10. CASE ANALYSIS Read the following Closing Case and answer the questions that follow. CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 96 08/06/19 07:41 PM CLOSING CASE LOGITECH’S GLOBAL APPROACH Logitech, a computer technology company, was co-founded in 1982 in Apples, Vaud, Switzerland, by Daniel Borel, Pierluigi Zappacosta and Giacomo Marini. The former are Stanford alumni and classmates, while the latter was an engineer at Olivetti and IBM. United in their vision of a global operation, they rejected the ‘typical’ start-up strategy of targeting niche markets and instead set their sights on configuring a global organisation. From its inception, Logitech faced the challenge of entering a crowded and highly competitive market in personal computer peripherals. This market includes products such as keyboards, Bluetooth speakers, webcams and (what would become Logitech’s hallmark offering) computer mouses. To differentiate itself from its competitors, Logitech’s strategy was four-pronged: continued innovation, high-brand recognition and robust retail presence, all supported by an effective global supply chain and consequently lower production costs. Within just five years, Logitech had achieved its global ambitions, with research and development (R&D) and manufacturing operations in Switzerland, the United States and Taiwan. It also laid the groundwork for continuing success and innovation; it pioneered infra-red tracking in computer mouses and was the first company to make wireless mouses and keyboards. Today, through products such as mouses, keyboards and webcams that cost under US$100, Logitech reports annual sales of more than US$1.5 billion. programming R&D work. Ergonomic design work (the look and feel of Logitech products) is based in Ireland, where it is outsourced to a design company. Manufacturing is now based in Asia, an outcome of a course charted in the late 1980s when Logitech opened a factory in Taiwan. At the time, most Logitech products were produced in the United States. The company was vying for the business of the two biggest original equipment manufacturing (OEM) customers: Apple Computer and IBM. These companies were buying their computer mouses from a Japanese company called Alps, which was also supplying Microsoft. By shifting its manufacturing to a new factory in Taiwan, Logitech was able to produce a highly competitive product that was better designed, manufactured at a higher volume and offered for a lower cost. Taiwan boasted a well-developed supply base of parts, a qualified labour force and an overall robust and growing local computer industry. Importantly, Logitech also availed itself of an excellent deal on rent. To encourage and nurture early-stage innovators in the expanding technology sector, Taiwan offered space in its science-based industrial park in Hsinchu for the modest fee of CHAPTER 2 hiL23674_ch02_055-100.indd 97 © suphakit73/Shutterstock Since its remarkable first years, Logitech has persevered in its global approach and continues to thrive. Loyal to its roots, Logitech remains a Swiss company and retains R&D operations in Switzerland. Its headquarters, however, are now based in Fremont, California, neighbour to many of America’s technology companies, such as Google. It employs 450 people in Fremont across areas including global marketing, finance, logistics operations and software THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 97 08/06/19 07:41 PM US$200 000. Logitech signed the lease, and when it shortly thereafter won Apple’s contract, production in the Taiwan location soon outpaced the US facility. Logitech concentrated its manufacturing in Taiwan, and the plant’s capacity soon reached 10 million computer mouses annually. In the late 1990s, recognising a need for increased production capacity, Logitech established plants in China, where a wide variety of its retail products are currently created. The Wanda, a wireless infrared mouse and one of Logitech’s most successful products, provides an effective case study for understanding the reality of the company’s global operations. The Wanda is assembled in a Logitech factory in Suzhou, China. This factory employs 4000 people, such as 18-year-old Wang Yen, who comes from the impoverished rural province of Anhui. Each day, she sits at a conveyor belt, plugging three tiny pieces of metal into circuit boards. She performs this function 2000 times every day, for compensation equivalent to US$75 a month, to help create the Wanda—a product that will sell to US consumers for about US$40. Such economic exploitation is not Logitech’s alone. Many other companies rely on exploitative practices in China to support their manufacturing operations. According to China’s ministry of commerce, foreign companies account for three-quarters of China’s hightech exports. China’s top 10 exporters include US companies with Chinese operations, such as Motorola and Seagate Technology, a maker of computer disk drives. Intel now produces some 50 million chips a year in China, the majority of which end up in computers, and other goods that are exported to other parts of Asia or back to the United States. SOURCES: V.K. Jolly, M. Alhuhta and J. Jeannet, ‘Challenging the incumbents: how high-technology start-ups compete globally’, Journal of Strategic Change, 1 (1992), pp. 71–82; V.K. Jolly and K.A. Bechler, ‘Logitech: the mouse that roared’, Planning Review, 20(6) (1992), pp. 20–34; K. Guerrino, ‘Lord of the mice’, Chief Executive, July 2003, pp. 42–4; A. Higgins, ‘As China surges, it also proves a buttress to American strength’, The Wall Street Journal, 30 January 2004, pp. A1, A8; J. Fox, ‘Where is your job going?’, Fortune, 24 November 2003, pp. 84–8, accessed via www.logitech.com on 15 February 2010. CLOSING CASE DISCUSSION QUESTIONS a. Is Logitech an INV/born global? Explain. b. Explain how trade lowers the costs of making Logitech computer peripherals such as mouses and keyboards, and increases the diversity of products available to consumers. c. Using the theories discussed in this chapter, explain the way in which Logitech has configured its global operations. Why does the company manufacture in China and Taiwan, undertake basic R&D in California and Switzerland, design products in Ireland, and coordinate marketing and operations from California? d. Why do you think the company decided to shift its corporate headquarters from Switzerland to Fremont, California? e. To what extent can Porter’s diamond help to explain the choice of Taiwan as a major manufacturing site for Logitech? f. Why do you think China is now a favoured location for so much high-tech manufacturing activity? How will China’s increasing involvement in global trade help that country? How will it help the world’s developed economies? What potential problems are associated with moving work to China? 98 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 98 08/06/19 07:41 PM ENDNOTES 1. H.W. Spiegel, The Growth of Economic Thought, Durham, NC: Duke University Press, 1991. 2. S. Hollander, The Economics of David Ricardo, Buffalo: The University of Toronto Press, 1979. 3. D. Ricardo, The Principles of Political Economy and Taxation, Homewood, IL: Irwin, 1967 [1817]. 4. For example, R. Dornbusch, S. Fischer and P. Samuelson, ‘Comparative advantage: Trade and payments in a Ricardian model with a continuum of goods’, American Economic Review, 61 (December 1977), pp. 823–39. 5. B. Balassa, ‘An empirical demonstration of classic comparative cost theory’, Review of Economics and Statistics, 1963, pp. 231–8. 6. See P.R. Krugman, ‘Is free trade passé?’, Journal of Economic Perspectives, 1 (Fall 1987), pp. 131–44. 7. P. Samuelson, ‘Where Ricardo and Mill rebut and confirm arguments of mainstream economists supporting globalization’, Journal of Economic Perspectives, 18(3) (Summer 2004), pp. 135–46. 8. P. Samuelson, ‘The gains from international trade once again’, Economic Journal, 72 (1962), pp. 820–9. 9. S. Lohr, ‘An elder challenges outsourcing’s orthodoxy’, The New York Times, 9 September 2004, p. C1. 10. P. Samuelson, ‘Where Ricardo and Mill rebut and confirm arguments of mainstream economists supporting globalization’, op. cit., p. 143. 11. For example, J.D. Sachs and A. Warner, ‘Economic reform and the process of global integration’, Brookings Papers on Economic Activity (1995), pp. 1–96; J.A. Frankel and D. Romer, ‘Does trade cause growth?’, American Economic Review, 89(3) (June 1999), pp. 379–99; and D. Dollar and A. Kraay, ‘Trade, growth and poverty’, Working Paper, Development Research Group, World Bank, June 2001. 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Leontief, ‘Domestic production and foreign trade: The American capital position re-examined’, Proceedings of the American Philosophical Society, 97 (1953), pp. 331–49. 18. See H.P. Bowen, E.E. Leamer and L. Sveikaysks, ‘Multicountry, multifactor tests of factor abundance theory’, American Economic Review, 77 (1987), pp. 791–809. 19. R.M. Stern and K. Maskus, ‘Determinants of the structure of US foreign trade’, Journal of International Economics, 11 (1981), pp. 207–44. 20. D. Trefler, ‘The case of the missing trade and other mysteries’, American Economic Review, 85 (December 1995), pp. 1029–46. 21. D.R. Davis and D.E. Weinstein, ‘An account of global factor trade’, American Economic Review, December 2001, pp. 1423–52. 22. R. Vernon, ‘International investments and international trade in the product life cycle’, Quarterly Journal of Economics, May 1966, pp. 190–207; and R. Vernon and L.T. 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Chandler, Scale and Scope, New York: The Free Press, 1990. 27. P. Krugman, ‘Does the new trade theory require a new trade policy?’, World economy, 15(4), 1992, pp. 423–442. 28. M.E. Porter, The Competitive Advantage of Nations, New York: Free Press, 1990. For a good review of this book, see R.M. Grant, ‘Porter’s Competitive Advantage of Nations: An assessment’, Strategic Management Journal, 12 (1991), pp. 535–48. 29. B. Kogut (ed.), Country Competitiveness: Technology and the Organizing of Work, New York: Oxford University Press, 1993. 30. Porter, The Competitive Advantage of Nations, op. cit., p. 121. 31. John H. Dunning, ‘Location and the multinational enterprise: Neglected factor?’, Journal of International Business Studies, First Quarter 1998, pp. 45–63. 32. Anthony R. Gargano, ‘An awakening’, Broadcast Engineering, 49(3) (March 2007), p. 220. 33. J.P. Womack, D.T. Jones and D. Roos, The Machine that Changed the World, New York: Rawson Associates, 1990. 34. D.T. 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Rose, ‘Foreign direct investment location strategies in the tire industry’, Journal of International Business Studies, 33 (2002), pp. 593–602. 39. P. Jha, ‘Amazon, Walmart, now Alibaba — Indian retail headed towards an oligopoly’, Newsclick, 22 August 2018, accessed via www.newsclick.in/ amazon-walmart-now-alibaba-indian-retail-headed-towards-oligopoly. 40. For example, see S.H. Hymer, The International Operations of National Firms: A Study of Foreign Direct Investment, Cambridge, MA: MIT Press, 1976; A.M. Rugman, Inside the Multinationals: The Economics of Internal Markets, New York: Columbia University Press, 1981; D.J. Teece, ‘Multinational enterprise, internal governance, and industrial organization’, American Economic Review, 75 (May 1983), pp. 233–8; C.W.L. Hill and W.C. Kim, ‘Searching for a dynamic theory of the multinational enterprise: A transaction cost model’, Strategic Management Journal (special issue), 9 (1988), pp. 93–104. 41. J.H. Dunning, Explaining International Production, London: Unwin Hyman, 1998. 42. P. Krugman, ‘Increasing returns and economic geography’, Journal of Political Economy, 99(3) (1991), pp. 483–99. 43. J.M. Shaver and F. Flyer, ‘Agglomeration economies, firm heterogeneity, and foreign direct investment in the United States’, Strategic Management Journal, 21 (2000). 44. Australian Bureau of Statistics, ‘Small and Medium Enterprises’, Cat. No. 8141.0 (1998). 45. T. Clark, D. Pugh and G. Mallory, ‘The process of internationalization in the operating firm’, International Business Review, 6 (1997), pp. 605–23. 46. J. Johanson and F. Wiedersheim-Paul, ‘The internationalization of the firm: Four Swedish cases’, Journal of Management Studies, 1975, pp. 305–22. 47. S. Cavusgil, ‘On the internationalization process of firms’, European Research, 8 (1980), pp. 273–81. 48. M. Czinkota, Export Development Strategies: US Promotion Policy, New York: Praeger, 1982. 49. T. Rao and G. Naidu, ‘Are the stages of internationalization empirically supportable?’, Journal of Global Marketing, 6(1/2) (1992), pp. 147–70. 50. O. Andersen, ‘On the internationalization process of firms: a critical analysis’, Journal of International Business Studies, 24(2) (1993), pp. 209–31. 51. Johanson and Wiedersheim-Paul, ‘The internationalization of the firm: Four Swedish cases’, op. cit. 52. J. Johanson and J. Vahlne, ‘The internationalization process of the firm—a model of knowledge development and increasing foreign market commitments’, Journal of International Business Studies, 8(1) (1977), pp. 23–32. THEORIES OF TRADE, INVESTMENT AND INTERNATIONALISATION 99 08/06/19 07:41 PM 53. D. Sullivan and A. Bauerschmidt, ‘Incremental internationalization: a test of Johanson and Vahlne’s thesis’, Management International Review, 30(1) (1990), pp. 19–30. 54. Andersen, ‘On the internationalization process of firms: A critical analysis’, op. cit. 55. Y. Kwon and M. Hu, ‘Comparative analysis of export-oriented and foreign production-oriented firms’ foreign market entry decisions’, Management International Review, 35(4) (1995), pp. 325–36. 56. A. Millington and B. Bayliss, ‘The process of internationalization: UK companies in the EC’, Management International Review, 30(2) (1990), pp. 151–61. 57. See J. Bell, ‘The internationalization of small computer software firms: A further challenge to “stage” theories’, European Journal of Marketing, 29(8) (1995), pp. 60–75; and G. Knight and S. Cavusgil, ‘The born global firm: A challenge to traditional internationalization theory’, Advances in International Marketing, 8 (1996), pp. 11–26. 58. J. Johanson and J. Vahlne, ‘The mechanism of internationalization’, International Marketing Review, 7(4) (1990), pp. 11–24. 59. J‐E. Vahlne and J. Johanson, ‘The Uppsala model on evolution of the multinational business enterprise: from internalization to coordination of networks’, International Marketing Review, 30(3) (2013), pp. 189–210. 60. Andersen, ‘On the internationalization process of firms: A critical analysis’, op. cit. 61. Such as J. Lim, T. Sharkey and K. Kim, ‘An empirical test of an export adoption model’, Management International Review, 31(1) (1991), pp. 51–62; and S. Reid, ‘The decision-maker and export entry and expansion’, Journal of International Business Studies, 12 (1981), pp. 101–12. 62. E.M. Rogers, Diffusion of Innovation, New York: The Free Press, 1962. 63. Lim, Sharkey and Kim, ‘An empirical test of an export adoption model’, op. cit. 64. T. Clark, D. Pugh and G. Mallory, ‘The process of internationalization in the operating firm’, International Business Review, 6 (1997), pp. 605–23. 65. L. Leonidou and C. Katsikeas, ‘The export development process: An integrative review of empirical models’, Journal of International Business Studies, 27(3) (1996), pp. 517–51. 66. S. Reid, ‘Managerial and firm influences on export behavior’, Journal of the Academy of Marketing Science, 11 (1983), pp. 323–32; and 100 PART 2 67. 68. 69. 70. 71. 72. 73. 74. 75. 76. T. Madsen and P. Servais, ‘The internationalization of born globals: An evolutionary process?’, International Business Review, 6 (1997), pp. 561–83. Bell, ‘The internationalization of small computer software firms: A further challenge to “stage” theories’, op. cit.; and Knight and Cavusgil, ‘The born global firm: A challenge to traditional internationalization theory’, op. cit. B. Oviatt and P. McDougall, ‘Toward a theory of international new ventures’, Journal of International Business Studies, 25(1) (1994), pp. 45–64. AMC and McKinsey, Emerging Exporters: Australia’s High ValueAdded Manufacturing Exporters, Melbourne: Australian Manufacturing Council, 1993; Knight and Cavusgil, ‘The born global firm: A challenge to traditional internationalization theory’, op. cit.; and Madsen and Servais, ‘The internationalization of born globals: An evolutionary process?’, op. cit. Knight and Cavusgil, ‘The born global firm: A challenge to traditional internationalization theory’, op. cit. D. Skene, ‘Born global firms: a growing feature of Australia’s internationally active business community’, Australian Trade and Investment Commission (Austrade), 19 December 2017, accessed via www.austrade.gov.au/News/ Economic-analysis/born-global-firms-a-growing-feature-of-australiasinternationally-active-business-community on 29 March 2019. AMC and McKinsey, Emerging Exporters: Australia’s High Value-Added Manufacturing Exporters, op. cit. Ibid. L. Welch and R. Luostarinen, ‘Internationalization: Evolution of a concept’, Journal of General Management, 14(2) (1988), pp. 34–55. P.W. Liesch, M. Steen, S. Middleton and J. Weerawardena, Born to be Global: A Closer Look at the International Venturing of Australian Born Global Firms, Sydney: Australian Business Foundation, 2007. Lieberman and Montgomery, ‘First-mover advantages’, op. cit. See also Robinson and Min, ‘Is the first to market the first to fail?’, op. cit; W. Boulding and M. Christen, ‘First mover disadvantage’, Harvard Business Review, October 2001, pp. 20–21; and R. Agarwal and M. Gort, ‘First mover advantage and the speed of competitive entry’, Journal of Law and Economics, 44 (2001), pp. 131–59. CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch02_055-100.indd 100 08/06/19 07:41 PM © HaJingjing/Shutterstock CHAPTER 3 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT CHAPTER 3 hiL23674_ch03_101-158.indd 101 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 101 08/06/19 07:44 PM INTERNATIONAL BUSINESS GRADUATE ATTRIBUTES (IBGAs) This chapter’s content, learning resources and case studies provide you with the opportunity to develop a number of International Business Graduate Attributes (IBGAs), including the following: IBGA1 IBGA2 IBGA3 IBGA4 IBGA5 Discipline Knowledge and Skills Critical Analysis Problem Solving Ethical Decision Making Communication LEARNING OBJECTIVES (LOs) 3.1 3.2 3.3 3.4 3.5 102 PART 2 Identify and describe the policy instruments used by governments to influence international trade and foreign direct investment. Identify and evaluate the arguments for government intervention in international trade and foreign direct investment. Describe current international trade and foreign direct investment issues, and discuss how the World Trade Organization is addressing these issues. Identify and compare the different levels of regional economic integration. Examine the implications for international business strategies of international trade barriers and the increasing number of bilateral and regional trade agreements. CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 102 08/06/19 07:44 PM OPENING CASE UNEASE OVER CHINA’S RARE EARTH TRADE POLICIES Neither really rare nor particularly earthy (as the Australian national science agency, CSIRO, puts its), rare earth elements—with such exotic names as neodymium, europium, ytterbium and lutetium—are a group of 15 speciality metals, along with an additional two closelyrelated elements. They have unique physical and chemical properties that make them critical to an ever-increasing variety of applications and demand in the electronics and cutting-edge technology industries, as well as in the search for energy efficiency and greenhouse gas reduction. The metals have been used, for example, to develop stronger magnets that have improved the performance of electric motors, more effective rechargeable batteries and catalysts that reduce toxins from exhaust emissions and aid in the refining of oil. Global demand for rare earths is estimated to have grown on average by 10 per cent per annum over the past two decades. To many governments and industries, the production of these metals is identified as a ‘strategic priority’. These elements are not rare in the literal sense. Cerium, for example, is the 25th most abundant element in the earth’s crust, as commonly occurring as copper. Rather, these elements are rare in an economic feasibility sense, since they are not often found in distinct deposits that are easy to mine in quantity. Most natural deposits are in China, and in 2015, China accounted for more than 90 per cent of global rare earth production and at one stage accounted for 97 per cent of production. This dominance put rare earths at the top of the ‘risk list’ compiled by the British Geological Survey. China realised the strategic importance of rare earths in the 1970s and embarked on rapidly growing exploitation of its vast natural advantage in the metals, estimated to be equivalent to nearly 40 per cent of the world’s total supply. During the 1980s, Chinese production increased rapidly at a rate of 40 per cent per annum. In 1992, the Chinese leader, Deng Xiaoping, boasted: ‘There is oil in the Middle East. There is rare earth in China.’ By the 1990s, China had overtaken the United States as the CHAPTER 3 hiL23674_ch03_101-158.indd 103 major supplier of rare earths and now dominates the world’s production. Understandably, the United States and Japan, among other nations, have felt vulnerable being so dependent on China’s rare earth production. In 2010, China dramatically reduced exports of rare earths to Japan as the Chinese trade ministry stopped issuing licences for Chinese companies to export to Japan. Such dramatic cuts, however, did not apply to the United States and Europe which, like Japan, were seen by China as major economic and strategic competitors. Diplomatic relations between China and Japan had been strained for some time. However, China claimed that the decision was consistent with one it had made a year earlier to begin to scale back all exports of rare earths. True to its word, during the second half of 2010, export quotas to all countries were slashed further by nearly 70 per cent. The cut in quotas, combined with increases in Chinese domestic consumption and attempts by importers to stockpile reserves, led to an almost eightfold increase in the average global price of rare earths in the 12 months after July 2010. The unease felt by importing nations over China’s actions over export quotas came to a head in 2012. The United States, the European Union and Japan were successful in having the World Trade Organization (WTO) investigate whether China, a member of the WTO, had violated the international rules of trade by restricting the export of rare earths. China responded to the accusations claiming that the export cuts were justified and necessary to preserve an exhaustible natural resource and to control serious environmental problems caused by rare earth mining and refining. To these ends, China claimed that it had to close down many smaller and less-efficient mines. These concerns about supply being subject to the will and caprices of the Chinese government have understandably caused importing nations to try to expand their own supplies of rare earths. THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 103 08/08/19 11:28 AM © Bjoern Wylezich/Shutterstock production, planned for 2020–21. Meanwhile, a Canadian company and another Australian company are developing a mining project in Canada’s Northwest Territories. Yttrium, a rare earth element often used to produce LEDs. Australian mining companies Alkane Resources and Arafura Resources are, as of 2019, developing large projects to extract rare earths. Alkane’s investment is the most advanced poly-metallic project of its kind outside of China, while Arafura’s project could supply up to 10 per cent of the world’s demand for neodymium and praseodymium when in full China, however, is not standing still. Not only is it continuing to exploit its own natural endowments, but it is also seeking to take control over deposits elsewhere in the world. For example, China’s Shenghe Resources Holding Co has announced a joint venture on rare earths with Greenland Minerals to develop resources in that country, and the company is participating in a number of other undertakings, including the Mountain Pass rare earth mine in California, the Kvanefjeld poly-metallic deposit in Greenland and a rare earth metallurgical and separating plant in Vietnam. Demand for rare earths is continuing to outstrip supply and for now China continues to have the advantage. But the market is not standing still and ultimately a more diversified supply will develop, which will be good for the many companies that rely on a stable supply of this critical resource. SOURCES: S. Mertzman, ‘What are rare earths, crucial elements in modern technology? 4 questions answered’, The Conversation, 16 August 2018, accessed via http://theconversation.com/what-are-rare-earths-crucial-elements-in-modern-technology-4-questions-answered-101364 on 21 February 2019; CSIRO, ‘The rare earth challenge’, Resourceful, 7 (June 2015), accessed via www.csiro.au/en/Research/MRF/Areas/Resourceful-magazine/Issue-07/Rare-earth-challenge on 21 February 2019; M. Bohlsen, ‘Australia preparing to meet the world’s demand for rare earths’, Investor Intel, 29 January 2019, accessed via https://investorintel. com/sectors/technology-metals/technology-metals-intel/australia-preparing-meet-worlds-demand-rare-earths on 21 February 2019; F. Egbaria, ‘Rare earths MMI: Canadian, Australian firms join forces for Canadian rare earths project’, Metal Miner, 6 February 2019, accessed via https://agmetalminer.com/2019/02/06/rareearths-mmi-canadian-australian-firms-join-forces-for-canadian-rare-earths-project on 21 February 2019; ‘New Chinese JV for rare earth minerals from Greenland’, World Nuclear News, 23 January 2019, accessed via www.world-nuclear-news.org/Articles/New-Chinese-JV-for-rare-earth-minerals-from on 21 February 2019; P. Cai and P. Wen, ‘China blocks rare earth exporter’, The Sydney Morning Herald, 19 December 2011; A. Currie, ‘China set to define future market for rare earth metals’, Rare Earth Investing News, 7 March 2012, accessed via http://rareearthinvestingnews.com/6335/china-define-future-market-rare-earth-metals-quota on 7 August 2012; D. Palmer and S. Moffett, ‘US, EU and Japan take on China over rare earths at WTO’, Reuters, 13 March 2012, accessed via www.reuters.com/ article/2012/03/13/us-china-trade-eu-idUSBRE82C0JU20120313 on 8 August 2012. INTRODUCTION FREE TRADE The absence of barriers to the free flow of goods and services between countries 104 PART 2 In Chapter 1, we described the growth and pattern of foreign trade and investment in the global economy and the extent to which the countries of the world have increasingly become linked economically. Chapter 2 laid out a case for free trade. Free trade refers to a situation in which a government does not attempt to restrict what its companies and citizens can buy from or sell to another country. In a world without trade barriers, trade patterns are determined by the relative productivity of different factors of production in different countries. As we saw in Chapter 2, free trade generates efficient use of resources and greater competitive forces than is the case with restricted trade, and is thus a stimulus to economic growth. Although many governments are nominally committed to free trade, they are readily persuaded by political and economic forces, both internal and external to the home country, to intervene in international trade. Often the intervention is introduced to protect CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 104 08/06/19 07:44 PM the interests of politically important groups in the home country, although it may be warranted on public interest grounds. The arguments for and against protectionism are discussed in more detail later in this chapter. This chapter is titled ‘the political economy of trade and investment’, a nomenclature given to issues surrounding government intervention in trade and investment. As such, the politics enacted through government involvement interact with the economics of international trade and investment. In Chapter 2, we also looked at explanations and motives for foreign direct investment (FDI). These explanations identified the circumstances where it was more advantageous for the company to conduct its international business using FDI rather than an alternative mode. National governments, however, may take the view that such investment is not in the public interest or that it could do harm to certain interest groups. Governments therefore may not be prepared to allow foreign companies to have complete freedom over FDI in host countries. While strong cases can be made at the levels of the global economy, the national economy and the company, for free international trade and investment, the reality is that trade and investment is not unrestricted and companies have to conform to many government interventions. However, the impacts on international business are not necessarily always negative. Like most policy interventions there will be companies that gain and companies that lose, and some policy interventions set out to positively assist international business through trade and particularly through investment. The Opening Case illustrates the nature of these political realities. The Chinese government was quick to realise the strategic value of rare earths, and with the support of its government, Chinese mining companies have come to be enormously influential in global production. The case highlights both the economic and political motives for China to maintain this dominance and the instruments it uses to attain this goal. Understandably, other nations that have come to depend on Chinese rare earths imports have become uneasy with China’s market dominance. Their concerns were warranted when China began to reduce rare earths export quotas. Japan reacted in a tit-for-tat response by subsidising its own manufacturers to find alternatives to China’s rare earths. The Australian government reacted by prohibiting Chinese investment in the development of one of Australia’s largest rare earth mines. A group of importers, the United States, the European Union and Japan, reacted by challenging China’s restrictions on exports at the WTO. Their complaint to the WTO was that China, as a member of the WTO, had violated the international rules of trade by using export quotas to advantage its own manufacturers and to pressure foreign companies that needed access to rare earths to relocate to China. China argued that its export quotas were not trade protectionism and were necessary to control the environmental problems caused by its rare earths mining. The political dimension is clearly important in the rare earths case. But it is also clear that the business dimension is equally dynamic. An obvious response to geographic concentrations of important resources is to diversify supply if possible and that is happening as Australian mining companies, along with companies from other nations, are seeking to develop mines in other parts of the world. Chinese companies are doing this as well, to pre-empt these defensive manoeuvres by competitors and to maintain the national resource advantage—and market power—that China has. Clearly there is also an incentive to develop technological alternatives to rare earths, as has been the case in energy markets, where renewables (wind and solar in particular) have increasingly taken the place of fossil fuels such as oil and coal. However, no clear alternatives for rare earths are currently on the horizon. We start this chapter by describing the range of policy instruments that governments use to intervene in international trade. This is followed by an explanation and assessment of the trade-related political and economic arguments that governments put forward for such intervention. The broader mix of political and economic forces and systems that together CHAPTER 3 hiL23674_ch03_101-158.indd 105 PROTECTIONISM Government intervention in international trade and investment to protect or advance the interests of certain sections of the economy or the nation as a whole THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 105 08/06/19 07:44 PM POLITICAL ECONOMY The political, economic and legal systems and forces that govern an economy and business activity govern the economy and international business activity in general are part of a nation’s political economy. Following an examination of trade issues, we then look at the benefits and costs of FDI to host and home countries and at the policy instruments that countries use to regulate FDI. In the penultimate section we outline attempts by governments at the multilateral, regional and bilateral levels to establish agreements on the regulation of international trade and investment. This section includes an examination of the role of the WTO and regional economic integration (REI). We conclude the chapter with a discussion on the implications of this material for international business decisions. INSTRUMENTS OF TRADE POLICY LO 3.1 There are many forms of government intervention in international trade. Some are aimed at restricting or promoting trade—for example, import quotas and export subsidies. Others intervene with trade even though they may appear to have been designed for some other policy objective—for example, food labelling laws and product standards. The latter are less obvious barriers to trade. Table 3.1 illustrates the variation in the barriers that are imposed, particularly among the non-tariff barriers. The instruments of intervention that we consider are tariffs, subsidies, import quotas, voluntary export restraints, local content requirements, administrative policies and anti-dumping duties. TABLE 3.1 Barriers to trade Tariffs Anti-dumping duties Subsidies Custom inspection practices Quotas Discretionary product classifications Voluntary export restraints Authorisation procedures Embargoes Multiple exchange rates Local content requirements Health and safety assessments Licence fees Labelling laws Preferential licensing Government preferred suppliers Product standards Tariffs TARIFF A tax levied by governments on imports or exports SPECIFIC TARIFF A tariff levied as a fixed charge for each unit of good imported AD VALOREM TARIFF A tariff levied as a proportion of the value of the imported good 106 PART 2 A tariff is a tax levied on imports (or exports). Tariffs fall into two categories: a specific tariff is levied as a fixed charge for each unit of a good imported (e.g. $3 per barrel of oil); while an ad valorem tariff is levied as a proportion of the value of the imported good (e.g. 15 per cent). In most cases, tariffs are placed on imports to protect domestic producers from foreign competition by raising the price of imported goods. Tariffs also produce revenue for the government. An important aspect of an import tariff is who benefits and who loses. The government benefits because the tariff increases government revenue. Consumers lose because they must pay more for certain imports and/or purchase less desirable products. Domestic producers, at least those in the targeted industry, gain because the tariff affords them some protection against foreign competitors by increasing the cost of imported foreign goods. They are able to increase prices. Those producers, however, who use the imported product as an input to their own production lose as their costs of production rise. They are penalised as it becomes more difficult for them in turn to compete in either the domestic or the export market. CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 106 08/06/19 07:44 PM The Australian Productivity Commission provides dollar estimates of the extent to which different industry groups are assisted or penalised by tariffs. As noted in its ­2016–17 report: ‘The Commission estimates that gross assistance to industry provided by the Australian Government was $19.3 billion and that net assistance (after deducting the cost penalty of tariffs) was $13.4 billion in 2016–17. This was a substantial increase on last year’s estimate of $9.7 billion in net assistance. These estimates are conservative as they exclude harder-to-quantify assistance: favourable finance (loans, debt, equity, guarantees); local purchasing preferences, such as for defence equipment; and regulatory restrictions on competition.’1 An important observation from these data is that not all industry groups receive assistance from tariff protection but all industry groups incur input penalty costs from tariffs. In general, two conclusions can be derived from economic analysis of the effect of import tariffs.2 First, tariffs are pro-producer and anti-consumer. While they protect producers from foreign competitors, this restriction of supply also raises domestic prices. Second, import tariffs reduce the overall efficiency of the world economy because a protective tariff encourages domestic companies to produce products at home that, in theory, could be produced more efficiently abroad. Globally, agricultural trade is the most distorted sector of trade in goods. Tariffs on manufactured goods tend to be much lower. Average tariffs for agricultural goods are three times higher than for non-agricultural goods. Some agricultural tariffs are as high as 800 per cent.3 As in other countries, Australia’s tariffs on manufactured goods have declined. A tariff rate of 5 per cent is applied to most manufacturing imports, and many items enter the country duty free. Tariffs on exports are less common than tariffs on imports. In general, export tariffs have two objectives: (1) to raise revenue for the government; and (2) to reduce exports from a sector, often for political reasons. Argentina has just imposed a temporary two-year export duty for any language translation services rendered in that country but used abroad in some way. (Argentina is a major hub for Spanish translation services worldwide.) The intent of this tax seems to be mainly for revenue, given its temporary nature and the fact that obviously Argentina has no economic interest in reducing its translation services exports.4 Meanwhile, in 2012 Indonesia imposed a 20 per cent tax on the export of unprocessed minerals, including nickel, tin and gold. While one aim of the tax was to raise revenue and share the benefits of mining, other aims were to ensure domestic supplies and encourage miners to locate processing plants in Indonesia.5 In 2018, US President Donald Trump engaged in a trade war with China, using tariffs as a political instrument. On coming into office, President Trump committed to redressing the large and widening trade imbalance between China and the United States. In trade negotiations with China, he threatened to impose increased tariffs on a range of goods imported from China (and some other countries) if the trade imbalance could not be reduced by other means. He did impose the increased tariffs, with threats to impose more if China and the United States could not agree on new arrangements more favourable to the latter. After decades of unprecedented growth throughout the world, at least partially attributed to declining tariffs and the freeing of international trade, President Trump’s trade intervention has signalled that tariffs and other forms of trade intervention remain potent instruments that some governments may use for political ends.6 Subsidies A subsidy is a government payment to a domestic producer. As a non-tariff barrier, subsidies take many forms, including cash grants, low-interest loans, tax breaks and government equity participation in domestic companies. By lowering production costs, CHAPTER 3 hiL23674_ch03_101-158.indd 107 SUBSIDY Government financial assistance to a domestic producer THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 107 08/06/19 07:44 PM ANOTHER PERSPECTIVE FREE TRADE AND EFFICIENCY VS FAIR TRADE AND JUSTICE The fair trade approach is to use a product-labelling system that assures customers that any certified product they buy conforms to certain ‘standards’ in the way that it has been produced, traded, processed and packaged. These standards include direct purchase from the producer, an agreed minimum price for the producer, and an additional charge for development and technical assistance to be paid to the producer. WEF participants regard the labelling system as a non-tariff barrier to trade but the fair trade proponents argue that it enables the customer in the supermarket to see a more direct connection between their purchase and a positive benefit for the farmer in the developing country. The fair trade approach positions trade justice as a premium-brand value for which the customer will be willing to pay more while being assured that the farmer will get a fair share of the benefits of trade. © Thinglass/Shutterstock The World Economic Forum (WEF) (www.weforum. org) is an independent economic organisation whose stated mission is to ‘improve the state of the world’. The WEF is an advocate of free trade and investment. In its view, the collapse of barriers to trade and investment over time has led to increased efficiency and global economic growth. According to the Fairtrade Foundation (www.fairtrade.net), however, contrary to the predictions of international trade theory, trade liberalisation has not been a win–win outcome for all participants. Because of market imperfections, the benefits have not been evenly spread and free trade has not relieved poverty—for example, poverty remains for the agricultural producers in developing countries. Fair trade organisations advocate a more even distribution of the benefits of trade. subsidies help domestic producers in two ways. They allow them to: (1) compete against foreign imports; and (2) gain export markets. Agriculture is one of the largest beneficiaries of subsidies in most countries. The Cairns Group, founded in Cairns in 1986, is a group of 19 developed and developing agricultural exporting countries. These include Australia, New Zealand, Brazil and Canada, but not the United States or any European Union country. The group seeks to influence trade negotiations in organisations such as the WTO and to reduce the domestic subsidies and protection that farmers, particularly in developed countries, receive from their governments. The group claims that the subsidies distort global agricultural markets and reduce the earning capacities of the farmers of developing countries. One study estimated that if developed countries abandoned subsidies to farmers, global trade in agricultural products would be 50 per cent higher and the world as a whole would be better off by US$160 billion.7 A more recent study estimated that removing all barriers to trade in agriculture (both tariffs and subsidies) worldwide would raise world income by US$180 billion.8 This increase in wealth arises from the more efficient use of agricultural land. 108 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 108 08/06/19 07:44 PM When tariff support and subsidy support are combined for agriculture, as shown in Figure 3.1, the equivalent of 20 per cent of farmers’ receipts on average in OECD countries is derived from government assistance; that is, from taxpayers and additional charges to consumers. FIGURE 3.1 Support for agriculture in selected OECD and emerging economies (percentage of gross farm receipts, 1995–97, 2008–10 and 2015–17) 80 70 Percentage 60 SOURCES: Data derived from OECD, Agricultural Policy Monitoring and Evaluation 2011: OECD Countries and Emerging Economies, OECD, September 2011, accessed via www. oecd.org/t ad/agriculturalpoliciesand support/agriculturalpolicymonitoringand evaluation2011oecdcountries andemergingeconomies.htm on 8 August 2012; www.oecd.org/agriculture/topics/ agricultural-policy-monitoring-andevaluation/ accessed on 4 March 2019. 50 40 30 20 10 0 Japan Korea 1995−97 European Union 2008−10 Canada United States Australia New Zealand China Russia 2015−17 Figure 3.1 also illustrates why countries such as Australia and New Zealand lobby against the ‘unfairness’ of such support, which makes it more difficult for Australian and New Zealand farmers to compete in foreign markets. For example, in the period 2015–17, government support payments, as a percentage of gross income, accounted for an average of 18.3 per cent for farmers in the European Union, 9.9 per cent for farmers in the United States, 49.2 per cent for farmers in Japan and 53.5 per cent for farmers in the Republic of Korea.9 In 2015–17, total support to domestic agriculture in the OECD countries averaged US$317 billion (€285 billion) per year, on average. The objectives for agricultural support policies vary across the OECD countries. For example, Japan and Korea are concerned about self-sufficiency in rice production; the United States is concerned with providing an income safety net for its farmers; and the European Union’s objectives are mixed as it attempts to accommodate the interests of 28 members. Non-agricultural subsidies tend to be much lower than agricultural subsidies, but they can still be significant and the source of trade disputes between governments. For example, subsidies were given to Boeing of the United States and Airbus of Europe by their respective governments to help them lower the cost of developing new commercial jet aircraft and to compete against each other in the aircraft market. Likewise, China has heavily subsidised the development of its new commercial passenger jet and many other internationally competitive industries. Claims and counterclaims of unfair competition as a result of the subsidies found their way on several occasions to the WTO dispute settlement process. In 2018–19 the US government threatened further tariffs against China, motivated in part by claims of unfair government subsidies to Chinese companies delivered in a variety of forms including state-directed lending, direct investments, tax breaks and local government incentives.10 Of course, subsidies of this sort are common throughout the world. The conflict is over how motivated countries are by a desire to distort world trade and how effective they are in actually doing so. The main gains from subsidies accrue to domestic producers, whose international competitiveness is increased as a result. However, government subsidies must be paid for, typically, by taxing individuals or by citizens forgoing government budget expenditures on other desired public goods and services. The question of whether subsidies, as with CHAPTER 3 hiL23674_ch03_101-158.indd 109 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 109 08/06/19 07:44 PM other forms of protection, sustain the viability of business in the long term is debatable. Rather, they tend to protect the inefficient and promote excess production. For example, agricultural subsidies: (1) allow inefficient farmers to stay in business; (2) encourage countries to overproduce heavily subsidised agricultural products; (3) encourage countries to produce products that could be grown more cheaply elsewhere and imported; and (4) therefore reduce international trade and business opportunities in agricultural products. Import quotas and voluntary export restraints IMPORT QUOTA A direct restriction on the quantity of some goods that can be imported into a country TARIFF RATE QUOTA The process of applying a lower tariff rate to imports within the import quota than those over the quota VOLUNTARY EXPORT RESTRAINT (VER) A quota on a trade imposed by the exporting country, typically at the request of the importing country’s government QUOTA RENT The extra profit producers make when supply is artificially limited by an import quota LOCAL CONTENT REQUIREMENT A requirement that some specific fraction of a good be produced domestically 110 PART 2 An import quota is a direct restriction on the quantity of some good that may be imported into a country. The restriction is usually enforced by issuing import licences to a group of individuals or companies. A hybrid of a quota and a tariff is the tariff rate quota. It is a two-tier tariff system. Under a tariff rate quota, a lower tariff rate is applied to imports within the quota than those over the quota. Often the in-quota tariff is zero but the above-quota can be prohibitive. For example, until very recently a 10 per cent tariff was applied to up to 25 000 tonnes of annual imports of whey for powdered baby formula in Japan. Imports exceeding the amount were subject to a tariff rate of 29.8 per cent plus extra charges of ¥99 to ¥1023 per kilogram. To promote the use of baby formula in the country (which Japanese health officials believe improves health outcomes) a cut in the tariff was planned to begin mid-2019.11 A variant on the import quota is the voluntary export restraint. A voluntary export restraint (VER) is a quota on trade imposed by the exporting country, typically at the request of the importing country’s government. The implementation of a VER is generally the result of bilateral negotiations. For example, in 2006, China and South Africa agreed that China would restrict textile exports to South Africa to support the struggling South African textile industry.12 Exporters agree to VERs because they fear more damaging punitive tariffs or import quotas might follow if they do not. As with tariffs and subsidies, both import quotas and VERs benefit domestic producers by limiting import competition. Quotas do not benefit consumers. When imports are limited to a low percentage of the market by a quota or VER, the price is bid up for that limited foreign supply. If a domestic industry lacks the capacity to meet demand, an import quota can raise prices for both the domestically produced and the imported good. Domestic producers and licensed importers gain extra profit. This was the case for Fonterra when it monopolised the EU import quota of New Zealand butter (see Another Perspective: ‘A licence to profit’). This extra profit when supply is artificially limited by an import quota is referred to as a quota rent. Local content requirements A local content requirement is a requirement that some specific fraction of a good be produced domestically. The requirement can be expressed either in physical terms (e.g. 75 per cent of the component parts for a product must be produced locally) or in value terms (e.g. 75 per cent of the value of a product must be produced locally). Local content regulations have been widely used by developing countries to shift their manufacturing base from the simple assembly of products whose parts are manufactured elsewhere into the local manufacture of component parts. They have also been used in developed countries to try to protect local jobs and industry from foreign competition. A prevalent form of local content requirements is the so-called culture quota, particularly as it applies to television and radio broadcasting. Cultural rationales for these local content requirements tend to be couched in terms of preserving local culture and CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 110 08/06/19 07:44 PM ANOTHER PERSPECTIVE A LICENCE TO PROFIT In July 2006, New Zealand butter exports to the European Union were temporarily suspended, threatening a loss to New Zealand of NZ$250 million in trade per annum. Europe is New Zealand’s biggest butter market, comprising 28 per cent of its total butter exports. New Zealand’s global dairy giant, Fonterra, markets nearly 95 per cent of New Zealand’s butter. New Zealand had an EU quota of 77 204 metric tonnes of butter per year. In effect, Fonterra, via a UK subsidiary, became the sole licence holder in the European Union to import New Zealand butter. The European Union gave notice to Fonterra that it would lose its status as the sole importer. The threat to the quota arose as a result of a German dairy company, Egenberger, winning a case in the European Court of Justice that found that Fonterra’s control of New Zealand butter imports through its London subsidiary was monopolistic and discriminatory. Egenberger argued that any European importer should be able to purchase butter from New Zealand. Urgent government-to-government negotiations ensued and a new agreement was struck. As a traditional importer, Fonterra was allowed to keep more than half the quota. At least six new importers were to be guaranteed access over time to the remaining share of the quota. The loss of quota meant that Fonterra would lose significant quota rents. Fonterra had long benefited from EU price guarantees and quotas on butter and other dairy products; but after the liberalisation of the European dairy market, the demand for traditional dairy products such as butter has fallen. With increased life expectancy and people adopting healthier lifestyles, Fonterra embarked on a strategic reorientation of its European business. It has moved into higher value-added dairy product ingredients and products as convenience food and health food products with less reliance on imported commodities such as butter and cheese. SOURCES: ‘EU to drop Fonterra butter monopoly’, Dairy Industries International, 71(11) (2006), p. 11; D. King, ‘The European Commission has agreed to slash its tariff on New Zealand butter by almost 20% and ended uncertainty about the future of the $250 million trade’, The Press, 1 December 2006, p. B10; Netherlands Embassy, ‘Reset for a dairy giant’, Investor Testimonial from Fonterra, Wellington, New Zealand, 2011, accessed via http://newzealand. nlembassy.org/trade-amp-investment/investment/investor-testimonial-from-fonterra.html on 12 August 2012. promoting national cohesion and identity. An economic rationale is the protection of the local film and music industries. Local culture is often perceived to be under threat from US film, television and music. Despite the heavy negotiations, under the Australia–United States Free Trade Agreement, which came into force on 1 January 2005, Australia was not swayed to relax its culture quota requirements. Australia maintained the existing requirement of 55 per cent local content transmission quota on programming on free-to-air commercial television.13 As a consequence of the 2007–09 Global Financial Crisis (GFC), the WTO identified that member countries had invoked more than 80 new protectionist measures for local industry. One such measure was the US American Recovery and Reinvestment Act 2009, which provided funding for a stimulus package of US$787 billion. It contained a ‘Buy American’ provision that requires all iron, steel and manufactured goods used in any government works to be produced in the United States.14 Local content regulations protect the domestic producer by limiting foreign competition. Domestic producers benefit, but the restrictions on imports raise the prices of imports or encourage overseas suppliers to lower the quality of imports. Either way, the consumer loses. CHAPTER 3 hiL23674_ch03_101-158.indd 111 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 111 08/06/19 07:44 PM Administrative policies ADMINISTRATIVE TRADE POLICIES Rules and procedures adopted by governments that can be used to restrict imports or boost exports Administrative trade policies are bureaucratic rules that, either by design or by default, make it difficult for imports to enter a country. For example, at one point the Netherlands exported tulip bulbs to almost every country in the world except Japan. In Japan, customs inspectors insisted on checking every tulip bulb by cutting it vertically down the middle, and even Japanese ingenuity could not put them back together. France once required that all imported videotape recorders arrive through a small customs entry point that was both remote and poorly staffed. The resulting delays kept Japanese VCRs out of the French market until a VER agreement was negotiated.15 China is the major market for Australian wool. China’s wool imports are regulated by a tariff quota, but there is also a mandatory re-inspection and re-classification of wool by Chinese officials on the wool import’s arrival in China. These actions are considered unnecessary, as the wool has already been tested by the Australian Wool Testing Authority in accordance with internationally defined rules and regulations.16 China argues that the threats to health from the insecticides contained in wool justify additional inspection. The duplication increases the transaction costs of exporting wool to China. In this particular case, however, the Australian wool trade with China boomed nonetheless. Australia exported 271 million kilograms of wool fibre to China in 2017, a sharp rise from the pre1980 figure of less than 10 million kilograms. Strong economic demand can still trump trade barriers if market conditions are right.17 Labelling regulations can be used to restrict trade. Different countries have different wine labelling regulations. The Australian wine industry estimated that it incurred an additional cost of nearly $25 million in 2012 because producers have to print a different label for each export market. For example, there are 14 elements with requisite formats that must be included in the design of a label for wine exports to the European Union.18 As with all instruments of trade policy, administrative instruments generally benefit producers and hurt consumers, who are denied access to possibly superior foreign products. It should be noted, though, that administrative procedures may nonetheless yield non-trade benefits if properly designed and administered. Australian quarantine restrictions are meant to keep out invasive and damaging species and microbes, and labelling requirements can aid consumer health and safety. These non-trade benefits can potentially outweigh the costs. A careful cost–benefit analysis should be applied to administrative policies, although often this is not done. Anti-dumping policies DUMPING Selling goods in a foreign market for less than their cost of production or below their fair market value ANTI-DUMPING POLICIES Rules designed to penalise foreign companies that engage in dumping and thus protect domestic producers from unfair foreign competition TRADE REMEDY A measure taken by a country to block market access on the grounds of unfair pricing by exporters 112 PART 2 In the context of international trade, dumping is variously defined as selling goods in a foreign market at below their costs of production or as selling goods in a foreign market at below their ‘fair’ market value. The fair market value of a good is normally judged to be greater than the costs of producing that good because the fair market value includes a ‘fair’ profit margin. Dumping is a way to unload excess production in foreign markets. Some dumping may be the result of predatory behaviour, with producers using substantial profits from their home markets to subsidise prices in a foreign market with a view to driving local competitors out of that market. The aim of anti-dumping policies is to protect domestic producers from ‘unfair’ foreign competition. Anti-dumping is an example of a ‘trade remedy’. A trade remedy is a national measure to block market access on the grounds of unfair pricing by exporters. Other trade remedies frequently imposed by governments include countervailing duties and safeguard measures. As a WTO member, in order to apply anti-dumping measures, a country has to demonstrate that the dumping is causing, or threatening to cause, material injury to CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 112 08/06/19 07:44 PM competing domestic producers. Anti-dumping measures include temporary customs duties or tariffs. These tariffs increase the price of the import to a ‘non-injurious’ level. Special duties may also be imposed on imports that benefit from subsidies granted by foreign governments, which are deemed to threaten or cause injury to a local industry. These measures are described as countervailing duties. The tariffs imposed can be substantial and are intended to have an immediate protective effect, although they can stay in place for an extended period of time, usually about five years. An aim of the WTO rules is to prevent the use of anti-dumping measures as just another form of protection. There was a nearly twofold increase in anti-dumping investigations in Australia in 2017 and recent changes to Australia’s anti-dumping laws place a greater legal burden on overseas businesses in pursuing them.19 Anti-dumping and countervailing duties are legitimate responses in some cases to protectionist practices followed elsewhere. But, like other tariff measures, their net effect is to restrict competition, cause higher prices and as a consequence hurt consumers and domestic downstream industries. WHY GOVERNMENTS INTERVENE IN TRADE COUNTERVAILING DUTIES Temporary tariffs imposed to protect domestic producers from the dumping of imports that have benefited from foreign government subsidies LO 8.3 There are political and economic arguments for intervention in trade. The political arguments are concerned with protecting the interests of certain groups within a nation (normally, producers) often at the expense of other groups (normally, consumers). The economic arguments for intervention are typically concerned with boosting the overall wealth of a nation (to benefit all, producers and consumers). Political arguments for intervention Political arguments include preserving jobs, protecting industries deemed important for national security, retaliating against unfair foreign competition, protecting consumers from ‘dangerous’ or unsafe products, furthering the goals of foreign policy, advancing the human rights of individuals in exporting countries, and more recently in confronting climate change. Protecting jobs and industries The most common political argument for government intervention is that it is necessary to protect jobs and maintain ‘essential’ industries, particularly those related to manufacturing. There is political appeal in arguing that jobs should be protected from ‘unfair’ foreign competition, and that certain industries should be protected and maintained for defence reasons. With many international trade agreements restricting the use of tariffs, governments have resorted to non-tariff barriers to protect domestic industries. Until very recently, the motor vehicle industry in Australia had received substantial government financial assistance over a long time period, the argument being, in the words of several prime ministers, ‘for the good of the economy and the nation’. Before the removal of government support and the subsequent exit of all motor vehicle manufacturers from Australia, the Australian motor vehicle industry employed 55 000 workers directly and another 200 000 in supporting sectors. It had been a political imperative for governments to continue to provide financial assistance to keep the motor vehicle industry viable and to maintain the associated jobs offered in key political districts. However, the fiscal expense of supporting these jobs finally caused the government to cut all industry assistance in 2014 (although some assistance for retraining of displaced car workers is continuing for the near term). The funds for these subsidies were finally determined to be better used elsewhere, since the Australian motor vehicle industry will never be globally competitive.20 CHAPTER 3 hiL23674_ch03_101-158.indd 113 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 113 08/06/19 07:44 PM Likewise, the EU Common Agricultural Policy (CAP) was designed to protect the jobs of Europe’s politically powerful farmers by restricting imports and guaranteeing prices. However, the higher prices that result from such interventions cost the consumers of protected products dearly, support inefficiency and reduce the costcompetitiveness of other industries down the production chain that use the protected products as inputs. Meanwhile, after his election in 2016, US President Donald Trump vowed to bring manufacturing jobs back to the United States that were sent overseas when the US manufacturing industry sought to improve its international competitiveness by relocating various value chain activities overseas to locations with the productive capabilities to perform these activities competitively. For some time, the internationalisation of production has seen millions of US manufacturing jobs move overseas. National security Countries sometimes argue that it is necessary to protect or restrict certain industries, such as aerospace, advanced electronics and semiconductors, because they are important for national security. Although import controls are not as common for defence and national security reasons as they used to be, export controls over such sensitive products remain pervasive. For example, 41 countries, including Australia and New Zealand, are participating countries of the Wassenaar Arrangement.21 This arrangement seeks the cooperation of members to enact legislation to control the export of conventional arms and dual-use goods and technologies to certain countries as declared by individual members. Many items and services used in the Australian mining and exploration industries are subject to export controls and sanctions. These include certain survey equipment, spectrometers, chemical processing equipment and even certain professional services, depending on the destination.22 One technology export that raises considerable security concerns is encryption technology. It is used to protect information sent over the internet. A concern for law enforcement and national security agencies is that if terrorists and organised crime get control of the so-called strong encryption technologies, the agencies would be less able to secure public safety and combat terrorism. Although formal import controls on foreign technology on the basis of national security are not used as much as they once were, policy pronouncements against specific foreign companies and rejection of those companies to install government projects has very recently made a comeback. The US government has claimed that technology provided by the Chinese company Huawei is a security risk because Huawei is said to be indirectly controlled by the Chinese government and therefore the company’s components should not be used in upgrades to mobile phone networks to the 5G standard. Several US allies have said that they will no longer use Huawei for various projects as a result. Huawei denies these charges and there is hot debate internationally over their veracity.23 This shows that informal actions can be as important as formal controls. (See Management Focus: ‘Sanctions, U-turns and accusations of money laundering at Standard Chartered’ on Iranian sanctions for more about this issue.) The protection of farmers is often justified as a political imperative for net foodimporting countries to ensure income and food security for the nation. In low-income agricultural economies, such protection is seen as necessary to ensure viable incomes for the large rural-based population. Food security dominates Japan’s agricultural policies. Japan imports 60 per cent of its food. Japan argues that it needs to produce a certain portion of food on its own to secure a safe and steady supply in the event of war, disease or natural disaster. Six agricultural products, including rice and wheat, are declared by Japan to be too politically sensitive to be included in negotiations on trade liberalisation and must continue to be protected by high tariffs. 114 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 114 08/06/19 07:44 PM Retaliation Some argue that governments should use the threat to intervene in trade policy as a bargaining tool to force policy changes—for example, to free up trade and force trading partners to ‘play by the rules of the game’. The success of such intervention depends in the main on the bargaining strength of the home government. A decade ago, the US government used the threat of punitive trade sanctions to try to get the Chinese government to enforce its intellectual property laws to combat copyright infringements. After the United States threatened to impose 100 per cent tariffs on a range of Chinese imports, the Chinese government agreed to tighter enforcement of intellectual property regulations.24 China is in a much stronger bargaining position today relative to the United States, and in any case this is a risky strategy. Nonetheless, once again the United States and China are engaged in a retaliatory trade war. While both countries understand that freer trade is beneficial, they still revert to retaliatory trade intervention in an attempt to achieve political and economic ends.25 The pressured government may respond to the imposition of punitive tariffs by raising trade barriers of its own. The results could be higher trade barriers all around and an economic loss to all involved, not to mention the loss of cordial diplomatic relations. As is being evidenced at the present time, these interventions have the potential to become systemic, affecting many more countries than those directly implicated. Protecting consumers Many governments have regulations to protect consumers from unsafe products. The indirect effect of such regulations is to limit or possibly ban the importation of certain products. The WTO Agreement on the Application of Sanitary and Phytosanitary (SPS) Measures allows governments to restrict or prohibit trade in order to protect human, animal or plant life and health, provided they do not discriminate or use this as disguised protectionism. As noted above, China uses this argument to justify additional inspections of wool imports from Australia. Australia itself has a strict quarantine regime and it has often been accused of violating the SPS agreement and using quarantine as a means of protection. Complaints to the WTO against Australia’s quarantine regime have related to imports of salmon from the United States and Canada, fresh fruit and vegetables from the Philippines, and apples from the United States and New Zealand. As one example, the WTO was asked to rule on Australia’s regulations on plain packaging requirements applicable to tobacco products and packaging by Ukraine, Honduras and the Dominican Republic. It is a public health issue for Australia, but a trademark issue and restraint of trade issue for the complainants. In June 2018 the WTO ruled in Australia’s favour, arguing that the public health benefits justified the restrictions, a ruling that could open the way for other countries to impose similar restrictions.26 Mad cow disease, foot-and-mouth disease, genetically modified (GM) grains and hormonetreated beef have been the trigger for the application of a number of SPS prohibitions over the last decade in the beef trade, particularly between the United States, the European Union and Japan. Australia as a beef exporter has often benefited by bans placed by Japan and the European Union on US and Canadian beef imports under SPS provisions. Furthering foreign policy objectives Governments sometimes use trade policy to support their foreign policy objectives.27 Trade sanctions have been used to pressure or punish ‘rogue states’ that, in the view of the government, do not abide by international law or norms. Usually the country imposing the sanctions is relatively more economically powerful, and for sanctions to work effectively a sufficient number of nations must simultaneously apply the sanctions. Getting cooperation on the imposition of sanctions can be difficult, as each nation tends to have its own economic and political interests to pursue. For example, Australia did not follow the United CHAPTER 3 hiL23674_ch03_101-158.indd 115 TRADE SANCTIONS Government actions that restrict or prohibit trade with a country in order to bring about a political change in that country THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 115 08/06/19 07:44 PM States and European countries in placing trade sanctions on Myanmar’s military regime that were aimed at forcing political change and a return to democracy. For its ‘autonomous sanctions’, Australia tends to resort to financial and travel sanctions on individuals and the suspension of aid, rather than sanctions on the trade of goods and services from the targeted countries. Australia currently imposes financial and travel sanctions on a variety of countries, including Syria, Zimbabwe, Somalia, North Korea and Iran. Myanmar has had sanctions eased and reimposed since 2012 as conditions in that country have fluctuated.28 Protecting human rights Governments of Western democracies have often been pressured by civil society groups to use trade policy to try to improve human rights and political freedoms in trading partners. During the period leading up to China becoming a member of the WTO in 2001, there was opposition to China’s application for membership based on China’s human rights record. The debate focused on whether to grant most favoured nation (MFN) status to China. If China did not attain MFN status, tariffs would have risen to about 40 per cent. Opponents of China’s application pointed to the 1989 Tiananmen Square massacre, China’s continuing subjugation of Tibet and the quashing of political dissent as indications of the country’s disregard for human rights.29 The critics argued that the United States should withhold MFN status—that is, punish China with higher tariff rates—until China showed measurable improvement in its human rights record. In the end, the argument for coupling trade policy to human rights and democratic reforms did not hold sway. The emergence of China as an economic superpower has led the governments of Australia, New Zealand, Canada and the European Union to take a somewhat similar pragmatic stance in their bilateral trade negotiations with China. The Chinese government has been accused internationally of various human rights abuses (such as discrimination against its ethnic Muslim Uighur minority) but Western governments have given mostly muted responses.30 Pragmatism aside, a counterargument to using trade barriers in a punitive way to advance democracy and human rights is that the best way to change the political and social situation in a country is to engage it through increased international trade. This is an argument discussed further in Chapter 6. Increasing international trade opens up society to new ideas and raises the income levels of countries. As ideas spread and the economy becomes richer and more open, people begin to demand, and generally receive, better treatment with regard to their political freedom in line with their increased economic freedom to trade. Limiting trade, on the other hand, may do more harm than good to the people suffering abuse. The Australian and New Zealand governments rejected calls to impose trade sanctions on Fiji following the military coup in December 2006. They did not wish to cause a loss of jobs and force consumer prices higher, outcomes that would have affected mostly the poorer citizens of Fiji, generated further political unrest and, as a consequence, brought about harsher repression by the military regime. Protecting the environment This has become an important policy objective for many nations, fuelled by the growing concern over carbon emissions and global warming. The nature of climate change is that it is collectively caused and its solution requires collective action. To this end, 125 countries signed up to the so-called Paris Agreement in 2015, agreeing to measures to keep the global temperature rise this century well below 2 degrees Celsius above pre-industrial levels and aiming for a hoped-for target of 1.5 degrees Celsius.31 Of course, there has been both domestic and international push-back to this particular effort and other efforts to limit carbon emissions. Trade unions and industry lobbyists in import-competing and export 116 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 116 08/06/19 07:44 PM industries that are high emitters (such as steel, cement, glass, coal, aluminium, chemicals, and pulp and paper) have argued that such controls would disadvantage them competitively in world markets if other countries did not impose similarly strict controls on emissions. Meanwhile, developing countries, particularly India and China, have made equity arguments regarding the amount of sacrifice that they should make as opposed to developed countries. Even though China has recently overtaken the United States as the world’s greatest polluter, most of the harmful gas emissions today result from the actions of the now-rich industrial nations over the past 200 years. There are claims that levels of per capita emissions are higher in the industrial countries than in the developing countries, and that many of the goods manufactured in developing countries are produced by subsidiaries of multinational enterprises headquartered in industrial countries for export back to the industrial countries. Despite these tensions, most countries, including the United States, did agree in Paris in 2015 to commit to measures that could hurt some domestic industries but do so for the greater good. Unfortunately, that moment of hope has since been overtaken by disagreement and dispute. The Paris Agreement was mostly voluntary, with specifics to be negotiated later. Donald Trump removed the United States from the accord after his election in 2016 and while the remaining signatories still support the agreement, negotiations between them to come up with detailed action plans have become mired in dispute.32 Few countries are currently meeting the 1.5 degrees Celsius target, including Australia, and the Intergovernmental Panel on Climate Change (IPCC) claims that the Paris Agreement will not achieve its stated goals.33 In part, this is occurring because domestic fossil fuel and other carbon-emitting industries in the remaining Paris signatories have been fairly successful in getting local government support or in interpreting the Paris Agreement in minimalist ways (e.g. claiming carbon emission reductions that are more based on creative climate accounting than any real change). International cooperation is made more complex when the existing policies applied by governments are themselves contradictory in relation to mitigating carbon emissions. (See Emerging Markets: ‘The BRICs: Electrical appliances and contrary energy-efficient policies’.) Economic arguments for intervention While there is strong endorsement of free trade based on the international trade theories explained in Chapter 2, strategic trade policy and some acceptance of the infant industry argument remains. EMERGING MARKETS THE BRICs: ELECTRICAL APPLIANCES AND CONTRARY ENERGY-EFFICIENCY POLICIES Emerging and populous economies such as Brazil, Russia, India and China (the BRICs) are expected to experience a substantial growth in the demand for residential energy. Encouraging consumers to CHAPTER 3 hiL23674_ch03_101-158.indd 117 use energy-efficient domestic appliances will be an essential component of any strategy to reduce greenhouse gas emissions in these countries. Trade and energy policies, however, may actually be THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 117 08/06/19 07:44 PM discouraging the uptake of the more energy-efficient appliances. Table 3.2 shows the average electricity prices charged to residential consumers in the BRIC countries and the average tariffs imposed on the imports of four common household appliances during the period 2008–11. The average prices paid by residents for electricity in the BRIC countries are low. In Australia, Japan and the European Union, the comparable prices are generally much higher, such as 26 US cents per kilowatt hour (kwh) in Australia in June 2018. Residents in three of the BRIC countries are paying less than one-third of the price paid in Australia. Governments maintain low residential electricity prices in order to assist lowincome earners and to achieve income redistribution and social welfare objectives. The import tariffs imposed by the BRIC countries on appliances on the other hand are high by international standards. Most OECD countries and many developing countries apply a tariff of 5 per cent or less on electrical appliances. Most of the tariffs on these imports in BRIC countries are two to four times higher than the OECD average. The combined effect of low electricity prices and high import tariffs is likely to continue to slow the take up in the BRIC countries of the more energy-efficient appliances. With low electricity prices, consumers have little incentive to adopt energy-saving practices and to purchase newer, energy-saving appliances. Instead, they are encouraged to hold on to their older, energy-inefficient appliances for longer. Import tariffs favour the sale of the locally manufactured product. If the local manufacturers have not kept pace with the technological changes that have seen the improvements in the energy efficiency of appliances, consumers will continue to buy the cheaper, but less efficient version, of the appliance. By limiting international trade, the tariff limits product choice and reduces the competitive pressure on the local producers to match world best practice in the design and manufacture of energy-efficient products. A greater diffusion of energy-efficient appliances among households could make a significant contribution to meeting climate-change targets in the populous BRIC countries, but their current energy and trade policies are acting against such diffusion. TABLE 3.2 Average ad valorem tariffs (per cent) on domestic appliances (2008–11), and average residential electricity prices (US cents per kwh, 2018)—BRIC economies AVERAGE RESIDENTIAL ELECTRICITY PRICE IN JUNE 2018 (US CENTS) AVERAGE AD VALOREM TARIFF (PER CENT) IN 2008–11 COUNTRY (BRIC ECONOMIES) AIR CONDITIONERS REFRIGERATORS TELEVISIONS LIGHTING Brazil 17.0 17 20 20 18 Russia 6.0 15 20 20 20 India 8.0 10 10 10 10 China 8.0 15 10 30 9 SOURCES: There is quite a bit of variation in estimates of residential electricity prices, although the order of magnitude and rank orderings tend to be the same. The figures for the table are taken from ‘Electricity prices’, June 2018, accessed via www.globalpetrolprices.com/electricity_prices on 5 March 2019. Other sources include: ‘World energy prices: an overview, 2018’, International Energy Agency, accessed via www.iea.org/publications/ freepublications/publication/WorldEnergyPrices2018Overview.pdf on 6 March 2018 (note that raw data are available only for purchase); ‘Electricity price statistics, 2018’, Eurostat, accessed via https://ec.europa.eu/eurostat/statistics-explained/index.php/Electricity_price_statistics on 5 March 2019 (this source only contains EU countries); K. Ahimoto, T. Homma, J. Oda, F. Sano, K. Wada, R. Janssen and R. Steenblik, Promoting Energy Efficiency Through Trade, OECD Working Paper no. 2011-07, accessed via www.oecd.org/tad/environmentandtrade/49338989.pdf on 16 August 2012. The infant industry argument INFANT INDUSTRY ARGUMENT This calls for the protection of an emerging industry until it becomes efficient enough to compete in the world market 118 PART 2 The infant industry argument is one of the oldest economic arguments for government intervention in trade. It was prevalent up until the 1970s in countries which adopted a policy of import substitution by which high protective barriers were used to support and encourage a growing manufacturing industry, resulting in a more diverse economy with less dependence on agriculture. In Australia, tariffs, quotas, subsidies and local content requirements were imposed to maintain the competitive position of the expanding manufacturing industries against imports, culminating in high rates of protection for CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 118 08/06/19 07:44 PM manufacturers of textiles, clothing, footwear, motor vehicles and white goods.34 The argument supporting protection is that many developing economies have a potential comparative advantage in manufacturing, but new manufacturing industries cannot initially compete with the established industries in the more developed countries. Governments should temporarily support new industries until they have grown strong enough to meet international competition. Free trade economists remain critical of this argument, for two main reasons. First, protection of manufacturing from foreign competition does no good unless the protection helps make the industry efficient. There are a few historical examples where such protection in some cases helped a domestic industry to take root sooner than it might have (e.g. the tinplate industry in late 19th century America).35 However, more typical is the experience of the Australian car industry. Through its import substitution policy, Australia built up its motor vehicle industry behind tariff barriers and quotas. By the ­mid-1980s, tariffs on passenger motor vehicles were 57.5 per cent but the industry had become one of the world’s most inefficient. By the end of the 1980s, labour productivity in the Australian motor vehicle industry lagged substantially behind world best practice. Whereas it took about 16 labour hours in Japan and 25 in the United States to assemble a standard car, it took nearly 40 hours in Australia.36 Australia was not alone at the time in adopting import substitution policies. The Brazilian motor vehicle industry has suffered a similar fate. After 30 years of protection, the Brazilian industry had also become one of the world’s most inefficient.37 Second, the infant industry argument relies on an assumption that companies are unable to borrow money from the private domestic or international capital market to make profitable long-term investments. Consequently, governments are required to subsidise longterm investments. Given the development of global financial markets over the past 20 years, this assumption no longer looks as valid as it once did. Today, if a developing country has a potential comparative advantage in a manufacturing industry, companies in that country should be able to borrow money for required investments. The private financial markets should be able to assess better than governments whether or not a company or an industry can profitably exploit the potential comparative advantage. The only industries that would require government protection would be those that are not worthwhile assisting. Strategic trade policy Some new trade theorists have proposed the strategic trade policy argument.38 As explained in Chapter 2, the new trade theory argues that in industries where substantial economies of scale exist, the world market will profitably support only a few companies. Countries may come to dominate the export of certain products simply because they have companies that were able to capture first-mover advantages. The long-term dominance of Boeing in the commercial aircraft industry has been attributed to such factors. The strategic trade policy argument has two components. First, a nation’s economy will benefit if the government can somehow ensure that the company or companies that gain first-mover advantages in an industry are domestic rather than foreign enterprises. The government needs to pick a potential winner and use subsidies to support these promising companies that are active in newly emerging industries. Advocates of this argument point to the substantial research and development (R&D) grants that the US government gave Boeing in the 1950s and 1960s, which helped give the company its competitive dominance in the newly emerging market for passenger jets. In both the infant industry and strategic trade policy argument, there is a requirement that government be able to pick potential winners— industries or businesses that have the potential to prosper and stand on their own feet. Governments are not always good at picking winners. See Management Focus: ‘Trying to pick a winner: Government support of the magnesium industry’. In this case, some CHAPTER 3 hiL23674_ch03_101-158.indd 119 STRATEGIC TRADE POLICY Government policy aimed at helping the country’s domestic firms gain first-mover advantages or overcome the first-mover advantages of foreign firms in global markets that will profitably support only a few firms THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 119 08/06/19 07:44 PM interesting hypothetical scenarios arise. What would have been the cumulative costs to taxpayers, shareholders and customers today if Australian governments had continued to subsidise AML in the belief that they were on a winner over the long term in supporting a magnesium smelter in Australia? Would the company have built the necessary technological and entrepreneurial capacities to enable it to change strategic direction and survive globally if it was to continue to be dependent on government subsidies? In these types of cases, there is a presumption that government bureaucrats can better spot a potential winner than private investors. Also, government policies can often have unintended consequences. For example, see Emerging Markets: ‘The BRICs: Electrical appliances and contrary energy-efficient policies’, earlier in this chapter. The second component of the strategic trade policy argument is that it might pay a government to intervene in an industry by helping domestic firms overcome the barriers to entry created by foreign companies that have already reaped first-mover advantages. This argument underlies government support of Europe’s Airbus, Boeing’s major competitor. Airbus had less than 5 per cent of the world commercial aircraft market when it began production in the mid-1970s. By 2010, it had increased its share to 45 per cent, threatening Boeing’s long-term dominance of the market. Airbus achieved this position with the assistance of US$15 billion in subsidies from the governments of Great Britain, France, Germany and Spain.39 Without this subsidy, Airbus most likely would never have been able to break into the world market. If these arguments are correct, they support a rationale for government intervention in international trade. A combination of home-market protection and subsidies may be needed. Subsidies might be needed to support development work aimed at commercialising emerging technologies, and export-promoting subsidies for the chosen companies to enable them to establish first-mover advantages or overcome the established first-mover advantages of foreign competitors in the world market. The free trade argument revisited BEGGAR-THY-NEIGHBOUR POLICY A policy that yields economic benefits to the home country but only at the expense of making other countries incur economic losses Strategic trade policy arguments challenge the rationale for unrestricted free trade. Economists are still generally sceptical. Paul Krugman, one of the economists responsible for the development of the new trade theory, points out that strategic trade policy, in practice, may be unworkable. The two reasons are retaliation and government capture.40 Strategic trade policy aimed at establishing domestic companies in a dominant position in a global industry is a beggar-thy-neighbour policy, a policy that boosts national income at the expense of other countries. A country that attempts to use such policies will probably provoke retaliation resulting in a trade war between two or more interventionist governments, with all being made worse off. The tit-for-tat granting of agricultural assistance packages to appease the farming lobbies of Japan, the EU and the United States is an example. Retaliatory action can be avoided if governments negotiate and establish ‘the rules of the game’ that minimise the use of trade-distorting interventions. The WTO seeks to do this, as we will examine later in this chapter. Governments do not always act in the national interest when they intervene in the economy. Politically important interest groups often influence them, not always to the national good. The European Union’s support for the CAP arose because of the political power of French and German farmers. A failing of strategic trade policy in the real world of politics is that such a policy is almost certain to be captured by special-interest groups within the economy, who will distort it to their own ends. Krugman concludes that in his home country, the United States: To ask the Commerce Department to ignore special-interest politics while formulating detailed policy for many industries is not realistic: To establish a blanket policy of free 120 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 120 08/06/19 07:44 PM trade, with exceptions granted only under extreme pressure, may not be the optimal policy according to the theory but may be the best policy that the country is likely to get.41 MANAGEMENT FOCUS TRYING TO PICK A WINNER: GOVERNMENT SUPPORT OF THE MAGNESIUM INDUSTRY Magnesium alloys allow the economic mass production of strong, thin-walled, lightweight shapes and objects. Similar aluminium objects would be 50 per cent heavier. When it is used with aluminium it improves the strength, corrosive resistance, weld-ability and tear-ability of aluminium. In the late 1990s, magnesium was hailed as the metal of the future, with the demand from the world’s automotive industry expected to be immense. This optimism spawned a number of mineral-processing proposals in Australia, a process that turns raw magnesite into finished magnesium. The largest proposal at the time was that of the Australian Magnesium Corporation (AMC). It proposed building a $1.7 billion, 90 000 tonnes per year, processing plant at Stanwell, near Rockhampton, Queensland. As it was unable to purchase an existing technology in what was now a very competitive global market, AMC with the assistance of the CSIRO developed its own low-cost process technology. It built and operated a demonstration plant to prove the technology to potential investors. To the regional and national economies, the project promised 2000 jobs and $500 million in revenue per year. During 2000–03, AMC set about raising capital and commenced construction. However, signs of trouble soon began to appear. Construction costs rose above expectations and there was a shortfall in the capital raising. The state government of Queensland provided $100 million to guarantee dividend payments to investors for three years. It provided another $50 million for infrastructure assistance. The national government provided $100 million to guarantee loans and another $50 million for CSIRO to develop the new processing technology. After four years, with the plant in the very early phases of construction, in June 2003 the project collapsed and was mothballed. Shareholders lost $500 million and taxpayers lost $240 million after salvaging some assets. The blowout in the construction costs was widely broadcast as the cause of the collapse, but perhaps there were more fundamental causes. In an assessment CHAPTER 3 hiL23674_ch03_101-158.indd 121 of the industry, the then chairman of AMC admitted to the reality of the time that the persistent low magnesium prices, the high value of the Australian dollar and cheap metal imports from China would most likely preclude any new investment in magnesium smelting in Australia. How prophetic those sentiments were. In the meantime, AMC looked to move on. By 2006, it had changed its business model and, as a reflection of the new direction, it changed its name to Advanced Magnesium Limited (AML). The Brisbane-based AML’s principal activities were now researching, developing, manufacturing and selling new proprietary magnesium alloys and technologies to die casters for end use in the automotive, electronics and hardware industries. AML no longer sought to manufacture magnesium or its proprietary alloys itself. Instead, it outsourced the manufacture of its alloys under licence to alloy producers in China, Japan and Europe—AML’s main regional markets. In 2008–09, AML made another change to its business model. It identified a number of weaknesses with the licensing agreements with manufacturers. AML realised that it lacked control over its supply chain and as a consequence, the quality of the product and the quality of service provided to its customers was falling. Consequently, in 2009, AML returned to manufacturing its magnesium alloys itself. It entered into a joint venture to build and operate a greenfield magnesium facility in China, the Henan Keweier Alloy Materials Co. Ltd (HNKWE), of which AML owned 53 per cent. HNKWE supplied AML’s alloys to all its customers in China, Europe, the United States and Japan. China is the world’s biggest producer of both primary magnesium ingot (90 per cent of the global supply) and magnesium alloys. AML’s executive chairman at the time of establishing the joint venture declared, ‘[T]he ideal location in Henan province, the availability of skilled labour and the support of both local and provincial governments should ensure that the company makes significant market inroads over the next 12 months’. THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 121 08/06/19 07:44 PM © Marianna Ianovska/Shutterstock More company changes were to follow. In 2011, AML took over the Magontec Group, originally a German alloy maker, and changed its name to Magontec. With the takeover, the company acquired more smelting and manufacturing capacity in Germany and China, together with recycling plants in Germany, China and Romania. As a result of the takeover, it is now a more diversified company. Magontec, now headquartered in Sydney, continues to employ its research and technology to develop and produce magnesium alloys for the die-casting industries and it produces magnesium anodes to combat corrosion for the water storage and heating industries. Its latest project is on a vast estate in China owned by its Chinese partner, Qinghai Salt Lake Group (QSLG). QSLG was given Australian Foreign Investment Review Board (FIRB) approval to own a 30 per cent stake in Magontec. In return, QSLG provided the capital for the company’s Chinese cast-house facility, which opened on the estate in April 2018. This facility converts solid pure magnesium produced by QSLG into magnesium alloy. Magontec is now a very different company from its original AMC conception. In order to remain viable, it has had to change strategic direction on more than one occasion. Even if it had remained purely a primary ingot smelting operation, AMC and its successors were able to achieve in China what in essence they were unable to achieve at Stanwell, even with significant taxpayer support. And even so the company, while viable, is not a great economic performer. The Chinese facility remains well under capacity because QGSL is not able to deliver the magnesium in the quantities it had hoped to. And the company’s share price and economic performance have been relatively flat. The AMC story provides a cautionary tale for advocates of the infant industry argument and for government support of emerging industries. SOURCES: K. Askew, ‘Flash burn’, The Sydney Morning Herald, 5 July 2003, ‘Business’, p. 43; A. Fraser, ‘Mag deal cost the taxpayers $240m’, The Australian, 26 March 2004, ‘Finance’, p. 23; ‘Magnesium firm does its brass’, The Sunday Mail, Brisbane, 15 August 2004, ‘Finance’, p. 91; ‘Stanwell smelter loses its political lifebuoy’, The Advertiser, 20 March 2004, ‘Finance’, p. 78; Advanced Magnesium Limited, Annual Report, 2006 and Annual Report, 2009; Magontec, ‘Letter to shareholders’, Australian Stock Exchange, 23 May 2012, accessed via www.asx.com.au/asxpdf/20120523/ pdf/426f3m1054jlp4.pdf on 16 August 2012; Magontec, ‘Investor relations—Annual Report, 2011’, accessed via http://mgl.live.irmau.com/IRM/content/ welcome.html on 17 August 2012; M. Smith, ‘Magontec hunts for fortune on China’s salt lake plains’, Australian Financial Review, 6 August 2018, accessed via www.afr.com/news/world/asia/magontec-hunts-for--fortune-on-chinas-salt-lake-plains-20180725-h135bj on 5 March 2019; Magontec Limited (MGL.AX), ‘Yahoo Finance’, accessed via https://au.finance.yahoo.com/quote/MGL.AX?p=MGL.AX on 5 March 2019. GOVERNMENT CAPTURE When policy to regulate private interest groups for the benefit of the public interest is distorted by the political pressure of these private interest groups to serve their own rather than the public’s interests PART 2 WHY GOVERNMENTS INTERVENE IN FDI As with trade, international business must contend with government interventions in foreign direct investment. While there are benefits to a national economy of attracting FDI, there are also costs and these costs often incite some form of political reaction. In the next two sections, we explore the motives and means of government intervention in FDI. We start by identifying the potential benefits and costs of FDI, first from the perspective of a host (receiving) country, and then from the perspective of the home (source) country. In the following section, we look at the policy instruments governments use to manage FDI. LO 3.2 122 Because of retaliation and government capture, strategic trade policy could leave all countries involved worse off, and trade more distorted, than if a hands-off approach had been adopted in the first place. But, of course, hope springs eternal for those advocating strategic trade policy, reinforced by the occasional seeming success (such as Airbus). CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 122 08/06/19 07:44 PM Host-country benefits and costs The main benefits and costs of inward FDI for a host country arise from balance-of-payments effects, resource-transfer effects, employment effects and the effects on competition, economic growth and national sovereignty. Some effects are short term and direct; others are more long term and have flow-on or spillover effects on other parts of the economy. Balance-of-payments effects A country’s balance of payments (BOP) summarises both its payments to and its receipts from other countries. The balance of payments account is discussed in more detail in Chapter 7. Governments normally are concerned when their country is running a large deficit on the current account component of their balance of payments. (Colloquially, the country is ‘living beyond its means’.) This current account balance tends to make the news headlines. The current account records foreign expenditures and receipts relating to the exports and imports of goods and services and income payments. As explained in Chapter 7, the means by which a nation can continue to support a persistent current account deficit is by borrowing from abroad or by selling off assets to foreigners—for example, selling shares, real estate and whole businesses. Since national governments and the general public invariably dislike increasing foreign debt and seeing a large proportion of the country’s productive assets fall into foreign ownership, they prefer their nation not to run large current account deficits. (Colloquial metaphors such as ‘selling the family farm’ or ‘pawning the family silver’ raise political sensitivities.) There are two ways in which FDI can help reduce a current account deficit. FDI may be a substitute for imports of goods or services. For example, as a result of Toyota once establishing a motor vehicle manufacturing plant in Australia, Australia’s imports of Japanese vehicles are reduced. A second potential benefit arises when the MNE uses its foreign subsidiary in a host country to export goods and services to other countries. For example, in 2007, just before the onset of the global recession, Australia was exporting $4 billion worth of motor vehicles out of plants that were all wholly owned subsidiaries of foreign companies. There are, however, two possible adverse effects of FDI on the balance of payments. First, set against the initial capital inflow that comes with FDI must be the subsequent repatriation of profits (dividends) from the foreign subsidiary to its parent company. Such outflows can contribute significantly to a current account deficit. This is the case for Australia, as discussed in Chapter 7. A second concern arises when a foreign subsidiary imports a substantial number of its inputs from abroad. A response by foreign companies to this type of criticism is to pledge to use more local content. BALANCE OF PAYMENTS (BOP) The national accounts that summarise both payments to and receipts from foreigners CURRENT ACCOUNT The part of the balance of payments that records transactions involving the export or import of goods and services and income payments Resource-transfer effects Foreign direct investment can make a positive contribution to the economic growth of an economy by supplying capital, technology and management resources that would otherwise not be available.42 While, for example, new technologies can raise the productivity and competitiveness of existing industries and promote new industries, many countries lack the R&D resources and management skills required to develop or commercialise these new technologies. A study of FDI by the OECD found that foreign investors invested significant amounts of capital in R&D in the countries in which they had invested, suggesting that not only were they transferring technology to those countries, but they may also have been upgrading existing technology or creating new technology in those host countries.43 There are also spillover benefits. For example, local personnel who are trained in the subsidiary of a foreign MNE may leave the company and use their new skills to improve the operations of existing local businesses or to establish new local businesses. CHAPTER 3 hiL23674_ch03_101-158.indd 123 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 123 08/06/19 07:44 PM Employment effects Foreign direct investment can create new jobs. The employment effects are both direct and indirect. Direct effects arise when a foreign MNE employs a number of host-country workers. Indirect effects arise when jobs are created in upstream and downstream companies in the supply chain. The indirect employment effects are often as large as, if not larger than, the direct effects. For example, by the mid-2000s, Japan-based Toyota had invested US$13.4 billion in the US economy. It directly employed through its operations 32 000 people, but in total it was responsible for nearly 400 000 jobs when account is taken of the indirect employment in car dealerships and suppliers. These are gross totals, however. Against these ‘new’ added jobs, domestic jobs may be lost as a result, yielding a lower net gain in employment. Given the market success of the Toyota-branded motor vehicles at the time, the Ford Motor Company planned to lay off nearly 30 000 workers and close 16 plants in North America, and General Motors planned to lay off 25 000 employees and close 12 plants.44 And even if these jobs were replaced by new ones, plant closures can result in significant costs to individuals and their communities if people lose their jobs and are forced to relocate. On the other hand, proponents of FDI would argue that the plant closures are not a consequence of FDI per se but the result of Toyota’s superior competitiveness. This jobsubstitution criticism of FDI would seem to have more weight when it takes the form of an acquisition of an established enterprise, as opposed to a greenfield investment. Jobs may be lost as the MNC tries to restructure the operations of the acquired business to improve its operating efficiency. However, even when taking over an existing company, research suggests that enterprises acquired by foreign companies in OECD countries tend in the long run to increase their employment base at a faster rate than domestic rivals. The same study found that foreign companies also tended to pay higher wage rates than domestic companies, suggesting that the productivity of employees was higher.45 Effect on competition and economic growth When FDI takes the form of a greenfield investment, the result is to establish a new enterprise which, in turn, can increase the level of competition in a national market. For example, the German supermarket chain ALDI moved into Australia in the mid-2000s, breaking down the market dominance previously enjoyed by Coles and Woolworths. After that, foreign retailers such as Zara and H&M entered Australia, disrupting the domestic retailing industry. Amazon’s 2017 entry into the country turned out to be less momentous than expected, but the company continues to expand slowly, offering prospects for further change.46, 47 New foreign competition such as this can broaden choice and drive down the prices of goods and services for consumers, especially in countries like relatively oligopolistic Australia. Increased competition tends to also stimulate capital investments in plant, equipment and R&D as companies seek to gain an edge over their rivals. As a result, there is increased productivity, product and process innovations, and greater economic growth.48 On the other hand, FDI may have an adverse effect on competition if subsidiaries of foreign MNCs have greater economic power than locally owned competitors. The foreign MNC may be able to draw on funds generated in the company elsewhere in the world to subsidise its costs in the host market. It may have effective control of global marketing networks and the control of upstream and downstream stages of the production chain in the key markets of the world. Consequently, local companies will have difficulty competing in both domestic and global markets. These restrictive practices could drive the local company out of business. If the FDI is in the form of acquisitions that involve the mergers and takeovers of established companies rather than greenfield investments, then the effect on competition is likely to be adverse as the subsidiary exploits its market power. This outcome, however, is 124 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 124 08/06/19 07:44 PM more likely the result of the lax enforcement of the host government’s competition policy than FDI per se. In Australia, the competition watchdog, the Australian Competition and Consumer Commission (ACCC), can block mergers and acquisitions that are assessed to have a detrimental effect on competition. Host governments worry that FDI is accompanied by some loss of economic independence. The concern is that key decisions that can affect the host country’s economy will be made by a foreign parent that has no real commitment to the host country, and over which the host country’s government has no real control. This is partially a felt psychic cost, but the practice of transfer pricing provides evidence of a potential economic cost. Because of TRANSFER PRICING The pricing of goods and services the high proportion of intra-company trade, the prices of a country’s imports and exports traded between the subsidiaries may be manipulated by the MNC among its own subsidiaries or related parties for its own of the same company by the benefit, rather than for the benefit of the host economy and its balance of payments. company itself that best serves the company’s interest By manipulating the prices charged on the goods and services traded between related parties in different countries with different rates of tax, an MNC can shift profits to low-tax states and receive a tax benefit. The international shifting of profits may be beneficial to the business, but it means some countries lose tax revenue. There are also balance-of-payments effects, as the prices of exports and imports will not reflect true market prices. Along with other governments, the Australian government has tax laws and tax treaties (Australia has tax treaties with over 40 countries) to attempt to counter the inappropriate use of transfer pricing to reduce tax obligations, but it is questionable how effective these laws are. As we discussed in Chapter 1, another concern about the loss of national sovereignty NATIONAL SOVEREIGNTY The freedom of a nation from and autonomy, particularly when overlaid with issues of national security, is the growth of external control over domestic sovereign wealth funds (SWFs). SWFs have existed since the 1950s, but it is the dramatic matters increase in their total size over the last 15 years that has given cause for concern. Many in the Western industrial nations are concerned because a large number of SWFs are controlled by authoritarian governments. For example, government-controlled Chinese entities have increased their investment in Australian agriculture, causing considerable angst about food security and inciting several politicians and farmer organisations to call for greater scrutiny and control of such investment. (It is important to note, however, that Britain, China and the United States are the top three largest holders, in that order. It is not so much foreign ownership itself that is seen to be a problem but the perceived nature of the owner.)49 Over the past decade, Chinese entities have also taken a large stake in Rio Tinto, one of the largest mineral resources companies in the world; the government of Qatar has sought a controlling interest in Sainsbury, one of Britain’s largest supermarket chains; and Gazprom airport workers refuelling an Airbus at Moscow Gazprom, a Russian government-controlled conglomerate, Sheremetyevo airport. has a strategic interest in the energy sectors in a number of countries and a stake in Airbus.50 There is concern that such investments are being undertaken to secure control of strategically important industries in order to gain both political and financial leverage. The danger for international business is that the political sensitivity over the growth of SWFs will lead to greater investment protectionism, albeit aimed at foreign government-controlled entities, but this will also limit the FDI opportunities of private business investors. CHAPTER 3 hiL23674_ch03_101-158.indd 125 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 125 08/06/19 07:44 PM © Alexander Tolstykh/Shutterstock National sovereignty and autonomy Home-country benefits and costs The benefits and costs of FDI to the home (source) country arise in three areas: balance-ofpayments effects, employment effects and resource-transfer effects. Balance-of-payments effects The home country’s balance of payments benefits from the inward flow of repatriated foreign earnings. FDI can also benefit the home country’s balance of payments if the foreign subsidiary creates demands for home-country exports such as capital equipment, intermediate goods and complementary products. There are, however, negative impacts of FDI on the home country’s balance of payments. First, the balance of payments suffers from the initial capital outflow required to finance the FDI. This effect, however, is usually more than offset by the subsequent inflow of foreign earnings. Second, the current account of the balance of payments suffers if the purpose of the foreign investment is to serve the home market with imports from a low-cost production location. Third, the current account of the balance of payments suffers if the FDI is a substitute for direct exports. Employment effects Positive employment effects arise when the foreign subsidiary creates demand for homecountry exports. These effects can be enhanced when it is a deliberate policy of the home government to tie aid given to developing countries for large capital projects with conditions that favour home-country companies. These aid conditions may require that equipment and other materials be imported from the donor country.51 A negative employment effect occurs when outward FDI creates foreign operations that replace domestic production, often described as ‘exporting jobs’ and ‘offshoring’. In the Management Focus: ‘Trying to pick a winner’, the magnesium producer AML invested in smelters and manufacturing joint ventures in China to produce its alloys. Jobs that could have been created in Australia have been created offshore as a result of these FDI outflows. To put the extent of the potential job loss from outward FDI in perspective for Australia, the aggregate FDI outflow from Australia is in fact minor compared to the FDI inflow that Australia attracts. Reverse resource-transfer effect Benefits of FDI arise when the home-country MNC learns valuable skills from its exposure to foreign markets that can subsequently be transferred back to the home country. This amounts to a reverse resource-transfer effect. Through its exposure to a foreign market, an MNC can learn about superior management techniques and superior product and process technologies. These resources can then be transferred back to the home country, contributing to the home country’s economic growth rate.52 GOVERNMENT POLICY INSTRUMENTS AND FDI LO 3.1 In view of the benefits and costs of FDI, we now turn our attention to the policy instruments that home (source) countries and host (destination) countries use to regulate FDI to advance their economic and political interests. Home-country policies Depending on their economic and political goals, home countries may either restrict or encourage certain FDI by their home country companies. Policies designed to encourage outward FDI include foreign risk insurance, capital assistance, tax incentives and political pressure. Policies designed to restrict outward FDI include exchange controls, taxes and sanctions. 126 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 126 08/06/19 07:44 PM Encouraging outward FDI Many investor nations now have government-backed insurance programs to cover major types of foreign investment risk. The types of risks insurable through these programs include the risks of expropriation (nationalisation), war losses and the inability to transfer profits back home. These political and legal risks are examined in more detail in Chapter 6. Such programs are particularly useful in encouraging companies to undertake investments in politically unstable countries.53 As a further incentive to encourage domestic companies to undertake FDI, many countries have eliminated double taxation of foreign income (i.e. taxation of income in both the host country and the home country). Last, and perhaps most significantly, a number of investor countries have used their political influence to persuade host countries to relax their restrictions on inbound FDI. For example, the bilateral Australia–United States Free Trade Agreement (AUSFTA) gives US companies easier investment access to Australia than that given to investment from other countries, including New Zealand, even though Australia has a long-established free trade agreement with New Zealand, the Closer Economic Relations (CER) agreement. Restricting outward FDI Controls on the movement of foreign currency have been used to limit capital outflows out of concern for the country’s balance of payments and exchange rate volatility. As FDI is for the long term, it is the short-term flows of foreign investment that are more the target of such controls. Governments today are less likely to impose foreign exchange controls except in times of financial and political crises. For example, during the 1997–98 Asian financial crisis, one of Thailand’s responses was to impose foreign exchange controls and limit outward capital flows. Brazil, India and China imposed exchange controls on capital outflows during the 2007–09 GFC. In 2011, Argentina required its insurance companies to repatriate all their investments abroad in order to stem the flight of capital. Countries have occasionally manipulated tax rules to try to encourage their companies to invest at home. The objective behind such policies is to create wealth—and hopefully jobs—at home rather than in other nations. Finally, as a complement to trade sanctions, countries impose sanctions that prohibit national companies from investing in certain countries for political reasons. For example, US rules prohibited US companies from investing in countries such as Cuba and Iran, because the regimes in these countries are judged by US policymakers to be following policies contrary to US interests. Foreignowned companies can also be caught up in such regulations if they operate in the United States. See, for example, how US sanctions almost resulted in a major British bank losing its US banking licence, in Management Focus: ‘Sanctions, U-turns and accusations of money laundering at Standard Chartered’. Host-country policies Host countries adopt policies designed to both encourage and restrict inward FDI. Encouraging inward FDI Given the economic benefits of FDI, it is common for governments to offer incentives to foreign firms to invest in their countries, and in the current era, governments are actively wooing FDI. Such incentives take many forms but the most common are tax concessions, government-funded infrastructure, low-interest loans, and grants or subsidies. Nations, and states within nations, often compete with one another to attract desirable investments. In this competitive bidding environment, MNCs can often squeeze out very significant concessions from host governments. CHAPTER 3 hiL23674_ch03_101-158.indd 127 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 127 08/06/19 07:44 PM Australia is one of the world’s largest food-producing countries, and it is strategically located near the expanding South-East Asian markets, yet many of its value-adding foodprocessing factories closed or moved offshore in the first decade of the 2000s. Food companies, many of which are foreign owned, that abandoned local processing during that time include Heinz (tomato processing), McCain Foods (frozen vegetables), SPC Ardmona (canned fruit) and Murray Goulburn (powdered milk), with thousands of jobs lost.54 Thailand tried to be the beneficiary of the restructuring of the Australian food-processing industry at the time, with the government giving high-priority status to the foodprocessing sector, especially trying to attract FDI in higher value-adding food processing rather than primary food production. An interesting example is medical foods. Medical foods are foods developed for the specific dietary management of a disease or condition for which there are distinctive nutritional requirements. For FDI in the manufacture of medical food, the Thai government offers the following package of incentives: import duty exemption on machinery; an eight-year corporate income tax exemption (a ‘tax holiday’); a further 50 per cent reduction of corporate income tax for five years after the tax holiday, a double deduction for transport, electricity and water supply costs; and a 25 per cent deduction for construction costs in addition to the normal depreciation. The one restriction is that the plant is to be located anywhere in Thailand except Bangkok.55 Did these inducements work? They seemed to for a while. After 2008, Australia became a net importer of manufactured food and grocery products. Indonesia, Malaysia, Vietnam and Thailand attracted the majority of FDI spent within the Association of Southeast Asian Nations (ASEAN) in 2018. But Thailand has since fallen from first to fourth place, partly because of political risk concerns around stability under military junta rule. However, Thailand still receives a great deal of Japanese inward FDI.56 MANAGEMENT FOCUS SANCTIONS, U-TURNS AND ACCUSATIONS OF MONEY LAUNDERING AT STANDARD CHARTERED British-based bank Standard Chartered (SC) is one of the world’s most international banks, operating in 63 markets worldwide and with more than 80 per cent of its income and profits derived from Asia, Africa and the Middle East (as of 2017). Although the bank does provide domestic consumer banking in some of the markets in which it operates, it is predominantly a wholesale banker that provides banking and financing services to multinationals and institutions, including state-owned enterprises and wealth funds. It specialises in the emerging markets of Asia, Africa and the Middle East, where it has operated for 150 years. Although SC’s presence in the United States is seemingly small, it is an important operation for SC. 128 PART 2 The US dollar is the major currency of international trade and finance (and thus referred to as a global reserve currency). The United States is the major economy of the world and the role of SC is to facilitate cross-border trade and investment among its customers in both the United States and the emerging markets. This role involves the exchange of foreign currencies and the clearing of interbank payments. In the United States, SC was estimated to process about US$195 billion every day in this role for its global clients in 2012, earning itself considerable fees. In that year, SC’s banking operations in the United States were threatened with closure based on questions about its past compliance with US sanctions law. The New York State Department of Financial Services CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 128 08/06/19 07:44 PM (NYDFS) threatened to withdraw SC’s banking licence over alleged illegal financial dealings with Iran. The NYDFS, which oversees the core of the US banking system, accused SC of wilfully hiding some 60 000 financial transactions worth nearly US$240 billion with Iranian clients over the period 2001–07 in violation of US sanctions. SC rejected the charges. On the announcement of the charges, the value of shares in SC fell by nearly 17 per cent. US sanctions prevent banks operating in the United States from doing business with Iran in response to the concerns of the US government over the funding of terrorism and the spread of nuclear weapons. SC was accused of violating and exploiting, for its own benefit, an exemption to these sanctions known as the U-turn exemption. This exemption applied during the period 2001–07 and was revoked later in 2008. Under this exemption, banks in the United States were allowed in some circumstances to undertake so-called U-turn transactions with Iranian financial institutions. U-turn transactions move money for Iranian clients among non-Iranian foreign banks, such as banks in the UK and the Middle East. Under the U-turn exemption, a US financial institution could clear these transactions as long as they were initiated through non-Iranian banks offshore from the United States and outside Iran, and were routed back to non-Iranian banks offshore and outside Iran. The aim was to deny Iran access to the United States and international financial systems while still allowing non-Iranian banks access to a dollar clearing-house function in the United States. US banks were expected to abide by documentary and due diligence obligations to comply with the exemption. They were expected to monitor the wire-transfer messages that they got from the other banks. Wire transfers were conducted using the SWIFT (Society for Worldwide Interbank Financial Telecommunication) payment system. These messages contained customer names, bank names and addresses associated with the payments. If the banks did not have enough identifying information related to the transfer or the information identified proscribed entities or individuals, they were supposed to cease the transaction and freeze the assets. The allegations against SC were centred on U-turn transactions undertaken between 2001 and 2007. SC was accused of ‘wire-stripping’; that is, SC was accused of removing the identifying information from payment messages or falsifying such information so that Iranian transfers would pass undetected through sanctions filters. The NYDFS claimed that SC had ‘laundered’ as much as US$250 billion of Iranian money over the period in question in this manner. SC denied that the alleged deception had occurred. It responded by declaring that it had not intentionally removed critical information from wire messages. It declared that following a voluntary review by external consultants and lawyers of its U-turn transactions involving Iran, it had found that ‘99.9 per cent of the transactions’ (nearly all of some 150 million messages) did comply. It claimed that the value of transactions about which there was some doubt was under US$14 million. SC went open with its internal review, waiving its lawyer– client privileges and providing all the relevant US agencies with the information and analysis. The bank also declared that it had ceased all new business with Iranian customers in 2008. SC was called before the NYDFS to explain the apparent violations of the sanctions laws and demonstrate why its New York banking licence should not be revoked. The outcome of the hearing announced in 2013 was an agreed settlement and a fine of US$340 million. Under the terms of the agreement SC agreed to allow a government anti-laundering monitor to operate in their New York office for two years and to increase its own staff of in-house auditors to monitor compliance with US sanctions. The fine impost is relatively insignificant for a company with an annual profit of US$3.95 billion, but SC remains under the threat of additional penalties from other US regulatory authorities, such as the US Treasury and the FBI. These agencies are concerned about possible ‘criminal conduct’ involved when removing the Iranian names to evade detection by US banking authorities. Other than the possibility of losing its New York banking licence, the most serious outcome of these money-laundering charges is the reputational damage done to SC’s brand, particularly in its major markets, the emerging markets, where Standard Chartered is a household name. SOURCES: Standard Chartered, Annual Report 2017, accessed via www.sc.com/annual-report/2017/media/doc/standard-chartered-annual-report-2017. pdf on 6 March 2019; K. Scannell and T. Braithwaite, ‘Size of StanChart problem U-turn dependent’, Financial Times, 7 August 2012; BBC News, ‘Standard Chartered shares plunge on laundering charges’, BBC News Business, 7 August 2012, accessed via www.bbc.co.uk/news/business on 8 August 2012; D. Rushe and J. Treanor, ‘Standard Chartered bank accused of scheming with Iran to hide transactions’, The Guardian, 7 August 2012; Australian Financial Press, ‘Standard Chartered fined $340m over Iran deals’, AFP, Yahoo!7 News, 15 August 2012, accessed via http://au.news.yahoo. com/world on 7 August 2012. CHAPTER 3 hiL23674_ch03_101-158.indd 129 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 129 08/06/19 07:44 PM EXPORT PROCESSING ZONE (EPZ) Area of a country where barriers to trade are reduced and other incentives are created in order to attract foreign investors The creation of an export processing zone (EPZ) is one means of providing incentive packages to foreign investors. In an EPZ, barriers to imports are reduced and the occupants enjoy a variety of concessions compared to the regulatory and fiscal demands placed on businesses in the rest of the country. For example, concessions may relate to more liberal employment and environmental regulations, less rigorous approval processes, better-quality infrastructure at lower cost, and tax reductions or exemptions. EPZs attract a significant amount of FDI, and significant shares of developing countries’ manufactured exports originate in EPZs.57 EPZs have been widely used in Vietnam, for example. The first EPZ was established in the Socialist Republic of Vietnam in 1991. These are joined with industrial zones (IZs). By mid-2016, there were 16 EPZs and 325 IZs, together attracting foreign investment amounting to US$150 billion, about half of the total cumulative FDI inflows. Investment in industrial parks (IP) and EPZs rose by close to 40 per cent between the first half of 2016 and 2017 to US$384.3 million.58 Restricting inward FDI Host governments use a wide range of controls to restrict FDI. Table 3.3 lists the types of barriers that an investor may face. The two most common are ownership restraints and performance requirements. Ownership restraints can take several forms. In some countries, foreign companies are excluded from specific fields, such as exclusion from tobacco and mining in Sweden and from the development of certain natural resources in Brazil, Finland and Morocco. In other industries, foreign ownership may be permitted, although a significant proportion of the equity of the subsidiary must be owned by local investors. Foreign ownership is restricted to 25 per cent or less of an airline in the United States. TABLE 3.3 Host-country barriers to FDI Entry and establishment Prohibited or restricted entry to sensitive or strategic industries Confinement of foreign investment to priority sectors and selected locations Requirement to meet social and environmental obligations Discretionary interpretations of the ‘national interest’ criteria Visa restrictions on key personnel Location of headquarters for a specific region or global market in the host country Ownership and control Requirement for joint ventures Limits to level of foreign ownership Ownership restrictions contingent on satisfying performance requirements Nationality requirements for executives and managers Listing on local stock exchanges Mandatory transfer to some local ownership in the future Performance requirements Export a given level or percentage of goods and services Supply exports to a particular region or global market exclusively from the host country Restrict imports according to levels of exports and foreign exchange earnings generated by the foreign investment Achieve a given level or percentage of local content and give preference to local suppliers Transfer technology and intellectual property to local business Achieve a given level of R&D in the host country Hire a given level or share of nationals Procedural restrictions Prolonged application, authorisation and registration processes Extensive and ongoing reporting requirements Involvement of different levels of bureaucracy and government Discriminatory treatments Affirmative actions that apply restrictions, incentives and criteria differently for local and foreign investors Corruption in official decision making Lack of transparency with respect to laws, regulations, procedures and administrative rulings and judicial decisions SOURCES: Based in part on M. Kohr, The Investment Issue in Trade Agreements: A Development Perspective, Third World Network, November 2006, accessed via www.twnside.org.sg; Bureau of Industry Economics, Foreign Direct Investment in APEC: A Survey of the Issues, Commonwealth of Australia, November 1995, ch. 5. 130 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 130 08/06/19 07:44 PM In Australia, foreign ownership in Qantas is restricted to less than 50 per cent and no single foreign entity can control more than 25 per cent. Specific legislation governs the foreign ownership of Qantas, the Qantas Sales Act 1992. In India, foreign companies were prohibited from owning media businesses until 2001, when the rules were relaxed, allowing foreign companies to purchase up to 26 per cent of a foreign newspaper.59 In New Zealand, consent is required if the foreign investor intends to acquire or establish a 25 per cent or more ownership or controlling interest in a business worth more than NZ$100 million, ‘sensitive land’ or fishing quotas. When giving consent based on an assessment of the ‘national interest’, the relevant government minister is required to take into account various cultural and environmental factors, including the protection and enhancement of indigenous fauna and flora, salmon and protected wildlife, and historic heritage.60 The rationale underlying establishment and ownership restraints seems to be twofold. First, foreign companies are often excluded from certain sectors on the grounds of national security or unfair competition. There is a view that local companies might not be able to develop unless foreign competition is restricted by a combination of import tariffs and controls on FDI. This is a variant of the infant industry argument discussed earlier. Second, ownership restraints, typically in the form of mandatory joint ventures, are based on a belief that local ownership maximises the resource-transfer and employment benefits of FDI for the host country. It is believed that shared ownership speeds up the diffusion of the MNC’s valuable technology. Performance requirements are controls over the behaviour of the MNC’s local subsidiary and can take many forms, as shown in Table 3.3. The most common set of conditions relate to local content, exports, technology transfer and local participation in top management. As with establishment and ownership restrictions, the logic underlying performance requirements is that they help to maximise the benefits and minimise the costs of FDI for the host country. Performance requirements tend to be more common in less developed countries where governments seek to maximise the development potential of FDI.61 TRADE AND FDI LIBERALISATION As we have seen, there are strong economic arguments for unrestricted trade and for the free movement of investment across borders to enable production to occur in optimal locations. Moves to achieve liberalisation, with varying degrees of success, have occurred at different levels—unilateral, bilateral, regional and multilateral. Because of the quid pro quo nature of international negotiations, unilateral action by a government to extensively liberalise trade on its own is not common. Unilateral action on trade tends to be taken only for a specific purpose; for example, to give aid to a developing country by providing duty and quota-free market access for its products. Similarly, unilateral action on FDI is usually in the form of the relaxation of regulations or the offer of incentives to encourage an inflow of FDI to a particular industry. Governments, however, are often willing to negotiate with other governments to formulate agreements on how to proceed with liberalisation. These agreements may be bilateral, as with the CER agreement between Australia and New Zealand. They may be regional, such as the United States–Canada–Mexico Agreement (USCMA, the successor to the North American Free Trade Agreement [NAFTA]; see Country Focus, ‘USA: The new protectionism’) between the United States, Canada and Mexico. And some are more global or multilateral, such as the General Agreement on Tariffs and Trade (GATT), which now operates under the auspices of the WTO. As of 2019, 164 countries were members of the WTO. The vast majority of members are also parties to one or more regional trade agreements (RTAs). There has been a marked increase in the number of regional and CHAPTER 3 hiL23674_ch03_101-158.indd 131 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 131 08/06/19 07:44 PM bilateral agreements in the last two decades. The WTO estimates that 479 cumulative notifications of RTAs were in force as at 2019.62 We will focus here on the multilateral and regional agreements, with bilateral agreements considered as a type of regional agreement. We begin by examining multilateral agreements and follow with an examination of regional economic integration. COUNTRY FOCUS USA: THE NEW PROTECTIONISM It was almost done and dusted: the Trans-Pacific Partnership (TPP) would have been the world’s largest free trade deal, covering 40 per cent of the global economy, when former US President Barack Obama was preparing to finalise the deal to be submitted to Congress for ratification. However, the election of 2016 intervened and Obama’s successor, Donald Trump, decided to pull out of the deal entirely. Trump also threatened to pull out of NAFTA—which had established a largely free-trading area between the United States, Canada and Mexico—unless he could renegotiate it to eliminate what he considered unfair disadvantage to the United States. The result was USMCA, concluded in 2018, which readjusted NAFTA more towards US interests (e.g. lowering existing protections for Canadian dairy farmers), though not as radically as some might have expected. Early in his administration Trump raised tariffs on certain imports, especially from China, in order to force China and others to open up more to US exports. Trump’s overall stated rationale for these moves is that the United States is too highly subsidising a world economic order that benefits other countries. With respect to trade in particular, Trump argues that other countries impose unfair barriers to US exports, and that US manufacturing employment and output have suffered as a result. His constant refrain is that while the United States should be a leader in the world, the current arrangements are against US interests, a situation he is trying to correct. Of course, the United States can afford to act unilaterally. It remains the largest economy in the world, by far the largest military power, and the US dollar is still the currency used to price many international commodities such as oil. Australia, though quite wealthy in GDP per capita terms, is too small to be able to ‘go it alone’. Indeed, after the United States pulled out of the TPP, the Australian government pushed the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (TPP-11), a free trade agreement between Australia, Brunei Darussalam, Canada, Chile, Japan, Malaysia, Mexico, Peru, New Zealand, Singapore and Vietnam. The TPP-11 was signed by 11 countries on 8 March 2018, with a few modifications to the original agreement and without the participation of the United States. While trade agreements always © Pool/Getty Images 132 Trump has pushed against other major multilateral arrangements outside trade as well, pulling out of the agreement to remove sanctions on Iran in exchange for Iran’s agreement to end its development of nuclear isotopes needed for nuclear weapons, and pulling out of the Paris Accord on climate change. He has also called on other countries to pay more into various collective security arrangements such as the North Atlantic Treaty Organization (NATO). PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 132 08/06/19 07:44 PM involve costs to particular sectors in particular countries, and present specific policy problems at times, Australia and its TPP-11 co-signatories thought the deal was beneficial enough, even without the United States and with questions remaining about particular provisions (such as investor dispute resolution mechanisms that would override national government policies in some cases). Even Donald Trump indicated he might bring the United States back into the deal at a later stage, although it is unclear how serious he was. What is clear is that the United States is currently leading the charge for the primacy of national over common interests in international agreements, even though the United States was instrumental in shaping those very agreements. There is an obvious domestic political motivation behind this. But if every country goes this way, and the United States slowly loses its global economic primacy over time, the future looks very unsettled indeed. Cameron Gordon Australian National University SOURCES: J. McBride and A. Chatzky, ‘What Is the Trans-Pacific Partnership (TPP)?’, Council on Foreign Relations, 4 January 2019 accessed via www.cfr. org/backgrounder/what-trans-pacific-partnership-tpp; Australian Government, accessed via https://dfat.gov.au/trade/agreements/not-yet-in-force/tpp11/Pages/transpacific-partnership-agreement-tpp.aspx; Country profile, The World Bank, accessed via https://databank.worldbank.org/data/embed-int/ CountryProfile/id/b450fd57. Trade and FDI liberalisation and the WTO LO 3.3 While many governments may recognise the value of trade liberalisation, they may be unwilling to unilaterally lower their trade barriers for fear that other nations might not follow suit. The essence of the problem is a lack of trust. Such a deadlock can be resolved if both countries agree on a set of rules, a trade agreement, to govern cross-border trade and lower trade barriers. But who is going to monitor the governments to make sure that they are playing by the trade rules? And who is going to impose sanctions on a government that cheats? An independent referee is needed. This referee could monitor trade between the countries, make sure that all abide by the rules, and impose sanctions on a country if it transgresses. While it might sound unlikely that any government would compromise its national sovereignty by submitting to such an arrangement, since World War II an international trading framework has evolved that has exactly these features. For its first 50 years, this framework was known as GATT. Since 1995, it has been known as the WTO. From an international business point of view, three key functions of the WTO provide a more orderly and predictable trading environment. These functions are: • the provision of a global forum in which to negotiate lower trade barriers • the application of the principle of non-discrimination to negotiations to avoid a complex of different trading regimes among nations • the provision of a rules-based system for the orderly means of resolving trade disputes among nations. TRADE AGREEMENT Defines the set of rules for the conduct of trade GATT and the WTO The foundation for the current WTO global trading system was GATT, established in 1947. GATT was a multilateral agreement whose objective was to liberalise trade. It was a response to the economic damage wreaked on the world economies prior to World War II as a result of protectionist, beggar-thy-neighbour trade policies. GATT provided a set of rules on the conduct of trade policy and a means for their enforcement. Agreements on the rules were struck through negotiation and reached by consensus. Negotiations have continued over a number of ‘rounds’ (which take their name from the place of the initial negotiation). The last and longest round completed to date was the Uruguay Round, which CHAPTER 3 hiL23674_ch03_101-158.indd 133 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 133 08/08/19 11:28 AM MOST FAVOURED NATION (MFN) PRINCIPLE Requires a member of the WTO to extend to all its trading partners the same trading concessions that it gives to its most favoured trading partner NATIONAL TREATMENT PRINCIPLE Requires that national and foreign trade and investment be treated equally 134 PART 2 went from 1986 to 1994. The Doha Round commenced in 2001, but it has made halting progress, punctuated by missed deadlines and on-again, off-again negotiations. Non-discrimination underpins the negotiations and agreements of GATT and now the WTO. It is embodied in two principles: the Most Favoured Nation (MFN) principle and the National Treatment principle. Member countries cannot normally discriminate between trading partners. MFN requires that if a country and its trading partner have agreed to reduce a trade barrier (usually a tariff), then that same favour must be granted to all other members of the WTO. The National Treatment principle requires that national and foreign businesses be treated equally in all areas of trade and investment. By applying these principles, trade liberalisation initiatives are diffused across the entire membership. Under GATT, the enforcement of compliance with the agreements relied on the cooperation of members. If a country believed that one of its trading partners was violating a GATT regulation, it could ask the Geneva-based bureaucracy that administered GATT to investigate. If the complaints were valid, member countries could be asked to pressure the offending party to change its policies. In general, such pressure was sufficient, but a greater pressure could be applied with the threat of expulsion from GATT. During the 1970s and 1980s the global economy was racked with a series of economic recessions. Governments in Western Europe and North America were confronted with factory closures and rising unemployment in the face of increasing import competition, particularly from the rapidly developing Asian economies. In response, these governments sought to devise forms of protection other than tariffs for their manufacturing industries and began to use subsidies to maintain their share of global agricultural trade. In the assessment of the later WTO, ‘These changes undermined GATT’s credibility and effectiveness’.63 Other shortcomings with GATT became evident. GATT tended to focus on tariffs and trade in manufactured goods, but non-tariff barriers were becoming more prevalent, trade in services was growing rapidly, and efforts to liberalise agricultural trade had been unsuccessful. Against this background, in 1986, GATT members embarked on their eighth round of negotiations, the Uruguay Round. After seven years, an agreement was reached that finally went into effect on 1 July 1995. The agreement contained such provisions as reducing the developed countries’ tariffs on manufactured goods to below 4 per cent, substantially reducing agricultural subsidies, improving market access for trade in services, enhancing the protection of intellectual property, and establishing the WTO to implement the GATT agreement. The clarification, strengthening and extension of GATT rules and the creation of the WTO held out the promise of more effective policing and enforcement of the global trading system. For example, the Uruguay Round agreement gave the WTO a mandate to extend global trading rules to three areas of growing interest to international business—trade in services, the protection of intellectual property and the liberalisation of FDI. The WTO’s General Agreement on Trade in Services (GATS) extended free trade agreements to services. The WTO’s Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) aimed to narrow the gap in the way intellectual property rights were protected around the world and to bring them under common international rules. The Agreement on TradeRelated Investment Measures (TRIMS) partially liberalised FDI. As the name suggests, TRIMS applied not to all government controls of FDI but only to national regulations on FDI that might restrict trade. For example, agreement was reached to reform national FDI regulations that prohibited or restricted foreign investment in the telecommunications and financial services industries. The TRIMS agreement acknowledged two realities of these industries: (1) the link between services and FDI, that is, that services in the main need to be produced where they are consumed; and (2) the global nature of industries such as telecommunications and financial services. TRIMS had the potential as a set of ground rules to bring about an extensive liberalisation of FDI; however, its scope was severely curtailed CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 134 08/06/19 07:44 PM by WTO members. Few nations, particularly the net recipients of FDI, were prepared to cede control of FDI to an international body. Multilateral institutions have had little success in the pursuit of a universal and binding investment agreement, similar to the one governing trade. An investment agreement, sponsored mainly by the developed countries, was put forward for inclusion on the 2001 Doha agenda. Led by Malaysia and India, the developing country members rejected the proposed agenda item, and negotiations for an investment agreement were officially dropped off the Doha agenda in 2004. The developing countries argue that to apply GATTtype rules and principles such as MFN and national treatment to investment flows would damage their development prospects. They argue that MFN and national treatment would make it virtually impossible to regulate the quantity and quality of foreign investment in a manner that is consistent with their individual development goals. Developing countries also argue that today’s developed countries are somewhat hypocritical in what they are pushing to impose on developing countries in relation to FDI liberalisation. When today’s developed economies including the United States, Germany, Japan, Taiwan and Korea were developing and were the net recipients of foreign investment, they had imposed strict regulations on foreign investment.64 In 1995, the Organization for Economic Cooperation and Development (OECD) initiated discussion on an investment agreement. The OECD, often described as the ‘rich nations club’, provides a forum in which governments consider research and analysis and avenues for collaboration on a variety of economic and policy issues affecting their economies. The members include most EU countries, the United States, Australia, New Zealand, Japan and South Korea. A draft of a multilateral agreement on investment (MAI) was drawn up that would make it illegal for signatory states to discriminate against foreign investors. It proposed a dispute settlement process and it would be open to non-members. The talks broke down in early 1998, primarily because the United States refused to sign the proposed agreement on the grounds that it contained too many exceptions that would weaken its powers. Environmental and labour groups also campaigned against the MAI, criticising the proposed agreement because it contained no binding environmental or labour agreements. Under the Uruguay Round agreement, the WTO took over the responsibility for arbitrating trade disputes and monitoring the trade policies of member countries, which before had relied on a mutual monitoring mechanism. While the WTO operates on the basis of consensus as GATT did, in the area of dispute settlement member countries are no longer able to block adoption of arbitration decisions. Once appeals, if any, have been determined, trading partners have the right to compensation or, in the last resort, to impose commensurate trade sanctions on offenders who fail to comply with the recommendations of the arbitration process. Unresolved issues and the Doha Round In Doha, Qatar, in November 2001, member governments agreed to launch a new round of negotiations. Agreeing on an agenda for the Doha Round proved difficult. First, a proposed agenda would need to include a number of issues that had remained unresolved in the WTO for some years after the Uruguay Round and persisted in the main post-2001. Inside the WTO, these key issues included the increase in anti-dumping policies, the high level of protectionism in agriculture, the lack of strong protection for intellectual property rights in many nations, and the continued limited market access caused by high tariff rates on non-agricultural goods and services in many nations, particularly in emerging economies. We will examine each of these issues shortly. Second, adding to the difficulty of gaining consensus on any agenda and agreement for new trade and investment rules was the greater diversity of objectives and priorities of a much larger WTO membership. Developing countries make up nearly two-thirds of CHAPTER 3 hiL23674_ch03_101-158.indd 135 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 135 08/06/19 07:44 PM the WTO membership. There was a growing concern among these countries and among a diverse collection of civil society groups outside the WTO that the WTO agreements on trade and investment liberalisation had not yielded the economic development outcomes promised and instead had tended to favour the interests of developed countries. In light of the concerns and debates about free trade and economic development that surfaced in Seattle and elsewhere, as a concession to the developing countries, the new talks in Doha were launched with a general focus on development through fairer trade. The round was named the Doha Development Agenda (DDA) with the promise of boosting global trade with a development focus. Anti-dumping actions The first of the issues that Doha might have been expected to resolve is the extensive use by some countries of anti-dumping policies—as we noted earlier, a type of trade remedy. Over the period from 1995 to 2017, WTO members reported initiating 5529 anti-dumping actions to the WTO. India, the European Union and the United States initiated the largest number of anti-dumping actions, accounting for almost one-third of the total of these actions over this period. India initiated 888, the United States 659 and the European Union 302 actions. The top three sectors for which actions were invoked over this period were the base metals and articles sector (1692); products of the chemical and allied industries (1114); and resins, plastics and articles, and rubber and articles (726).65 These industries have experienced intense competition and excess production capacity. The WTO suggested that the trend reflected persistent protectionist tendencies. When the WTO signalled that anti-dumping would be a focus of the Doha Round, the number of antidumping actions declined somewhat for a period after 2001, as seen in Figure 3.2, but with the advent of a global recession in 2008, the number of actions began again to rise. FIGURE 3.2 Anti-dumping actions, 2000–2017 400 SOURCE: Constructed by the author from WTO statistics. World Trade Organization, ‘Anti-dumping’, accessed via www. wto.org/english/tratop_e/adp_e/AD_ InitiationsByRepMem.xls on 7 March 2019. 350 300 250 200 150 100 Rest of the world European Union United States 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1995 0 1996 50 India Agricultural protection The second issue is agricultural protection. Protectionism in agriculture remains high, as we outlined earlier in this chapter. Whereas the world trade-weighted average of manufactured goods tariffs was about 7 per cent in 2016, in 136 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 136 08/06/19 07:44 PM agriculture it was around 16 per cent and some individual rates can be much higher.66 In all cases except Australia, the tariff protection given to agricultural products is higher than that for non-agricultural products. In addition to high tariffs, agricultural producers also benefit from substantial subsidies. The extent of the total combined government assistance given to farmers was shown earlier in Figure 3.1. The biggest defenders of the existing system of agricultural assistance have been the advanced nations of the world, which tend to use income and price support instruments rather than tariff protection. In contrast, developing nations have been pushing hard for reforms to such financial assistance packages, which they cannot match in order to allow their producers greater access to the protected agricultural markets of the developed nations. Intellectual property protection The third issue is the enforcement of rules for intellectual property (IP). The TRIPS regulations obliged WTO members to grant and enforce patents lasting at least 20 years and copyrights lasting 50 years. Developing countries initially were given some leeway in regard to how long they had to implement this agreement and later, as a further concession as part of the Doha negotiations, easier access to new technologies—in particular, pharmaceuticals. The WTO believes that reducing piracy rates in areas such as pharmaceuticals and software will have a significant impact on the volume of world trade and increase the incentive for producers to invest in the creation of intellectual property. Within the WTO, however, opinions differ on the effectiveness of TRIPS. Some believe, particularly the developed countries whose industries undertake significant R&D expenditure, that the WTO protections of IP do not offer sufficient protection. As a consequence, some developed countries have gone outside the WTO and used bilateral agreements to secure their IP rights. (We discuss further the protection of IP in Chapter 6.) Civil society groups have expressed concern that although the TRIPS agreement within the WTO had been strengthened in favour of developing countries by giving them easier access to IP, it was now being circumvented by bilateral agreements. These bilateral agreements are in favour of the industries of the developed countries, with detrimental effects on the citizens of the poorer members of the WTO (see Another Perspective: ‘Patents versus patients’). Market access The fourth issue is the tariff protection of non-agricultural products and services imposed by the emerging countries. In the WTO negotiations, the developed countries have pushed for a reduction in the industrial tariffs of these emerging economies. They claim that these markets have been closed to their manufacture exports by the high tariffs. Some, although limited, agreement on liberalisation was achieved during the initial phases of the Doha Round. For example, countries with big pharmaceutical sectors acquiesced to demands from African, Asian and Latin American nations on the issue of drug patents and generic drugs. The TRIPS agreement declares that WTO regulation on intellectual property ‘does not and should not prevent members from taking measures to protect public health’. The United States bowed to pressure from virtually every other nation to negotiate revisions of anti-dumping rules, which the United States has used extensively to protect its steel producers from foreign competition. The European Union had to scale back its efforts to include environmental policy in the trade talks, primarily because of pressure from developing nations that see environmental protection policies as trade barriers by another name. Progress in the Doha Round of global trade talks over the past decade, however, has been minimal when compared to the agenda of unresolved issues, despite the urging of influential organisations such as the G8 + 5 to complete the round.67 The key stumbling blocks remain the differences among major WTO members on agricultural trade and CHAPTER 3 hiL23674_ch03_101-158.indd 137 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 137 08/06/19 07:44 PM industrial market access. The United States, the European Union and Japan are reluctant to make significant cuts to their agricultural assistance packages. India and Indonesia, as low per capita income countries, insist on maintaining the right to impose ‘safeguard’ tariffs to protect their own farmers in the case of a sudden surge in food imports. Low-income countries argue that they should be given the flexibility to be able to impose such tariffs to protect their small-scale farmers, even if it means breaching pre-Doha bound tariffs. Larger emerging market economies such as Brazil, India, Chile and Turkey remain reluctant to open up their industrial goods and services markets to foreign competition, and in the case of India this extends to agricultural products as well. In addition, the current trade environment, with aggressive imposition of selective tariffs by the United States, is not boding well for further general opening. ANOTHER PERSPECTIVE PATENTS VERSUS PATIENTS © Tom Grill/Getty Images In 2001, at the commencement of the Doha Round, WTO members amended the TRIPS agreement. The intellectual property rules were relaxed to allow developing countries easier and more affordable access to generic pharmaceuticals to counter life-threatening diseases such as HIV/AIDS. The concession was permitted under a public health safeguard exemption. The US government, allegedly at the behest of its pharmaceutical industry, has been accused of seeking higher levels of IP protection in developing countries than applied at the time of the WTO safeguards agreement. Outside the WTO framework, the United States has negotiated numerous bilateral free trade agreements that impose what are described as ‘TRIPSplus’ IP rules. These rules weaken or eliminate the public safeguards allowed under TRIPS. The time period for IP protection of branded and patented drugs is extended and parallel imports are limited. Brand name companies are able to conceal for a longer period of time data that generic companies would use to bring their own versions of drugs to the market. Generic production and competition is reduced and drug prices remain high. Access to the more affordable generics is delayed. SOURCE: Oxfam, ‘Patents vs patients: five years after the Doha Declaration’, Policy and Analysis, 95 (14 November 2006), accessed via www.oxfam.org/ en/policy on 30 January 2007. It remains to be seen if and when the Doha Round of talks will be completed. At a meeting in late 2011, the WTO Trade Negotiations Committee concluded that an agreement on agriculture, non-agriculture market access, trade remedies and intellectual property was unlikely to be achievable in the near term.68 The last WTO ministerial 138 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 138 08/06/19 07:44 PM meeting was held in Nairobi in December 2015 and no meeting has been held since.69 It is now accepted that, although not formally concluded, the Doha Round, and the agenda it represents, is informally ‘dead’. New contexts, new agenda for Doha The relevance of the Doha Round agenda has come under question for two reasons. The first set of questions relates to the plight of the developing countries and the perceived failure of the Doha Round to deliver on the promise that it would be a ‘development’ round, a promise offered to get the developing countries to buy into another round of trade liberalisation talks. According to the critics, developing countries were expecting special and differential treatment in their favour in negotiated agreements. Expectations were raised, for example, that the rich countries would reform their agricultural policies to end the dumping of surplus product. The agreements would provide developing countries with sufficient ‘policy space’, as with ‘safeguard’ tariffs, to protect their vulnerable farmers and infant manufacturing and service industries, and the negotiations would include increasing the access to rich-country markets for the manufactures and farm products of the developing countries. Instead, according to the critics, the Doha Round descended into a rather traditional ‘market-access’ round with negotiations crafted more around the interests of the developed countries by focusing on issues such as agricultural and non-agricultural market access, access to the market for services and the protection of intellectual property. This led one critic to ask, ‘What happened to “development” in the WTO’s Doha Round?’70 In the meantime, the developed countries, using their bargaining power, have gone outside the WTO framework and negotiated bilateral and regional trade agreements which have included rules governing FDI, services, intellectual property and government procurement that grant more favourable conditions than could have been negotiated at the WTO, yet do nothing about trade-distorting agricultural subsidies. These agreements were viewed with angst by the developing world because they both place severe restrictions on the very policies that developing countries need to fight poverty and inequality and threaten the multilateral trade system. According to the critics, to restore the credibility of the Doha Round and to continue to champion the causes of multilateralism and the benefits of trade and investment liberalisation, the Doha Round needs to be put back on the ‘development’ track.71 The second set of questions relates to the fundamental shifts that have occurred in the global economy since 2001, leading one group of researchers to conclude, ‘The Doha process has been Nero-like in dwelling on issues of relatively minor consequence while the burning issues of the day are not even on the agenda’.72 Between 2002 and 2007, the world experienced the largest consecutive period of economic growth ever. Since then the landscape has changed from one of surpluses to one of shortages. Today the issue is the threat to economic security, broadly defined. The rising price of commodities has threatened the food and energy security of countries. The global recession of post-2007 has strengthened the belief of the middle class and workers in developed countries that freer trade will threaten their economic security and standard of living. There is concern that the increasing volume of sovereign wealth funds could threaten the financial security of countries as sudden changes (perhaps politically motivated) may destabilise foreign currency exchange rates and share markets. There is the added threat to national security if these funds gain control of strategic industries. And there is the threat of the effect of climate change on environmental security. The rules being negotiated at Doha do not have sufficient scope to address these security issues adequately.73 For example, two types of trade policy interventions have exacerbated the food crisis, export restrictions on food and trade-related biofuels policies in the industrial countries. CHAPTER 3 hiL23674_ch03_101-158.indd 139 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 139 08/06/19 07:44 PM The lack of progress at Doha has the potential to seriously erode the legitimacy of the WTO and multilateralism. Does multilateralism still matter? Although there has been little recent progress on trade and FDI liberalisation at the multilateral level (see Figure 3.3), trade in goods and services and investment flows have been continuing to grow. This growth, in large part, is due to the rapid expansion of the number of regional trade agreements. This is the very time, however, when multilateralism may matter more than ever. There are many salient issues where there is a commonality of interests that need to be dealt with at a global level including global terrorism, food security and climate change. And there are the issues relevant to the developing countries that now make up the vast majority of the WTO membership and include the emerging global trading powerhouses of Russia, China and India. The developed countries may find more comfort in bargaining with these emerging powers in a multilateral context than a bilateral or regional context. FIGURE 3.3 FDI regulatory changes 2007–17: liberalising and restricting (percentage) 90 80 70 Percentage SOURCE: Drawn from data from UNCTAD, World Investment Report 2018, Table III.1, p.80, accessed via https://unctad.org/en/ PublicationsLibrary/wir2018_en.pdf on 7 March 2019. 100 60 50 40 30 20 10 0 2007 2008 Liberalising 2009 2010 2011 2012 2013 2014 2015 2016 2017 Restricting REGIONAL ECONOMIC INTEGRATION The move towards regional economic integration REGIONAL ECONOMIC INTEGRATION (REI) The integration of economies arising from agreements among countries to reduce the barriers to the international flow of goods, services and factors of production among them EUROPEAN UNION (EU) A group of European nations, originally established as a customs union, now well progressed towards an economic union and with some features of a political union 140 PART 2 As noted earlier, the last few decades have witnessed an unprecedented proliferation of regional trade arrangements. National governments have been active in negotiating agreements with other selected national governments to facilitate increased cooperation among themselves. The political economy of trade and investment extends to increased government involvement in negotiating regional economic agreements. This is evidence of an accelerated trend towards a reliance on regional agreements as opposed to the more global and multilateral agreements to trade and investment liberalisation conducted under the auspices of the WTO. Many of these regional agreements are bilateral. As these agreements aim to liberalise cross-border trade and investment flows between the signatory countries, their economies become more closely integrated. Regional economic integration (REI) arises from agreements (usually but not always among countries in a geographic region) to reduce to varying degrees the barriers to the free flow of goods, services, capital and human resources across national borders. The European Union, the ASEAN Free Trade Area (AFTA), the Japan–Australia Economic Partnership Agreement (JAEPA), the United States–Mexico–Canada Agreement (USMCA) (NAFTA) and Asia–Pacific Economic Cooperation (APEC) are examples of REI, at varying degrees of integration. Nowhere has the movement towards REI been more comprehensive than in Europe. While the seeds for the formation of the European Union were sown back in 1951, on 1 January 1993 the European Union (EU) formally removed many barriers to doing business CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 140 08/06/19 07:44 PM across borders within the EU in an attempt to create a single market. The member states, with a few exceptions, have adopted a single currency, the euro. They established over time EU-wide supranational political and economic institutions in an attempt to harmonise economic policy across all members. In 2007, the EU expanded to 27 countries covering most of the continent of Europe. The current membership of 28 is shown in Map 3.1. (However, the EU could shrink back to 27 if the United Kingdom leaves in 2019.) The EU has the world’s third-largest population after China and India, with, as of 1 January 2018, a population of about 512.6 million people74 and with a nominal GDP estimated at $18.8 trillion (nominal) representing around 22 per cent of the global economy.75 As the EU has grown, it has become a major global economic and political power. Similar, but less ambitious, moves towards REI via bilateral and regional trade agreements are being pursued elsewhere in the world and they are proliferating. Australia has negotiated many such agreements. Australia and New Zealand established the Closer Economic Relations (CER) Trade Agreement in 1983, but more recently Australia has completed bilateral trade agreements with the United States, Thailand, Singapore, Chile, Korea, Malaysia, Indonesia, China and Japan. Australia and New Zealand completed a plurilateral trade agreement, a region-to-region multi-country agreement: the ASEAN–Australia–New Zealand Free Trade Area (AANZFTA). AANZFTA exists while at the same time Australia and New Zealand individually retain their bilateral agreements with a number of these same ASEAN countries. Australia is also involved in negotiations on regional agreements—a Pacific Agreement on Closer Economic Relations (PACER) with Pacific Island Forum members, the China–Australia Free Trade Agreement (ChAFTA) and the TPP-11. Elsewhere in the world, Canada, Mexico and the United States long ago implemented NAFTA, which has been replaced with USMCA. In South America in 1991, Argentina, Brazil, Paraguay (currently suspended) and Uruguay implemented an agreement known as Mercosur, with Venezuela joining in 2012. In 2003, AFTA came into full effect between the original five member states of the Association of Southeast Asian Nations (ASEAN)— Indonesia, Malaysia, the Philippines, Singapore and Thailand—but has since been expanded to include Myanmar (formerly Burma), Cambodia, Laos, Brunei Darussalam and Vietnam (see Map 3.2). The Common Market for Eastern and Southern Africa (COMESA), established in 1994, currently has 19 member countries, stretching from Egypt in the north to Swaziland in the south of the African continent. The Asia–Pacific Economic Cooperation (APEC) was founded in 1990 at the suggestion of Australia. APEC currently has 21 member states, including such economic powerhouses as the United States, Russia, Japan and China. APEC is much more of a forum for discussion about the ways member states could work together for greater economic integration than an agreement that binds member governments to implement trade and investment liberalisation. Trade and investment liberalisation goals are to be achieved by members acting unilaterally according to their own, individually constructed action plans that are voluntary and non-binding. While the move towards REI is generally seen positively, some observers worry that it will lead to a world in which regional trade blocs compete against each other. In this possible future scenario, free trade will exist within each bloc, but each bloc will develop a ‘fortress’ mentality and protect its market from outside competition, possibly with tariffs. The spectre of the EU and USMCA turning into economic fortresses that shut out foreign producers with high-tariff barriers is worrisome to those who believe in unrestricted free trade. If such a situation were to materialise, the resulting decline in trade between blocs could more than offset the gains from free trade within blocs. With these issues in mind, the following sections will explore the economic and political debate surrounding REI, paying particular attention to the economic and political benefits and costs of integration. We begin by examining the levels of integration that are theoretically possible. CHAPTER 3 hiL23674_ch03_101-158.indd 141 CLOSER ECONOMIC RELATIONS (CER) A free trade agreement between Australia and New Zealand dating from 1983 NORTH AMERICAN FREE TRADE AGREEMENT (NAFTA) Free trade area between Canada, Mexico and the United States MERCOSUR Pact between Argentina, Brazil, Paraguay, Venezuela and Uruguay to establish a free trade area ASSOCIATION OF SOUTHEAST ASIAN NATIONS (ASEAN) Formed in 1967 and has since established a free trade agreement involving Brunei, Cambodia, Indonesia, Laos, Myanmar, Malaysia, the Philippines, Singapore, Thailand and Vietnam COMMON MARKET FOR EASTERN AND SOUTHERN AFRICA (COMESA) Established in 1994 with now 19 countries of Eastern and Southern Africa working towards forming a customs union ASIA–PACIFIC ECONOMIC COOPERATION (APEC) Made up of 21 member states whose goal is to increase multilateral cooperation in view of the economic rise of the Pacific nations THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 141 08/06/19 07:44 PM Lisbon French Guyana (FR) PORTUGAL S P A I Madrid C EL T IC S EA N BAY OF BISCAY I R ELA ND Réunion (FR) Mayotte islands (FR) Canary Is. (ES) Madeira (PT) UNITED Paris M E GULF OF LIONS D I SOURCE: www.consilium.europa.eu/media/30582/061_14_carte_a4_en_web.pdf T E F E R R A K RW Copenhagen NO D E N MA R K A G S K O AY R R A E A D R SL O VENIA Ljubljana T N IA IC S A E A S E HUNGAR Y A Budapest LATVIA Riga ESTONIA Tallinn Helsinki FINLAND Athens GREECE A EG EAN S EA Luxembourg Bulgaria Romania Slovenia Slovakia Finland Sweden Spain France Croatia Italy Cyprus CYPRUS Nicosia The protocol order of the Member States is based on the alphabetical order of their geographical names in the original language. United Kingdom Portugal Greece Latvia Poland Ireland EA Austria Netherlands Germany Estonia Malta Denmark Hungary Lithuania Belgium Czech Republic WHITE SEA BARENTS SEA Bucharest B ULG AR IA Sofia RO MAN IA Vilnius LITHUANIA Warsaw SL OV A K IA Bratislava IONIAN SEA CROATIA Zagreb Vienna A USTRIA M A LT A Valletta N TYRRHENIAN SEA Rome Prague Stockholm P O L A N D B SWEDEN CZ ECH R EPUBL IC Berlin ITAL Y G E R M A N Y A SE Luxembourg LUXEMBOURG BELGIUM Brussels THE NETHERLANDS Amsterdam F R A N C E C HANNE L London KINGDOM LIS H ENG Dublin NORTH SEA MAP 3.1 European Union members, 2019 (prior to slated exit of the United Kingdom) Council of the European Union Martinique (FR) Guadeloupe (FR) Azores (PT) NON-CONTINENTAL AND OVERSEAS TERRITORIES OF MEMBER STATES O C I T N A L T A N A E C L A G ULF OF BO TH NI S E A C I T © European Union, 2019 S 142 K hiL23674_ch03_101-158.indd AC PART 2 BL 142 A CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE 08/06/19 07:44 PM © Vector Value/Shutterstock MAP 3.2 ASEAN countries, 2018 Levels of economic integration LO 3.4 Several levels of economic integration are possible in theory. Figure 3.4 shows the different levels of integration and how they differ. From the least integrated to the most integrated— that is, from the shallowest to the deepest form of integration—are the free trade area (FTA), a customs union, a common market, an economic union and a political union as the most highly developed integrated area. There is a strong hierarchy of requirements as development from a FTA towards a political union progresses. The FTA as it relates to the trade in goods is the most common form, followed by the customs union. Many regional trade agreements cover international trade in both goods and services.76 A basic reason for the prevalence of FTAs is that the deeper the level of integration, the greater the loss of autonomy that member states have over not only trade and investment matters but also a broad range of domestic monetary and fiscal matters. There is concern over the loss of national sovereignty. A FTA, for example, typically concentrates on reducing import tariffs and quotas but a fully-developed economic union requires, among other features, a common currency, which involves a much greater sacrifice of national sovereignty, as Britain’s retention of its pound sterling attests, even though it is (at the time of writing) a member of the EU. In a free trade area, all barriers to the trade of goods and services among member countries are removed. Each country, however, is allowed to determine its own trade policies with non-members. For example, the tariffs placed on the products of non-member countries may vary from member to member. CER and USMCA are examples of FTAs. Because members in an FTA typically have different tariffs on their imports from non-members, it is necessary to have rules of origin. Rules of origin are designed to prevent trade deflection—that is, the re-routing of imports from non-members through the CHAPTER 3 hiL23674_ch03_101-158.indd 143 FREE TRADE AREA An area in which all barriers to the trade of goods and services among member countries are removed RULES OF ORIGIN Rules of origin are designed to prevent the re-routing of imports from outside a free trade area through the member that has the lowest trade barriers TRADE DEFLECTION The re-routing of imports from nonmembers through the member that has the lowest tariffs in a free trade area THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 143 08/06/19 07:44 PM member that has the lowest tariffs. The common criterion adopted for a rule of origin is the proportion of local content. For example, in the case of CER, the origin of a product is determined by the proportion of the value added to the inputs within Australia and New Zealand, typically 50 per cent for manufactured products, to enable the product to qualify for preferential treatment.77 Basically, rules of origin arise from the discriminatory preferential trade treatment that members of an FTA receive from each other but, unlike the MFN principle of the WTO, are not accorded to non-members. Rules of origin are complex and require a bureaucracy to implement them. FIGURE 3.4 Levels of integration, general characteristics Increasing integration, complexity and loss of autonomy Supranational government Common currency, harmonised monetary and fiscal policy Liberalised movement of the factors of production among members Common external tariffs Free trade among members Free trade area CUSTOMS UNION A group of countries committed to eliminating trade barriers and adopting a common external trade policy COMMON MARKET A group of countries committed to eliminating trade barriers, adopting a common external trade policy, and allowing factors of production to move freely between members 144 PART 2 Customs union Common market Economic union Political union A customs union eliminates trade barriers between member countries and, in addition, adopts a common external trade policy. Establishment of a common external trade policy necessitates significant administrative machinery to oversee trade relations with nonmembers. The European Union began as a customs union but it has now moved beyond this stage. The Andean Community, consisting of the Latin American nations of Bolivia, Colombia, Ecuador and Peru, seeks to be a customs union.78 The Andean Community established free trade between member countries and imposed common external tariffs on products imported from outside at one of four levels (5, 10, 15 or 20 per cent of the product’s ad valorem value) depending on the product’s level of processing and the domestic need. The previous levels of integration address trade barriers. A common market has no barriers to trade between member countries, includes a common external trade policy, but involves a greater degree of integration by allowing factors of production to move freely between members. Human resources and capital are free to move because there are no restrictions on immigration, emigration, or cross-border flows of capital between member countries. Establishing a common market demands a significant degree of CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 144 08/06/19 07:44 PM harmony and cooperation on fiscal, monetary and employment policies. Achieving this degree of cooperation has proven very difficult. This level of integration is made all the more difficult while immigration remains a politically sensitive issue. For years, the European Union functioned as a common market, although it has now moved beyond this stage. Mercosur, the South American grouping, hopes to eventually establish itself as a common market. An economic union entails even closer economic integration and cooperation than a common market. Like the common market, an economic union involves the free flow of products and factors of production between member countries and the adoption of a common external trade policy, but it also requires a common currency, harmonisation of members’ tax rates, and a common monetary and fiscal policy. Such a high degree of integration demands a coordinating bureaucracy and a significant sacrifice of national sovereignty to supranational institutions. The European Union is an economic union, although an imperfect one since not all its members have adopted the common currency (the euro) and differences in fiscal policy and regulations across members still remain. The 2011 eurozone crisis highlighted the dangers of a partial move towards an economic union—the adoption of a common currency but failure to harmonise members’ fiscal and monetary stances. We discuss the eurozone crisis in more detail in Chapter 4. The move towards economic union raises the issue of how to make the supranational institutions and coordinating bureaucracy accountable to the citizens of member nations. This happens through a political union in which a central political apparatus coordinates the economic, social and foreign policy of the member states. The EU is on the road towards a political union (interestingly, even though it has not achieved fullydeveloped economic union status). The European Parliament, which is playing an ever more important role in the EU, has been directly elected by citizens of the EU countries since the late 1970s. In addition, the Council of Ministers (the controlling, decision-making body of the EU) is composed of government ministers from each EU member. Historically, and somewhat peripherally to this discussion, Australia and the United States provide examples of political unions. Once independent states in these countries have been effectively combined into a single nation, politically, with all the features of an economic union. Ultimately, the EU may move towards a similar federal structure: the United States of Europe. But that is a big if, as the ‘Brexit’ (a term conflating the words ‘British’ and ‘Exit’) crisis shows. A referendum held in the United Kingdom on 23 June 2016 asked voters whether the United Kingdom should leave or remain in the EU. Prior to the vote most pundits expected the referendum to fail. But the ‘leave’ side won by 52 per cent to 48 per cent and a long process was set in motion that was still ongoing at the time of writing. Secession from more complete political unions is very hard or impossible.79 The United States fought a bloody civil war in 1861–65 over secession by the southern states, with the union being victorious, and secession has never been seriously considered by any state or region since. But the EU’s political union is a work in progress, choosing a gradual approach which has had the benefit of achieving some real integration but at a cost of potential instability. The ultimate fate of the EU remains uncertain. ECONOMIC UNION A group of countries committed to removing trade barriers, adopting a common currency, harmonising tax rates, and pursuing a common external trade policy POLITICAL UNION A central political apparatus coordinating the economic, social and foreign policy of its member states The case for regional economic integration In this section, we examine the economic and political arguments for REI. We also identify two impediments that explain why most attempts to achieve comprehensive REI have been contentious and are faltering. In the section following, we look at the case against integration. CHAPTER 3 hiL23674_ch03_101-158.indd 145 THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 145 08/06/19 07:44 PM The economic case for integration STATIC EFFECT The effect of freer trade on the economy and business resulting from a reallocation of resources from a less efficient to a more efficient use of resources DYNAMIC EFFECT The ongoing effect of freer trade on the economy and business resulting from the stimulus of expanding markets and more intense competition The economic case for REI consists of essentially the economic arguments for free trade. Freer trade as a result of REI will allow firms and countries to shift resources and specialise in the production of goods and services that they can produce most efficiently, resulting in economic growth and higher standards of living. This reallocation to a more efficient use of resources is the static effect of freer trade. With free trade also comes access to larger markets and more intense international competition, which stimulate enterprise and innovation. This longer term, ongoing effect is the dynamic effect of freer trade. We identified earlier in this chapter how FDI can transfer technological, marketing and managerial know-how to host nations. In sum, economic theory suggests that opening up economies to free trade and investment is an economic growth, positive-sum game, in which all participating countries stand to gain in the longer run. Although the WTO has been moving the world towards a free trade regime on a multilateral basis, in a world of many nations and many political ideologies, it is very difficult to get all countries to agree on a common set of rules. It has not yet happened, and free trade globally is unlikely ever to be achieved. REI can be seen as an attempt to achieve the gains from the free flow of trade and investment between countries that have not yet been attainable under the WTO. REI is a second-best outcome when global free trade is unlikely. The political case for integration TEST PREP Preparing for a test? Use LearnSmart to help you remember what you’ve learned. The political argument for REI is of no lesser importance than is the economic case. Linking neighbouring economies and making them increasingly economically dependent on each other creates incentives for political cooperation and reduces the potential for conflict. In addition, by grouping their economies, the countries can enhance their political weight in world affairs. This leads to the establishment of cooperation and political dialogue with global economic and political powers that a country as an individual would be unlikely to achieve. In fact, the EU was originally initiated to best ensure European countries would not again go to war among themselves. The argument is that when independent countries are inextricably tied economically, there are compelling incentives not to engage in political hostilities. Impediments to integration Comprehensive REI has not been easy for countries to achieve or sustain. One impediment is that REI will generate winners and losers, and the losers will be an ongoing source of political opposition. Moving to a freer trade regime involves painful adjustments. For example, progress on the Japan–Australia Economic Partnership Agreement (JAEPA), particularly in relation to agricultural issues, was slow because of the Japanese government’s reluctance to reduce the assistance given to Japanese farmers. The Japanese stance on agriculture was motivated by a self-sufficiency imperative resulting from the food shortages and starvation experienced by Japan during and after World War II. Again, this is an issue of national sovereignty, which takes us to the second impediment to integration. A second impediment to integration, very much related to the first, arises from concerns over national sovereignty, which we identified earlier to explain the prevalence of FTAs. This has been a major stumbling block in the EU. To achieve full economic union, the EU introduced a common currency, the euro, controlled by a central EU bank. Most countries joined, but the United Kingdom refrained, unwilling to relinquish control of its monetary policy to the EU. This was in part due to the financial sector in London, which feared losing some control over its business, and in part because of pride in economic independence under the pound sterling, a currency that has existed for many centuries. (This was also a prime reason for not joining the eurozone as well.) 146 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 146 08/06/19 07:44 PM As mentioned earlier, issues of national sovereignty have become major concerns for the United Kingdom as the public voted to exit the EU, a process that created profound problems for the UK government. No other country has elected to exit the EU and, as such, there are no guidelines on how this exit is to be achieved. Brexit set off extended negotiations between the UK government and EU bureaucracy, but no final determination had been achieved at the time of writing. The UK parliament voted against adopting the terms of the exit put forward by former British Prime Minister Theresa May, an historic parliamentary loss to a British prime minister. Brexit is an unprecedented phenomenon in the context of regional economic integration, as exit from such a formal agreement is contrary to the general trend of increased regional economic integration and countries’ willingness to engage in increased economic integration. There remains much uncertainty as to the final outcome regarding Brexit, but it is clear that issues of national sovereignty remain high even in our globalising world.80 The case against regional economic integration Irrespective of Brexit, most agree that any reduction in trade barriers is likely to be beneficial and that REI agreements such as FTAs are building blocks towards freer global trade—freer in the sense that totally free trade does not seem possible. Some economists, however, have expressed concern that the benefits of regional integration have been oversold while the costs have often been ignored.81 They point out that the benefits of regional integration are determined by the extent of trade creation, as opposed to trade diversion. Trade creation occurs when an FTA can create trade that would not have existed otherwise. For example, it occurs when a member’s higher-cost producers are replaced by the lower-cost producers of other members from within the FTA. The benefits of trade creation are about replacing an inefficient supplier with a more efficient supplier from within the FTA, which is a positive static effect. Trade creation will also generate dynamic effects. Trade diversion occurs when lower-cost non-member suppliers are replaced by higher-cost suppliers from within the FTA. As a result of the FTA, trade is diverted away from a more efficient supplier outside the FTA towards a less efficient supplier within the FTA, a negative static effect. Under the right conditions, a regional FTA will benefit the world only if the amount of trade it creates exceeds the amount it diverts. Although, by strict interpretation, FTAs violate the WTO’s Most Favoured Nation principle, in theory WTO rules should ensure that an FTA does not result in trade diversion. These rules allow FTAs to be formed only if the members set tariffs that are not higher or more restrictive to outsiders than the ones previously in effect. A study of the ASEAN FTA found that the FTA did not lessen import growth from nonmembers. It also found that the reduction of tariffs among members flowed on to a reduction of tariffs to non-members; that is, in accord with MFN tariff reduction.82 However, as we saw earlier, GATT and the WTO do not cover some non-tariff barriers. As a result, regional trade blocs could emerge whose markets are protected from outside competition by high non-tariff barriers. In such cases, the trade diversion effects might outweigh the trade creation effects. Another potentially trade-distorting outcome of the proliferation of FTAs is the increasing bureaucracy associated with the administration and enforcement of the diverse and overlapping rules that govern FTAs. The costs of doing international business in certain regions may increase, diverting trade and reducing overall productivity. CHAPTER 3 hiL23674_ch03_101-158.indd 147 TRADE CREATION Occurs within a free trade area due to the replacement of high-cost domestic or external producers by low-cost producers inside the free trade area TRADE DIVERSION Occurs within a free trade area when low-cost external suppliers are replaced by high-cost suppliers inside the free trade area THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 147 08/06/19 07:44 PM FOCUS ON MANAGERIAL IMPLICATIONS How should the international manager respond to changes in government policies regulating international trade and FDI? There are two approaches to this question. The first concerns the impact of trade and investment barriers on a company’s strategy. The second relates to the role that companies can play in influencing trade and investment policies. How does the accelerated movement towards regional economic integration affect international business? International businesses need to consider how to position themselves so that they can realise the opportunities that REI creates and minimise any threats. LO 3.5 BARRIERS AND FIRM STRATEGY Trade and FDI barriers affect a company’s location choices by constraining into what countries the company can disperse its value activities. For example, import tariff barriers put a foreign company at a competitive disadvantage vis-à-vis local competitors. In response, the company may find it economical to relocate production facilities to the protectionist country so that it can compete on an even footing and benefit itself from the protection. Import quotas may encourage a similar relocation response even though it may result in higher production costs. In order to conform to local content regulations, a company may have to locate more production activities in a given market than it would otherwise. Even when trade barriers do not exist, the company may still want to locate some production activities in a given country to reduce the threat of trade barriers being imposed in the future. Other strategies are affected. For example, the threat of anti-dumping action limits the ability of a company to use aggressive pricing to gain market share in a country. Similarly, FDI barriers such as ownership restraints and performance requirements reduce the company’s flexibility to respond to competitive market forces. It may be forced to commit more resources, or a different mix of resources and products, to a location than is optimal. One strategy the company can adopt is to play one country or level of government off against another in order to reduce or evade investment barriers. The strategy, however, could be detrimental to the company in the long run as the abandoned countries may restrict the company’s imports in the future. 148 PART 2 POLICY IMPLICATIONS Companies can and do exert a strong influence on government policy. This influence can encourage protectionism, for example, as we saw in the cases involving anti-dumping policies, or it can encourage removal of barriers, such as the push by farmers through the Cairns Group to reduce agricultural protection. It is probably in the best long-run interests of the business community to encourage their governments to aggressively promote freer trade and investment, and to achieve this by strengthening the multilateral trade system of the WTO, even though in the short run they are benefiting from bilateral and regional trade agreements. Companies have much more to gain from government efforts to open protected markets to imports and FDI than from government efforts to support certain domestic industries. For example, companies of all national origins increasingly depend for their competitive advantage on globally dispersed supply chains and production systems. Where a company depends on a global supply chain, for that company to argue for protection results not so much in a ‘beggar-thyneighbour’ outcome but a ‘beggar-thyself’ outcome. International business groups have been a driving force in the formation of bilateral and regional FTAs.83 They have had success in lobbying their governments to win market access for their goods and services, which they were unable to achieve through the multilateral WTO system. They have been able to use their political influence to have strong and binding agreements related to FDI and intellectual property included in bilateral RTAs, which are not included in WTO rules. For example, the Australia–United States FTA (AUSFTA) applies the principle of national treatment to FDI and raises the threshold value of FDI, below which no host government review is required. Bilateral FTAs, however, have sometimes caused a political backlash against foreign companies, particularly when there is significant difference between the economic and political powers of the two member countries. MNCs are seen as being able to exploit the favourable power differential of their home government. For example, the US pharmaceutical MNCs have been CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 148 08/06/19 07:44 PM able to have regulations governing the development, production and pricing of pharmaceutical products in partner countries relaxed via bilateral FTAs. Such power under AUSFTA brought about changes to Australia’s Pharmaceutical Benefits Scheme. (See also Another Perspective: ‘Patents versus patients’.) If the political backlash is potentially significant, there is need for the MNCs to allay the concerns of host governments and of the relevant civil society groups in order to win their support. Corporate Watch (www. corporatewatch.org.uk), Corpwatch (www.corpwatch. org) and Oxfam International (www.oxfam.org) are three organisations that communicate positive and negative stories about MNCs and their operations in both developed and developing countries. OPPORTUNITIES FROM REGIONAL ECONOMIC INTEGRATION The creation of a single integrated region opens up markets that were formerly protected from foreign competition. The single market becomes more attractive to companies external to the region, and for companies in the region, foreign competition intensifies. Nonetheless, to fully exploit the opportunities, it may pay companies external to the region to set up subsidiaries within the region. Opportunities arise from the inherent lower costs of doing business in a single market as opposed to many national markets. Free movement of goods across borders, harmonised product standards and simplified tax regimes make it possible for companies to realise significant transaction cost savings. There are also location economies and economies of scale. Production can be centralised in those locations in the region where the mix of factor costs and skills is optimal. As a cautionary note, however, enduring differences in culture and competitive practices, as across the EU members, can still limit the ability of companies to realise cost economies by centralising production and producing a standardised product.84 THREATS FROM REGIONAL ECONOMIC INTEGRATION REI also presents a number of threats to international business. The business environment within each grouping will become increasingly more competitive. For example, before the Single European Market came CHAPTER 3 hiL23674_ch03_101-158.indd 149 into force in 1993, a Volkswagen Golf cost 55 per cent more in Britain than in Denmark and 29 per cent more in Ireland than in Greece.85 Over time, these price differentials virtually vanished as a result of the EU single market. A threat to those companies outside these trading areas arises from the likely long-term improvement in the competitive position of many companies within the areas. This is particularly relevant in the EU, where many companies that historically had a highcost structure were limited in their ability to compete globally with North American and Asian companies. The creation of a single market and the resulting increased competition in the EU forces EU companies to reduce their cost structure. This is transforming many companies into efficient global competitors. Another threat to companies outside the region is the threat of being shut out of the single market by the creation of a trade ‘fortress’. The charge that REI might lead to a fortress mentality is most often levelled at the EU. This tends to apply to imports and investment in certain politically sensitive areas, such as motor vehicle manufacturing. Non-EU companies might be well advised, therefore, to set up their own EU operations and so enjoy the protection afforded by the EU. Finally, where the level of REI has developed to that of the EU, institutions and regulations governing business are more uniformly and consistently applied across the member nations. For example, this is the role of the European Commission with respect to competition policy. There is less opportunity for foreign investors to exploit any differences in regulations or in the consistency of the enforcement of these regulations among member countries. The bargaining power of the MNC is reduced. The European Commission is increasingly willing and able to intervene and impose conditions promoting competition, including the regulation of mergers and acquisitions. This is a threat to international business in so far as it limits the ability of companies to pursue the corporate strategy of their choice. The ability of an MNC to take advantage of the political and economic power of its home government in bilateral as well as multilateral negotiations is also curtailed. The European Commission is responsible for negotiating agreements such as FTAs on behalf of the EU. It enables the member countries to speak as one in international forums such as the WTO. THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 149 08/06/19 07:44 PM KEY TERMS PAGE 112 administrative trade policies 106 ad valorem tariff 112 anti-dumping policies 141Asia–Pacific Economic Cooperation (APEC) 141Association of Southeast Asian Nations (ASEAN) 123 balance of payments (BOP) 120 beggar-thy-neighbour policy 141 Closer Economic Relations (CER) 144 common market 141Common Market for Eastern and Southern Africa (COMESA) 113 countervailing duties 123 current account 144 customs union 112 dumping 146 dynamic effect 145 economic union 140 European Union (EU) 130 export processing zone (EPZ) 104 free trade 143 free trade area 122 government capture 110 import quota 118 infant industry argument 110 local content requirement 141 Mercosur 134Most Favoured Nation (MFN) principle 125 national sovereignty 134 National Treatment principle 141North American Free Trade Agreement (NAFTA) 106 political economy 145 political union 105 protectionism 110 140 143 106 146 119 107 106 110 133 147 143 147 112 115 125 110 quota rent regional economic integration (REI) rules of origin specific tariff static effect strategic trade policy subsidy tariff tariff rate quota trade agreement trade creation trade deflection trade diversion trade remedy trade sanctions transfer pricing voluntary export restraint (VER) SUMMARY The goal of this chapter was to explain how the political and economic realities of international trade and FDI impact on companies as they venture across international borders, and how governments intervene in trade and investment across national borders. We reported the various instruments of trade and FDI policy and reviewed the political and economic arguments for government intervention. We then described attempts to liberalise international trade and investment. At the multilateral level, we examined the progress of liberalisation at the WTO. Most attempts at liberalisation in recent times have occurred at the regional and bilateral levels. Following an account of how the various levels of economic integration differ, we reviewed the economic and political debates surrounding regional economic integration. The chapter concluded with an assessment of how business may be affected by the various government interventions in international trade and investment and the various attempts to liberalise trade and investment at the multilateral and regional levels. The chapter made the following points: 1. Trade policy instruments, including tariffs and non-tariffs measures such as subsidies, anti-dumping regulations, local content requirements and administrative procedures tend to be pro-producer and anti-consumer. 4. The problems with protectionist trade policies are twofold: (a) such a policy may invite retaliation, in which case all will lose; and (b) the policy may be captured by specialinterest groups, which will distort it for their own ends. 2. Political arguments for intervention are concerned with protecting the interests of certain groups, often at the expense of other groups, and with using trade to promote political goals such as foreign policy, human rights and environmental and consumer protection. Economic arguments for intervention are about boosting the overall wealth of a nation. 5. While host countries benefit from FDI in terms of resource transfer effects, employment effects and balance-of-payments effects, there are also costs. Governments, particularly those in developing countries, insist on retaining autonomy over the regulation of FDI in order to maximise its development benefits. Host countries offer incentives to attract FDI to advance their development policies. 3. The infant industry argument for government intervention contends that governments should temporarily support particular new industries. Strategic trade policy suggests that governments can help domestic companies gain firstmover advantages in global industries where economies of scale are important. These arguments assume that governments can identify potentially successful industries. 150 PART 2 6. A cost to a home country of FDI is the export of jobs, and while there are calls for restrictions on the outflow of FDI, most restrictions on FDI are imposed by host countries. 7. The GATT and its successor, the 164-member WTO, seek to provide a more orderly and predictable trading framework by establishing principles and rules governing CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 150 08/06/19 07:44 PM the imposition of trade and investment barriers and the resolution of trade and investment disputes among nations. 8. The last completed round of negotiations, the Uruguay Round, which established the WTO, strengthened the world trading system by extending GATT rules to services, increasing protection for intellectual property and enhancing monitoring and enforcement mechanisms. Progress in the current Doha Round of negotiations on a number of longstanding, unresolved issues has stalled. Two issues that are restricting progress are the unwillingness to date of countries such as the United States, the European Union and Japan to make significant cuts to their agricultural protection and of the developing countries, particularly the larger emerging market economies such as Brazil, India and China, to open up their markets to industrial goods and services. 9. New global contexts have presented new challenges for the Doha Round to which it is not adequately responding. Developing countries, the majority of WTO members, feel that they are disadvantaged when required to implement WTO agreements and, therefore, seek compensation. The current negotiation agenda is failing to address issues relevant to the economic security of nations and individuals. The lack of progress in the Doha Round is threatening multilateralism. 10. The slow progress with the WTO multilateral negotiations on the liberalisation of international trade and investment CHAPTER 3 hiL23674_ch03_101-158.indd 151 is a factor promoting the proliferation of regional and bilateral agreements. With the move towards bilateral agreements, many countries are members of more than one agreement. 11. Regional and bilateral agreements can result in different levels of economic integration. In order of increasing integration, they include a free trade area, a customs union, a common market, an economic union and a political union. Few have moved beyond the free trade area level of integration largely because of fear of loss of national sovereignty. 12. There are political and economic arguments in favour of regional economic integration. The economic arguments stand on the balance between trade creation and trade diversion effects. 13. The opening up of markets to foreign competition by regional trade agreements creates investment and trade opportunities and threats for companies both within and outside these regions. 14. Trade and investment barriers act as a constraint on a company’s ability to disperse its various production activities to optimal locations around the globe. With global supply chains, international business may have more to gain from government efforts to open protected markets to imports and foreign direct investment than from government efforts to protect domestic industries from foreign competition. THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 151 08/06/19 07:44 PM INTERNATIONAL BUSINESS GRADUATE ATTRIBUTES (IBGAs): LEARNING AND ASSESSMENT TASKS IBGA1: DISCIPLINE KNOWLEDGE AND SKILLS 1. While many countries recognise the benefits of dismantling trade barriers through the multilateral WTO system, the developing countries have significant reservations. Establish an argument against developing countries withdrawing from WTO negotiations on the liberalisation of trade and investment. 2. Outline the economic and political arguments for REI. Given these arguments, explain why there are not more substantial examples of integration such as the EU in the world economy. Brexit retains daily news headlines worldwide: are the issues that have created the incentive for the United Kingdom to want to exit the EU systemic to the concept of REI? IBGA3: PROBLEM SOLVING 3. Your company is considering exporting its food and agriculture products to Malaysia, but management’s current knowledge of the country’s trade policies and barriers for this sector is limited. Conduct research of relevant traderelated databases to identify any information on Malaysia’s current requirements governing trade in agriculture products. Starting points for research could be Austrade (www.austrade.gov.au/country-profile-index/default.aspx), APEC Import Regulations site (www.apec.org/Home/ Groups/Committee-on-Trade-and-Investment) and the globalEDGE site (http://globalEDGE.msu.edu). Prepare an executive summary of your findings and an assessment of the ease of entry to the Malaysian food market. 4. Your company exports to a country that is negotiating a bilateral trade agreement with your home country. Your export will be subjected to some form of trade restriction. Your government asks your advice as to whether, from the point of view of your business, you would prefer a tariff or a quota to be applied. Both would be set at reasonable, non-punitive levels. Outline your decision and the reasons for it. You may be able to illustrate your reasoning with arithmetic examples or diagrams. IBGA4: ETHICAL DECISION MAKING 5. ‘Governments should not consider human rights when granting preferential trading rights to countries.’ Debate this issue. 6. Trade and investment liberalisation is going to harm certain industries, companies and workers and benefit 152 PART 2 others. Role-play the positions of the various beneficiaries and losers. During debriefing as a group, develop a set of agreed values to guide the kinds of policies, domestic and international, that governments should adopt when pursuing trade policy reform. IBGA5: COMMUNICATION 7. Prepare a table with at least four columns that summarises the membership, goals and performance of at least five regional trade agreements (other than the EU, NAFTA, ASEAN and CER). Headings for the columns could include: ‘Official name’, ‘Membership’, ‘Target level of integration’ and ‘Current status’. ‘Current status’ could include a brief assessment of the progress towards integration. 8. Australia and Thailand have a free trade agreement that took effect in 2005. In 2006, Australia imposed antidumping duties in the form of increased tariffs on canned tuna and canned pineapple imports from Thailand. Thai imports had exceeded the quota and, as a safeguard to protect Australian food producers, the anti-dumping measures were triggered. You are a researcher for the general manager of an Australian company that processes canned tuna and pineapples in Thailand and then exports them to Australia and other countries in the region. Prepare a 15-minute presentation to managerial staff examining and recommending alternatives on how the company should respond should such an event occur again. IBGA1: DISCIPLINE KNOWLEDGE AND SKILLS IBGA2: CRITICAL ANALYSIS 9. CASE ANALYSIS Read again the Opening Case, ‘Unease over China’s rare earths trade policies’ and answer the following questions. a. Are governments justified in identifying the mining and refining of rare earths as a strategic priority? b. What goals does China expect to achieve by restricting the export of rare earths? Will these restrictions be effective in the long run? c. What role is the WTO expected to play in this case? d. Whose interests are government interventions in the mining and refining of rare earths serving? 10. CASE ANALYSIS Read the following Closing Case and answer the questions that follow. CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 152 08/06/19 07:44 PM CLOSING CASE MAKE IT AUSTRALIAN? FREE TRADE VERSUS NATIONAL IDENTITY The British like to joke that Australians are devoid of culture, but Australia most definitely has a distinct identity of its own. Australians are laid back, informal, good-humoured, extrovert, beach-dwelling individualists with an unusual affection for barbecued prawns. Australia is known for its fair-mindedness, tolerance, forthrightness and accomplishments in art, sport and industry. Australians are entitled to regard their defining differences as something worth cultivating and protecting and, like other countries, Australia has stories that need retelling: stories of crises, failure, hardship, enmity and errors of judgement that challenged its people and shaped their character. International law acknowledges that all nations, even those without their own states, are entitled to preserve and celebrate their distinctive attributes and histories in order to maintain their collective identities. Indeed, this principle is foundational to contemporary international order. Problematically, healthy contemporary international order also necessitates that countries should engage in unobstructed exchange with one another. Clearly, there is a contradiction at work here, because the more business a country has with another, the more like that other nation it will become. As globalisation has proceeded over the last half century, virtually every CHAPTER 3 hiL23674_ch03_101-158.indd 153 © structuresxx/Shutterstock Trade policy is not just about taxing incoming freight from abroad to fund government spending, or cynical vote-winning protectionism that delays structural economic adjustment. It is ultimately a matter of balancing the general good of international commerce against legitimate domestic priorities that demand tight control over cross-border flows. One such priority is the cultivation and protection of national culture. A nation is not merely a geographic market: it is defined by the values, practices, symbols and sense of history and destiny that its members share. country has opened itself to influences from abroad, principally in the form of traded goods and services, foreign investment, and immigration and tourism. This has given rise to dire warnings that national identities are being erased in the face of global cultural homogenisation, or overwhelmed by the sheer volume of cultural product from the United States. In response to the threat of erosion of national identity posed by trade and investment liberalisation, many countries, Australia included, legislate special protections for industries associated with the reproduction of their distinctive culture, such as music, film and television. Limited protection of these industries is permitted under multilateral trading rules administered by the WTO, on the grounds that they uphold non-commercial values and should not be subject to the rules applied to general manufactured goods, like washing machines and sports equipment, or services like insurance and banking. The General Agreement on Trade in Services (GATS) adopts what is known as a positive list approach to deregulation: it allows countries to nominate how they will open specific services to non-discriminatory access for fellow WTO members. Australia, like many other THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 153 08/06/19 07:44 PM countries, has not listed broadcasting and audiovisual services among them. Protection of creative industries from global competition is not done through tariffs, but through an array of industry regulations that inhibit the participation of foreign competitors. Content quotas, for example, reserve a minimum amount of airtime for locally produced shows and songs. Public broadcasters, such as SBS in Australia, are subsidised by the state to ensure local programming, from news and documentaries to children’s programs, soap operas and game shows. These give the country a chance to see itself in action. Domestic producers of media content may also be eligible for government grants or favourable tax treatment from which foreign competitors are excluded. Policies concerning protection for creative and cultural industries vary with successive governments, depending on their commitment to free market principles, shifting international circumstances and the sense of threat to national security. In the 1950s, the liberal government of the day was the first to consider the regulation of Australian television, which was then free to screen content from any source. Australian writers warned that an unregulated industry would buy ready-made foreign programs rather than exert itself to create local alternatives. Sure enough, by the early 1960s Australian-made television accounted for only 1 per cent of broadcast time. The bulk of what was screened was imported from the United Kingdom and the United States. Later that decade, the Coalition government, persuaded by the need to protect Australian culture and foster a stronger sense of national identity, decided to devote public funds to support the Australian film and television industries. Unlike today, the need to protect jobs in the creative industries was not relied on as motivation for government intervention. Protection of the creative and cultural industries became entrenched in Australian policy over the following five decades. But in 2017 the pro-market Turnbull administration announced an ‘Australian 154 PART 2 screen content review’ that considered dismantling many of the protections enjoyed by the $3 billion Australian entertainment industry. Local actors, writers and directors feared the result would be an avalanche of foreign content, primarily from the United States, that would erase Australian stories from Australia’s screens. In response, a public lobby group called Make it Australian coalesced to apply pressure on the government to retain protective measures. The group is a collaboration of concerned nongovernment organisations, including the Australian Directors’ Guild, the Australian Writers’ Guild, the Media, Entertainment & Arts Alliance and Screen Producers Australia. The Make it Australian campaign not only relies on the cultural cost of deregulation, but also worries about lost jobs. This is normally a powerful political concern, if not a compelling economic one, but it is not clear how serious the impact of deregulation would be on Australian employment levels. The production of movies and television programming for overseas studios is big business in Australia and already sustains thousands of workers. Although actors like Chris Hemsworth, Cate Blanchett and Rose Byrne lent their voices to the Make it Australian campaign, all three are famous for their work in movies made by the major Hollywood studios—some of which, like Thor: Ragnarok, were filmed in Australia. The fundamental problem is that, without government support, Australians may see less of their own country reflected in the entertainment products they consume, which in turn erodes the nation’s sense of itself. In the words of playwright David Williamson, Australians might come to believe ‘that real life happens somewhere else and it’s spoken in American accents’. Furthermore, the world would hear less of, and lose an appreciation of, Australia’s unique storytelling voice. Movies like Mad Max, Crocodile Dundee, The Castle, Priscilla: Queen of the Desert, Romper Stomper, Gallipolli and Muriel’s Wedding have influenced audiences far beyond Australian shores. Just as important in this regard is Australian CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 154 08/06/19 07:44 PM music, which has been supported by local content quotas for radio. A senator from Western Australia recently proposed that the government should go even further, establishing a national station devoted entirely to Australian music. wants to offer even more generous tax breaks to offshore companies to entice them to film in its jurisdiction. Critics of this position complain that this would turn the Australian film industry into a Hollywood back-lot. Still, not all Australians are in favour of protection. For political parties like Australia’s Liberals and Nationals, cultural protection seems an unjustified intervention in entertainment trade that leads to inefficient allocation of resources and compromises Australia in its international relations with pro-trade allies such as the United States. To devoted trade enthusiasts, given how pervasive and amorphous culture is, all goods are ‘cultural’ goods due to how they are made or what they represent: a hamburger, sneakers, video games, wine, rice, clothing, even washing machines and insurance. Thus, there is no rationale to privilege popular music, films or television programs, and to do so is an admission that Australian-made products are not as marketable as their glamorous foreign counterparts. If Australian storytellers cannot lift their game, they should step aside. Australian-made campaigners fear that any reduction in quotas for local content will be binding on future governments thanks to obligations imposed by Australia’s free trade agreement with the United States, the Australia–United States Free Trade Agreement (AUSFTA). Unlike the multilateral GATS administered by the WTO, AUSFTA does not allow its signatories to nominate particular service industries to be opened to free trade. Instead, it presumes that protection of all service activities will be eliminated unless an exception was created for specific protective measures when the treaty came into force. Although Australia created reservations for its local broadcast quotas, this so-called negative list system of liberalisation means that any change by Australia favouring US imports will be irreversible while AUSFTA is in force. At a less ideological level, commercial television networks such as Seven, Nine and Ten want quotas replaced and regulations eased to give them greater strategic freedom. They want a more flexible system where they are awarded points based on the types of dramas they produce, and are opposed to any obligation to produce children’s programming. These companies observe that the competitive landscape has changed substantially since the 1960s, with online viewing and new service providers playing an increasingly important role. They consider the quota system increasingly unfair and ineffective. However, the same companies demonstrate the limitations of the private sector in serving the public interest with respect to cultural representation. For example, they do not use money saved on reduced broadcast licence fees to produce more local content. Instead, they buy shows from New Zealand that they can count as locally made thanks to the CER, with a resulting fall of 30 per cent in screen time for genuine Australian programs. Meanwhile, the Queensland government CHAPTER 3 hiL23674_ch03_101-158.indd 155 The Make it Australian campaign is concerned by recent experience in the United Kingdom, where local children’s programming collapsed so dramatically with the elimination of quotas that the government rushed to reinstate them. This example, in their view, makes it imperative that Australia maintain its existing quota levels, and extend them to new digital media platforms. An ever-larger proportion of the Australian media diet is comprised of streaming services from the likes of Netflix and Amazon. The Make it Australian campaign insists that the quotas imposed on radio and television can and should be extended to online video and music providers. If Australia were to take this path, it would be following the example of the EU, which requires that 30 per cent of a provider’s catalogue consists of European content. In the end, the demand for public protection of creative and cultural industries depends not on quantifiables like jobs created or revenue earned, but on intangible goods like cultural distinctiveness THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 155 08/06/19 07:44 PM and tradition. As the world becomes ever more integrated, national communities feel an urgent need to assert their uniqueness, even as that same integration undermines their ability to do so. The dilemma is stark: how important is increased efficiency to us, if that efficiency might mean the end of ‘us’? Brent Burmester University of Auckland SOURCES: J. Bavas, ‘Veteran screenwriter David Williamson calls for more local movies, as Queensland chases blockbusters’, ABC News, 17 March 2018, accessed via www.abc.net.au/news/2018-03-17/screenwriter-david-williamson-calls-for-more-local-movies/9557966; A. Broinowski, ‘The industry will be gutted: why Australian film and TV is fighting for its life’, The Guardian, 29 April 2018, accessed via www.theguardian.com/culture/2018/apr/29/thewhole-industry-will-be-gutted-why-australias-film-and-tv-industry-is-fighting-for-its-life; ‘Protectionism: a matter of national pride’, The Conversation, 25 January 2012, accessed via http://theconversation.com/protectionism-a-matter-of-national-pride-4983; ‘Make it Australian campaign takes the fight to Canberra’, IF Magazine, 26 June 2018, accessed via www.if.com.au/make-it-australian-campaign-takes-the-fight-to-canberra; N. Jolly, ‘Will higher Australian music quotas for radio make people buy Australian?’, The Industry Observer, 22 June 2018, accessed via https://theindustryobserver.thebrag. com/will-higher-australian-music-quotas-for-radio-make-people-buy-australian; I. Kostaki, ‘EU ministers agree to raise Netflix quota to 30%’, New Europe, 23 May 2017, accessed via www.neweurope.eu/article/eu-council-raises-eu-content-netflix-quota-30; A. Meade, ‘Children’s TV should be left to the ABC, Australian networks say’, The Guardian, 2 October 2017, accessed via www.theguardian.com/tv-and-radio/2017/oct/02/childrens-tv-shouldbe-left-to-the-abc-australian-networks-say. CLOSING CASE DISCUSSION QUESTIONS a. What might make it so difficult for Australian creative industries to produce local content that competes against imported media? b. Is the television business really any different from the breakfast cereal industry or from manufacturing sun umbrellas in terms of its cultural importance? c. Is there a contradiction in the idea that products of national cultural importance need protection from foreign imports? If something locally made is genuinely intrinsic to life in a particular country, how could there be any threat from something made somewhere else? 156 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 156 08/06/19 07:44 PM ENDNOTES 1. Productivity Commission, Trade and Assistance Review 2016–17, Australian Government, 26 April 2018, accessed via www.pc.gov.au/research/ ongoing/trade-assistance/2016-17 on 28 February 2019. 2. For a detailed welfare analysis of the effect of a tariff, see P.R. Krugman and M. Obstfeld, International Economics: Theory and Policy, New York: HarperCollins, 2000, ch. 8. 3. Department of Foreign Affairs and Trade, World Agricultural Markets— Unfair and Distorted, Agriculture and the WTO, DFAT, accessed via www.dfat.gov.au/trade/negotiations/trade_in_agriculture.html on 8 August 2012. 4. ‘Argentina’s language industry hit by new export tax 3 weeks ago’, Slator, Marion Marking, 4 February 2019, accessed via https://slator.com/ industry-news/argentinas-language-industry-hit-by-new-export-tax on 28 February 2019. 5. ‘Govt claims victory on mineral-export tax’, The Jakarta Post, 25 May 2012. 6. ‘A quick guide to the US–China trade war’, BBC News, 7 January 2019, accessed via www.bbc.com/news/business-45899310 on 28 February 2019. 7. The study was undertaken by K. Anderson, University of Adelaide. See ‘A not so perfect market’, The Economist; Survey of Agriculture and Technology, 25 March 2000, pp. 8–10. 8. K. Anderson, W. Martin and D. van ber Mensbrugghe, ‘Distortions to world trade: Impact on agricultural markets and farm incomes’, Review of Agricultural Economics, 28 (Summer 2006). 9. www.oecd.org/agriculture/topics/agricultural-policy-monitoring-andevaluation/ accessed on 4 March 2019. 10. M. Martina and D. Lawder, ‘Exclusive: China offers to end market-distorting subsidies but won’t say how’, Reuters, 15 February 2019, accessed via www.reuters.com/article/us-usa-trade-china-subsidies-exclusive/exclusivechina-offers-to-end-market-distorting-subsidies-but-wont-say-howidUSKCN1Q32X6 on 4 March 2019. 11. Jiji, ‘Japan to cut tariffs on whey for liquid baby formula’, Japan Times, 6 December 2018, accessed via www.japantimes.co.jp/news/2018/12/06/ business/japan-cut-tariffs-whey-liquid-baby-formula/#.XHyTN8AzaUk on 4 March 2019. 12. G. Mandigora, ‘South Africa’s textile export restraint agreement with China’, Trade Law Centre for Southern Africa, 4 July 2006, accessed via www. tralac.org/scripts/content.php?id=5040 on 22 January 2007. 13. Department of Foreign Affairs and Trade, ‘The Australia–United States Free Trade Agreement: the outcome on local content requirements in the audiovisual sector’, Australia–United States Free Trade Agreement, Backgrounders, n.d., accessed via www.dfat.gov.au/trade/negotiations/ us_fta/backgrounder/audiovisual.html on 27 January 2007. 14. Reported in Productivity Commission, Trade and Assistance Review ­ 2007–08, Australian Government Productivity Commission Annual Report Series, 2009, p. 118. 15. J. Bhagwati, Protectionism, Cambridge, MA: MIT Press, 1988; and ‘Japan to curb VCR exports’, The New York Times, 21 November 1983, p. D5. 16. ABARE, Agriculture in China: Developments and Significance for Australia, ABARE Research Report 06.2, Prepared for the Australian Government Department of Agriculture, Fisheries and Forestry, Canberra, March 2006. 17. ‘Australia celebrates over 50 years of wool trade to China’, The Land, 5 July 2018, accessed via www.theland.com.au/story/5507528/australiacelebrates-over-50-years-of-wool-trade-to-china/ on 6 March 2019. 18. Wine Australia, Label Approval Checklist—European Union, accessed via www.wineaustralia.com/australia/Portals/2/Exporting/Label%20 Approval%20Checklist%20-%20EU.pdf on 12 August 2012. 19. G. Di Lieto, ‘Australia may be engaging in “free trade” but it’s becoming more protectionist too’, The Conversation, 20 February 2018, accessed via https://theconversation.com/australia-may-be-engaging-in-free-trade-butits-becoming-more-protectionist-too-92025 on 6 March 2019. 20. ‘Transitioning Australia’s automotive manufacturing industry’, Department of Industry, Innovation and Science, 29 November 2018, accessed via www.industry.gov.au/funding-and-incentives/manufacturing/ transitioning-australias-automotive-manufacturing-industry on 4 March 2019. 21. For details of the Wassenaar Arrangement, consult the site www.wassenaar.org. 22. Department of Defence, ‘Export Controls on Mining and Exploration Equipment’, Australian Government, Fact Sheet, n.d., accessed via www. defence.gov.au/deco/publications/brochures/Mining_fact_sheet.pdf on 12 August 2012. CHAPTER 3 hiL23674_ch03_101-158.indd 157 23. J. Stubbs, ‘Europe calls for facts not fears in Huawei row’, IT News, 27 February 2019, accessed via www.itnews.com.au/news/europe-calls-forfacts-not-fears-in-huawei-row-519856 on 4 March 2019. 24. N. Dunne and R. Waters, ‘US waves a big stick at Chinese pirates’, Financial Times, 6 January 1995, p. 4. 25. D. Ten Kate, ‘Trump’s trade war with China may end in a draw’, Bloomberg, 4 March 2019, accessed via www.bloomberg.com/news/articles/2019-03-04/ trump-s-trade-war-with-china-may-end-in-a-draw on 5 March 2019. 26. T. Miles, ‘Australia wins landmark WTO ruling on plain cigarette packaging’, Sydney Morning Herald, 29 June 2018, accessed via www.smh.com.au/ politics/federal/australia-wins-landmark-wto-ruling-on-plain-cigarettepackaging-20180629-p4zoft.html on 5 March 2019. 27. P.S. Jordan, ‘Country sanctions and the international business community’, American Society of International Law Proceedings of the Annual Meeting, 20(9) (1997), pp. 333–42. 28. Department of Foreign Affairs and Trade, Australia and Sanctions, accessed via https://dfat.gov.au/international-relations/security/sanctions/Pages/ sanctions.aspx on 5 March 2019. 29. ‘Waiting for China: human rights and international trade’, Commonwealth, 11 March 1994; and ‘China: the cost of putting business first’, Human Rights Watch, July 1996. 30. ‘China events of 2017’, Human Rights Watch, accessed via www.hrw.org/ world-report/2018/country-chapters/china-and-tibet on 5 March 2019. 31. ‘What is the Paris Agreement?’, United Nations Climate Change, accessed via https://unfccc.int/process-and-meetings/the-paris-agreement/what-isthe-paris-agreement on 5 March 2019. 32. K. Mathiesen, ‘The “climate diaspora” trying to save the Paris Agreement from Trump’, The Guardian, 3 December 2018, accessed via www. theguardian.com/environment/2018/dec/03/save-paris-climate-agreementfrom-trump on 5 March 2019. 33. A. Ericson, ‘Few countries are meeting the Paris climate goals. Here are the ones that are’, Washington Post, 11 October 2018, accessed via www. washingtonpost.com/world/2018/10/11/few-countries-are-meeting-parisclimate-goals-here-are-ones-that-are/?utm_term=.a52da77d9c05 on 5 March 2019. 34. G. Banks, ‘Gaining from trade liberalisation: Some reflections on Australia’s experience’, New Horizons in Trade Conference, Adelaide, Australian Productivity Commission, 5 June 2003, accessed via www.pc.gov.au/ speeches/cs20030605/index.html on 30 January 2007. 35. D.A. Irwin, ‘Did late-nineteenth-century US tariffs promote infant industries? Evidence from the tinplate industry’, The Journal of Economic History, 60(2) (2000), pp. 335–60. 36. Industry Commission, The Automotive Industry, Vol. 1, The Report, 58 (26 May 1997), p. xxxi. 37. ‘Brazil’s auto industry struggles to boost global competitiveness’, Journal of Commerce, 10 October 1991, p. 6A. 38. For reviews, see J.A. Brander, ‘Rationales for strategic trade and industrial policy’, in P.R. Krugman (ed.), Strategic Trade Policy and the New International Economics, Cambridge, MA: MIT Press, 1986; P.R. Krugman, ‘Is free trade passé?’, Journal of Economic Perspectives 1 (1987), pp. 131–44; and P.R. Krugman, ‘Does the new trade theory require a new trade policy?’, World Economy, 15(4) (1992), pp. 423–41. 39. ‘Airbus and Boeing: the jumbo war’, The Economist, 15 June 1991, pp. 65–6. 40. For details see Krugman, ‘Is free trade passé?’ (1987), op. cit. and Brander, ‘Rationales for Strategic Trade and Industrial Policy’, op. cit. 41. Krugman, ‘Is free trade passé?’ (1987), op. cit. 42. R.E. Lipsey, ‘Home and host country effects of FDI’, National Bureau of Economic Research, working paper no. 9293, October 2002; and X. Li and X. Liu, ‘Foreign direct investment and economic growth’, World Development, 33 (March 2005), pp. 393–413. 43. Reported in ‘Foreign friends’, The Economist, 8 January 2000, pp. 71–2. See also K. Saggi, ‘Trade, foreign direct investment and international technology transfer’, World Bank Research Observer, 17 (2002), pp. 191–235. 44. K. Thuermer, ‘Automotives: Toyota: land of opportunity’, Foreign Direct Investment (London), 1 December 2006, p. 1; ‘Contribution of Toyota to the economies of fourteen states and the United States’, Center for Automotive Research, June 2005, accessed via www.cargroup.org/documents/Toyota. pdf on 30 January 2007. 45. ‘Foreign friends’, The Economist (2000), op. cit. 46. L. Busby, ‘From Bi-lo to Lidl: the changing face of Australia’s retail sector and tips for staying relevant’, Smart Company, 23 November 2017, accessed via www.smartcompany.com.au/business-advice/bi-lo-lidl-changing-faceaustralias-retail-sector-tips-staying-relevant/ on 5 March 2019. THE POLITICAL ECONOMY OF TRADE AND INVESTMENT 157 08/06/19 07:44 PM 47. S Sarkar, ‘Amazon Prime Day in Australia: What to expect during Prime Day 2019’, TechRadar, 27 February 2019, accessed via www.techradar.com/au/ news/amazon-australia-prime-day on 5 March 2019. 48. R. Ram and K.H. Zang, ‘Foreign direct investment and economic growth’, Economic Development and Cultural Change, 51 (2002), pp. 205–25. 49. M. Cranston, ‘Foreigners increase farmland ownership’, Australian Financial Review, 20 December 2018, accessed via www.afr.com/real-estate/ foreigners-increase-farmland-ownership-20181220-h19bta on 7 March 2019. 50. A. Mattoo and A. Subramanian, Currency Undervaluation and Sovereign Wealth Funds: A New Role for the World Trade Organization, Policy Research Working Paper Series 4668, The World Bank. 51. ‘Discreditable exports’, Financial Times, London, 14 July 2000, p. 16. 52. This idea has been articulated, although not quite in this form, by C.A. Bartlett and S. Ghoshal, Managing Across Borders: The Transnational Solution, Boston: Harvard Business School Press, 1989. 53. EDS, ‘EDS best shore SM ensures right blend, great value’, accessed via www.eds.com/services/bestshore/ on 31 January 2007; T. Pullar-Strecker, ‘EDS meets job-creation target’, The Dominion Post, 26 January 2006, p. C3. 54. S. Neales, ‘Grim forecast for food industry’, The Australian, 8 March 2012. 55. N. Thirawat, ‘International Investment Policy and Thailand’s Food Processing Sector’, European Journal of Scientific Research, 78 (4), 2012. 56. Australian Food and Grocery Council and A.T. Kearney Australia, The 2020 Industry at Crossroads, November 2011, accessed via www. afgc.org.au on 21 August 2012; ‘Thailand: ASEAN Insights: Thailand — Onward To Industry 4.0’, Clyde & Co, 17 January 2019, accessed via www.mondaq.com/x/772052/Inward+Foreign+Investment/ ASEAN+Insights+Thailand+onward+to+industry+40 on 7 March 2019. 57. World Trade Organization, World Trade Report 2006, WTO, Executive Summary, p. xxv. 58. Dezan Shira & Associates (K. Das), ‘Vietnam’s industrial zones focusing on SMEs for investment’, Vietnam Briefing, accessed via www.vietnam-briefing. com/news/vietnams-industrial-zones-focusing-smes-investment.html on 7 March 2019. 59. S. Rai, ‘India to ease limits on foreign ownership of media and tea’, The New York Times, 26 June 2002, p. W1. 60. Overseas Investment Office, Selling New Zealand Assets to Overseas Investors, Land Information New Zealand, accessed via www.linz.govt.nz/ overseas-investment on 21 August 2012. 61. L.D. Qiu and Z. Tao, ‘Export, foreign direct investment and local content requirements’, Journal of Development Economics 66 (October 2001), pp. 101–25. 62. World Trade Organization, ‘Welcome to the Regional Trade Agreements Information System (RTA-IS)’, accessed via https://rtais.wto.org/UI/ PublicMaintainRTAHome.aspx on 7 March 2019. 63. World Trade Organization, Understanding the WTO (WTO, 2005), ch. 1, p. 17, accessed via www.wto.org/english/thewto_e/whatis_ e/tif_e/utw_ chap1_e.pdf on 3 January 2007. 64. H-J. Chang, ‘Foreign investment regulation in historical perspective? Lessons for the proposed WTO agreement on investment’, Third World Network, March 2003, accessed via www.twnside.org.sg/title/joon2.doc on 31 January 2007. 65. World Trade Organization, ‘Anti-dumping initiations: by sector’, accessed via www.wto.org/english/tratop_e/adp_e/AD_InitiationsBySector.xls on 7 March 2019. 66. Trade Policy 2016: G20 Policies and Export Performance of the Least Developed Countries, United Nations Conference on Trade and Development (UNCTAD), Key Statistics and Trends, 2017, Table 3b, page 7, accessed via https://unctad.org/en/PublicationsLibrary/ditctab2016d2_ en.pdf on 7 March 2019. 67. The G8 + 5 consists of the G8 (Canada, France, Germany, Italy, Japan, Russia, United Kingdom, United States) and five emerging economies (Brazil, China, India, Mexico, South Africa). 158 PART 2 68. Reported in Productivity Commission, Trade and Assistance Review 2010–11, Annual Report, June 2012, p. 95, op. cit. 69. F. Ismail, ‘Why there’s an urgent need to revive the Doha Round of trade talks’, The Conversation, 4 October 2016, accessed via https:// theconversation.com/why-theres-an-urgent-need-to-revive-the-doharound-of-trade-talks-66286 on 7 March 2019. 70. Oxfam International, Empty Promises: What Happened to ‘Development’ in the WTO’s Doha Round, Oxfam Briefing Paper 131, 16 July 2009. 71. The importance of freeing up agricultural trade for development is discussed in K.A. Elliot, Delivering on Doha: Farm Trade and the Poor, Washington: Center for Global Development, Institute for International Economics, 2006. 72. A. Mattoo and A. Subramanian, Multilateralism Beyond Doha, The World Bank, Policy Research Working Paper, 4735, September 2008, p. 2. 73. For a detailed discussion of how well the WTO is equipped in dealing with trade barriers that have arisen in response to security issues, see Mattoo and Subramanian, Multilateralism Beyond Doha (2008), op. cit. 74. ‘Population on January 1’, Eurostat, accessed via https://ec.europa.eu/ eurostat/tgm/table.do?tab=table&init=1&language= en&pcode=tps00001&plugin=1 on 7 March 2019. 75. ‘Gross domestic product at market prices’, Eurostat, accessed via https://ec.europa.eu/eurostat/tgm/refreshTableAction. do;jsessionid=9ea7d07e30dd3bf0a52b9a8a474c872db039e243c026. e34OaN8Pc3mMc40Lc3aMaNyTa3eQe0?tab= table&plugin=1&pcode=tec00001&language=en on 7 March 2019. 76. ‘WTO Regional Trade Agreements and the WTO’, accessed via www.wto. org/english/tratop_e/region_e/scope_rta_e.htm on 7 March 2019. 77. Productivity Commission, Rules of Origin under the Australia–New Zealand Closer Economic Relations Trade Agreement, June 2004, accessed via www.pc.gov.au/__data/assets/pdf_file/ 0011/16499/roo.pdf on 30 August 2012. 78. Membership of RTAs can change frequently as economic and political circumstances change. Such has been the experience of the Andean Community. In 2006, Venezuela, a long-term member, withdrew from the Andean Community because other members had established FTAs individually with the United States, a political foe of Venezuela. 79. ‘Brexit: your simple guide to the UK leaving the EU’, BBC News, 28 February 2019, accessed via www.bbc.com/news/uk-46318565 on 7 March 2019. 80. Ibid. 81. See J. Bhagwati, ‘Regionalism and multilateralism: an overview’, Columbia University discussion paper 603, Department of Economics, Columbia University, New York; A. de la Torre and M. Kelly, ‘Regional trade arrangements’, International Monetary Fund occasional paper 93, Washington DC, March 1992; J. Bhagwati, ‘Fast track to nowhere’, The Economist, 18 October 1997, pp. 21–4; J. Bhagwati, Free Trade Today, Princeton and Oxford: Princeton University Press, 2002; and B.K. Gordon, ‘A high risk trade policy’, Foreign Affairs, 82(4) (August 2003), pp. 105–15. 82. H. Calvo-Pardo, C. Freund and E. Ornelas, The ASEAN Free Trade Agreement: Impact on Trade Flows and External Trade Barriers, The World Bank, Policy Research Working Paper, 4960, June 2009. 83. Mattoo and Subramanian, Multilateralism Beyond Doha (2008), op. cit., pp. 17–19. 84. Consider the case of Atag Holdings, a Dutch maker of kitchen appliances, in T. Horwitz, ‘Europe’s borders fade’, The Wall Street Journal, 18 May 1993, pp. Al, A12; ‘A singular market’, The Economist, 22 October 1994, pp. 10–16; and ‘Something dodgy in Europe’s single market’, The Economist, 21 May 1994, pp. 69–70. 85. E.G. Friberg, ‘1992: Moves Europeans are making’, Harvard Business Review, May–June 1989, pp. 85–9. CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch03_101-158.indd 158 08/06/19 07:44 PM © ashwin/123RF.com CHAPTER 4 FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM CHAPTER 4 hiL23674_ch04_159-206.indd 159 FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 159 08/07/19 04:03 PM INTERNATIONAL BUSINESS GRADUATE ATTRIBUTES (IBGAs) This chapter’s content, learning resources and case studies provide you with the opportunity to develop a number of International Business Graduate Attributes (IBGAs), including the following: IBGA1 IBGA2 IBGA3 IBGA5 IBGA7 Discipline Knowledge and Skills Critical Analysis Problem Solving Communication Global Perspective LEARNING OBJECTIVES (LOs) LO 4.1 LO 4.2 LO 4.3 LO 4.4 LO 4.5 160 PART 2 Explain the forces that influence exchange rates. Outline the nature and functions of foreign exchange markets, and the international monetary system and its institutions. Assess the effectiveness of different exchange rate regimes in reconciling national policy goals and the goal of international monetary stability. Demonstrate the impact of exchange rates on international business decisions. Recommend strategies that international business can use to reduce foreign exchange rate risks. CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 160 08/07/19 04:03 PM OPENING CASE THE MEXICAN PESO, THE JAPANESE YEN AND POKÉMON GO The diverging values of the yen and the peso are a function of their exchange rates against the US dollar. Most trades between the yen and the peso are converted through the US dollar, rather than traded directly. This is because the US dollar is the world’s most widely traded and liquid currency. It is easier to trade dollars for yen, and dollars for pesos, than it is to trade yen for pesos. For much of 2016, the yen gained against the dollar, while the Mexican peso fell, leading to a fall in the peso/yen exchange rate. The strength of the yen reflected the belief that Japan is a safe haven in which to park cash. Although the Japanese economy has been stagnant for decades, inflation is low and the yen has been a strong currency. The Mexican peso is the most liquid emerging market currency, which makes it an easy one to sell when investors worry about the economic strength of developing economies, which they did in 2015 and 2016. To compound matters, worries about the health of the Mexican economy following the election of Donald Trump to the US presidency put further pressure on the peso. The Mexican peso hit a record low against the US dollar following Trump’s election. © Bloomberg/Getty Images Nintendo’s hit game Pokémon Go is a lot less lucrative in Mexico than the Japanese company originally thought it would be. This is because Mexicans purchase the ‘PokéCoins’ they need to navigate the game in Mexican pesos, and the peso has been falling in value against the Japanese yen. Back in early 2015, 1 Mexican peso bought 8 Japanese yen. By September 2016, 1 peso was worth only about 5.1 Japanese yen. This meant that when pesos spent on Pokémon Go were translated back into Japanese yen, they were worth less in yen, which negatively affected Nintendo’s profits from Mexico. In addition to Nintendo, the fall in the value of the peso against the yen has created problems for other Japanese companies. Japanese car makers have significant assembly operations in Mexico. Companies such as Toyota and Mazda import a large number of specialty electronic components from suppliers in Japan. The price of these components has gone up when translated into pesos, raising costs for their Mexican operations and making them less profitable. On the other hand, the weak peso has boosted demand for some Mexican products in Japan. For example, Japan imports a large quantity of frozen Mexican pork. The price has fallen when translated into yen and demand has surged. Mexico dices up the pork and exports it to Japanese convenience stores, where it is sold in bento boxes. The dicing process is labour-intensive—and one less step they have to perform in Japan. Mexico can do it cheaper, and the currency moves have only added to the cost savings, which is good for Japanese consumers. SOURCES: J. Wernau, ‘Pokéman Go illustrates a currency problem’, The Wall Street Journal, 11 August 2016; E. Holodny and P. Crowe, ‘Mexican peso crashes to record low’, Business Insider, 8 November 2016; ‘Peso falls to session lows after meeting between US and Mexico presidents falls through’, Reuters, 26 January 2017. CHAPTER 4 hiL23674_ch04_159-206.indd 161 FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 161 08/07/19 04:03 PM INTRODUCTION LO 4.1 Like many enterprises in the global economy, the Japanese companies discussed in the opening case are affected by changes in the value of currencies on the foreign exchange market. The case illustrates that what happens in the foreign exchange market can have a fundamental impact on the sales profits of an enterprise. Accordingly, it is very important for managers to understand how the foreign exchange market works and what the impact of changes in currency exchange rates might be for their enterprise and its strategy. When conducting business domestically, the buyer and the seller use a single currency, typically their home country currency. In a foreign transaction, however, the buyer and seller may use two or more different currencies which are continuously changing in relative buying or selling power to each other, through the dynamic foreign exchange market mechanism. As exchange rates change, the price competitiveness of traded goods will change, as will the currency value of costs and sales earnings. Some businesses will gain, while others will lose. Consequently, the exchange rate is often the most crucial variable in international business decisions and performance, and what happens in the foreign exchange market can have a fundamental impact on the sales, profits and strategy of an enterprise. Hence, one of the most important aspects of successful international trade is understanding the movement and volatility of different currencies and determining which represent the least risk when agreeing to payment terms and transactions. For example, an Australian importer may agree to purchase organic cocoa from a Malaysian exporter who requests to be paid in the Malaysian currency, ringgits (MYR). The Australian importer will need to buy the appropriate number of ringgits in the foreign currency (or foreign exchange) market at the going market rate (the exchange rate) using Australian dollars (AUD). The importer will then, usually through an intermediary such as a bank, make a payment as agreed to the Malaysian exporter in ringgits. If the exporter requested payment in US dollars (USD) rather than ringgits, which is quite often the case, the importer would need to enter the foreign exchange market to purchase US dollars and remit the payment in that currency. The Australian importer in effect operates in two markets—the organic cocoa market and the foreign exchange market—and must consider the price in each market to assess whether the international transaction is profitable. The Malaysian price of organic cocoa in ringgits may be low, but that advantage could be negated if the Australian dollar falls in value relative to the ringgit—that is, if the dollar price of a ringgit rises. The higher dollar price may make Malaysian organic cocoa difficult to sell in Australia. On the other hand, if the Malaysian ringgit fell in value relative to the Australian dollar, Malaysian organic cocoa imports in terms of price competitiveness would become more attractive to Australian consumers. In that case, a fall in the value of the ringgit would benefit Malaysian exporters. The foreign exchange rate also influences decisions beyond those related to the international trade in goods and services. For example, to undertake foreign direct investment (FDI), a business needs to buy foreign currency to move capital into a country or sell foreign currency to repatriate profits. Portfolio investors buy and sell foreign currencies as they seek the best returns from trading internationally in financial assets as shares and government securities. Consequently, the exchange rate is a key variable in many international decisions and needs to be closely monitored. Exchange rate implications arise when the following strategic questions are considered. 162 PART 2 • Where will the company get the best return on foreign investment? • Where will the company locate production? CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 162 08/07/19 04:03 PM • From where will the company source its supplies? • In which currency will the company borrow? • In which currency will the company quote prices? • What will be the forecast earnings of the company’s subsidiaries in home currency terms? How can the company best protect future foreign cash flows against currency volatility and risk? • Owing to the importance of understanding exchange rate complexities for international business success, companies employ specialist finance and accounting experts to help them closely monitor currency exposure risks and strategically manage their foreign exchange activities. This chapter provides an overview of the main features of the international financial system in relation to the conduct of global business activity, and the strategic implications for management. The international financial system comprises a number of different financial markets and institutions. Figure 4.1 provides an overview of the different financial markets. Foreign exchange market: includes interbank market and securities exchanges FIGURE 4.1 International financial markets International financial markets International capital market: includes the bond market, the equities market and eurocurrency market The ‘foreign exchange market’ is the market where global currencies are bought and sold, and their exchange rates are determined. The ‘international capital market’ allows participants to invest and borrow across international borders through a variety of financial institutions managed by specialist bank and fund managers. Because most of the commercial and financial decisions undertaken by an international business are affected by the exchange rate, whether the business be a large multinational or a small exporter, this chapter will focus on the foreign exchange market and the regimes put in place to manage that market. It begins by examining how the foreign exchange market works and the forces that determine the exchange rate. It looks at the different exchange rate regimes to see how and why governments intervene in the foreign exchange market. The role and functions of an international monetary system are discussed, as well as the policy trade-offs for governments and the potentially destabilising impacts of policy spillovers. It is then illustrated how challenging this role is by examining the attempt to put in place an international rules-based system to govern the international monetary system (the Bretton Woods system), the international financial crises and the role of the International Monetary Fund (IMF). The final section examines the effect of exchange rate changes on international business, and the setting of prices in foreign markets to maintain profit mark-ups while remaining price competitive. The chapter concludes by highlighting the risks to international business of foreign exchange rate changes, along with the strategies that can be adopted to manage foreign exchange rate risk exposures. CHAPTER 4 hiL23674_ch04_159-206.indd 163 FOREIGN EXCHANGE MARKET A market for converting the currency of one country into that of another country FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 163 08/07/19 04:03 PM THE FOREIGN EXCHANGE MARKET EXCHANGE RATE The rate at which one currency is converted into another CRYPTOCURRENCIES Ditigal currencies that are independent of central authorities and use cryptography for their security The role of the foreign exchange market is to convert the currency of one country into that of another country. An exchange rate is the rate at which one currency is converted into another, or the price of a currency. The United Nations recognises 180 different currencies as legal tender, and as yet there is no single, globally accepted currency in the world economy, unlike the single, nationally accepted currency that is used in each domestic economy. Digital cryptocurrencies such as the bitcoin are also playing an increasingly important role as an alternative to hard global currencies, despite their unregulated ‘rogue’ reputation. (See Another Perspective: ‘The rise of cryptocurrencies’.) The foreign exchange market, therefore, is the mechanism that enables businesses and clients based in different countries to financially transact business trade with each other. The nature of the foreign exchange market The foreign exchange market is a global network of banks, brokers and foreign exchange dealers connected by electronic communications systems. When companies wish to convert currencies, they typically go through their own banks, rather than entering the market directly. The foreign exchange market has been growing at a rapid pace. Globally, between April 2004 and April 2016, foreign exchange turnover grew from ANOTHER PERSPECTIVE THE RISE OF CRYPTOCURRENCIES 164 PART 2 level. However, developing an integrated regulatory framework that has minimal impact on the existing payment, retail and banking sectors has proven complex and difficult. Leading banks from around the world, including the Lloyds Bank in the UK, the Bank of Scotland, JP Morgan and the Bank of America, have blocked their customers from purchasing © spaxiax/Shutterstock Will cryptocurrencies such as the bitcoin revolutionise the financial services industry? They are said to represent a faster, cheaper and more secure means of transacting online business processes all around the world, superseding the need to transact in foreign exchange markets. Owing to its decentralised peer-topeer exchange model, transacting in cryptocurrency circumvents central banking systems and authorities, enabling businesses to save on transaction fees and processing time delays. The genius of cryptocurrency lies in the underpinning encryption technology, which controls and verifies the issuing and transfer of funds, and negates the need for human auditing processes. This has raised many unique and challenging issues for traditional finance and accounting governance policy setters and financial regulators. Still in their infancy, in terms of mainstream institutional integration, many predict that transformative technologies such as the bitcoin may significantly drive the next wave of online small business proliferation at the global CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 164 08/07/19 04:03 PM cryptocurrencies owing to security concerns. Many countries around the world, as well as in Asia (Bangladesh, Cambodia, China, Indonesia, Nepal, Pakistan, Taiwan), have officially banned the use of bitcoin, and warn individuals of the risks associated with trading in unregulated cryptocurrencies. Risks include currency value volatility, technical security vulnerabilities (hacking), lack of institutional governance and its close association with money laundering and illegal black-market trading. Will country bans and bank blocking measures delay the mainstream global uptake of cryptocurrencies such as bitcoin? Or will their use continue to proliferate unfettered? Either way, the development of cryptocurrencies and their impact on the future of foreign exchange transactions is likely to be significant. US$1.9 trillion per day to US$5.1 trillion per day.1 In 2016, the most important trading centres were London (37 per cent of activity), New York (19 per cent), Singapore (8 per cent), Tokyo (6 per cent) and Hong Kong SAR (7 per cent).2 Major secondary trading centres include Zurich, Frankfurt, Paris and Sydney. The currencies that were traded the most (in descending order) were the US dollar (88 per cent), the euro (31 per cent), the Japanese yen (22 per cent), the pound sterling (13 per cent) and the Australian dollar (7 per cent). The Chinese renminbi was one of the highest performing emerging ARBITRAGE market currencies in 2016, as it almost doubled in turnover since 2013 to become the The purchase of securities in one eighth most traded currency, representing over 4 per cent of global trading. Obviously, market for immediate resale in the volume of foreign exchange trading far exceeds the needs of end users such as another market to profit from a price discrepancy importers, exporters and foreign direct investors. Most of the currency trading reflects interbank transactions and short-term international capital flows—for example, by hedge funds and superannuation funds diversifying their portfolios in foreign financial markets—and currency speculators. Three features of the foreign exchange market are of particular note. The first is that the market itself never sleeps, as the major trading centres are positioned around the world to accommodate the different time zones. The second feature of the market is the integration of the various trading centres around the world through highspeed computer linkages that have effectively created a single market. This integration implies there can be no significant difference in exchange rates quoted in the trading centres where a dealer could make a profit through arbitrage. Arbitrage is the buying of a currency Even though the British pound has declined in its importance as a that is priced low in a particular trading centre, vehicle currency, London still remains the key location for global and then immediately selling it in another for foreign exchange. CHAPTER 4 hiL23674_ch04_159-206.indd 165 FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 165 08/07/19 04:03 PM © Megan Hunter SOURCES: D. Chau, ‘Westpac, ANZ and NAB aren’t planning a bitcoin crackdown . . . yet’, ABC News online, 6 February 2018, accessed via www.abc.net. au/news/2018-02-05/big-four-banks-not-planning-bitcoin-clampdown-yet/9398234 on 4 December 2018; ‘Is bitcoin speculative foolery or a financial services breakthrough?’, Entrepreneur, accessed via https://au.finance.yahoo.com/news/bitcoin-speculative-foolery-financial-services-130000684.html on 7 December 2018; S. Cioroiu, ‘Update on bitcoin developments’, Diplo, 28 October 2014, accessed via www.diplomacy.edu/blog/update-bitcoindevelopments on 7 December 2018. ALGORITHMIC TRADING (AT) The application of computational algorithms to assist with the monitoring, identification and management of financial market transactions VEHICLE CURRENCY A national currency that is widely used in international transactions and is used as an intermediary unit to convert one currency to another a higher price, resulting in a profit yield from the transaction. If all dealers tried to cash in on the opportunity, however, the demand for the under-priced currency would quickly rise, resulting in an appreciation of its value and the disappearance of the price differential. Because foreign exchange dealers are always watching their computer screens for arbitrage opportunities, the few that arise tend to be small, and they disappear in minutes. Profiting from arbitrage speculation is increasing for dealers leveraging Algorithmic Trading (AT), however, which is the use of user-defined computerised algorithms to help monitor, identify and manage arbitrage opportunities occurring in high-frequency trading executions. AT has enabled dealers to capture advantage within milliseconds.3 The third feature of the foreign exchange market is the important role played by the US dollar. Although a foreign exchange transaction can involve any two currencies, most transactions involve US dollars on one side. This is true even when a dealer wants to sell a non-dollar currency and buy another. A dealer wishing to sell Korean won (KRW) for Brazilian real (BRL), for example, will usually sell the won for US dollars and then use the US dollars to buy real. Although this may seem a roundabout way of doing things, it is actually cheaper than trying to find a holder of real who wants to buy won. Because the volume of international transactions involving US dollars is so great, it is not hard to find dealers who wish to trade US dollars for won or real. Due to its central role in so many foreign exchange deals, the US dollar is a vehicle currency. The most traded currencies are also described as reserve currencies, hard currencies or key currencies in different contexts, which are often used to calculate cross rates (which are explained later in this chapter). The functions of the foreign exchange market FOREIGN EXCHANGE RISK The risk that changes in exchange rates will hurt the profitability of a business deal We will now look in more detail at the two main functions of the foreign exchange market: to ‘convert’ the currency of one country into the currency of another; and to provide some ‘hedge’ or insurance against foreign exchange risk.4 © RomanR/Shutterstock Currency conversion A distinguishing feature of international business is the need to transact in different currencies. 166 PART 2 Each country has a currency in which the prices of goods and services are quoted and transactions are financed. In Australia it is the dollar ($); in Great Britain, the pound sterling (£); in France and Germany it is the euro (€); in Japan, the yen (¥); and so on. In general, within the borders of a particular country, one must be able to access and use the national currency. For example, an Indonesian tourist visiting Australia wishing to purchase a souvenir must pay for the goods using Australian dollars. To access this currency, the tourist can use an ATM to withdraw Australian dollars using a credit/debit/travel money card (the participating bank automatically debits the home country account in Indonesian rupiah (IDR) using the spot exchange rate and adds an additional fee). Alternatively the tourist can go to a bank or foreign CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 166 08/07/19 04:03 PM exchange agency and exchange rupiah for dollars. Regardless of the method, when one currency is exchanged for another, the tourist is participating in the foreign exchange market. Businesses engaged in international trade and investment are by necessity major participants in the foreign exchange market, which has four main purposes. First, payments received for exports, income received from foreign investments, or income received, for example, from licensing agreements with foreign companies, may be in foreign currencies. To use those funds in its home country, the business must convert them to its home country’s currency. Second, foreign exchange markets are used to convert currencies when international businesses must pay a foreign entity for its products or services in the foreign country’s currency. Third, international business uses foreign exchange markets to convert to the host country’s currency when they undertake foreign direct investment. They use it also for portfolio investment when they have spare cash that they wish to invest for short terms in money markets. Consider an Australian company that has A$10 million it wants to invest for three months. The best interest rate it can earn on these funds in Australia may be 6 per cent. Investing in a South Korean money market account, however, may earn 12 per cent. Thus, the company may change its A$10 million into Korean won (KRW) and invest it in South Korea. Note, however, that the rate of return it earns on this investment depends not only on the Korean interest rate, but also on the expected changes in the value of the Korean won against the dollar in the intervening period. The kind of transaction described immediately above relates to a common form of speculation known as carry trade. Carry trade involves borrowing in one currency where the interest rates are low and then using the proceeds to invest in another currency where the interest rates are high. The speculative element of this trade is that its success is based upon the belief that there will be no adverse movements in exchange rates (or interest rates, for that matter) that will make the trade unprofitable. A relationship between interest rates and exchange rates is discussed in the next section. Currency speculation is the fourth use made of the foreign exchange market to convert one currency into another. Currency speculation typically involves the short-term movement of funds from one currency to another in the hope of profiting from changes in exchange rates. Consider again our Australian company with A$10 million to invest for three months. Suppose the company suspects that the Australian dollar is overvalued against the Japanese yen. That is, the company expects the value of the dollar to depreciate (fall) against that of the yen. Imagine the current dollar/yen exchange rate is A$1 = ¥120. The company exchanges its AU$10 million into yen, receiving ¥1.2 billion (AU$10 million × 120 = ¥1.2 billion). Over the next three months, the value of the dollar depreciates against the yen until A$1 = ¥100. (There is no guarantee that this depreciation would occur.) Now the company exchanges its ¥1.2 billion back into dollars and finds that it has A$12 million. The company has made A$2 million profit on currency speculation in three months on an initial investment of A$10 million (if its expectations about the exchange rates are realised). In general, however, speculation by definition is a very risky business. The company cannot know for sure what will happen to exchange rates. Although a speculator may profit handsomely if their speculation about future currency movements turns out to be correct, they can also lose vast amounts of money if it turns out to be wrong. Currency speculation is something for the foreign exchange specialist rather than the managers of firms, who need to be focusing more on the strategic and operational issues of conducting the business. CHAPTER 4 hiL23674_ch04_159-206.indd 167 CARRY TRADE Involves borrowing in one currency where the interest rates are low and then using the proceeds to invest in another currency where the interest rates are high CURRENCY SPECULATION Involves moving funds from one currency to another over the short term in the hope of profiting from changes in exchange rates FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 167 08/07/19 04:03 PM ANOTHER PERSPECTIVE GROWING PAINS WITH THE EURO It seems like experts and interested observers are always debating the merits of the euro and its likelihood of survival. Introduced in 1999 as the common currency to be used across all eurozone economies, the intention behind its original launch was to bring united trading power and increased prosperity to all. These ambitions have not been realised, however, where growth in the eurozone economy has slowed in comparison with other economies. For example, the US economy grew 13 per cent to 26 per cent larger than the eurozone economy between 2000 and 2016. The real GDP levels of the eurozone economy remained the same between 2001 and 2016. Many countries have been frustrated with the inability to control their own interest and exchange rate mechanisms, and having to answer to Germany’s heavy-handed role played in controlling the euro policy agenda. This has resulted in fierce bickering between countries unable to agree on how best to restructure and introduce institutions to ensure confidence in Europe’s future. It is difficult to compare the challenges within the EU with those of other nations that have faced similar problems and survived. But until the growing pains associated with the euro currency are resolved, it is difficult to predict its future. SOURCE: Adapted from J. Stiglitz, ‘The euro could be nearing a crisis: can it be saved?’, The Guardian, 13 June 2018, accessed via www.theguardian. com/business/2018/jun/13/euro-growth-eurozone-joseph-stiglitz. Hedging HEDGING The process of insuring one’s business against foreign exchange risk by using instruments such as forward exchanges and foreign exchange swaps SPOT EXCHANGE RATE The rate at which a foreign exchange dealer converts currency on any particular day 168 PART 2 The second function of the foreign exchange market is to provide insurance against foreign exchange risk, which is the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm. When a company insures itself against foreign exchange risk, we say that it is engaging in hedging. To explain how the market performs this function, we need to examine the following foreign exchange rates and transactions: • spot exchange rates • forward exchange rates • foreign exchange swaps. When two parties agree to exchange currency and execute the deal immediately (usually within two days), the transaction is referred to as a spot exchange. Exchange rates governing such ‘on the spot’ trades are referred to as spot exchange rates. The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day. Thus, when our Indonesian tourist withdraws foreign currency using a credit/debit/travel money card through an ATM, or goes to a bank to convert rupiah into Australian dollars, in order to buy souvenirs, the exchange rate used will be the spot rate for that day. Spot exchange rates are reported on a real-time basis on many financial websites. Table 4.1 shows the interbank exchange rates (these differ slightly from customer exchange rates) for a selection of currencies traded in the foreign exchange market as of 2:27 pm Sydney time on 4 December 2018. An exchange rate can be quoted in two ways—for example, as the CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 168 08/07/19 04:03 PM MAJOR RATES AUD/USD USD/CAD USD/CHF USD/DKK EUR/USD GBP/USD USD/HKD USD/JPY USD/NOK NZD/USD USD/SEK USD/SGD USD/ZAR BID ASK CROSS RATES BID ASK 0.7362 1.3185 0.9966 6.5633 1.1368 1.2737 7.8085 113.3040 8.5112 0.6957 9.00112 1.3653 13.6736 0.7363 1.3186 0.9970 6.5640 1.1371 1.2740 7.8090 113.3110 8.5172 0.6959 9.0039 1.3654 13.7036 AUD/AUD AUD/CAD AUD/CHF AUD/DKK AUD/EUR AUD/GBP AUD/HKD AUD/JPY AUD/NOK AUD/NZD AUD/SEK AUD/SGD AUD/ZAR 1.0000 0.9707 0.7337 4.8319 0.6474 0.5779 5.7487 83.4160 6.2661 1.0579 6.6268 1.0052 10.0667 1.0000 0.9708 0.7341 4.8327 0.6477 0.5780 5.7495 83.4273 6.2709 1.0583 6.6293 1.0053 10.0895 TABLE 4.1 Spot exchange rates, 2.27 pm, Sydney, 4 December 2018 NOTE: Bid (buy) is the rate at which a foreign exchange trader is willing to buy the currency. Ask (offer) is the rate at which the trader is willing to sell the currency. SOURCE: Travelex Exchange Rates, accessed via http://internationalpayments.travelex.com.au/exchange-rate, on 4 December 2018. amount of foreign currency A$1 will buy, or as the cost of Australian dollars to buy one unit of foreign currency. Thus, A$1 bought US$0.70 on 4 December 2018, or it cost A$1.43 to purchase US$1 (ignoring the difference between the bid (buy) and ask (sell) rates for the purpose of this exercise). Spot rates change continually, often on a minute-by-minute basis, although the magnitude of change over such short periods is usually small. The cross rate between two currencies is determined by reference to their respective rates quoted in a common third vehicle currency such as the US dollar. For example, the volume of direct exchange between the Australian dollar and the Norwegian krone is small relative to their exchange individually with the US dollar or euro. Consequently, an exchange rate (the cross rate) between the Australian dollar and the Norwegian krone (AUD/NOK in Table 4.1) can be calculated by reference to their individual values in US dollars or euros. When there is a time lag involved in the receipt of a payment, as is the norm with credit transactions, changes in spot exchange rates can be problematic for an international business. For example, a New Zealand company imports laptop computers from Japan. The company agrees to pay the Japanese supplier ¥100 000 in Japanese yen (JPY) for each laptop computer in 30 days’ time when the shipment arrives. Suppose when the purchase agreement is reached, the current New Zealand dollar/Japanese yen spot exchange rate is NZ$1 = JP¥79. At this rate, each computer costs the importer NZ$1265 (rounded), that is, 1265.82 = 100 000/79. The importer knows they can sell the computers the day they arrive for NZ$1500 each, which yields a gross profit of NZ$235 (rounded) on each computer ($1500 − $1265). However, the importer will not have the funds to pay the Japanese supplier until the computers have been sold. If over the next 30 days the dollar unexpectedly depreciates against the yen, say, to NZ$1 = JP¥65, the importer will still have to pay the Japanese company JP¥100 000 per computer, but in dollar terms that would be equivalent to NZ$1538 per computer (rounded), which is more than they can sell the computers for. A depreciation in the value of the dollar against the yen from NZ$1 = JP¥79 to NZ$1 = JP¥65 would transform a profitable deal into an unprofitable one. To insure or hedge against this risk, the New Zealand importer might want to engage in a forward exchange. A forward exchange occurs when two parties (usually a trader and their bank) agree to exchange currency at an exchange rate agreed upon today, but to delay the CHAPTER 4 hiL23674_ch04_159-206.indd 169 CROSS RATE The exchange rate between two currencies calculated by reference to their respective rates quoted in a common third currency FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 169 08/07/19 04:03 PM FORWARD EXCHANGE RATE The exchange rate calculated today based on future expectations for exchanging currency at some date in the future OUTRIGHT FORWARD When two parties agree today to exchange currency at an agreed rate at some specific date in the future. Sometimes called ‘foreign exchange forward’ FOREIGN EXCHANGE (FX) SWAP An agreement to exchange currencies on a specified date coupled with a reversal of the exchange at a later date at agreed rates 170 PART 2 settlement of the payment until some specific date in the future. The exchange rate agreed upon by the two parties determines the currency value of the future transaction, and is referred to as the forward exchange rate. For most major currencies, forward exchange rates are quoted for 30 days, 90 days and 180 days into the future. In some cases, it is possible to get forward exchange rates for several years into the future. Returning to our computer importer example, let us assume that the 30-day forward exchange rate for converting dollars into yen is NZ$1 = JP¥75. At the time, the importer signs the purchase contract with the Japanese supplier, the importer also enters into a 30-day forward exchange transaction with a foreign exchange dealer (usually their bank) to deliver yen at this 30-day rate. The importer is guaranteed that they will have to pay no more than NZ$1333 (rounded) for each computer ($1333 = $100 000/75). This guarantees the importer a profit of NZ$167 per computer ($1500 − $1333). They insure or hedge themselves against the possibility that an unanticipated change in the dollar/yen exchange rate will turn a profitable deal into an unprofitable one. In this example, the spot exchange rate (NZ$1 = ¥79) and the 30-day forward rate (NZ$1 = ¥75) differ. Such differences are normal, as they reflect the expectations of the foreign exchange market about future currency movements. In our example, the fact that NZ$1 bought more yen with a spot exchange than with a 30-day forward exchange indicates foreign exchange dealers expected the dollar to depreciate against the yen in the next 30 days. When this occurs, the dollar is selling at a discount on the 30-day forward market (i.e. it is worth less than it is on the spot market). Of course, the opposite can also occur. If the 30-day forward exchange rate was NZ$1 = ¥85, for example, NZ$1 would buy more yen with a forward exchange than with a spot exchange. In such a case, the dollar is selling at a premium on the 30-day forward market. This reflects the foreign exchange dealers’ expectations that the dollar will appreciate against the yen over the next 30 days. Not all companies hedge their foreign exchange risk using forward exchange contracts, nor do they hedge each foreign exchange transaction.5 However, both small and large traders—exporters and importers—typically hedge against currency losses when the home currency is high (as was the case in Australia in 2013). Very large and diverse companies, such as commodity producer BHP, may only hedge a small proportion of their revenue using financial instruments, as operating in many different countries and commodity markets provides a natural offset or a ‘natural’ hedge. (We will examine natural hedges in more detail in the last section of this chapter.) Across the entire portfolio, losses and gains from unexpected changes in the prices of currencies and commodities may offset each other in part or in full. However, BHP may use forward exchange to hedge just its net foreign exchange risks, which is not an appropriate strategy for smaller companies with little or no currency and product diversification. The option to enter a forward exchange contract is very important to companies engaged in international business; however, they make up a relatively small proportion of an increasing global turnover in foreign exchange instruments. The turnovers of spot exchange and what is described as a foreign exchange (FX) swap (another form of a hedge) are proportionally much larger (with the latter being the most popular hedging instruments among financial institutions). Unlike the foreign exchange forward (also referred to as an outright forward), a foreign exchange swap involves a pair of offsetting transactions. It contains forward exchange elements but involves two transaction elements, rather than just one. A foreign exchange (FX) swap is the exchange of two currencies on a specified date coupled with a reversal of the exchange of the two currencies at a later date at rates agreed at the time of the contract. For example, the pair of offsetting transactions may include a spot/forward pairing or a forward/forward pairing. Other instruments include more exotic forms of hedging including currency swaps, options and futures. CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 170 08/07/19 04:03 PM Swaps are transacted between international borrowers and lenders, between banks and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange risk. A common kind of swap is spot against forward. Consider an Australian company that takes out a foreign currency loan to fund its domestic operations. At the same time that the company, through its bank, converts the borrowed foreign funds to Australian dollars on the spot market, with the agreement of the bank, it buys forward the foreign currency needed to repay the foreign currency loan when the loan is due. No uncertainty with respect to exchange rate changes now exists. Hedging is not without costs. Presumably in the case of a foreign currency loan, over the period of the loan, it has been put to profitable use. One cost of hedging comprises the direct fees paid to the financial intermediaries to set up and transact the hedges. Another cost is any collateral requirement that the bank may demand in setting up the hedge. A third cost is the opportunity cost of forgone profit. Hedging denies the company the opportunity to profit from a favourable change in the exchange rate, as was the case with the industrial manufacturer Embraer from Brazil (see Management Focus: ‘Embraer and the gyrations of the Brazilian real’). In a sense, these costs could be regarded as the premium for foreign exchange risk insurance. MANAGEMENT FOCUS EMBRAER AND THE GYRATIONS OF THE BRAZILIAN REAL For many years, Brazil was a country battered by persistently high inflation. As a result, the value of its currency, the real, depreciated steadily against the US dollar. This changed in the early 2000s, when the Brazilian government was successful in bringing down annual inflation rates into the single digits. Lower inflation, coupled with policies that paved the way for the expansion of the Brazilian economy, resulted in a steady appreciation of the real against the US dollar. In May 2004, 1 real bought US$0.3121; by August 2008, 1 real bought US$0.65, an appreciation of more than 100 per cent. The appreciation of the real against the dollar was a mixed bag for Embraer, the world’s largest manufacturer of regional jets of up to 110 seats and one of Brazil’s most prominent industrial companies. Embraer purchases many of the parts that go into its jets, including the engines and electronics, from US manufacturers. As the real appreciated against the dollar, these parts cost less when translated into reals, which benefited Embraer’s profit margins. However, the company also prices its aircraft in US dollars, as do all manufacturers in the global market for commercial CHAPTER 4 hiL23674_ch04_159-206.indd 171 jet aircraft. So, as the real appreciated against the dollar, Embraer’s dollar revenue was compressed when exchanged back into reals. To try to deal with the impact of currency appreciation on its revenue, in the mid-2000s, Embraer started to hedge against future appreciation of the real by buying forward contracts (forward contracts give the holder the right to exchange one currency—in this case, dollars—for another—in this case, reals—at some point in the future at a predetermined exchange rate). If the real had continued to appreciate, this would have been a great strategy for Embraer because the company could have locked in the rate at which sales made in dollars were exchanged back into reals. Unfortunately for Embraer, as the GFC unfolded in 2008, investors fled to the dollar, which they viewed as a safe haven, and the real depreciated against the dollar. Between August 2008 and November 2008, the value of the real fell by almost 40 per cent against the dollar. But for the hedging, this depreciation would have actually increased Embraer’s revenue in reals. Embraer, however, had locked itself into a much higher real/ dollar exchange rate, and the company was forced to FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 171 08/07/19 04:03 PM take a $121 million loss on what was essentially a bad currency bet. Since the shock of 2008, Embraer has cut back on currency hedging, and most of its dollar sales and purchases are not hedged. This makes Embraer’s sales revenue very sensitive to the real/dollar exchange rate. By 2010, the Brazilian real was once more appreciating against the US dollar, which pressured Embraer’s revenue. By 2012, however, the Brazilian economy was stagnating, while inflation was starting to increase again. This led to a sustained fall in the value of the real, which fell from 1 real = US$0.644 in July 2011 to 1 real = US$0.32 by February 2017, a depreciation of 50 per cent. What was bad for the Brazilian currency, however, was good for Embraer, whose share price surged to the highest price since February 2008 on speculation that the decline on the real would lead to a boost in Embraer’s revenue when expressed in reals. SOURCES: D. Godoy, ‘Embraer rallies as Brazilian currency weakens’, Bloomberg, 31 May 2013; K. Kroll, ‘Embraer fourth quarter profits plunge 44% on currency woes’, Cleveland.com, 27 March 2009; ‘A fall from grace: Brazil’s mediocre economy’, The Economist, 8 June 2013; ‘Brazil’s economy: the deterioration, The Economist, 7 December 2013. DETERMINATION OF THE EXCHANGE RATE LO 4.2 If we can understand how exchange rates are determined, we may be able to forecast exchange rate movements. Because future exchange rate movements influence export and import opportunities, financing decisions, the profitability of investment and the price competitiveness of foreign-traded products, this is valuable information for an international business. Unfortunately, there is no simple explanation. The forces that determine exchange rates are complex, and no theoretical consensus exists, even among academic economists who study the phenomenon every day. Consequently, it is beyond the scope of this book to delve too deeply into these theoretical explanations. The most general explanation is that exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another. However, while differences in relative demand and supply explain the determination of exchange rates, this explanation does not tell us what factors underlie the decisions to buy and sell a currency. The state of a country’s economy with respect to its money supply, interest rates, trade balances and production levels may be expected to influence the decision to buy and sell its currency. Such fundamental economic factors, however, do not seem to affect exchange rates, at least in the short run.6 Indeed, one reviewer concluded that economists have found that the best forecast of the exchange rate in the short run is whatever it happens to be today.7 Despite disagreement on the single best explanation, economists seem to agree that three factors have an important impact on the longer-run, future exchange rate movements: price inflation, interest rates and market psychology.8 Prices and exchange rates LAW OF ONE PRICE The principle that in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in the same currency 172 PART 2 To understand how prices are related to exchange rate movements, we first need to discuss an economic proposition known as the law of one price. We will then discuss the theory of purchasing power parity (PPP), which links changes in the exchange rate between two countries’ currencies to changes in the countries’ price levels. The law of one price The law of one price states that in competitive markets free of transportation costs and barriers to trade (such as tariffs), identical products sold in different countries must sell for CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 172 08/07/19 04:03 PM the same price when their price is expressed in terms of the same currency. For example, if the exchange rate between the British pound and the Australian dollar is £1 = A$1.50, a jacket that retails for A$75 in Sydney should sell for £50 in London (since A$75/1.50 = 50). Consider what would happen if the jacket cost £40 in London (A$60). At this price, it would pay a trader to buy jackets in London and sell them in Sydney, an example of arbitrage, with an initial profit of A$15 on each. However, the process of arbitrage increases the demand for jackets in London, which would raise their price in London, and would increase the supply of jackets in Sydney, which would lower their price there, other things remaining unchanged including the exchange rate staying at £1 = A$1.50. The process would continue until the prices were equalised and arbitrage is no longer profitable. The prices might equalise at £45 (A$67.50) in London and A$67.50 in Sydney. Purchasing power parity (PPP) If the law of one price were true for all goods and services, an exchange rate based on purchasing power could be found from any individual set of prices. By comparing the prices of identical products in different currencies, it would be possible to determine the ‘real’ or purchasing power parity (PPP) exchange rate, assuming markets are free of any impediments. Thus, if a basket of goods costs A$200 in Australia and the identical basket cost ¥20 000 in Japan, PPP theory predicts that the dollar/yen exchange rate should be A$200/¥20 000, or A$0.01 per Japanese yen (i.e. A$1 = ¥100). The magazine The Economist regularly publishes its own version of the PPP theorem, which it refers to as the ‘Big Mac index’ or ‘burgernomics’. The Economist has selected McDonald’s Big Mac as a proxy for a basket of goods because it is produced according to more or less the same recipe in nearly 120 countries. The Big Mac PPP is the exchange rate that would have hamburgers costing the same in each country. According to The Economist, comparing a country’s actual exchange rate with the one predicted by the PPP theorem based on the relative prices of Big Macs is a test on whether or not a currency is undervalued. This is not a totally serious exercise, as The Economist admits, but it does provide us with a useful illustration of the PPP theorem. A sample of developed and emerging economies selected from the Big Mac index for July 2018 is shown in Table 4.2. To calculate the index, The Economist converts the price of a Big Mac in a country into US dollars, the main vehicle currency, at current exchange rates and divides that by the average price of a Big Mac in the United States. According to the PPP theorem, the prices should be the same. If they are not, it implies that the currency is either overvalued against the US dollar or undervalued. The PPP theory argues that the exchange rate will change if relative prices change. The PPP view of exchange rate determination is that exchange rate movements tend to offset changes in relative prices (e.g. due to differences in national inflation rates) so that the ‘real’ exchange rate remains the same (‘real’ reflects purchasing power.) For example, imagine there is no price inflation in Australia, while prices in Japan are increasing by 10 per cent a year. At the beginning of the year, a basket of goods costs A$200 in Australia and ¥20 000 in Japan, so the dollar/ yen exchange rate, according to PPP theory, should be A$1 = ¥100. At the end of the year, the basket of goods still costs A$200 in Australia, but it costs ¥22 000 in Japan. PPP theory predicts that the exchange rate should change as a result. The new exchange rate will be ¥1 = $0.0091 (E$/¥ = A$200/¥22 000 or A$1 = ¥110). Because of 10 per cent price inflation, the Japanese yen has depreciated by 10 per cent against the Australian dollar. One dollar will buy 10 per cent more yen at the end of the year than at the beginning. In essence, PPP theory predicts that a country in which price inflation is running high should expect to see its currency depreciate against that of countries in which inflation rates are lower. This is intuitively appealing, but is it true in practice? Extensive empirical testing of PPP theory has yielded mixed results.9 Although PPP theory seems CHAPTER 4 hiL23674_ch04_159-206.indd 173 PURCHASING POWER PARITY (PPP) An adjustment in gross national income per capita to reflect differences in the cost of living FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 173 08/07/19 04:03 PM TABLE 4.2 The Big Mac index, selected countries, July 2018 COUNTRY United States Australia Brazil United Kingdom Chile China Euro India Indonesia Japan Mexico Poland Russia South Africa South Korea Switzerland IN LOCAL CURRENCY (ROUNDED) 6 6 17 3 2640 21 4 173 31500 390 49 10 130 31 4500 6.50 IN US$ IMPLIED PPP FX RATE (PX/P$) 5.51 5.51 5.51 5.51 5.51 5.51 5.51 5.51 5.51 5.51 5.51 5.51 5.51 5.51 5.51 5.51 1 1.10 3.07 0.58 479.13 3.72 0.73 31.40 5716.88 70.78 10.23 1.83 23.59 5.63 816.7 1.18 ACTUAL FX RATE 1 1.34 3.84 0.75 651.73 6.62 0.85 68.83 14360 111.25 15.74 3.69 62.14 13.36 1116.0 0.99 UNDER(–)/OVER(+) VALUED, % 0 −18 −20 −23 −27 −44 −14 −54 −60 −36 −53 −50 −62 −58 −27 +19 SOURCE: Original data extracted from Big Mac Index, December 2018, The Economist, accessed via https://www. economist.com/news/2018/07/11/the-big-mac-index on 4 December 2018. © Ingram Publishing/SuperStock to yield relatively accurate predictions in the long run, it does not appear to be a strong predictor of short-run movements in exchange rates covering time spans of five years or less.10 Several factors may explain these results.11 These factors include the price differentials created by transport costs, barriers to trade and the market power of multinational corporations to set prices, control distribution channels and differentiate product offerings between nations.12 Other factors include government intervention in foreign exchange markets to influence the value of their currencies, and the impact of investor psychology, which is discussed later in this chapter. Interest rates and exchange rates FISHER EFFECT The theory that nominal interest rates (i) in each country equal the required real rate of interest (r) and expected rate of inflation (I) over the time period for which the funds are to be lent. That is, i = r + I 174 PART 2 Interest rate differentials and inflation expectations are considered to influence exchange rates. In countries where inflation is expected to be high, interest rates will also be high because investors want compensation for the decline in the value of their money over time. This relationship between inflation and the interest rate, formalised by the economist Irving Fisher in 1930, is referred to as the Fisher Effect (or the Domestic Fisher Effect, to distinguish it from the International Fisher Effect). The Fisher Effect states that a country’s nominal interest rate (i) is the sum of the required real rate of interest (r) and the expected rate of inflation (I) over the period for which the funds are to be lent. The real interest rate is what an investor or lender expects to yield from their investment after accounting for any change in the purchasing power of their money due to inflation. More formally, i = r + I. For example, if the real rate of interest in a country is 5 per cent and annual inflation is expected to be 10 per cent, the nominal interest rate will be 15 per cent. As predicted by CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 174 08/07/19 04:03 PM To test the Big Mac index, which applies the purchasing power parity (PPP) theory using the price of a Big Mac in various markets to determine the equilibrium value of the foreign currency, The Economist established a Starbucks index in 2004. Like the Big Mac, a cup of Starbucks coffee can be found in many foreign markets and can be seen as a proxy for a basket of goods. The results of the Starbucks index followed the Big Mac index in most markets, except in Asia, where the former indicated that the dollar was at parity with the Chinese yuan. The Big Mac index suggested that the yuan was heavily undervalued. Neither of these consumer items is a good proxy for a basket of goods, but comparing their relative prices with exchange rates is an interesting and playful approach to quickly grasping how under or overvalued the foreign currency is against the dollar. This obviously does not take into account whether you think a McDonald’s Big Mac or a Starbucks cup of coffee is overpriced © M. Unal Ozmen/Shutterstock ANOTHER PERSPECTIVE WHAT ABOUT THE STARBUCKS INDEX: A GOOD IDEA? or relatively cheap where you live! What would be a good Australian product, if sold worldwide, that could replace the Big Mac and Starbucks indices? the Fisher Effect, a strong relationship seems to exist between inflation rates and interest rates.13 When investors are free to transfer capital between countries, real interest rates should be the same in every country. If differences in real interest rates emerge between countries, arbitrage would soon equalise them. It follows from the Fisher Effect that if the real interest rate is the same worldwide, any difference in interest rates between countries reflects differing expectations about inflation rates. Thus, if the expected rate of inflation in Australia is greater than that in Japan, Australian nominal interest rates will be greater than Japanese nominal interest rates. Since we know from PPP theory that there is a link (in theory, at least) between inflation and exchange rates, and since interest rates reflect expectations about inflation, it follows that there must also be a link between interest rates and exchange rates. The country with the higher market (or nominal) interest rate has the higher inflation rate and, therefore, the currency of that country should fall in value relative to other currencies. This link is known as the International Fisher Effect. The International Fisher Effect states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries. If the Australian nominal interest rate is higher than Japan’s, reflecting greater expected inflation rates, the value of the Australian dollar against the yen should fall by that interest rate differential in the future. So, if the nominal interest rate in Australia is 10 per cent and CHAPTER 4 hiL23674_ch04_159-206.indd 175 INTERNATIONAL FISHER EFFECT The theory that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between countries FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 175 08/07/19 04:03 PM in Japan it is 6 per cent, we would expect the value of the Australian dollar to depreciate by 4 per cent against the Japanese yen. In other words, this theory predicts that an interest rate differential in favour of Australia’s financial assets will be matched by an expected depreciation of the Australian dollar. Nominal interest rate differentials may be used to predict exchange rate movements. Do interest rate differentials help predict future currency movements? The evidence is mixed. In the long run, there seems to be a relationship between interest rate differentials and subsequent changes in spot exchange rates, but like PPP the International Fisher Effect is not a good predictor of short-run changes in spot exchange rates.14 The International Fisher Effect does remind us, however, that an investment in a foreign asset requires more than just a comparison of interest rate returns. One needs also to assess the expected changes in the exchange rate. The return on an investment depends on both the interest rate differential and the appreciation or depreciation of the exchange rate. The International Fisher Effect says that the interest rate return on the foreign investment will be offset by an exchange rate change. Investor psychology and the bandwagon effect BANDWAGON EFFECT When traders move like a herd, all in the same direction and at the same time, in response to each other’s perceived actions 176 PART 2 Various psychological factors play an important role in determining the expectations of market traders as to likely future exchange rates.15 In turn, expectations have a tendency to become self-fulfilling prophecies as traders ‘jump on the bandwagon’. For example, if more and more traders begin to sell a currency and buy another in expectation of a decline in the value of that currency, then that currency will most likely decline in value if enough traders jump on the bandwagon. With traders moving as a herd in the same direction at the same time—the bandwagon effect—the massive selling will force down the value and traders’ expectations are realised. The decline in value occurs not so much because of any major shifts in economic fundamentals, but because traders have followed the actions of others. According to a number of studies, investor psychology and bandwagon effects play a major role in determining short-run movements of exchange rates.16 These factors may explain why the PPP theory and the International Fisher Effect are not particularly good at explaining short-term movements in exchange rates. Investor psychology can be influenced by political factors, many of which are only loosely linked to economic fundamentals such as relative inflation rates. Also, idiosyncratic behaviour by politicians can both trigger and exacerbate bandwagon effects. Bandwagon effects and speculative attacks, together with ill-conceived policy decisions played major roles in the collapse of the Asian currencies during the financial crisis that erupted across South-East Asia in 1997.17 More recent political events that have increased the volatility of global currency market speculation include the Brexit referendum in the United Kingdom in 2016, where the country’s decision to split from the EU created an exogenous shock in the market that sharply impacted the value of the GBP. The election of US President Trump shortly after the Brexit announcement, a leader who heralded a new, independent and corporate style of leadership that prioritised domestic fiscal stimulus, resulted in the immediate strengthening of the US dollar. This was significant given the importance of the US dollar as a reserve currency in the global economy, and the correlating negative impact on the currencies of major trading partners. CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 176 08/07/19 04:03 PM THE INTERNATIONAL MONETARY SYSTEM It has been assumed to this point that the foreign exchange market was the primary institution for determining exchange rates. Furthermore, it was explained that the decision to buy or sell currencies in the foreign exchange market may be influenced by factors such as relative inflation rates and interest rates. Exchange rates, however, are often manipulated by governments to achieve certain policy goals. When a country allows the foreign exchange market to be free of any government intervention to determine the relative value of a currency, we say that the country is adhering to a freely floating exchange rate system. The world’s four major trading currencies—the US dollar, the EU euro, the Japanese yen and the British pound—are all free to float against each other. Australia and New Zealand also allow their exchange rates to float. In countries where the exchange rates are not determined by the free play of market forces, other systems or regimes are adopted to govern the exchange rate, such as the ‘daily fixed’ control of the Chinese renminbi by government authorities. (See Emerging Markets: ‘China’s exchange rate regime’.) These different regimes form part of the international monetary system in which foreign business operates. Before examining the nature and functions of the international monetary system, it is useful to understand the different exchange rate regimes. LO 4.1 FLOATING EXCHANGE RATE A system under which the exchange rate is determined and adjusted by the market forces of supply and demand INTERNATIONAL MONETARY SYSTEM The institutional arrangements countries adopt that govern exchange rates EMERGING MARKETS CHINA’S EXCHANGE RATE REGIME For years, there have been claims from politicians in the United States that the Chinese actively manipulate their currency, the yuan, keeping its value low against the US dollar and other major currencies in order to boost Chinese exports. In November 2015, for example, presidential hopeful Donald Trump claimed that ‘the wanton manipulation of China’s currency’ was ‘robbing Americans of billions of dollars in capital and millions of jobs’. But was this claim true? Would it even be possible for China to manipulate the foreign exchange markets to artificially depress the value of its currency? To answer these questions, one needs to look at the history of exchange rate determination for China and understand something about how the international monetary system actually works. For most of its history, the Chinese yuan was pegged to the US dollar at a fixed exchange rate. When China started to open up its economy to foreign trade and investment in the 1980s, the yuan was devalued by the Chinese government in order to improve the competitiveness of Chinese exports. Thus, the official yuan/USD pegged exchange rate was increased from CHAPTER 4 hiL23674_ch04_159-206.indd 177 1.50 yuan per US dollar in 1980 to 8.62 yuan per US dollar in 1994. With China’s exports growing and the country running a growing current account trade surplus, pressure began to increase for China to let its currency appreciate. In response, between 1997 and 2005, the exchange rate was fixed at 8.27 yuan per US dollar, which represented a small appreciation. One could argue that during this period, China’s currency was indeed undervalued and that this was the result of government policy. By the 2000s, China’s growing importance in the global economy and the rise of its export-led economy led to calls for the country to re-evaluate its fixed exchange rate policy. In response, in July 2005, the country adopted a managed floating exchange rate system. Under this system, the exchange rate for the yuan was set with reference to a basket of foreign currencies that included the US dollar, the euro, the Japanese yen, and the British pound. The daily exchange rate was allowed to float within a narrow band of 0.3 per cent around the central parity. The daily band was extended to 0.5 per cent in 2007, 1 per cent in 2012 and 2 per cent in 2014. FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 177 08/07/19 04:03 PM Over time, this managed-float system allowed for the appreciation of the Chinese yuan. For example, the exchange rate changed from 8.27 yuan per US dollar in mid-2005 to 6.0875 yuan per US dollar on 20 July 2015, representing an appreciation of 26 per cent. More generally, the effective exchange rate index of the yuan against a basket of more than 60 other currencies increased from 86.3 in July 2005 to 123.8 by early 2016, representing an appreciation of 43 per cent. The yuan appreciated by less than this against the US dollar primarily because the US dollar has also been relatively strong and appreciated against many other currencies over the same time period. These data suggest that rather than artificially trying to keep their currency undervalued, since July 2005 the Chinese have allowed the yuan to increase in value against other currencies, albeit within the constraints imposed by the managed float. In late 2015 this commitment was put to the test when a slowdown in the rate of growth of the Chinese economy led to an outflow of capital from China, which put downward pressure on the yuan. China responded by trying to maintain the value of the yuan, using its foreign exchange reserves, which are primarily held in US dollars, to buy yuan on the open market and shore up its value. Reports suggest that China spent $500 billion in 2015 to shore up the value of the yuan and more than $1 trillion in 2016. These actions reduced China’s foreign exchange reserves to $3.011 trillion by January 2017, the lowest level since 2012. China appears to be trying to keep the yuan from depreciating below 7 yuan to the US dollar. One reason for China trying to protect the value of the yuan against the US dollar: a large number of Chinese companies have US dollar-denominated debt. If the yuan falls against the US dollar, the price of serving that debt goes up when translated into yuan. This could stress those companies (possibly pushing some into bankruptcy) and make it more difficult for China to hit the government’s economic growth targets. Another reason: China might want to head off charges from the Trump administration that it continues to keep the value of its currency artificially low. SOURCES: T. Hult, ‘The US shouldn’t fret over cheaper yuan’, Time, 14 August 2015; ‘The yuan and the markets’, The Economist, 16 January 2016; M. Gesiotto, ‘The negative effects of China’s currency manipulation explained’, Washington Times, 13 November 2015; M. Slaughter, ‘The myths of China’s currency manipulation’, The Wall Street Journal, 8 January 2016; ‘The curious case of China’s currency’, The Economist, 11 August 2015; L. Wei, ‘China foreign exchange reserves keep dropping’, The Wall Street Journal, 8 January 2017. Exchange rate regimes in practice LO 4.3 FIXED EXCHANGE RATE SYSTEM The exchange rate is pegged and does not vary with market forces PEGGED EXCHANGE RATE The exchange rate is fixed relative to a reference currency or basket of currencies, and this exchange rate is defended by government intervention in the foreign exchange market 178 PART 2 Exchange rate regimes or systems range from a pure ‘free float’, where the exchange rate is determined by the unfettered market forces of demand and supply, to a fixed-peg system—more generally referred to as a fixed exchange rate system. A pegged exchange rate is one where the currency value is fixed in terms of some other currency or unit of money. In the past, currencies were pegged to gold but today many are pegged to other currencies, such as the US dollar, the euro or a basket of currencies. The almost pure form of a fixed-pegged system was the gold standard overseen by the British, which was effectively the international monetary system from 1880 to 1939. The International Monetary Fund classifies exchange rate regimes according to their degree of flexibility and the extent to which they limit a nation’s monetary policy independence.18 Leaving aside the issue of monetary policy independence for the moment, current exchange rate regimes fit somewhere along a continuum of flexibility (or the converse, a continuum of fixity) from a fixed-peg system to a free-float system, as shown in Figure 4.2. The exchange rate regimes at the left-hand end of the spectrum are characterised by purposeful government intervention, usually via their central banks. The aim is to establish and defend a particular exchange rate level or path in the face of contrary market forces. At the right-hand end, the foreign exchange market is free to determine the exchange rate; and away from the ends, there is a mix of different degrees of government interventions and market forces that determine the exchange rate. CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 178 08/07/19 04:03 PM Fixed peg Managed peg ‘Hard peg’ range Managed float Free float FIGURE 4.2 Degree of flexibility of exchange rate regimes ‘Soft peg’ range Increasing degree of flexibility Classifying exchange rate regimes is complicated, as there is a difference between de facto regimes (what countries follow in practice) and de jure regimes (what countries claim officially to practise). A further complexity is that countries change their regimes as economic conditions change, such as their stage of economic development, the level of global integration, and the country’s vulnerability to external economic and financial shocks. For example, the post-World War II history of Australia’s exchange rate regime changes is as follows: the Australian pound (before decimalisation in 1966) (later dollar) was fixed or pegged to the UK pound sterling until December 1971; fixed to the US dollar until September 1974; fixed to a trade-weighted basket of currencies until November 1976; on a variable peg against the trade-weighted basket until December 1983, then floated on 12 December 1983.19 Over time, Australia’s regime has moved to the right across virtually the full continuum in Figure 4.2. ANOTHER PERSPECTIVE SHOULD COUNTRIES BE FREE TO SET CURRENCY POLICY? Exchange rates are critically important in the global economy. They affect the price of every country’s imports and exports, companies’ foreign direct investment and—directly or indirectly—people’s spending behaviours. In recent years, disagreements among countries over exchange rates have become much more widespread. Some government officials and analysts even suggest that there is a ‘currency war’ among certain countries. The main issue is whether or not some countries are using exchange rate policies to undermine free currency markets and whether they intentionally, in essence, devalue their currency to gain a trade advantage at the expense of other countries. A weaker currency makes exports inexpensive (or at least cheaper) to foreigners, which can lead to higher exports and job creation in the export sector. SOURCE: R.M. Nelson, ‘Debates over exchange rates: overview and issues for Congress’, Congressional Research Service, 22 June 2018. Of 192 countries, 42 per cent operate exchange rate regimes in the intermediate ‘soft peg’ range and towards the ‘float’ range; nearly 13 per cent operate in the ‘hard peg’ range; and about 40 per cent operate in the ‘managed float’ to ‘free float’ range.20 Broadly speaking, how do peg systems and floating systems differ? In the ‘hard peg’ and ‘soft peg’ ranges, the main aim is to maintain a predetermined exchange rate against another currency or basket of currencies. There are many variants of ‘soft pegs’ in this middle range. Some systems have allowances for fluctuations of the exchange rate in a band around this peg. Others allow the peg to move incrementally up or down over time (the ‘crawling peg’). We will discuss the following two points in more detail shortly but, in brief, to maintain the peg (particularly if it is under threat of depreciation from CHAPTER 4 hiL23674_ch04_159-206.indd 179 FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 179 08/07/19 04:03 PM FOREIGN EXCHANGE RESERVES The reserves such as foreign currencies, gold, special credits and reserve positions with the IMF that central banks use to intervene in the foreign exchange market MANAGED OR ‘DIRTY’ FLOAT SYSTEM A system under which a country’s currency is nominally allowed to float freely against other currencies, but in which the government will intervene if it believes the currency has deviated too far from its fair value market forces), a country will need foreign exchange reserves to defend the peg. Foreign exchange reserves can comprise key currencies such as the US dollar, yen and euro, gold, special credits and reserve positions held with the IMF. Second, countries that adopt ‘hard’ and ‘soft’ peg regimes forgo to various degrees independent monetary policy. Countries operating exchange rate systems in these ranges, ranked in order from ‘hard peg’ to ‘soft peg’ (from left to right in Figure 4.2), include Hong Kong (SAR) and Saudi Arabia, which are anchored to the US dollar; Denmark, which is anchored to the euro; China, which uses a ‘monetary aggregate target’; New Zealand, which floats to an ‘inflation targeting framework’; and Russia, which free floats to an ‘inflation targeting framework’.21 Countries that operate in the floating rate regimes allow the foreign exchange market to determine the exchange rate. In this range some intervention may occur to manage short-term economic and financial shocks to the system. The Reserve Bank of New Zealand has not intervened in the foreign exchange market since the New Zealand dollar was floated in March 1985. It reserves intervention for cases of ‘extreme disorder’ in the foreign exchange market.22 When such intervention persists, however, one may question whether or not the regime is a true float system or a managed or ‘dirty’ float system. The more derogatory descriptor is often raised by other countries who feel they have been competitively disadvantaged by a country’s exchange rate policy. The term ‘dirty float’ is applied when it is thought that the goal of the intervention in reality is to maintain a target peg, and not the often-stated goal of limiting short-term volatility. Countries which operate in this ‘floating’ range—ranked in order of more interventionist (managed float) to less interventionist (free float)—include Brazil, Indonesia, Turkey, India, Australia, Poland and the United States.23 Unless the country is actively involved in managing the float, floating exchange rate regimes do not have as high a requirement as pegged rate regimes for foreign reserves, and floating exchange rate regimes afford a country greater monetary policy autonomy. Motives and means for managing the foreign exchange rate Although their exchange rate policies may result in different degrees of flexibility or fixity, governments or their central banks can use exchange rate changes to achieve a number of goals.24 Exchange rate policy can be used to control inflation, enhance the international competitiveness for domestic industries, correct a balance of payments deficit, and limit the impact on the economy of an external financial crisis. For example, the devaluation of a currency by 10 per cent is equivalent to a 10 per cent ad valorem tariff on imports and a 10 per cent ad valorem subsidy for exporters. Near two-thirds of the world’s economies operate a form of fixed or pegged exchange rate system. How does a country intervene in the foreign exchange market to defend and maintain its target peg? It does it by manipulating, to the extent that it can, the demand and supply of its currency in the foreign exchange market. For example, when Venezuela (a country that anchors its exchange rate to the US dollar) was experiencing higher inflation rates than its trading partners, the foreign exchange market would be putting downward pressure on the exchange rate (as predicted by the PPP theory). One source of such pressure would be the result of less demand for Venezuelan exports at the current exchange rate. Consequently, there would be less demand for the Venezuelan bolivar (VEF) in the foreign exchange market. Additional pressure would arise from shortterm capital outflows as investors, expecting a depreciation of the currency, look to invest in assets denominated in a stronger foreign currency. This action leads to an additional supply of Venezuelan bolivar in the foreign exchange market at the current exchange rate. To relieve the combination of these demand and supply pressures, Venezuela’s central 180 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 180 08/07/19 04:03 PM bank could have entered the foreign exchange market to buy up the extra bolivars being placed in the foreign exchange market at the current exchange rate. For this purpose, the central bank would have needed to use its holdings of reserves of foreign currencies and credits (particularly USD denominations) to exchange for bolivars, buying up the excess Venezuelan bolivars. Creating the extra demand holds up the price of the currency at or near the targeted rate or peg. There is one obvious limit to this method of intervention when there are mounting depreciation pressures on the currency: the central bank can intervene only to the extent that it has access to foreign exchange reserves. Unlike the US Federal Reserve, the central bank of Venezuela cannot print US dollars. Managing foreign exchange using these measures has been ineffective and beyond the reach of Venezuela, tragically. Since 2016, the economy has spiralled out of control. In 2018, the black-market exchange rate of the bolivar was devalued to around 100 000 per USD, down from 960 per USD in 2016 (and 64 USD in 2014). This epic decline of historic proportions has resulted in Venezuela being the poorest country in Latin America. In a desperate bid to reverse the woeful state of the country, some have suggested abandoning the bolivar altogether in favour of the USD. (To learn more about the background contributing to the downfall of the bolivar, see Another Perspective: ‘Can dollarisation save Venezuela?’) ANOTHER PERSPECTIVE CAN DOLLARISATION SAVE VENEZUELA? The country’s economic decline dates back to the rule of Hugo Chavez, who took power in 1999. Chavez significantly raised the royalty rate that foreign oil companies had to pay to the government. The oil companies responded by not investing in Venezuela and looking for oil elsewhere. Chavez then compounded the problem by pushing out the professional management of the state-run oil company, replacing them with his own political appointees. The result included underinvestment in exploration and extraction infrastructure and falling oil output. By 2017, CHAPTER 4 hiL23674_ch04_159-206.indd 181 © Digital Archive Japan/Alamy Stock Photo Venezuela is in deep trouble. Although the country boasts the largest oil reserves on the planet, a fact that should make it rich, poor governance (declining oil prices and US economic sanctions) has created an economic crisis of historic proportions and turned the country into the poorest nation in Latin America. The Venezuelan economy contracted by 16.5 per cent in 2016, and another 12 per cent in 2017, while unemployment surged to over 26 per cent. Due to food shortages, some two-thirds of the population have reported significant weight loss. oil output had fallen by 50 per cent from its peak in 1998, a major problem for a country where crude oil makes up about 95 per cent of exports. Early in his rule, Chavez spent oil revenue liberally on social programs, including price controls and fuel subsidies. Initially this helped the poor and boosted FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 181 08/07/19 04:03 PM his popularity. However, by 2012 significant strains were showing in the economy, including declining oil production and exports, rising unemployment, high inflation and ballooning government deficits. Chavez died in 2013 and was succeeded by Nicolas Maduro. Maduro continued on the trajectory set by Chavez. Unfortunately for Maduro, oil prices and output both fell sharply, reducing government revenue. Rather than abandoning the social programs and subsidies, Maduro simply expanded the government’s budget deficit, raising it to a staggering 38 per cent of GDP by 2017. He financed that deficit by printing money. Predictably, the result has been hyperinflation. The inflation rate surged to 250 per cent in 2016 and then to around 2700 per cent in 2017, the highest in the world. This made the country’s currency, the bolivar, virtually worthless, stifling commerce, which depends on a stable currency. On the foreign exchange market, the value of the bolivar collapsed, falling from 64 per US dollar in 2014 to 960 by early 2016 and around 100 000 by early 2018! It should be noted that this reflects the exchange rate on the black market. The official exchange rate set by the Venezuelan government, which no one pays any attention to, is 10 bolivars per US dollar. With the bolivar viewed as worthless, no one wants to trade with Venezuela unless they get paid in US dollars. With not enough US dollars in Venezuela to finance international transactions, that means a shortage of many goods. When a country experiences this kind of currency crisis, the normal response is to call in the International Monetary Fund (IMF). In return for a loan of funds, the IMF will often advocate austerity programs to reduce the government budget deficit, along with high-interest rates and tight controls over the growth in money supply to reduce inflation. Other policies advocated by the IMF include the removal of price controls and subsidies and the privatisation of state-owned enterprises. However, all of these actions are anathema to Maduro, who continues to adhere to a hard-line socialist ideology and blames foreign and domestic capitalists for his country’s ills. Opposition figures in Venezuela have suggested another solution to the country’s currency problems: dollarisation. This process would involve the government abandoning the bolivar and instead introducing cash denominated in US dollars to keep commerce moving. In fact, de facto dollarisation is already underway in Venezuela: increasingly, merchants are ignoring price controls and pricing goods in US dollars at their free market value. Unfortunately, Venezuela’s economic collapse has been so severe that most Venezuelans earn the equivalent of only a few US dollars per month, so this doesn’t help them. For dollarisation to work, the government would have to purchase about $10 billion worth of US notes and coins and put them in circulation. There are precedents for dollarisation. Ecuador adopted the US dollar in 2000 in order to overcome soaring inflation and a collapse in the value of its currency, the sucre. While the switch was painful— salaries initially fell by 40 per cent, and savings and pension accounts were ravaged—wages and prices stabilised and the economy recovered and started to grow again. However, Maduro has long vilified the United States, so it is difficult to see him backing a similar dollarisation effort for Venezuela. SOURCES: J. Otis and K. Vyas, ‘The dollar rescued Ecuador: can it save Venezuela?’, The Wall Street Journal, 27 March 2018; M. O’Brian, ‘Venezuela should be rich, but its government has destroyed its economy’, The Washington Post, 21 January 2015; P. Laya, ‘One dollar now buys 103 000 bolivars in Venezuela’s black market’, Bloomberg Markets, 1 December 2017. By the same token, under a situation where there are upward pressures on the currency, the process of intervention to hold down the exchange rate leads to an accumulation of foreign exchange reserves. The central bank sells its own currency in exchange for foreign currencies to maintain the target. For example, China and a number of other South-East Asian economies have run large trade surpluses with upward pressure on their exchange rates. Intervention to prevent the exchange rate rising has resulted in the accumulation of large foreign exchange reserve holdings by these countries. While this latter situation may appear not to act as a restraint on a central bank in holding the exchange rate at or near its desired pegged rate indefinitely, there can be significant flow-on effects to 182 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 182 08/07/19 04:03 PM the country’s money supply and domestic economy from these foreign exchange market interventions. Changes in the domestic money supply affect prices and interest rates, which in turn have an adverse effect on domestic economic stability and growth. This presents the policymakers with a dilemma as to whether the goal it is attempting to achieve via its exchange rate policy is worth the economic (and political) costs of domestic economic instability. Policymakers are frequently confronted with the dilemma of such policy trade-offs. We can illustrate this dilemma in the context of how a government would go about correcting a significant international balance of payments deficit. Two potentially conflicting goals are internal balance and external balance. The goal of internal balance is to keep the economy at or near full-capacity economic growth with near-full employment while avoiding excess inflation. The goal of external balance is to maintain the balance of payments at a level such that it avoids foreign debt positions that are unsustainable in the long run. Suppose there is a significant change in domestic demand favouring imports (e.g. consumers prefer quality imported products; businesses purchase more technologically advanced plant and equipment). The balance of payments moves into deficit. The demand for foreign currency will rise relative to the demand for the domestic currency in the foreign market at the current exchange rate. There is pressure on the domestic currency to depreciate. What can governments do when confronted with an external deficit and a preference to hold the exchange rate at a targeted pegged level? There are a number of options: INTERNAL BALANCE When the economy is operating at full capacity with near-full employment and price stability EXTERNAL BALANCE When the international balance of payments is such that foreign debt obligations into the future are sustainable for a country or its trading partners 1. It could defend the peg using its holdings of foreign exchange reserves at the current pegged rate, giving it some breathing space in the hope that economic conditions will change and that there will be some adjustment to import preferences. This option assumes that it has sufficient foreign exchange reserves. 2. It could reduce the demand for imports by using tariff and non-tariff barriers, and subsidise exports. In the context of being an open economy, this option may be limited. There may also be the risk of retaliation from trading partners if such a policy is perceived as a beggar-thy-neighbour strategy. (As discussed in the previous chapter, beggar-thy-neighbour policy is a policy that yields economic benefits to the home country, but only at the expense of making other countries incur economic losses.) 3. It could deflate the domestic economy and domestic demand with contractionary policies, such as a high-interest rate policy or reduced government expenditures. If the economy was already experiencing high rates of unemployment and business confidence was low, this would not be an economically or politically acceptable option. 4. It could allow the currency to depreciate. This is an option of last resort under a fixed exchange rate system. Each policy presents difficulties for decision makers. Policy 1 simply delays the inevitability of currency devaluation if the causes of the deficit are long term and fundamental (e.g. the country’s products are, for whatever the reason, never going to be attractive to customers). Policies 2 and 4 would most likely be seen as beggar-thy-neighbour policies, and the government would be seen as moving the burden of adjustment to its trading partners, inviting retaliation. Domestic economic and political goals would most likely be given preference over the impacts on other countries’ economies, ruling out policy 3. In situations of high unemployment and increasing balance of payments deficits among a number of countries, a likely outcome, therefore, could be trade wars in the form of increasing trade protection and competitive devaluations. Such events would greatly deter international trade and foreign investment. As we will see shortly, this in fact was CHAPTER 4 hiL23674_ch04_159-206.indd 183 FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 183 08/07/19 04:03 PM the context in which the Bretton Woods system was established in the 1940s. One goal of Bretton Woods was to prevent such trade wars. It was the same motivation behind the rhetoric of the leaders of the G20 economies during the 2007–09 GFC. They called for members and emerging market economies to restrain from adopting trade and exchange rate policies that would restrict foreign trade and investment, which has continued to be an important issue for subsequent G20 summits.25 Functions of an international monetary system A question arises as to whether the governments of countries that trade and invest with each other could come to some agreement or establish some international ‘rules of the game’ by which the types of dilemmas faced by individual countries (as discussed in the previous section) can be resolved without significant upset to international trade and investment. There are three functions that an international monetary system established by such an agreement needs to provide: adjustment, liquidity creation and confidence building.26 Adjustment ADJUSTMENT The process of restoring external balance An international monetary system needs to provide an orderly adjustment mechanism by which countries can correct internal and external imbalances. As we saw above, depending on the option chosen, the economic and political costs may be domestic or international—domestic in terms of the loss of economic stability internally; and international in terms of the adverse impacts on the economies of other countries, as well as the loss of the benefits from a reduction in international trade and investment that results from the growing uncertainty of unstable exchange rates and government interventions. Liquidity INTERNATIONAL LIQUIDITY The international money supply used to finance trade and investment and as reserves by central banks to achieve exchange rate and balance of payments policy goals An international monetary system must also provide sufficient international liquidity. International trade and investment requires money and a stable international finance system, the same as is required for a productive domestic economy. As there is no single global currency created by a global central bank, international liquidity is comprised of a mix of other countries’ currencies (in the main, the US dollar) and other money assets such as gold and credits held with the IMF. As we saw above, central banks need to hold or have access to reserves or liquidity to finance external imbalances, at least in the short term, before resorting perhaps to less palatable policy options; and they need reserves to defend a goal of stable exchange rates. The supply of international liquidity, therefore, depends on the capacity of the international monetary system to keep the exchange values of these money assets relatively stable—otherwise international traders and investors will not be willing to use them, and in effect the supply of international liquidity will be greatly reduced. Confidence CONFIDENCE The belief that the institutions and relations among countries are sufficiently robust to sustain the stability of the system in times of major imbalances 184 PART 2 The third function of an international monetary system is building confidence. Confidence in, or the credibility of, a financial system underpins its stability. Central banks and governments need some assurance that all members to an agreement will abide by the rules and be consistent with their pledges rather than pursue self-interest when it is economically or politically convenient. Deficit countries, particularly poorer countries, will need to be assured that there is a ‘lender-of-last-resort’ facility when the private foreign capital inflows that are used to finance their deficits slow or stop. Holders of reserve currencies would need to be confident that the reserve-currency countries will not pursue policies that sharply alter the value of the currencies that they hold in their reserves. CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 184 08/07/19 04:03 PM The rise and fall of the Bretton Woods system In 1944, near the end of World War II, representatives from 44 countries met at Bretton Woods, New Hampshire, in the United States, to design a new and enduring international monetary system that would facilitate postwar trade, investment and economic growth. Fresh in the minds of the countries’ representatives were the beggar-thy-neighbour exchange rate devaluations and protectionist policies that governments used to combat the high unemployment of the 1930s Great Depression, the hyperinflation in Germany and elsewhere, the trade wars, and the general economic disintegration that occurred between the two world wars. There was consensus that fixed exchange rates were desirable. The representatives recognised that the previous international monetary system based on the gold standard would not avoid a return to competitive devaluations. The major problem with the gold standard as previously constituted was that no multinational institution could stop countries from engaging in competitive devaluations. The representatives agreed that individual countries needed to give up national sovereignty over exchange rates. Exchange rates would become a matter for international management under the scrutiny of the International Monetary Fund (IMF). While the architecture of the international monetary system created under Bretton Woods was a creature of its time, issues such as the sharing of the burden of the adjustment process, the provision of international liquidity, the degree of domestic autonomy in policymaking, and the willingness of participating countries to cooperate and play by the rules still exist today. We can gain an understanding of the current international monetary system by an examination of the Bretton Woods system and its demise.27 The agreement reached at Bretton Woods established two multinational institutions: the IMF and the World Bank (or, more officially, the International Bank of Reconstruction and Development). Both institutions exist to this day. The task of the IMF would be to maintain order in the international monetary system by policing adherence to rules governing exchange rate adjustments. The task of the World Bank, with a much more long-term perspective, would be to promote general economic development. While the Bank was set up initially to aid the reconstruction of Europe’s war-torn economies, its task became one of promoting development in the poorer economies. The key concept of the Bretton Woods system was for countries to agree to have fixed but adjustable exchange rates. This system promised discipline, stability and flexibility. Fixing the exchange rate, it was thought, would reduce the volatility associated with floating exchange rates (not all economists agree that floating exchange rates are excessively volatile) and prevent competitive devaluations. A fixed exchange rate system was also seen as a mechanism for imposing monetary policy discipline on countries and for controlling inflation. Being able to adjust the exchange rate under the supervision of the IMF was thought to be able to provide sufficient flexibility to adjust to a persistent ‘fundamental disequilibrium’ in the balance of payments. As we noted above, the fundamentals of an economy may change, causing a change in the demand and supply of exports and imports. The economic conditions for a ‘fundamental disequilibrium’ are such that for the foreseeable future a nation’s products and its markets are never going to be attractive to traders and investors at the current exchange rate. A balance of payments deficit will persist and a country will find it difficult to finance the deficit at the current exchange rate peg. In the case of a fundamental disequilibrium, a devaluation of the currency (a downwards adjustment of the peg) could be permitted to restore the external balance. The belief was that the devaluation would enable governments to sidestep painful domestic policy adjustments such as deflation of the domestic economy, slowing economic growth and rising unemployment; and from an international perspective, remove the need to resort to trade CHAPTER 4 hiL23674_ch04_159-206.indd 185 FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 185 08/07/19 04:03 PM IMPOSSIBLE TRINITY ARGUMENT The argument that it is not possible to have simultaneously a fixed exchange rate, a free flow of capital and an independent monetary policy 186 PART 2 and investment barriers. An ‘approved’ devaluation according to the rules would be an orderly adjustment to exchange rates that would be transparent and not perceived as a selfserving, beggar-thy-neighbour initiative. Policy cooperation across countries was necessary to build confidence and stability. To support the fixed peg in the absence of a fundamental disequilibrium, the IMF stood ready to supplement the foreign exchange reserves of a member from that member’s IMF credits and a pool of foreign currencies provided in various quotas by other members. The temporary official financing of external imbalances through the IMF provided a smooth adjustment process. It provided access to the necessary foreign exchange and confidence that imbalances could be corrected without undue disturbances to trade flows, employment and economic growth. At the time, international private capital flows were expected to play a limited role in financing external imbalances. Controls would be imposed to protect the domestic economy from any instability arising from short-term private capital outflows and inflows. The Bretton Woods system operated effectively until the late 1960s, when it began to show signs of strain. Although the institutions remained, the system in effect collapsed in 1973, as adherence to the ‘rules of the game’ of the ‘fixed but adjustable peg system’ lessened. The international financial environment today is now vastly different to that of the time of Bretton Woods. As we saw earlier, the vast majority of countries now operate under a soft peg or floating exchange rate regime. The major currencies fluctuate in response to the market forces. Private capital flows now play a much more dominant role than they did in the 1950s and 1960s. As the global economy has grown and financial markets have become more integrated, private international capital flows have grown. Countries now tend to use international private capital inflows, rather than ‘official’ central bank and IMF sources, to finance balance of payments imbalances. Controls over private capital flows, a key element of Bretton Woods, have become ineffective, and many countries have abandoned them.28 While there is no consensus on the reasons for the demise of Bretton Woods, the increasing reliance on private foreign capital flows and a combination of issues related to adjustment, liquidity and confidence undermined the Bretton Woods system. The rise in capital flows created a major strain on the system. According to economists, it is not possible for a country to have simultaneously a fixed exchange rate regime, free cross-border capital flows, and an independent monetary policy dedicated to domestic macroeconomic policy goals such as low inflation and full employment. This is the impossible trinity argument. The ‘trilemma’ is that as countries become unwilling or unable to control international private capital flows, they will have to forgo using monetary policy to attain domestic economic goals if they wish to maintain a fixed exchange rate. Monetary policy becomes subservient to the goal of maintaining the peg. Not surprisingly, governments would give higher priority to domestic economic and political interests than to the stability of the international monetary system. There was an incentive to flaunt the rules of the game of the Bretton Woods system. They instead would allow some adjustment to their exchange rate to assist the attainment of domestic goals. Such unilateral action is symptomatic of beggar-thy-neighbour policies. As the prevalence of floating exchange regimes attests, today countries rely more on exchange rate changes to adjust for external balance problems and target monetary policy at domestic inflation and employment goals. The rules of the game relating to the official adjustment process also required that both deficit countries and surplus countries cooperate and take action to correct a fundamental disequilibrium in the balance of payments. A deficit in one country means there are surpluses in other countries. By the rules of the game, the deficit countries could devalue officially and surplus countries should revalue their currencies upwards. Surplus countries, CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 186 08/07/19 04:03 PM however, would be loath to place their economy at a competitive disadvantage by revaluing their currency upwards. Consequently, in practice, the burden of adjustment usually fell on deficit countries to devalue. As it became evident to the foreign exchange market as to which country was experiencing exchange rate difficulties, speculative attacks on the deficit country’s currency would occur. These attacks were facilitated by the mobility of private foreign capital and tended to increase the size of the devaluation. Speculative attacks and a disproportionate acceptance of the burden of adjustment undermined confidence in the capacity of the international monetary system under the Bretton Woods regime to benefit all member countries. When a currency was under speculative attack, central banks often did not have access to sufficient foreign exchange reserves, either from their own reserves or IMF reserves, to defend a targeted exchange rate peg. A further weakness of the Bretton Woods system was the special role played by the US dollar. The US dollar had become the de facto global currency and the main source of international liquidity. However, whenever the US economy and the US balance of payments experienced significant imbalances, confidence in the stability of the international monetary system would wane. The imbalances would give rise to speculation in the foreign exchange market that the US dollar would need to be devalued. A bout of speculation in 1972 saw the US dollar devalued, virtually destroying, at the time, confidence in the US dollar as a reserve currency and leading ultimately to the demise of the Bretton Woods system. A role for the IMF The IMF was created in 1945 to support, via short-term loans, a system of fixed exchange rates with a view to stabilising exchange rates, adjusting balance of payments imbalances, stabilising the international monetary system and facilitating trade. This followed the traumatic experiences of the severe economic crises of the 1930s Great Depression, and the non-cooperation and beggar-thy-neighbour economic policies among the major trading nations of the time to correct internal and external imbalances. The IMF was the watchdog of the rules-based Bretton Woods international monetary system, which included obligations for members to maintain fixed exchange rates and to control private foreign capital flows. Following the collapse of the Bretton Woods system in the 1970s and an increasing reliance by members on floating exchange rates and on private capital flows to correct and finance balance of payments imbalances, the IMF was forced to find a new reason for existence. Periodic national and regional financial crises that have arisen post– Bretton Woods, particularly among developing and emerging market economies, have demanded that the IMF’s role move beyond support for countries to retain a particular exchange rate system.29 While it always was a core responsibility of the IMF, the focus now is assisting nations with balance-of-payment problems to find sufficient financing on affordable terms to meet their net international payments. Confronted with the CHAPTER 4 hiL23674_ch04_159-206.indd 187 © Alexandros Michailidis/Shutterstock New role Christine Lagarde headed the IMF from July 2011 to July 2016. FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 187 08/07/19 04:03 PM CURRENCY CRISIS When a speculative attack on an exchange rate threatens a sharp depreciation in the value of the currency and the capacity of authorities to defend the value BANKING CRISIS When a loss of confidence in the banking system leads to a run on banks, as individuals and companies withdraw their deposits need to put together financial rescue packages for countries and regions that periodically have experienced damaging financial crisis, IMF resources now play an important role in helping countries ‘rebuild their international reserves, stabilise their currencies, continue paying for imports, and restore conditions for strong economic growth, while undertaking policies to correct underlying problems’.30 The nature of financial crises to which the IMF has responded varies, but they tend to contain one or more of the elements of a currency crisis, a banking crisis and a debt crisis.31 A currency crisis occurs when a speculative attack on an exchange value of a currency results in a sharp depreciation in the value of the currency. During the Asian financial crisis of 1997–98, the Thai baht depreciated by more than 30 per cent. Such a crisis often forces monetary authorities to draw down and often exhaust their foreign exchange reserves and sharply increase interest rates to defend the prevailing exchange rate. The IMF arranged a rescue package of US$17.2 billion for Thailand to combat speculative attacks on the baht. In 2002, the IMF lent Brazil US$30 billion to stabilise the value of its currency and avoid similar speculative attacks. A banking crisis refers to a loss of confidence in the banking system that leads to a run on banks, as individuals and companies withdraw their deposits. This crisis of confidence may arise as financial institutions begin to experience an increase in non-performing loans and loan defaults and a deterioration of their capital base. When President Abdel Fattah al-Sisi came to power in a 2013 military coup, he promised to fix Egypt’s mounting economic problems. Three years later, those problems had only intensified: the country was struggling with low economic growth; 13 per cent unemployment; a 12 per cent inflation rate; a large trade deficit, amounting to 7 per cent of GDP; a persistent budget deficit of around 12 per cent of GDP; and public debt that stood at 92 per cent of GDP. In addition, the tourism trade, a major source of foreign currency, had collapsed in the wake of concerns about terrorism, which included an Islamic State-linked insurgency in the Sinai Peninsula that claimed the bombing of a Russian passenger jet in 2016; foreign direct investment, another source of foreign currency, had also slumped in the wake of Egypt’s economic and political problems. One major issue was a lack of foreign currency in the country, which made it difficult to pay for imports and resulted in shortages of key commodities. For example, 188 PART 2 © Baloncici/Shutterstock COUNTRY FOCUS EGYPT AND THE IMF CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 188 08/07/19 04:03 PM Egypt imports one-third of its sugar. By mid-2016, this commodity was in short supply due to the inability of Egyptian traders to get the foreign currency required to pay for imported sugar. Historically, in times of trouble, the oil-rich Arab states of the Persian Gulf had loaned foreign currency to Egypt at low-interest rates, but a collapse in oil prices had left those states financially strained and loans were not forthcoming. In an indication of the depth of Egypt’s problems, while the official exchange rate of the Egyptian pound was pegged at 9 pounds to the US dollar, the black market rate had soared to 18 pounds to the US dollar. In mid-2016, with its foreign exchange reserves being rapidly depleted, the Egyptian government applied to the IMF for a loan. The IMF agreed to loan Egypt up to $12 billion, but only if the government undertook a number of economic reforms. These included liberalising the exchange rate, letting the Egyptian pound float against other currencies. The thinking was that the pound would immediately depreciate against major currencies such as the US dollar and the euro, making Egyptian exports cheaper and its imports more expensive. This should help the country to improve its trade deficit and earn more foreign currency. At the same time, the IMF required the Egyptian government to implement an austerity program that included an immediate end to energy subsidies, which had kept energy prices artificially low; reforms to public enterprises to make them more efficient; tighter monetary policy to rein in inflation; and the imposition of a value-added tax to raise government revenue. In November 2016, Egypt let the pound float freely. It immediately lost 50 per cent of its value against the US dollar, trading at around 13 pounds to the dollar. The depreciation continued into the new year, falling to 19 pounds to the dollar by mid-January 2017, and bringing the official exchange rate and the black market rate into equality. Egypt also moved rapidly to impose the value-added tax. In return, the IMF released the first $2.75 billion of its loan to Egypt. Further tranches of the loan will be released as Egypt makes progress on the economic reforms advocated by the IMF. Only time will tell whether these policies will work. In addition to a fall in the value of the pound, the immediate impact included a surge in the annual inflation rate to around 20 per cent. The IMF envisages the inflation rate falling to 7 per cent within three years, while there should be sharp improvements in both the trade deficit and the budget deficit. However, the planned austerity measures carry significant political risks for the Egyptian government. If protests materialise over short-term hardships, the government might cave in to political pressure and pull back from the IMF-mandated reforms. If that happens, the IMF might withhold further installments under the loan program, and the Egyptian economy could continue to deteriorate. SOURCES: H. Mahfouz and P. Schemm, ‘Struggling Egypt devalues currency by almost 50% ahead of IMF loan’, The Washington Post, 3 November 2016; L. Noueihed and A. Aboulenein, “Egypt on track to receive IMF loan’s second tranche’, Reuters, 18 January 2017; ‘State of denial’, The Economist, 6 August 2016; CIA World Fact Book, Egypt, accessed via www.cia.gov/library/publications/the-world-factbook February 2017. Since 2007, banking systems all around the world have been significantly impacted by the GFC. Referred to by the IMF as the ‘Great Recession’, it has witnessed the largest number of systemic banking crises ever recorded since the Great Depression, which have mainly affected advanced economies (including the United Kingdom and the United States), in contrast to earlier crises that were mainly associated with developing countries.32 Iceland’s and Ireland’s troubled banking systems are calculated to be responsible for among the top 10 costliest banking crises since the 1970s, with Ireland’s being the costliest banking crisis since the Great Depression. (Read about Iceland’s crisis in detail in Country Focus: ‘IMF and Iceland’s economic recovery’.) Banking crises appear to run in cycles and often coincide with credit cycles, with a cluster of crises preceding the GFC in the 1990s (the Asian crisis of 1998, Tequila crisis of 1995 and transition economies in 1991). These were preceded by the Latin American debt crisis in the early 1980s. The IMF has gone to great efforts to support its member countries throughout the GFC, committing over US$600 billion in loans and policy assistance to those most affected.33 A foreign debt crisis is a situation in which a country cannot service its foreign debt obligations of loan and interest payments, whether private-sector or government debt. Common causes of CHAPTER 4 hiL23674_ch04_159-206.indd 189 FOREIGN DEBT CRISIS When foreign debt, whether privatesector or government debt, has become so large that the country cannot service its debt obligations of loan and interest payments FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 189 08/07/19 04:03 PM these crises include high inflation rates, a worsening balance of payments deficit, fiscal profligacy and excessive borrowing, and asset-price inflation (such as sharp increases in shares and property).34 In 2010, the IMF in combination with the European Union put together a rescue package of €110 billion to help reduce Greece’s debt. A second package of €130 billion was provided to Greece during 2012 when debt was forecast to grow to 190 per cent of GDP. Over the period 1970–2017, an IMF study identified 151 banking crises, 236 currency crises and 74 sovereign crises.35 Apart from the banking crises in the developing countries of Guinea-Bissau, Moldova and Ukraine in 2014, the world at large has experienced a relatively calm period in relation to major debt crisis since the GFC. While it may have been thought with the collapse of the Bretton Woods system that the role of the IMF within the international monetary system would diminish, its role and activities have been reshaped and to some degree strengthened,36 while its influence on countries’ policies has increased considerably. There are those, however, who are critical of the expanding role of the IMF, particularly given its present structure.37 We will examine these criticisms shortly. In performing its new role, the IMF now gives greater emphasis to three core activities: surveillance, technical assistance and, as we have already noted, lending. COUNTRY FOCUS IMF AND ICELAND’S ECONOMIC RECOVERY succession, the local stock market plunged 90 per cent and unemployment increased nine-fold. The krona, Iceland’s currency, plunged on foreign exchange markets, pushing up the price of imports, and inflation soared to 18 per cent. Iceland appeared to be in free fall. The economy shrank by almost 7 per cent in 2009 and another 4 per cent in 2010. To stem the decline, the government secured $10 billion in loans from the IMF and other countries. The Icelandic government lacked the funds to bail out the banks, so it decided to let the big three fail. In quick 190 PART 2 © McGraw-Hill When the GFC hit in 2008, tiny Iceland suffered more than most. The country’s three biggest banks had been expanding at a breakneck pace since 2000, when the government privatised the banking sector. With a population of 320 000, Iceland was too small for the banking sector’s ambitions, so the banks started to expand into other Scandinavian countries and the United Kingdom. They entered local mortgage markets, purchased foreign financial institutions and opened foreign branches—attracting depositors by offering high-interest rates. This expansion was financed by debt, much of it structured as short-term loans that had to be regularly refinanced. By early 2008, the three banks held debts that amounted to almost six times the value of the entire economy of Iceland! So long as they could periodically refinance this debt, it was not a problem. However, in 2008 global financial markets imploded following the bankruptcy of Lehman Brothers and the collapse of the US housing market. In the aftermath, financial markets froze. The Icelandic banks found that they could not refinance their debt, and they faced bankruptcy. CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 190 08/07/19 04:03 PM The government also stepped in to help local depositors, seizing the domestic assets of the Icelandic banks and using the IMF and other loans to backstop deposit guarantees. Far from implementing austerity measures to solve the crisis, the Icelandic government looked for ways to shore up consumer spending; for example, it provided means-tested subsidies to reduce the mortgage interest expenses of borrowers. The idea was to stop domestic consumer spending from imploding and further depressing the economy. With the financial system stabilised, thanks to the IMF and other foreign loans, what happened next is an object lesson in the value of having a floating currency. The fall in the value of the krona helped boost Iceland’s exports, such as fish and aluminium, while depressing demand for costly imports, such as cars. By 2009, the krona was worth half as much against the US dollar and the euro as it was in 2007 before the crisis. Iceland’s exports surged and imports slumped. While the high cost of imports did stoke inflation, booming exports started to pump money back into the Icelandic economy. In 2011, the economy grew at a rate of 3.1 per cent. This was followed by 2.7 per cent growth in 2012 and 4 per cent growth in 2013, while unemployment fell from a high of nearly 10 per cent to 4.4 per cent at the end of 2013. SOURCES: C. Forelle, ‘In European crisis, Iceland emerges as an island of recovery’, The Wall Street Journal, 19 May 2012, pp. A1, A10; ‘Coming in from the cold’, The Economist, 16 December 2010; C. Duxbury, ‘Europe gets cold shoulder in Iceland’, The Wall Street Journal, 26 April 2012; ‘Iceland’, The World Factbook 2013, Washington, DC: Central Intelligence Agency, 2013. Surveillance Surveillance involves monitoring and consulting members with regard to the national and international consequences of their domestic macroeconomic and financial policies. With the collapse of Bretton Woods, surveillance and policy advice by the IMF now play key roles in safeguarding the confidence levels and the stability of the international monetary system. In a globally integrated financial system, there is a recognition that domestic macroeconomic stabilisation performance and policy can have significant spillover effects on other countries and the international financial system. Policy cooperation along with sound domestic financial systems and the macroeconomic stability of domestic economies of members are considered prerequisites to build confidence and stability in the international financial system and trading system. Every country that joins the IMF is required to subject its economic and financial policies to the scrutiny of the IMF and the international community. To these ends, IMF surveillance includes assessing a country’s vulnerability to crisis, identifying the strengths, risks and vulnerabilities of its financial systems, and assisting with formulating appropriate policy responses. Each year the IMF writes reports on countries’ economic situation and provides policy recommendations. The IMF also monitors economic and financial developments at the regional and global levels.38 Multilateral consultations and surveillance are new tools of the IMF (dating from 2007) that are designed to foster debate and policy actions on issues of systemic or regional importance. By monitoring, for example, international capital developments, it looks for early warning signs of vulnerabilities and potential instability in the international financial system. Inadequate surveillance reduces the effectiveness of the IMF’s early warning systems, thus limiting its capacity to prevent crises. A notable failure was the lack of sufficient warning of the 2007–09 GFC because of inadequate surveillance of the financial institutions and markets of the systemically important advanced countries.39 The IMF, however, has not been alone in missing the early warning signs of crises. CHAPTER 4 hiL23674_ch04_159-206.indd 191 SURVEILLANCE The IMF monitors and consults members with regard to the national and international consequences of their domestic macroeconomic and financial policies FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 191 08/07/19 04:03 PM Technical assistance Technical assistance aims to build the human and institutional capacities of countries to design and implement sound economic policies. It provides research, advice and training in areas including the regulation and supervision of financial systems, legal frameworks, taxation and fiscal, monetary and exchange rate policies. Lending CONDITIONALITY A requirement that countries which borrow from the IMF commit to specified economic and financial policies As of 31 October 2018, the IMF was committing loans to 36 member countries that were struggling with economic and currency problems.40 All IMF loans come with conditions attached. Conditionality is a requirement that countries that borrow from the IMF commit to specified economic and financial policies. Conditionality enables the IMF to monitor whether the loan is being used effectively and to safeguard IMF resources. The tailored program of policies to which a country must commit seeks to take into account the causes of the crises specific to the country. There are multiple possible causes of financial crises, domestic and external. Domestic causes include natural disasters, political instability, excessive money supply, unsustainable government budget deficits and overvalued exchange rates. External causes include a collapse of export prices, a sudden increase in import prices, sudden foreign capital outflows, and reduced access to international credit with rising interest rate costs.41 In general, the IMF insists on a combination of tight macroeconomic policies, including cuts in public spending, higher interest rates, and tight monetary policy. It also often pushes for structural and institutional change, such as the deregulation of sectors formerly protected from domestic and foreign competition, privatisation of state-owned assets, and better financial reporting from the banking sector. The IMF’s monitoring role is not without its critics. The criticisms include matters of conditionality and ‘mission creep’, inappropriate policies, moral hazard and governance. Conditionality and mission creep MISSION CREEP A situation where an organisation expands its activities beyond its original mandate 192 PART 2 The IMF loan conditions have been criticised for being too heavy handed and too political. For example, in the 1997–98 Asian crisis, the IMF loan conditions required South Korea to open up its banking sector to US and other foreign banks. In Indonesia, it demanded the breaking up of a clove monopoly, petrol pricing reform and the removal of subsidies on basic foodstuffs and energy. These requirements gave rise to widespread street protests and unleashed a chain of events that led eventually to the collapse of the government. A similar story was played out nearly 15 years later in Europe when the conditions of austerity and structural change imposed by IMF–EU financial rescue packages generated widespread political turmoil and upheaval in Greece and Spain. Critics argue that the IMF, via conditionality, oversteps the mark by attempting virtually to micro-manage economies.42 This criticism embodies the notion of mission creep. The term mission creep describes the situation where an organisation expands its activities beyond its original mandate. With respect to conditionality, the conditions imposed by the IMF have expanded over time. They have enlarged from those more directly related to balance of payments and macroeconomic stability (e.g. issues of overvalued exchange rate, growing government budget expenditures, and inflationary money supply expansions) to include, in more recent times, requirements for institutional and structural change (e.g. the privatisation of public enterprises, opening markets to foreign financial firms, breaking up local monopolies, anti-poverty measures, and the prevention of money-laundering and terrorist financing).43 To some critics, this expansion transgresses the national sovereignty and policy autonomy of the loan recipient countries.44 The additional conditions and austerity measures imposed by the IMF became incentives for countries to shun assistance from the IMF. The reaction of the Asian nations that were forced to borrow from the IMF during the financial crises of the late 1990s CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 192 08/07/19 04:03 PM was to look for ways to reduce their reliance on IMF loans in the future. They did this by running up large current account surpluses and building up foreign exchange reserves. In their minds, large reserves would provide insurance against any speculative attack on their currencies and enable them to withstand any sudden ‘hot money’ capital outflows. In 2000, smarting at the perceived highhandedness of the IMF bailout conditions, all ASEAN member countries plus China, Japan and Korea began to pool—like an IMF pool, but on a regional basis—a small fraction of their combined holdings of reserves as pledges (the money is still held by the individual central banks) under what became known as the Chiang Mai Initiative (CMI).45 In 2010, in the face of the GFC, a new agreement was reached in Beijing between South Korea, China, Japan and the 10 members of ASEAN to extend (and supersede) the Chiang Mai Initiative into the new and improved Chiang Mai Initiative Multilateralization (CMIM). This agreement aimed to establish a regional financial market surveillance organisation governed by a single contract, and to build a self-managed foreign reserve pooling arrangement, which stood at US$240 billion in 2012. However, there are many critics who argue that the CMIM is too limited and may not be even usable.46 Having learned a lesson about the conditionality of IMF loans during the Asian financial crisis, the Asian economies began to build surpluses. There are serious shortcomings of this initiative from the point of view of a stable international monetary system. These surpluses formed part of the global imbalances, which, as we noted in Chapter 1, became a fundamental cause of the 2007–09 GFC. Not all countries can run undervalued exchange rates and have balance-of-payments surpluses. Such action is a beggar-thy-neighbour tactic, and the danger is that countries that suffer a competitive disadvantage will take unilateral action that is contrary to the internationally agreed ‘rules of the game’. Another negative outcome is that developing nations are using their export earnings to accumulate financial assets, rather than finance the imports of new plant, equipment and technology necessary to promote economic development. Further evidence of mission creep is the expanded nature of IMF lending. Critics argue that the IMF should curtail its lending and require countries to access the private international capital market. Lending should be limited to providing temporary liquidity only in extreme cases.47 IMF lending to date has included long-term lending with more of an economic development focus than a temporary assistance focus. The critics argue that development loans are more the province of the World Bank and regional development banks such as the Asian Development Bank and the European Bank of Reconstruction and Development. Inappropriate policies Another criticism of the IMF is that its ‘one-size-fits-all’ approach to macroeconomic policy is inappropriate to many countries. As we noted above, to different degrees, each financial crisis may comprise elements of currency, banking and debt crisis. The IMF has tended to require a traditional mix of fiscal policies (higher taxes and less government spending) and tighter monetary policy (higher interest rates and less credit availability). These policies may have been well suited to countries suffering from high inflation, or that had a temporary liquidity problem, in that they were unable to earn enough foreign currency to service and repay foreign debts. This was the case in Latin America in the 1980s, but not the problem in Asia in the 1990s. The problem in Asia was one of insolvency—a privatesector debt crisis with deflationary undertones.48 Critics argued that the traditional mix of policies actually increased the probability of widespread corporate defaults as a result of higher interest rates, depressed growth and higher unemployment. The IMF rejected the criticism, arguing that the central task was to build confidence in the national currencies. Stabilising price inflation and improving the value of a national currency would reduce the foreign debt burden and make it easier for companies to service their debt. Seldom is CHAPTER 4 hiL23674_ch04_159-206.indd 193 FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 193 08/07/19 04:03 PM there consensus among economists as to the appropriateness of policies, so criticisms of IMF prescriptions will persist. In support of the IMF position, in Asia, Latin America and Central and Eastern Europe, the economies did recover fairly quickly from their respective crises after IMF intervention. Moral hazard MORAL HAZARD People behave recklessly because they know they will be saved if things go wrong IMF lending for purposes other than the emergency relief of illiquidity is an incentive for governments and private investors to undertake larger but more risky and unsustainable borrowings. These, in turn, become a potential source of financial crisis. This is the problem of moral hazard. Moral hazard arises when people behave recklessly because they know they will be saved by others (usually the taxpayer) if things go wrong. In the aftermath of the Asian crisis, critics argued that many Japanese and Western banks were far too willing to lend large amounts of capital to overleveraged Asian companies during the boom years of the 1990s. It was argued that the banks should have been forced to pay the price for their rash lending, even if it meant some banks may have collapsed.49 By providing support to these countries, the IMF reduced the probability of default and in effect bailed out the banks whose loans gave rise to the crisis. The bailouts of financial institutions undertaken by industrialised countries during the 2007–09 GFC and later in the eurozone with the backing of the IMF have also been criticised because they are unlikely to constrain reckless risk-taking by ‘too big to fail’ financial institutions. ‘Too big to fail’ bailouts such as the recapitalisation of financial institutions by governments and government-subsidised asset guarantees and funding are considered to create significant moral hazard as they undermine proper incentives and market discipline.50 The counterargument is that widespread debt defaults would result in the failure of large financial institutions and, unlike the past where impacts were more local or regional, the impacts are now felt globally. Failures could lead to a meltdown in global financial markets and serious declines in global equity markets as occurred in 2007–09. This was the risk the IMF was trying to avoid by stepping in with financial support although policies may not have been always appropriate.51 Governance Critics argue that the quotas and voting power of IMF members reflect the world of the 1940s. The industrial states of Europe and the United States are over-represented and have too much influence in IMF decision making. Fast-growing economies, particularly in Asia, remain under represented relative to their weight in the world economy. There are calls for governance reforms that increase the quotas (which determine voting power) and voice of the new centres of economic growth and wealth (more colloquially described as ‘chairs and shares’ reform). Without these reforms, the legitimacy and effectiveness of the IMF to prevent financial crisis will be reduced in the eyes of many countries in the world economy.52 In 2006, China, South Korea, Mexico and Turkey received quota increases. In 2008, the IMF governors voted for changes to the quota and voting share structure for 54 countries to enhance the participation and voice of emerging market and developing countries. In 2010, the IMF increased all quotas by 100 per cent resulting in the BRIC countries being among the 10 largest shareholders in the IMF. The next round of reviews, planned to assess the size and composition of quotas and voting rights, will take place in 2019.53 Many criticise the slow pace of governance reform particularly the over-representation of European economies in light of the eurozone crisis. Brazil and China are among the emerging economies that have contributed significantly to IMF funds, which have been used by the IMF to assist struggling eurozone countries. There has subsequently been a push that the countries offering this money should be granted greater voting rights within the IMF organisation.54 194 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 194 08/07/19 04:03 PM IMF in the global financial architecture Seven decades on from its birth, the IMF’s fundamental objective remains one of maintaining international monetary stability to facilitate the expansion of international trade and investment. However, the global financial architecture has changed. The rulesbased system of Bretton Woods has been virtually replaced by a ‘non-system’ that allows national governments to determine their own exchange rate regime and the degree of control they have over foreign capital flows. This ‘non-system’, however, still provides the functions of adjustment, liquidity and confidence. Currently, adjustment occurs using exchange regimes across the full spectrum of flexibility; liquidity is provided by a basically unregulated international private capital market, with the IMF also providing loans to cover short-term foreign exchange shortages; and confidence relies on cooperation and the willingness of national governments to undertake domestic policies and structural reforms (particularly with respect to strengthening the financial sector) that are ‘acceptable’ in the sense of forgoing domestic political expediency for the collective international good. It is in relation to confidence, in particular, that the IMF has a credible and positive role to play. The IMF does not play alone in this role. Policy debate, surveillance and expertise are dispersed among numerous bodies, including the G20, the Bank for International Settlements (BIS) and the Financial Stability Board (FSB). The G20 came into being in 1999, around the time of the Asian financial crisis. The G20 comprises the seven major industrialised nations— Britain, Canada, France, Italy, Japan, Germany and the United States—plus Argentina, Australia, Brazil, China, India, Indonesia, Mexico, Russia, Saudi Arabia, South Africa, South Korea and Turkey, along with the European Union. Its membership is more representative of the 21st century global economy and financial system than other groups such as the G8. Established in 1930, the BIS is the world’s oldest international financial organisation. Based in Basel, Switzerland, the BIS serves as a discussion forum, an advisory body and a bank to the central banks of nations. In this role, it fosters international monetary and financial cooperation. Fifty-five central bank institutions currently have rights of voting and representation at BIS general meetings. The FSB (initially the Financial Stability Forum) was also convened around the time of the Asian financial crisis, in 1999. Its goal is to promote international financial stability through information exchange and international cooperation in financial sector supervision and surveillance. It brings together senior representatives of national financial authorities (e.g. central banks, supervisory authorities and treasury departments), international financial institutions, international regulatory and supervisory groupings, committees of central bank experts and the European Central Bank. These non-IMF groups, from time to time, have become the focus of policy debate and policy coordination. They gather key officials together regularly to identify potential threats to global stability and policy responses. One advantage they have is that their membership is not as broad and unwieldy as that of the 189-member IMF. They are more flexible and more likely to agree on responses to systemic risks in the global economy. However, they have their own shortcomings with respect to legitimacy and capacity. They are, in the main, forums for discussion and consultative bodies, rather than decision-making bodies. They rely on domestic governments to implement rule changes and adopt procedures in their own countries. On the other hand, the IMF already has formal mandates and resources to back up its deisions to promote international financial stability and restore and monitor a rules-based system. It has near universal representation that favours multilateralism over nationalism. These other groups will not supplant the IMF, but in order to retain a central role in the international financial architecture in the 21st century, the IMF needs to adapt. These adaptations have commenced. It has begun to strengthen its surveillance function, facilitate international cooperation among national financial regulators, and rebalance quotas and representation in its decision-making forums.55 CHAPTER 4 hiL23674_ch04_159-206.indd 195 TEST PREP Preparing for a test? Use LearnSmart to help you remember what you’ve learned. FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 195 08/07/19 04:03 PM FOCUS ON MANAGERIAL IMPLICATIONS Throughout this chapter we have alluded on several occasions to the potential impact on international business of changes in foreign exchange rates. It is critical that international companies understand the influence of exchange rates on the profitability of trade and investment contracts. Changes in exchange rates bring about changes in the prices of traded goods and services. Setting the price to remain competitive and maintain market share in foreign markets is also complicated by exchange rate changes, as adverse changes can put at risk apparently profitable deals. In this section, we look at the impact of exchange rate changes on international business operations in more detail, and how companies may manage these impacts. We begin by looking at the relationship between exchange rates and the pricing of goods in foreign markets. We follow with a discussion of the risks to which business can be exposed as a result of exchange rate changes and the strategies they may employ to mitigate these risks. LO 4.4 EXCHANGE RATES AND PRICE SETTING With dramatic swings in exchange rates, particularly in a freely floating exchange rate regime, setting prices for internationally traded goods is a challenge for international business management. The extent to which an international business adjusts prices in a foreign market as the EXCHANGE RATE PASS-THROUGH result of an exchange The extent to which an international rate change is called business adjusts prices in a foreign market as the result of an exchange exchange rate passrate change through. We can illustrate the type of pricing dilemma confronted by exporters and the pass-through concept with the numerical examples in Tables 4.3A and 4.3B. Suppose the ex-factory price of the Australian produced farm machinery is A$35 000 and the current exchange rate is A$1.60 = US$1.00. The price in the US market at this exchange rate is US$21 875, ignoring all transaction costs and assuming the manufacturer and all agents through the supply chain are satisfied that the existing mark-ups at these prices give acceptable sales and profits. Suppose 196 PART 2 now the Australian dollar appreciates towards parity, illustrated by moving down the left-hand column of Tables 4.3A and 4.3B. If the manufacturer passes through 100 per cent of the impact of the exchange rate change, as in Table 4.3A, US prices rise. If the exchange rate went to parity, it would result in a significant price rise of 60 per cent. If the exchange rate went to $1.40, the price increase would be 14 per cent. With a price rise in the US, sales would be expected to fall and market share to decline. The extent of the fall, and the extent to which the exporter is willing and able to pass through the exchange rate change, depends on a number of factors. One factor is the sensitivity of customers to price changes. If US customers buy farm machinery for non-price reasons, such as unique capability, the fall in sales will not be as great when prices rise. Another factor is the amount of competition. If other American and foreign farm machinery manufacturers offer similar machines, a price rise is likely to see a marked fall in market share. A third factor is the impact of the exchange rate change on the costs of production. If a large proportion of inputs to the production of the farm machines in Australia are imported, the costs of imported inputs will decrease as a result of the appreciation of the Australian dollar. As a result, the ex-factory price can be lowered and the foreign price rise can be reduced. If all the price-sensitivity factors align adversely against the exporter, the exporter may be forced to accept lower mark-ups. This is illustrated in Table 4.3B. If the US market for this type of farm machinery is very price-sensitive, as illustrated here, the exporter may be forced to price to what the market determines—in this case, US$21 875. In other words, the exporter has no market power to adjust prices upwards and must take the US dollar price as a given. In this situation, when the Australian dollar appreciates, the impact of the exchange rate change is on mark-ups and the ex-factory price. The pass-through is 0 per cent, as the motor-vehicle exports are priced to the market conditions. If the impact of exchange rate appreciation is such that it causes substantial cuts to ex-factory prices, a scenario arises that the export venture is no longer a sound business proposition. Of course, if the CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 196 08/07/19 04:03 PM TABLE 4.3A 100 per cent pass-through EXCHANGE RATE EX-FACTORY PRICE IN A$ FOREIGN MARKET PRICE IN US$ A$1.60 = US$1.00 A$1.40 = US$1.00 A$1.00 = US$1.00 (parity) A$35 000 A$35 000 A$35 000 US$21 875 US$25 000 US$35 000 TABLE 4.3B Pricing-to-market (0 per cent pass-through) EXCHANGE RATE EX-FACTORY PRICE IN A$ FOREIGN MARKET PRICE IN US$ A$1.60 = US$1.00 A$35 000 US$21 875 A$1.40 = US$1.00 A$1.00 = US$1.00 (parity) A$30 625 A$21 875 US$21 875 US$21 875 exchange rate depreciates, we have a more favourable mirror image of this scenario from the exporter’s point of view. FOREIGN EXCHANGE RISK Sellers (and buyers) prefer quotes and invoices in their own currency, as it means that the other party bears any foreign exchange rate risk. The choice of the invoice currency will be part of the price and contract negotiations between the buyer and seller. The decision will depend on which party has the negotiating power. A seller that is competing against other suppliers for a customer’s signature and wishes to keep prices stable in the foreign market may choose to invoice in the buyer’s currency as an inducement. Invoicing in the buyer’s currency may swing the deal, but the seller is now exposed to exchange rate risk. We next discuss what these risks are to sellers (and buyers), and how to hedge foreign currency receivables (and payments) to insure against exchange rate-related losses. These risks are usually divided into three main categories: transaction exposure, translation exposure, and economic exposure. LO 4.5 Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. Such exposure includes obligations for the purchase or sale of goods and services at agreed prices, paying dividends and the borrowing or lending of funds in foreign currencies. This is the TRANSACTION EXPOSURE The extent to which the income from individual transactions is affected by fluctuations in foreign exchange values CHAPTER 4 hiL23674_ch04_159-206.indd 197 money lost or gained due to an adverse or favourable movement in exchange rates between the time when a deal was signed and when the payment is due. Translation exposure is TRANSLATION EXPOSURE The extent to which the reported the impact of currency consolidated results and balance exchange rate changes sheets of a corporation are affected on the reported financial by fluctuations in foreign exchange statements of a company. values Translation exposure is concerned with the present measurement of past events. It is sometimes described as ‘balance sheet’ exposure. Translation is a change in monetary expression, rather than involving a physical conversion of one currency for another. It does not involve an actual cash flow. Changes in exchange rates impact the earnings, assets and liabilities of an international firm when they are translated and reported in the local currency. The resulting accounting gains or losses are said to be unrealised—that is, they are ‘paper’ gains and losses, but they are still important. Consider an Australian company with a subsidiary in Thailand. If the value of the Thai baht depreciates significantly against the Australian dollar, this would substantially reduce the dollar value of the Thai subsidiary’s equity. In turn, this would reduce the total dollar value of the company’s equity reported in its consolidated balance sheet. The decrease in value of equity would raise the apparent leverage of the company (its debt ratio), which could increase the company’s cost of borrowing and potentially limit its access to the capital market. Similarly, if the value of the baht depreciates rapidly against that of the dollar over a year, this will reduce the dollar value of the baht profit made by the Thai subsidiary, resulting in negative translation exposure. Economic exposure ECONOMIC EXPOSURE The extent to which a company’s is the extent to which future international earning power a company’s future is affected by changes in exchange international earning rates power is affected by changes in exchange rates. There is not only a conversion effect, as with transaction exposure, but also a price-competitive effect. Hence, economic exposure is concerned more with the long-run effect of changes in exchange rates on prices, sales and costs, and future operating cash flows. This is distinct from transaction exposure, which is concerned with the effect of exchange rate changes on individual transactions, most of which involve commitments already in place and are short-term affairs that will be FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 197 08/07/19 04:03 PM executed within a few weeks or months. Transaction exposure may be considered a subset of economic exposure. In the longer term, a wide and sustained swing in the value of a currency affects the international pricecompetitiveness of exporters and those domestic companies competing against imports. A sustained loss of price-competitiveness may require a company to take long-term solutions such as relocating its production facilities to another country, particularly to a country that comprises a very large share of its export market. REDUCING RISK EXPOSURES Reducing transaction and translation exposures A number of strategies can help companies to minimise their transaction and translation exposures. These strategies primarily protect short-term cash flows from adverse changes in exchange rates. Earlier in this chapter, we discussed two of these strategies: entering into forward exchange rate contracts, and buying swaps. In addition to using these financial instruments, firms’ transaction and translation exposures may be reduced by ‘natural’ hedges. A natural NATURAL HEDGE Hedging opportunities that arise hedge arises out of the from the way in which a business structure of business operates operations that create offsets between foreign currency receipts and payments. Restructuring business operations to create these offsets may reduce or eliminate transaction and translation exposures. The net exposures remaining after natural hedges may then be addressed by using financial instruments as forward and swap contracts. One such natural hedge is through leading and lagging payables and receivables—that is, paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements. A lead strategy involves attempting to LEAD STRATEGY collect foreign currency An attempt to collect foreign currency receivables early when receivables (payments a foreign currency is expected from customers) early to depreciate and to pay foreign when a foreign currency currency payables before they are is expected to depreciate, due when a currency is expected to and paying foreign appreciate currency payables (payments to suppliers) before they are due when a currency is expected to appreciate. A lag strategy involves delaying collection of foreign currency 198 PART 2 LAG STRATEGY receivables if that An attempt to delay collection of currency is expected to foreign currency receivables if that appreciate and delaying currency is expected to appreciate payables if the currency and to delay payables if that is expected to depreciate. currency is expected to depreciate Leading and lagging involves accelerating payments from weak currency to strong currency countries and delaying inflows from strong currency to weak currency countries. Lead and lag strategies can be difficult to implement, however. The company must be in a position to exercise some control over payment terms. Small companies do not usually have this kind of bargaining power, particularly when they are dealing with important customers who are in a position to dictate payment terms. Currency diversification and matching are natural hedges. Large multinational companies such as BHP operating in many different countries have their receipts, payments, assets and liabilities denominated in many different currencies. Diversification acts to reduce overall foreign exchange exposures. An appreciation of one currency means the depreciation of another, so, in the mix of currencies, gains may offset losses. A natural hedge occurs when there is a match of the currency denomination of receipts and payments.56 For example, if an Australian manufacturer exports a finished product to the United States and imports major component parts from the United States, foreign exchange exposure from these trades is limited. The income stream from exports ‘naturally’ hedges the risk associated with the US dollar import payment. Establishing foreign currency bank accounts to make payments and receive income in the foreign currency of the country with which a company trades is another mechanism for limiting exposure. This is not an option for a company that requires foreign earnings to maintain a sufficient cash flow for the business at home. Natural hedging can also arise through the conditions negotiated in contracts. The inclusion of automatic price escalation clauses relating to exchange rate changes and the determination of the invoicing currency can reduce the risk for one of the parties to the transaction. Whether or not a company can use contract conditions as a hedge depends on their bargaining power in the contract negotiations. For many smaller international businesses, natural hedging may not be viable because of their limited regional diversity of operations, cash flow demands and negotiating power. CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 198 08/07/19 04:03 PM Reducing economic exposure Reducing economic exposure requires strategic choices that go beyond the realm of financial management. It requires restructuring operations and involves decisions on the location of production, sourcing of supplies and the diversification of markets. The key to reducing economic exposure is to distribute the firm’s productive assets and sources of supplies to various locations so that the company’s long-term financial wellbeing is not severely affected by adverse changes in particular exchange rates. In theory, by locating production in different regions that use different currencies, the firm can adjust capacity utilisation so that it produces or sources more of its product in the region where the currency values are most favourable. OTHER STEPS FOR MANAGING FOREIGN EXCHANGE RISK The international company needs to develop a mechanism for ensuring it maintains an appropriate mix of strategies for minimising its foreign exchange exposure. Although there is no universal agreement as to the components of this mechanism, a number of common themes stand out. First, central control of exposure is needed to protect resources efficiently and ensure that each sub-unit adopts the correct mix of strategies. Many companies have set up in-house foreign exchange centres. Although such centres may not be able to execute all foreign exchange deals— particularly in large, complex multinationals where myriad transactions may be pursued simultaneously— they should at least set guidelines for the company’s subsidiaries to follow. exposure, which may have more profound long-term implications. Companies need to develop strategies for dealing with economic exposure such as moving production to multiple country locations to maximise flexibility, price competitiveness and the ability to respond rapidly to major currency fluctations. Third, the need to forecast future exchange rate movements cannot be overstated, though this is a tricky business. There is no model that comes close to perfectly predicting future movements in foreign exchange rates. The best that can be said is that in the short run, forward exchange rates provide the best predictors of exchange rate movements, and in the long run, fundamental economic factors—particularly relative inflation rates—should be watched because they influence exchange rate movements. Fourth, companies need to establish good reporting systems so the central finance function (or the inhouse foreign exchange centre) can regularly monitor the company’s exposure positions. Such reporting systems should enable the company to identify any exposed accounts, the exposed position by currency of each account, and the time periods covered. Foreign exchange software solutions play an important role in providing management with the ability to easily track and monitor their currency exposure across all facets of the organisation. Developments in technology have enabled companies to streamline their data-collection processes, produce real-time foreign exchange exposure reports, improve forecasting in foreign exchange movements, and hence manage exposure risks more effectively and efficiently. Second, companies should distinguish between, on the one hand, transaction and translation exposure and, on the other, economic exposure. Many companies seem to focus on reducing their transaction and translation exposure and pay scant attention to economic CHAPTER 4 hiL23674_ch04_159-206.indd 199 FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 199 08/07/19 04:03 PM KEY TERMS 184 166 165 176 188 167 192 184 169 164 188 167 197 164 196 183 adjustment Algorithmic Trading (AT) arbitrage bandwagon effect banking crisis carry trade conditionality confidence cross rate cryptocurrencies currency crisis currency speculation economic exposure exchange rate exchange rate pass-through external balance 174 178 177 189 163 180 166 170 170 168 186 183 175 184 177 198 Fisher Effect fixed exchange rate system floating exchange rate foreign debt crisis foreign exchange market foreign exchange reserves foreign exchange risk foreign exchange (FX) swap forward exchange rate hedging impossible trinity argument internal balance International Fisher Effect international liquidity international monetary system lag strategy 172 198 180 192 194 198 170 178 173 168 191 197 197 166 law of one price lead strategy managed or ‘dirty’ float system mission creep moral hazard natural hedge outright forward pegged exchange rate purchasing power parity (PPP) spot exchange rate surveillance transaction exposure translation exposure vehicle currency SUMMARY This chapter explained how foreign exchange markets work, the forces that determine exchange rates, and the attempts to construct a stable international monetary system. It examined the implications for international business of changes in exchange rates and international monetary instability, and the strategies that management may employ to address such factors. The chapter made the following points: 1. Two key functions of the foreign exchange market are to convert the currency of one country into the currency of another, and to provide insurance against foreign exchange risk. Foreign exchange risk can be reduced by using financial instruments such as forward exchange and foreign exchange swaps. 2. The laws of one price and purchasing power parity (PPP) theory predict that the exchange rate will change if relative prices change. These predictions tend to be more accurate in the long term than the short term. 3. Nominal interest rates reflect expectations about inflation. The International Fisher Effect predicts that, for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates. 4. Monetary authorities intervene to varying degrees in the foreign exchange market to achieve internal and external balance goals. The target of the intervention is usually the level or volatility of the exchange rate. Intervention will result in the accumulation or depletion of the foreign exchange reserves that are available to the monetary authority. 5. Current exchange rate regimes range over a continuum of flexibility (or fixity) between the extremes of fixed and floating exchange rates. The world’s four major trading currencies—the US dollar, the EU euro, the Japanese yen and the British pound—are all free to float against each other. Australia and New Zealand also allow their 200 PART 2 currencies to float. China pegs its exchange rate daily but allows it to fluctuate within a band around the peg. 6. The challenge for domestic governments and the international monetary system is to reconcile the goals of internal balance and external balance of national economies. To reconcile the potential conflict between these goals and maintain international monetary stability, an international monetary system must provide all nations with a mechanism for the adjustment of external imbalances without severely damaging the internal balance, a source of international liquidity to assist adjustment, and a means of building their confidence in the system. 7. In order to attain international monetary stability, the Bretton Woods system, overseen by the IMF, established essentially a fixed exchange rate system with the value of each currency pegged to the value of the US dollar. Discrete exchange rate variations were allowed only in times of external imbalances of ‘fundamental disequilibrium’. The IMF provided short-term loans to correct temporary imbalances. 8. The Bretton Woods system collapsed in 1973 primarily due to speculative attacks on currencies fostered by the asymmetrical adjustment mechanism and to a loss of confidence in the US dollar, the main source of international liquidity. Under its rules, the Bretton Woods system was unsuccessful in its attempt to reconcile internal and external balance goals. CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 200 08/07/19 04:03 PM 9. Although the Bretton Woods system has collapsed and the role of the IMF as an international manager of exchange rates has diminished, a series of regional and global financial crises has given the IMF the opportunity to reshape and strengthen its role. This new role, which is not without its critics, is performed through the functions of surveillance, lending and technical assistance. 10. Domestic political realities often mean that domestic policy goals will get preference over the goal of international monetary stability. To minimise beggarthy-neighbour policies, international cooperation is essential for international monetary stability. The IMF can become a credible forum for facilitating international cooperation by strengthening and broadening the scope of its surveillance activities and rebalancing the quotas and voice in its decision making to reflect the changing structure of the global economy. CHAPTER 4 hiL23674_ch04_159-206.indd 201 11. A changing exchange rate may force an international business to adjust prices. The business needs to decide how much of the exchange rate change to pass through to the foreign market. There is a need to balance the impact on profits with the retention of market share. 12. Fluctuating exchange rates expose an international business to three types of foreign exchange risk: transaction exposure, translation exposure and economic exposure. Ways of managing transaction and translation exposures include buying forward, using foreign exchange, and natural hedges, such as leading and lagging payables and receivables. Reducing a company’s economic exposure requires longer-term strategic choices about the sources of supplies and the location of production plants. FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 201 08/07/19 04:03 PM INTERNATIONAL BUSINESS GRADUATE ATTRIBUTES (IBGAs): LEARNING AND ASSESSMENT TASKS IBGA1: DISCIPLINE KNOWLEDGE AND SKILLS 1. Explain why many countries choose to operate a managed float system. 2. Compare and contrast the circumstances under which it is better to set prices for international trade in either the home-country or the host-country currency. IBGA2: CRITICAL ANALYSIS 3. CASE ANALYSIS Read the following Closing Case and answer the questions that follow. IBGA3: PROBLEM SOLVING 4. Your firm manufactures light bulbs. In mid-June, you receive an order for 10 000 light bulbs from Japan. Payment of ¥400 000 is due in mid-December. You expect the yen to rise from its present rate of A$1 = ¥100 to A$1 = ¥70 by December. You can borrow yen at 6 per cent a year. Explain what you should do. 5. Two countries, South Africa and Australia, each produce a similar basket of goods and services. Suppose the price of this basket in Australia was A$2000 and the price (in rand) in South Africa is R12 000. Calculate the following. a. According to PPP theory, what should be the dollar/ rand spot exchange rate? b. Suppose over the next 12 months the price of the basket is expected to rise to A$2200 in Australia and to R15 000 in South Africa. What should be the oneyear forward dollar/rand exchange rate? c. Given your answers to a and b, and given that the current interest rate in Australia is 5 per cent per annum, what would you expect the current interest rate to be in South Africa? IBGA5: COMMUNICATION 6. Search the website of the Reserve Bank of Australia (RBA) for historical data on exchange rates. Construct a graph that compares changes in the AUD/USD exchange rate to the Trade Weighted Index (TWI) over the past three years. The TWI is essentially an exchange rate against a trade-weighted basket of currencies, rather than a single currency, and includes the currencies of Australia’s principal trading partners. These weights reflect the 202 PART 2 composition of Australia’s two-way merchandise trade and are provided on the RBA website. Accompanying the graph, write a brief 250-word analysis about any observable differences in the pattern of the two exchange rate measures and probable causes of these differences. 7. Prior to 2009, Iceland was one of the richest countries in the world on a per capita basis. However, the GFC of the late 2000s wreaked economic and political havoc on the country. In 2008, the krona collapsed, as did the country’s three largest banks, which were subsequently nationalised. The economy declined by 10 per cent. Political protest saw the long-serving, business-friendly national government defeated in the elections held in early 2009, and the country was forced to secure help from the IMF. The IMF designed a reform plan as part of a US$6 billion loan package, funded jointly by the IMF and Iceland’s Nordic neighbours. The IMF claims that it no longer pushes countries to make fundamental changes— so-called structural adjustments—to their economies. Over the last decade, Turkey has also been a recipient of IMF loans, conditional on adopting a package of reforms. Turkey is a different economy to Iceland. Prepare a presentation to your class that outlines and compares the key elements of the IMF packages to Iceland and Turkey. Explain the reasons for differences in the packages. Assess whether or not structural adjustment was part of the packages. Useful websites include the IMF (www.imf. org/external/country/index.htm) and the financial press (e.g. The Economist at www.economist.com/). IBGA7: GLOBAL PERSPECTIVE 8. Explain the concept of contagion in the context of financial crises; for example, the 1997 Asian financial crisis or the 2007–09 GFC. 9. The IMF notes: ‘There is no domestic solution to global problems’. In light of the global cooperation forged during the 2007–09 GFC, the G20 initiated a ‘mutual assessment process’. This process essentially involves assessing the multilateral compatibility of national economic policies and the aggregate impact of such policies on achieving global economic outcomes. Search the IMF website (www. imf.org) for more details of this process. Illustrate using examples from the past—dating back to the pre-Bretton Woods days to more recent times, the actions of national governments that proved to be unable to solve global problems. CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 202 08/07/19 04:03 PM CLOSING CASE THE FLUCTUATING VALUE OF THE YUAN GIVES CHINESE BUSINESS A LESSON IN FOREIGN EXCHANGE RISK Between 2015 and early 2018, the Chinese currency, the yuan, fluctuated significantly in value against the US dollar, giving Chinese businesses an object lesson in the importance of managing for foreign exchange risk. From August 2015 to December 2016, the value of the yuan depreciated by 12 per cent from 6.2 yuan to the US dollar to 6.95 yuan. This depreciation was triggered by a slowdown in the Chinese economy, which led to an outflow of capital from China. Even though the Chinese government spent heavily trying to prop up the value of the yuan, using $1.5 trillion of dollar-denominated foreign exchange reserves to purchase yuan, it could not halt the decline in the value of the yuan against the dollar. While the depreciation in the yuan boosted exports, it also resulted in an unanticipated increase in the yuan price of key imports, which raised costs for a number of Chinese companies. In 2015, about 980 listed Chinese companies reported combined foreign exchange losses of 48.7 billion yuan, almost 13 times higher than in 2014, according to data compiled by Bloomberg. Hardest hit were Chinese airlines, many of which imported aviation fuel that was paid for in dollars. As the cost of fuel in terms of yuan went up, their profits slumped. In total, the Chinese airline sector registered foreign exchange losses of 17.9 billion yuan in 2015, compared with 951.7 million a year earlier. The big three state-owned airlines—China Southern Airlines, China Eastern Airlines and Air China—suffered 15.85 billion yuan in foreign-exchange currency losses in 2015. In 2017, conditions reversed. Between January 2017 and April 2018 the yuan appreciated in value by 10 CHAPTER 4 hiL23674_ch04_159-206.indd 203 per cent against the US dollar, increasing from 6.95 yuan to the dollar to 6.27 yuan. The appreciation was due to a number of factors, including a return to stronger growth in China and the election of Donald Trump in the United States. The latter event seems to have reduced the confidence that foreign investors had in the United States and resulted in an outflow of capital as investors sought to diversify their holdings of foreign assets and currency. The dollar also fell after members of the Trump administration made statements suggesting that they were happy to see it decline, since that boosted US exports. The appreciation in the value of the yuan against the dollar from January 2017 onwards reduced the yuan costs for Chinese companies that imported goods priced in dollars, such as aviation fuel. Thus Air China noted in its 2017 annual report that a 1 per cent gain in the yuan against the greenback could boost its net profits by about 280 million yuan, primarily due to reductions in the cost of aviation fuel. On the other hand, the appreciation of the yuan raised the dollar price of Chinese exports. Many exporters saw their profits squeezed as a result. In early February 2018, Guangdong Goworld, a supplier to Apple, said in a stock exchange filing that it had suffered an estimated foreign exchange loss of 45 million yuan (US$7.2 million) in January 2018 owing to a stronger yuan. The January figure alone was equal to 94 per cent of its foreign exchange losses for the first three quarters of 2017. It also translated into 34 per cent of its net profits in the first nine months of 2017. The Shenzhen-listed company manufactures and sells printed circuit boards, liquid crystal displays (LCDs) and ultrasonic electronic measuring FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 203 08/07/19 04:03 PM instruments to developed markets including the United States, Europe, Australia and Japan. In another example, a spokesperson for Zhejiang NHU, a producer of vitamins, said that even as the vitamin export market experienced a boom in 2017, the company suffered millions of yuan in foreign exchange losses. The basic problem was that the company negotiated dollar prices for its vitamins in 2016, but by the end of 2017, each dollar of sales was yielding less revenue when translated back into yuan (thanks to the appreciation of the yuan). To deal with this problem, the company set up a team to discuss the issue and employed means such as hedging and forward exchange transactions to try to minimise foreign exchange risks. SOURCES: M. Zhang and D. Ren, ‘It has dealt us a heavy blow’, South China Morning Post, 7 April 2018; X. Yu, ‘Chinese companies foreign exchange losses soared last year’, South China Morning Post, 6 April 2016; ‘Exporters feel the bite of a stronger yuan’, Global Times, 2 April 2018. CLOSING CASE DISCUSSION QUESTIONS a. What could Zhejieng NHU have done to mitigate its foreign exchange losses? b. What were the reasons for the yuan appreciating between January 2017 and April 2018? c. What triggered the fall of the yuan between 2015 and 2016? d. What is the easiest way for SMEs to hedge against foreign exchange risks? 204 PART 2 CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 204 08/07/19 04:03 PM ENDNOTES 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. Bank for International Settlements, Triennial Central Bank Survey of Foreign Exchange Turnover in April 2016, accessed via www.bis.org/publ/rpfx16fx. pdf on 3 December 2018. Ibid., Table 6. www.investopedia.com/articles/forex/053115/basics-forex-algorithmictrading.asp A detailed description of the economics of foreign exchange markets can be found in P.R. Krugman, M. Obstfeld and M. Melitz, International Economics: Theory and Policy, New York: Prentice Hall, 2011. Austrade, ‘Export pricing and quotations’, accessed via www.austrade.gov. au/Australian/Export/Guide-to-exporting/Export-pricing on 10 December 2018. G. Hopper, ‘What determines the exchange rate: economic factors or market sentiment?’, Business Review, September/October 1997. Ibid. For a comprehensive review, see M. Taylor, ‘The economics of exchange rates’, Journal of Economic Literature, 33 (1995), pp. 13–47. Economists have been investigating this issue for a considerable time. See H.J. Edison, J.E. Gagnon and W.R. Melick, ‘Understanding the empirical literature on purchasing power parity’, Journal of International Money and Finance, 16 (February 1997), pp. 1–18; J.R. Edison, ‘MultiCountry evidence on the behavior of purchasing power parity under the current float’, Journal of International Money and Finance, 16 (February 1997), pp. 19–36; K. Rogoff, ‘The purchasing power parity puzzle’, Journal of Economic Literature, 34 (1996), pp. 64–78; D.R. Rapach and M.E. Wohar, ‘Testing the monetary model of exchange rate determination: New evidence from a century of data’, Journal of International Economics, December 2002, pp. 35–95; and M.P. Taylor, ‘Purchasing power parity’, Review of International Economics, August 2003, pp. 436–56. M. Obstfeld and K. Rogoff, ‘The six major puzzles in international economics’, National Bureau of Economic Research working paper no. 7777, July 2000. Ibid. See M. Devereux and C. Engel, ‘Monetary policy in the open economy revisited: price setting and exchange rate flexibility’, National Bureau of Economic Research working paper no. 7665, April 2000. See also P. Krugman, ‘Pricing to market when the exchange rate changes’, in S. Arndt and J. Richardson (eds), Real Financial Economics, Cambridge, MA: MIT Press, 1987. For a summary of the evidence, see the survey by M.P. Taylor, ‘The economics of exchange rates’, op. cit. R.E. Cumby and M. Obstfeld, ‘A note on exchange rate expectations and nominal interest differentials: a test of the Fisher Hypothesis’, Journal of Finance, June 1981, pp. 697–703; and L. Coppock and M. Poitras, ‘Evaluating the Fisher Effect in long-term cross country averages’, International Review of Economics and Finance, 9 (2000), pp. 181–203. Taylor, ‘The economics of exchange rates’, op. cit.; see also R.K. Lyons, The Microstructure Approach to Exchange Rates, Cambridge, MA: MIT Press, 2002. See H.L. Allen and M.P. Taylor, ‘Charts, noise, and fundamentals in the foreign exchange market’, Economic Journal, 100 (1990), pp. 49–59; and T. Ito, ‘Foreign exchange rate expectations: micro survey data’, American Economic Review, 80 (1990), pp. 434–49. G. Stevens, The Asian Crisis: A Retrospective, Address to the Anika Foundation Luncheon, Reserve Bank of Australia, 18 July 2007. International Monetary Fund, ‘De facto classification of exchange rate regimes and monetary policy framework’, July 2006, accessed via www.imf. org/external/np/mfd/er/2006/eng/0706.htm on 10 December 2018. The Reserve Bank of Australia, ‘The exchange rate and the Reserve Bank’s role in the foreign exchange market’, January 2018, accessed via www.rba. gov.au/mkt-operations/ex-rate-rba-role-fx-mkt.html on 10 December 2018. International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions 2017, accessed via www.imf.org/~/media/Files/ Publications/AREAER/areaer-2017-overview.ashx on 5 December 2018. Ibid. N. Bjorksten and A. Brook, ‘Exchange rate strategies for small open developed economies such as New Zealand’, Bulletin, Reserve Bank of New Zealand, 65(1), p. 23. International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions 2017, op. cit. CHAPTER 4 hiL23674_ch04_159-206.indd 205 24. R. Mareno, Motives for Intervention, Bank for International Settlements, BIS Papers no. 24, May 2005, accessed via www.bis.org/publ/bppdf/bispap24b. pdf on 10 December 2018. 25. Group of Twenty, Declaration: Summit on Financial Markets and the World Economy, Washington, 15 November 2008. 26. See R. Gilpin, Global Political Economy: Understanding the International Economic Order, Princeton: Princeton University Press, 2001, pp. 242–50; G. Meier, The International Environment of Business: Competition and Governance in the Global Economy, Oxford: Oxford University Press, 1998, pp. 427–30. 27. For a more detailed account of the demise of Bretton Woods, see R. Solomon, The International Monetary System 1945–1981, New York: Harper & Row, 1982. 28. P.R. Krugman and M. Obstfeld, International Economics, op. cit, Ch 15; B. Eichengreen, Globalizing Capital: A History of the International Monetary System, Princeton: Princeton University Press, 1996. 29. For an excellent overview of the changing role of the IMF prior to the Global Financial Crisis of 2007, see M. Parkinson and A. McKissack, ‘The IMF and the challenge of relevance in the international financial architecture’, Economic Roundup, Australian Government, The Treasury, Winter 2003. 30. International Monetary Fund, Factsheet: IMF Lending, March 2018, accessed via www.imf.org/external/np/exr/facts/howlend.htm on 8 December 2018. 31. L. Laeven and F. Valencia, Systemic Banking Crises Database: An Update, International Monetary Fund (IMF) Working Paper 12/163, 1 June 2012, accessed via www.imf.org/external/pubs/ft/wp/2012/wp12163.pdf on 10 December 2018. 32. Ibid. 33. International Monetary Fund, Factsheet: How the IMF Promotes Global Economic Stability, accessed via www.imf.org/external/np/exr/facts/ changing.htm on 10 December 2018. 34. International Monetary Fund, World Economic Outlook, 1998. 35. L. Laeven and F. Valencia, IMF Working Paper: Systemic Banking Crisis Revisited, accessed via www.imf.org/~/media/Files/Publications/WP/2018/ wp18206.ashx on 5 December 2018. 36. R. Altman, ‘The great crash, 2008: a geopolitical setback for the West’, Foreign Affairs, 88(1) (January/February 2009); M. Goldstein, ‘A grand bargain for the London G20 summit: insurance and obeying the rules’, VoxEU.org, February 2009, accessed via https://voxeu.org/article/grandbargain-london-g20-summit on 10 December 2018. 37. M. Feldstein, ‘Refocusing the IMF’, Foreign Affairs, 77(2) (March/April 1998). 38. International Monetary Fund, Factsheet: How the IMF Promotes Global Economic Stability, March 2018, accessed via https://www.imf.org/en/ About/Factsheets/Sheets/2016/07/27/15/22/How-the-IMF-PromotesGlobal-Economic-Stability on 10 December 2018. 39. Parkinson and McKissack, ‘The IMF and the challenge of relevance in the international financial architecture’ (2003), op. cit.; International Monetary Fund, Initial Lessons of the Crisis for the Global Architecture and the IMF, Strategy, Policy and Review Departments, 18 February 2009, accessed via www.imf.org/external/np/pp/eng/2009/021809.pdf on 10 December 2018. 40. International Monetary Fund, IMF Lending Arrangements as of October 2018, accessed via www.imf.org/external/np/fin/tad/extarr11. aspx?memberKey1=ZZZZ&date1key=2020-02-28 on 5 December 2018. 41. International Monetary Fund, Factsheet: IMF Lending, March 2018. Available https://www.imf.org/en/About/Factsheets/IMF-Lending, accessed 10 December 2018. 42. J. Sachs, ‘Power unto itself’, Financial Times, 9 December 1997, p. 11; M. Feldstein, ‘Refocusing the IMF’, Foreign Affairs, 77(2) (March/April 1998). 43. S. Babb and A. Buira, Mission Creep, Mission Push and Discretion in Sociological Perspective: The Case of IMF Conditionality, Geneva, 8–9 March 2004, accessed via www.g24.org/wp-content/uploads/2016/01/ Mission-Creep-Mission-Push-and-Discretion-in-Sociological-Perspective. pdf on 10 December 2018. 44. Feldstein, ‘Refocusing the IMF’ (1998), op. cit. 45. ‘Reshaping the IMF’, The Economist, 22 April 2006, p. 83. 46. The Asian Century Institute, Chiang Mai Initiative: An Asian IMF?, 5 April 2017, accessed via http://asiancenturyinstitute.com/economy/248-chiangmai-initiative-an-asian-imf on 10 December 2018. 47. D. Dodge, ‘The evolving international monetary order and the need for an evolving IMF’, Bank of Canada Review, Spring 2006. 48. Feldstein, ‘Refocusing the IMF’ (1998), op. cit.; Sachs, ‘Power unto itself’ (1997), op. cit., p. 11. 49. M. Wolf, ‘Same old IMF medicine’, Financial Times, 9 December 1997, p. 12. FOREIGN EXCHANGE AND THE INTERNATIONAL MONETARY SYSTEM 205 08/07/19 04:03 PM 50. S. Claessens, C. Pazarbasioglu, L. Laeven, M. Dobler, F. Valancia, O. Nedelescu and K. Seal, Crisis Management and Resolutions: Early Lessons from the Financial Crisis, IMF, March 2011, accessed via www.imf.org/ external/pubs/ft/sdn/2011/sdn1105.pdf on 10 December 2018. 51. Ibid. 52. J. Williamson, ‘Reforming the IMF’, VoxEU.org, February 2009, accessed via https://piie.com/commentary/op-eds/reforming-imf on 10 December 2018. 53. International Monetary Fund, Factsheet: IMF Quotas, April 2018, accessed via www.imf.org/en/About/Factsheets/Sheets/2016/07/14/12/21/ IMF-Quotas on 6 December 2018. 54. L. Wroughton, ‘IMF vote reform bogged down by delays, deadlock’, Reuters, 8 October 2012, accessed via www.reuters.com/ 206 PART 2 article/2012/10/08/us-imf-governance-idUSBRE8970B120121008 on 10 December 2018. 55. International Monetary Fund, Initial Lessons of the Crisis for the Global Architecture and the IMF, Strategy, Policy and Review Departments, 18 February 2009, accessed via https://www.imf.org/external/np/pp/ eng/2009/021809.pdf on 10 December 2018. 56. For examples of the use of matching see H. Kamil, How Do Exchange Rate Regimes Affect Firms’ Incentives to Hedge Currency Risk? Micro Evidence for Latin America, IMF Working Paper WP/12/69, March 2012, accessed via www.imf.org/external/pubs/ft/wp/2012/wp1269.pdf on 10 December 2018. CROSS-BORDER LINKAGES: TRADE, INVESTMENT AND EXCHANGE hiL23674_ch04_159-206.indd 206 08/07/19 04:03 PM 3 © Cherkas/Shutterstock COUNTRY DIFFERENCES CHAPTER 5 DIFFERENCES IN CULTURE CHAPTER 6 POLITICAL AND LEGAL ENVIRONMENTS CHAPTER 7 ECONOMIC ENVIRONMENT CHAPTER 8 ETHICS AND CORPORATE RESPONSIBILITY CHAPTER 9 COUNTRY MARKET RESEARCH hiL23674_ch05_207-254.indd 207 08/06/19 07:50 PM © Rawpixel.com/Shutterstock CHAPTER 5 DIFFERENCES IN CULTURE 208 PART 3 COUNTRY DIFFERENCES hiL23674_ch05_207-254.indd 208 08/06/19 07:50 PM INTERNATIONAL BUSINESS GRADUATE ATTRIBUTES (IBGAs) This chapter’s content, learning resources and case studies provide you with the opportunity to develop a number of International Business Graduate Attributes (IBGAs), including the following: IBGA1 IBGA2 IBGA3 IBGA5 IBGA6 Discipline Knowledge and Skills Critical Analysis Problem Solving Communication Social Interaction LEARNING OBJECTIVES (LOs) 5.1 5.2 5.3 5.4 5.5 Know what is meant by the culture of a society. Identify the forces that lead to differences in culture. Identify the business and economic implications of differences in culture. Understand how differences in culture influence the conduct of business. Develop an appreciation for the economic and business implications of cultural change. CHAPTER 5 hiL23674_ch05_207-254.indd 209 DIFFERENCES IN CULTURE 209 08/06/19 07:50 PM OPENING CASE EVOLVING CULTURE AT PANASONIC Founded by Ko–nosuke Matsushita in 1918, the consumer electronics giant Panasonic has grown from manufacturing light bulbs in Matsushita’s home in Osaka with three employees to a global giant with 250 000 employees and more than $70 billion in sales in 2018. With a founding philosophy of placing customer and employee needs first, Panasonic was at the forefront of Japan’s rise to the status of major economic power during the 1970s and 1980s (before 2009, Panasonic was known as Matsushita). Like many other longstanding Japanese businesses, Panasonic was regarded as a bastion of traditional Japanese values based on strong group identification, reciprocal obligations and loyalty to the company. Several commentators attributed Panasonic’s success, and that of the Japanese economy, to the existence of Confucian values in the workplace. At Panasonic, employees were taken care of by the company from ‘the cradle to the grave’. Panasonic provided them with a wide range of benefits including cheap housing, guaranteed lifetime employment, seniority-based pay systems and generous retirement bonuses. In return, Panasonic expected, and got, loyalty and hard work from its employees. To Japan’s postwar generation, struggling to recover from the humiliation of defeat, it seemed like a fair bargain. The employees worked hard for the greater good of Panasonic, and Panasonic reciprocated by bestowing ‘blessings’ on employees. However, culture does not stay constant. According to some observers, the generation born after 1964 lack the same commitment to traditional Japanese values as their parents. They grew up in a world that was richer, where Western ideas were beginning to make themselves felt and where the possibilities seemed greater. They did not want to be tied to a company for life, to be a ‘salaryman’. These trends came to the fore in the 1990s when the Japanese economy entered a prolonged economic slump. As the decade progressed, one Japanese company after another was forced to change its traditional ways of doing business. Slowly at first, troubled companies started to lay off older workers, effectively abandoning lifetime employment guarantees. As younger people saw this happening, they concluded that loyalty to a company 210 PART 3 might not be reciprocated, effectively undermining one of the central bargains made in postwar Japan. Panasonic was one of the last companies to turn its back on Japanese traditions, but in 1998, after years of poor performance, it began to modify traditional practices. The principal agents of change were a group of managers who had extensive experience in Panasonic’s overseas operations, and included Kunio Nakamura, who became the company’s chief executive in 2000. First, Panasonic changed the pay scheme for its 11 000 managers. In the past, the traditional twice-a-year bonuses were based almost entirely on seniority, but now Panasonic said they would be based on performance. In 1999, Panasonic announced this process would be made transparent: managers would be shown their performance rankings and how these fed into pay bonuses. As elementary as this might sound in the West, for Panasonic it represented the beginning of a revolution in human resource practices. About the same time, Panasonic took aim at the lifetime employment system and the associated perks. Under the new system, recruits were given the choice of three employment options. First, they could sign on to the traditional option. Under this, they were eligible to live in subsidised company housing, go free to companyorganised social events and buy subsidised services such as banking from group companies. They also still would receive a retirement bonus equal to two years’ salary. Under the second scheme, employees could forgo the guaranteed retirement bonus in exchange for a higher starting salary and keep perks such as cheap company housing. Under the third scheme, they would lose both the retirement bonus and the subsidised services, but they would start at an even higher salary. In its first two years of operation, only 3 per cent of recruits chose the third option—suggesting that there is still a hankering for the traditional paternalistic relationship—but 41 per cent took the second option. In other ways Panasonic’s designs are grander still. As the company has moved into new industries such as software engineering and network communications technology, COUNTRY DIFFERENCES hiL23674_ch05_207-254.indd 210 08/06/19 07:50 PM it has begun to sing the praises of democratisation of employees and it has sought to encourage individuality, initiative taking and risk seeking among its younger employees. But while such changes may be easy to articulate, they are hard to implement. For all of its talk, Panasonic has been slow to dismantle its lifetime employment commitment to those hired under the traditional system. This was underlined in early 2001 when, in response to continued poor performance, Panasonic announced it would close 30 factories in Japan, cut 13 000 jobs (including 1000 management jobs) and sell a ‘huge amount of assets’ over the next three years. While this seemed to indicate a final break with the lifetime employment system—it represented the first layoffs in the company’s history—the company also said unnecessary management staff would not be fired but instead transferred to higher growth areas such as health care. With so many of the company’s managers a product of the old way of doing things, a sceptic might question the company’s ability to turn its intentions into reality. As growth has slowed, Panasonic has had to cut back on its hiring, but its continued commitment to longstanding employees means that the average age of its workforce is rising. In the 1960s it was around 25; by the early 2000s it was 35, a trend that might counteract Panasonic’s attempts to revolutionise the workplace, for surely those who benefited from the old system will not give way easily to the new. Still, by the mid-2000s it was clear that Panasonic was making progress. After significant losses in 2002, the company broke even in 2003 and started to make profits again in 2004. New growth drivers—such as sales of DVD equipment—helped, but so did the cultural and organisational changes that enabled the company to better exploit these new opportunities. The company continued to make solid profits until 2009, when, like most enterprises, it was hit by the global recession. Panasonic’s response to this showed how much the company had changed. The company quickly announced that it would close 27 plants and lay off 15 000 employees, half of them in Japan, signalling, perhaps, the demise of its lifetime employment commitments that the founder made. Marking its 100th anniversary Panasonic will need to continue to innovate, adapt to changing competition and evolve its organisational culture to continue to succeed in the dynamic global marketplace. SOURCES: ‘Putting the bounce back into Matsushita’, The Economist, 22 May 1999, pp. 67–8; ‘In search of the new Japanese dream’, The Economist, 19 February 2000, pp. 59–60; P. Landers, ‘Matsushita to restructure in bid to boost thin profits’, The Wall Street Journal, 1 December 2000, p. A13; M. Tanikawa, ‘A pillar of Japan Inc. finally turns around; work in progress’, International Herald Tribune, 28 August 2004, pp. 17–18; ‘Panasonic will slash jobs, shut 27 plants’, Los Angeles Times, 5 February 2009, p. C3; Panasonic history accessed via www.panasonic-electric-works.com/en/100th-anniversary/timeline.htm on 14 October 2018; Forbes, www.forbes.com/companies/panasonic/#50ef318e5774, accessed on 14 October 2018. INTRODUCTION International business is different from domestic business because countries are different. In this chapter, we explore how differences and similarities in culture across countries can affect international business. Several themes run through this chapter. The first theme is that business success in a variety of countries requires cross-cultural literacy. By cross-cultural literacy, we mean an understanding of how cultural differences across and within nations can affect the way business is practised. In these days of global communications, rapid transportation and worldwide markets, it is easy to forget just how different various cultures really are. Underneath the veneer of modernism, deep cultural differences often remain. Westerners in general are quick to conclude that because people from other parts of the world also wear jeans, listen to Western popular music, eat at McDonald’s and drink Coca-Cola, they also accept the basic tenets of Western culture. However, this is not true. For example, increasingly, the Chinese are embracing the material products of modern society. Anyone who has visited China cannot fail to be struck by how modern many Chinese cities seem, with their skyscrapers, department stores and CHAPTER 5 hiL23674_ch05_207-254.indd 211 CROSS-CULTURAL LITERACY An understanding of how cultural differences across and within nations can affect the way business is practised DIFFERENCES IN CULTURE 211 08/06/19 07:50 PM © Glow Images freeways. Yet beneath the veneer of Western modernism, longstanding cultural traditions rooted in a 2000-year-old ideology continue to have an important influence on the way business is transacted in China. In China, guanxi— relationships backed by reciprocal obligations—are central to getting business done, and firms that lack sufficient guanxi may find themselves at a disadvantage. In this chapter, we argue that it is important for foreign businesses to gain an understanding of the culture that prevails in those countries where they do business. Another theme developed in this chapter is that a relationship may exist between culture and the cost of doing business in a country or region. Different cultural attributes may increase or lower the costs of doing business. Japan’s modernity and the appearance of Western For example, some observers have argued that cultural modernism do not translate into cultural similarity. factors lowered the costs of doing business in Japan and helped to explain Japan’s rapid economic ascent during the 1960s, 1970s and 1980s.1 However, as highlighted by the opening case, cultures change over time. This brings us to another theme that we explore in this chapter. Culture is not static. It can and does evolve, although the rate at which it can change is the subject of some dispute. In Australia and New Zealand, significant changes in culture have occurred during the past 60 years, partly due to the influx of new migrants and advances in technology. WHAT IS CULTURE? LO 5.1 CULTURE A system of values and norms that are shared among a group of people and that when taken together constitute a design for living Scholars have never been able to agree on a simple definition of culture. In the 1870s, the anthropologist Edward Tylor defined culture as ‘that complex whole which includes knowledge, belief, art, morals, law, custom, and other capabilities acquired by man as a member of society’.2 Since then, hundreds of other definitions have been offered. Geert Hofstede, an expert on cross-cultural differences and management, defined culture as ‘the collective programming of the mind which distinguishes the members of one human group from another . . . Culture, in this sense, includes systems of values; and values are among the building blocks of culture’.3 Another definition of culture comes from sociologists Zvi Namenwirth and Robert Weber, who see culture as a system of ideas and argue that these ideas constitute a design for living.4 Ed Schein (2010) defines the culture of a group as: . . . a pattern of shared basic assumptions learned by a group as it solved its problems of external adaptation and internal integration, which has worked well enough to be considered valid and, therefore, to be taught to new members as the correct way to perceive, think, and feel in relation to those problems.5 VALUES Abstract ideas about what a group believes to be good, right and desirable NORMS The social rules and guidelines that prescribe appropriate behaviour in particular situations 212 PART 3 This definition does not capture the size or location of the social unit. As Schein points out, within countries, minorities, religions and other social groups have cultures—macrocultures. Also, Schein identified the potential for large MNCs such as Unilever to have a corporate culture, in spite of the presence of a multitude of subcultures within the organisation. Here we follow Hofstede, Schein and Namenwirth and Weber, by viewing culture as a system of values and norms that are shared among a group of people, and that when taken together constitute a design for living. By values we mean abstract ideas about what a group believes to be good, right and desirable. Put differently, values are shared assumptions about how things ought to be.6 By norms we mean the social rules and guidelines that COUNTRY DIFFERENCES hiL23674_ch05_207-254.indd 212 08/06/19 07:50 PM prescribe appropriate behaviour in particular situations. We use the term ‘society’ to refer to a group of people who share a common set of values and norms. While a society may be equivalent to a country, some countries harbour several societies (i.e. they support multiple cultures), and some societies embrace more than one country. SOCIETY A group of people who share a common set of values and norms Values and norms Values form the bedrock of a culture. They provide the context within which a society’s norms are established and justified. They may include a society’s attitudes towards such concepts as individual freedom, democracy, truth, justice, honesty, loyalty, social obligations, collective responsibility, the role of women, love, sex, marriage, and so on. Values are not just abstract concepts; they are invested with considerable emotional significance. People argue, fight and even die over values such as freedom. Values are also often reflected in the political and economic systems of a society. Norms are the social rules that govern people’s actions towards one another. Norms can be subdivided further into two main categories: the routine conventions of everyday life, and other norms that are seen as central to the functioning of a society and to its social life. The routine conventions of everyday life Generally, these are social conventions concerning things such as the appropriate dress code in a particular situation, good social manners, eating with the correct utensils, neighbourly behaviour and the like. However, violation of these norms is not considered to be a serious matter. People who violate them may be thought of as eccentric or illmannered, but they are not usually considered to be evil or bad. In many countries, foreigners may initially be excused for violating some of these norms. Attitude towards time People are keenly aware of the passage of time in Australia, the United States and Northern European cultures such as Germany and Britain. Businesspeople are very conscious about scheduling their time and are quickly irritated when their time is wasted because a business associate is late for a meeting or they are kept waiting. They talk about time as though it were money, as something that can be spent, saved, wasted and lost.7 Alternatively, in Arab, Latin, Mediterranean and many Asian cultures, time has a more elastic character. Keeping to a schedule is viewed as less important than finishing an interaction with people. For example, an Australian or New Zealand businessperson might feel insulted if he or she is kept waiting for 30 minutes outside the office of a Latin American executive before a meeting, but the executive may simply be completing an interaction with an associate and view the information gathered from this encounter as more important than sticking to a rigid schedule. The Latin American executive intends no disrespect, but due to different perspectives about the importance of time, the Australian may see things differently. Similarly, Saudi attitudes to time have been shaped by their nomadic Bedouin heritage, in which precise time played no real role and arriving somewhere ‘tomorrow’ might mean next week. Like Latin Americans, many Saudis are unlikely to understand the general Western obsession with precise time and schedules, and Australians and New Zealanders need to adjust their expectations accordingly. However, it is not uncommon to find that businesspeople of cultures where precise timing is less important will accommodate the needs of business partners who view ‘time as money’. Rituals and symbols Rituals and symbols are the most visible manifestations of a culture and constitute the outward expression of deeper values. For example, upon meeting a foreign business executive, a Japanese executive will hold his or her business card in both hands and bow CHAPTER 5 hiL23674_ch05_207-254.indd 213 DIFFERENCES IN CULTURE 213 08/06/19 07:50 PM © Dave and Les Jacobs/Blend Images LLC while presenting the card to the foreigner.8 This ritual behaviour is loaded with deep cultural symbolism. The card specifies the rank of the Japanese executive, which is a very important piece of information in a hierarchical society such as Japan. (Japanese businesspeople often have business cards with Japanese printed on one side and English on the other.) The bow is a sign of respect, and the deeper the angle of the bow, the greater the reverence one person shows for the other. The person receiving the card is expected to examine it carefully, which is a way of returning respect and acknowledging the card giver’s position in the hierarchy. The foreigner is also expected to bow when taking the card, and to return the greeting by presenting the Japanese executive with his or her own card, similarly bowing in the process. Failure to bow and to read the given card, and to casually pocket it, violates this ritual and is considered rude. There are other norms that are seen as central to the functioning of a society and to its social life. They have much greater significance than the routine conventions of In a number of Asian countries there are deep-seated everyday life discussed above. Accordingly, violating these rituals associated with exchanging business cards and it is norms can bring serious retribution. These norms include important to follow these rituals. It is a mark of respect to your business partners. such factors as indictments against theft, adultery, incest and cannibalism. In many societies, certain norms have been enacted into law. Thus, all advanced societies have laws against theft, incest and cannibalism. However, there are also many differences between cultures. In Australia, for example, drinking alcohol is widely accepted, whereas in Saudi Arabia the consumption of alcohol is viewed as violating an important social norm and is punishable by imprisonment (as some Western citizens working in Saudi Arabia have discovered). ANOTHER PERSPECTIVE ONLINE VIEW OF OTHER CULTURES Visit the English versions of major foreign newspapers online to get a sense of their cultural values, social structure and markets. Look at the ads and business names. Check out the classifieds. See www.onlinenewspapers.com. Culture, society and the nation-state We have defined a society as a group of people who share a common set of values and norms; that is, people who are bound together by a common culture. There is not a strict one-to-one correspondence between a society and a nation-state. Nation-states are political creations. They may contain a single culture or several cultures. While the French nation can be thought of as the political embodiment of French culture, the nation of Canada has at least three cultures—an Anglo culture, a French-speaking ‘Quebecois’ culture and a Native American culture. In Australia, Indigenous people are an extremely diverse group 214 PART 3 COUNTRY DIFFERENCES hiL23674_ch05_207-254.indd 214 08/06/19 07:50 PM consisting of more than 500 distinct groups or ‘nations’: in the past, there were hundreds of languages and dialects and a multitude of distinct cultures.9 Many African nations have important cultural differences between tribal groups, as witnessed in the early 1990s when Rwanda dissolved into a bloody civil war between two tribes, the Tutsi and the Hutu. Like Africa, India is composed of many distinct cultural groups. During the first Gulf War (which began in 1990) Iraq was seen as a homogenous Arab nation. However, we have learned that several different societies exist within Iraq, each with its own culture and history. The Kurds in the north do not view themselves as Arabs and have their own distinct history and traditions. There are two Arab societies: the Shiites in the south, and the Sunnis who populate the middle of the country and who ruled Iraq under the regime of Saddam Hussein. (‘Shiite’ and ‘Sunni’ refer to different sects within the religion of Islam.) Among the southern Sunnis is another distinct society of 500 000 Marsh Arabs who live at the confluence of the Tigris and Euphrates Rivers, pursuing a way of life that dates back 5000 years.10 At the other end of the scale are cultures that embrace a number of nations. Several scholars argue that we can speak of an Islamic society or culture shared by citizens residing in different nations in the Middle East, in Asia and in Africa. To complicate things further, it is also possible to talk about culture at different levels. It is common to talk about ‘Australian society’ and ‘Australian culture’, but there are several societies within Australia—each with its own culture. Within Australia one can talk about Indigenous culture, Chinese culture, Italian culture, Indian culture and Greek culture. In Aotearoa (New Zealand), the relationship between culture and country is often ambiguous in Māori and non-Māori culture, each of which consists of several societies. One cannot always characterise a country as having a single homogenous culture; and even when one can, in a country such as Japan, one must also often recognise that the national culture is a mosaic of subcultures. The determinants of culture AOTEAROA Māori name for New Zealand LO 5.2 The values and norms of a culture do not emerge fully formed. They are the evolutionary product of a number of factors, including the prevailing political and economic philosophies; the social structure of a society; and the dominant religion, language and education (see Fig. 5.1). In addition, the political and economic philosophies influence FIGURE 5.1 The determinants of culture Religion Social structure Political philosophy Cultural norms and value systems Economic philosophy Language Education CHAPTER 5 hiL23674_ch05_207-254.indd 215 DIFFERENCES IN CULTURE 215 08/06/19 07:50 PM the value systems of a society. For example, the values found in Communist North Korea towards freedom, justice and individual achievement are clearly different from the values found in Australia, precisely because the two societies operate according to different political and economic philosophies. Below we discuss the influence of social structure, religion, language and education. The chain of causation runs both ways. While factors such as social structure and religion clearly influence the values and norms of a society, the values and norms of a society can influence social structure and religion. SOCIAL STRUCTURE SOCIAL STRUCTURE The basic social organisation of a society A society’s social structure refers to its basic social organisation. Although social structure consists of many different aspects, two dimensions are particularly important when explaining differences between cultures. The first is the degree to which the basic unit of social organisation is the individual, as opposed to the group. In general, Western societies tend to emphasise the primacy of the individual, whereas in many Asian societies the focus is on the group. The second dimension is the degree to which a society is stratified into classes or castes. Some societies are characterised by a relatively high degree of social stratification and relatively low mobility between strata (e.g. Indian society); other societies are characterised by a low degree of social stratification and high mobility between strata (e.g. the Australian, New Zealand and American societies). Individuals and groups LO 5.3 GROUP An association of two or more individuals who have a shared sense of identity and who interact with each other in structured ways on the basis of a common set of expectations about each other’s behaviour A group is an association of two or more individuals who have a shared sense of identity and who interact with each other in structured ways on the basis of a common set of expectations about each other’s behaviour.11 Human social life is group life. Individuals are involved in families, work groups, social groups, recreational groups, and so on. However, while groups are found in all societies, societies differ according to the degree to which the group is viewed as the primary means of social organisation.12 In some societies, individual attributes and achievements are viewed as being more important than group membership; in others, the reverse is true. The individual In many Western societies, the individual is the basic building block of social organisation. This is reflected not just in the political and economic organisation of society, but also in the way people perceive themselves and relate to each other in social and business settings. Researchers such as Harry Triandis suggested that individualistic societies can be subdivided into two subgroups—namely, horizontal and vertical individualism. Horizontally individualistic countries include Australia and the Scandinavian countries such as Sweden and Denmark where the emphasis is on independence of action and equality with others. (It is also important to note that within Australia and New Zealand, the Aboriginal and Māori people respectively tend to be group-oriented societies.) However, most wealthy Western countries, such as the United States and the United Kingdom, tend to be vertically individualistic countries where independence of action and standing out from others is emphasised.13 The emphasis on individual performance in many Western societies has both beneficial and harmful aspects. In Australia and the United States, the emphasis on individual performance finds expression in an admiration of rugged individualism and entrepreneurship. One benefit of this is the high level of entrepreneurial activity in Western societies. Individualism also finds expression in a high degree of managerial mobility between companies, and this is not always a good thing. Although moving from company to 216 PART 3 COUNTRY DIFFERENCES hiL23674_ch05_207-254.indd 216 08/06/19 07:50 PM company may be good for individual managers who are trying to build impressive resumés, it is not necessarily a good thing for companies. The lack of loyalty and commitment to an individual company, and the tendency to move on for a better offer, can result in managers who have good general skills but lack the knowledge, experience and network of interpersonal contacts that come from years of working within the same company. An effective manager draws on company-specific experience, knowledge and a network of contacts to find solutions to current problems, and Australian companies may suffer if their managers lack these attributes. One positive aspect of high-managerial mobility is that executives are exposed to different ways of doing business. The ability to compare business practices helps executives to identify how good practices and techniques developed in one company might be profitably applied to other companies. The emphasis on individualism may also make it difficult to build teams within an organisation to perform collective tasks. Individuals are always competing with each other on the basis of individual performance, so it may be difficult for them to cooperate. The emphasis on individualism in Australia and the United States, while helping to create a dynamic, entrepreneurial economy, may raise the costs of doing business due to its adverse impact on managerial stability and cooperation. The group In contrast to the Western emphasis on the individual, the group is the primary unit of social organisation in many other societies. For example, in Japan, the social status of an individual is determined as much by the standing of the group to which he or she belongs as by his or her individual performance.14 In traditional Japanese society, the group was the family or village to which an individual belonged. Today, the group has frequently come to be associated with the work team or business organisation to which an individual belongs. In a now-classic study of Japanese society, Chie Nakane noted how this orientation expresses itself in everyday life: When a Japanese faces the outside (confronts another person) and affixes some position to himself socially he is inclined to give precedence to institution over kind of occupation. Rather than saying, ‘I am a typesetter’ or ‘I am a filing clerk’, he is likely to say, ‘I am from B Publishing Group’ or ‘I belong to S company’.15 Nakane goes on to observe that the primacy of the group to which an individual belongs often evolves into a deeply emotional attachment in which identification with the group becomes all-important in one’s life. One central value of Japanese culture is the importance attached to group membership. This may have beneficial implications for business organisations. Strong identification with the group is urged to create pressures for mutual self-help and collective action. If the worth of an individual is closely linked to the achievements of the group (e.g. the company), as Nakane maintains is the case in Japan, this creates a strong incentive for individual members of the group to work together for the common good. Some argue that the success of Japanese enterprises in the global economy has been based partly on their ability to achieve close cooperation between individuals within a company and between companies. This has found expression in the widespread diffusion of self-managing work teams within Japanese organisations, the close cooperation among different functions within Japanese companies (e.g. among manufacturing, marketing and R&D) and the cooperation between a company and its suppliers on issues such as design, quality control and inventory reduction.16 In all these cases, cooperation is driven by the need to improve the performance of the group (i.e. the business organisation). The primacy of the value of group identification also discourages managers and workers from moving from company to company. Lifetime employment in a particular company was CHAPTER 5 hiL23674_ch05_207-254.indd 217 DIFFERENCES IN CULTURE 217 08/06/19 07:50 PM long the norm in certain sectors of the Japanese economy.17 Over the years, managers and workers build up knowledge, experience and a network of interpersonal business contacts. All these things can help managers perform their jobs more effectively and achieve cooperation with others. Social stratification LO 5.2 SOCIAL STRATA The hierarchical categories within a society, defined on the basis of such elements as family background, income and occupation All societies are stratified on a hierarchical basis into social categories—that is, into social strata. These strata are typically defined on the basis of characteristics such as family background, occupation and income. Individuals are born into a particular stratum. They become a member of the social category to which their parents belong. Individuals born into a stratum towards the top of the social hierarchy tend to have better life chances than those born into a stratum towards the bottom of the hierarchy. They are likely to have better education, health, standard of living and work opportunities. Although all societies are stratified to some degree, they differ in two related ways. First, they differ from each other with regard to the degree of mobility between social strata; second, they differ with regard to the significance attached to social strata in business contexts. Overall, social stratification is based on four basic principles:18 • social stratification is a trait of society, not a reflection of individual differences • social stratification carries over to the next generation • social stratification is generally universal but variable; for example, it is entrenched in rural India and to a lesser extent in urban areas • social stratification does not just involve inequality, it is also embedded in religious beliefs. Social mobility SOCIAL MOBILITY The extent to which individuals can move out of the strata into which they are born CASTE SYSTEM A closed system of stratification in which social position is determined by the family into which a person is born, and change out of that strata is usually not possible during a person’s lifetime CLASS SYSTEM A less rigid social stratification system, in which mobility is possible depending on a person’s achievements or even just luck 218 PART 3 The term social mobility refers to the extent to which individuals can move out of the strata into which they are born. Social mobility varies significantly from society to society. The most rigid system of stratification is a caste system. A caste system is a closed system of stratification in which social position is hereditary—that is, determined by the family into which a person is born—and change in that position is usually not possible during an individual’s lifetime. Often a caste position carries with it a specific occupation. Members of one caste might be shoemakers, members of another might be butchers and so on. These occupations are embedded in the caste and passed down through the family to succeeding generations. Although the number of societies with caste systems diminished rapidly during the 20th century, one partial example still remains: India has four main castes and several thousand sub-castes. Even though the caste system was officially abolished in 1949 (two years after India became independent) and made unlawful in 1976,19 it is still a force in Indian society where occupation and marital opportunities are still partly related to caste. A class system is a less rigid form of social stratification in which social mobility is possible. It is a form of open stratification in which the position a person has by birth can be changed through his or her own achievements or luck. Individuals born into a class at the bottom of the hierarchy can work their way up; conversely, individuals born into a class at the top of the hierarchy can slip down. While many societies have class systems, social mobility within a class system varies from society to society. For example, some sociologists have argued that Britain has a more rigid class structure than certain other Western societies, such as the United States20 and Australia. Historically, British society was divided into three main classes: the upper class, COUNTRY DIFFERENCES hiL23674_ch05_207-254.indd 218 08/06/19 07:50 PM COUNTRY FOCUS BREAKING INDIA’S CASTE SYSTEM AND GENDER DISCRIMINATION India’s ancient caste system, which places people into different categories based on birth and has long been an impediment to social mobility, is starting to fade among the educated urban middle class who make up the majority of employees in the high-tech economy. However, the same is not true in rural India where 70 per cent of the population still resides. There, caste and gender discrimination remain a pervasive influence. In 1950, the national constitution reserved 22.5 per cent of jobs for people from the lower castes, or Dalits (also known as ‘untouchables’), and for tribal people. In 1990, an additional 27 per cent of jobs were set aside for those known as ‘other backward castes’. Some Indian states set higher quotas, including Tamil Nadu, which reserves 69 per cent of government jobs for lower castes and other needy groups. Despite these longstanding policies and some spectacularly successful rags to riches stories, such as that of Kalpana Saroj, discrimination remains. Kalpana Saroj is a Dalit who heads Kamani Tubes and several other companies. She overcame discrimination, abject poverty, abuse and death threats to become the head of companies worth more than $200 million and is a multi-millionaire in her own right. Unfortunately, anecdotal and hard evidence suggests that the caste system and discrimination against women still play an important role in daily life in India. For example, a young female engineer at Infosys who grew up in a small rural village and is a Dalit recounts how she never entered the house of a Brahmin, India’s elite priestly caste, even though half of her village were Brahmins. When a Dalit was hired to cook at the © Mint/Contributor/Getty Images Modern India is a country of contrasts, steeped in history and traditions. It is the largest democracy in the world. In recent years India’s information technology sector has become one of the most vibrant worldwide, with companies such as Infosys and Wipro Ltd emerging as powerful global players. Through her perseverance and entrepreneurial spirit, Kalpana Saroj is one of only a few Dalits/women to have succeeded as a CEO in India. school in her native village, Brahmins withdrew their children from the school. The engineer herself is the beneficiary of a charitable training system that Infosys launched in 2006. Her caste is among the poorest in India, with some 91 per cent making less than $100 a month, compared to 65 per cent of Brahmins. To try to correct this historic inequality, politicians have talked for years about extending the employment quota system to private enterprises. The government has told private companies to hire more Dalits and members of tribal communities and has warned that strong measures will be taken if companies do not comply. Private employers are resisting government attempts to impose quotas, arguing with some justification that people who are guaranteed a job by a quota system are unlikely to work very hard. At the same time, progressive employers realise that they need to do something to correct the inequalities and that, unless India taps into the lower castes and women, it may not be able to find the employees required to staff rapidly growing high-technology organisations. SOURCES: ‘With reservations: business and caste in India’, The Economist, 6 October 2007, pp. 81–3; Eric Bellman, ‘Reversal of fortune isolates India’s Brahmins’, The Wall Street Journal, 24 December 2007, p. 4; Rajini Vaidyanathan, ‘From child bride to millionaire in India’, www.bbc.co.uk/news/ world-asia-india-18186908, accessed on 24 July 2012; ‘Meet Kalpana Saroj, Dalit entrepreneur who broke corporate hegemony’, The Indian Express, 5 February 2019, accessed via https://indianexpress.com/article/business/meet-kalpana-saroj-dalit-entrepreneur-who-broke-corporate-hegemony/ on 20 October 2018; www.kalpanasaroj.com/aboutus.aspx. CHAPTER 5 hiL23674_ch05_207-254.indd 219 DIFFERENCES IN CULTURE 219 08/06/19 07:50 PM © Rodrigo A Torres/Glow Images which was made up of individuals whose families for generations had wealth, prestige and, occasionally, power; the middle class, whose members were involved in professional, managerial and clerical occupations; and the working class, whose members earned their living from manual occupations. The middle class was further subdivided into the uppermiddle class, whose members were involved in important managerial occupations and the prestigious professions (e.g. lawyers, accountants, doctors), and the lower-middle class, whose members were involved in clerical work (e.g. bank tellers) and the less prestigious professions (e.g. schoolteachers). Historically, the British class system exhibited significant divergence between the life chances of members of different classes. The upper and upper-middle classes typically sent their children to a select group of private schools (known as public schools in Britain), where they would not mix with lower-class children, and where they picked up many of the speech accents and social norms that distinguished them as being from the higher strata of society. These same schools also had close ties with the most prestigious universities, such as Oxford and Cambridge. Until fairly recently, Oxford and Cambridge guaranteed a certain number of places for the graduates of these schools. Having been to a prestigious university, the offspring of the upper and upper-middle classes then had an excellent chance of being offered a prestigious job in companies, banks, brokerage companies and law firms run by members of the upper and upper-middle classes. In contrast, the members of the British working and lower-middle classes typically went to state-funded schools. The majority left school at 16, and those who went on to higher education found it difficult to get accepted into the best universities. When they did, they found that their lower-class accent and lack of appropriate social skills marked them as being from a lower social stratum, which made it difficult for them to access the most prestigious jobs. Thus, the class system in Britain perpetuated itself from generation to generation, and social mobility was limited. Although upward mobility was possible, it could not normally be achieved in one generation. While an individual from a working-class background may have established an income level of the upper-middle class, he or she may not have been accepted by others of that class due to different accent and background. However, by sending his or her offspring to the ‘right kind of school’, the individual could ensure that his or her children were accepted. According to many commentators, modern British society is now rapidly leaving this class structure behind and moving towards a classless society. However, sociologists continue to dispute this finding and present evidence that this is not the case. For example, a study reported that in the mid-1990s, state-funded schools in the London suburb of Islington, which has a population of 175 000, had only 79 candidates for university, while one prestigious private school alone, Eton, sent more than that number to Oxford and Cambridge.21 This, according to the study’s authors, implies that ‘money still begets money’. They argue that a good school means a good university, a good university means a good job, and merit has only a limited chance of elbowing its way into this tight little circle. The class system in Australia, New Zealand and the United States is less extreme than in Britain, and mobility is greater. Like Britain, Australia, New Zealand and the United States have their own upper, middle and working classes. However, class membership is determined to a much greater degree by individual economic achievements, as opposed Until the late 1970s, social mobility in China was very limited. to background and schooling. Thus, an individual can, by 220 PART 3 COUNTRY DIFFERENCES hiL23674_ch05_207-254.indd 220 08/06/19 07:50 PM his or her own economic achievement, move smoothly from the working class to the upper class within a lifetime. Successful individuals from humble origins may be highly respected in Australian and American society. There are many examples of people from humble beginnings rising to prominence in these societies; for example, Australia’s 24th prime minister, Paul Keating, came from a working-class background, starting work as a pay clerk.22 New Zealand’s prime minister in 1990 and later director-general of the World Trade Organization, The Right Hon. Michael Kenneth Moore, started work as a labourer and a painter.23 Another society where class divisions have historically been of some importance has been China, where there has been a longstanding difference between the life chances of the rural peasantry and urban dwellers. Ironically, this historic division was strengthened during the high point of Communist rule because of a rigid system of household registration that restricted most Chinese to the place of their birth for their lifetime. Bound to collective farming, peasants were cut off from many urban privileges—compulsory education, quality schools, health care, public housing, varieties of foodstuffs, to name only a few—and they largely lived in poverty. Social mobility was thus very limited. This system crumbled following reforms of the late 1970s and early 1980s and, as a consequence, migrant peasant labourers have flooded into China’s cities looking for work. Sociologists now hypothesise that a new class system is emerging in China based less on the rural– urban divide and more on urban occupation.24 Significance From a business perspective, the stratification of a society is significant if it affects the operation of business organisations. In American society, the high degree of social mobility and the extreme emphasis on individualism limit the impact of class background on business operations. The same is true in Japan, where most of the population perceives itself to be middle class. In a country such as Great Britain, however, the relative lack of class mobility and the differences between classes have resulted in the emergence of class consciousness. Class consciousness refers to a condition where people tend to perceive themselves in terms of their class background, and this shapes their relationships with members of other classes. This perception has been played out in British society in the traditional hostility between upper-middle-class managers and their working-class employees. Mutual antagonism and lack of respect historically made it difficult to achieve cooperation between management and labour in many British companies and resulted in a relatively high level of industrial disputes. However, the last two decades have seen a dramatic reduction in industrial disputes,25 which bolsters the arguments of those who claim that the country is moving towards a classless society. (The level of industrial disputes in the United Kingdom is now lower than in the United States.) Alternatively, as noted above, class consciousness may be re-emerging in urban China, and it may ultimately prove to be significant there. An antagonistic relationship between management and labour classes, and the resulting lack of cooperation and high level of industrial disruption, tends to raise the costs of production in countries characterised by significant class divisions. In turn, this can make it more difficult for companies based in such countries to establish a competitive advantage in the global economy. LO 5.3 CLASS CONSCIOUSNESS A condition where people tend to perceive themselves in terms of their class background, shaping how they relate with members of other classes LO 5.2 RELIGIOUS AND ETHICAL SYSTEMS Religion may be defined as a system of shared beliefs and rituals that are concerned with the realm of the sacred.26 Ethical systems refer to sets of moral principles or values that are used to guide and shape behaviour. Most of the world’s ethical systems are the product of religions. Thus, we can talk about Christian ethics and Islamic ethics. However, there is a major exception to the principle that ethical systems are grounded CHAPTER 5 hiL23674_ch05_207-254.indd 221 RELIGION A system of shared beliefs and rituals that are concerned with the realm of the sacred ETHICAL SYSTEMS A set of moral principles, or values, that are used to guide and shape behaviour DIFFERENCES IN CULTURE 221 08/06/19 07:50 PM in religion—Confucianism. Confucian ethics influence behaviour and shape culture in parts of Asia, but it is not considered a religion. The relationship between religion, ethics and society is subtle and complex. Among the thousands of religions in the world today, four dominate in terms of numbers of adherents: Christianity with 2.2 billion adherents, Islam with around 1.3 billion adherents, Hinduism with 875 million adherents (primarily in India) and Buddhism with 385 million adherents.27 Although many other religions have an important influence in certain parts of the modern world (e.g. Judaism, which has 15 million adherents), their numbers pale in comparison with the dominant religions (see Map 5.1). (However, as the precursor of both Christianity and Islam, Judaism has an indirect influence that goes beyond its numbers.) We will review these four religions, along with Confucianism, focusing on their business implications. Some scholars have argued that the most important business implications of religion centre on the extent to which different religions shape attitudes towards work and entrepreneurship, and the degree to which religious ethics affect the costs of doing business in a country. It is hazardous to make sweeping generalisations about the nature of the relationships between religion and ethical systems and business practice. Some scholars argue that there is a relationship between religious and ethical systems and business practice in a society, but in a world where nations with Catholic, Protestant, Muslim, Hindu and Buddhist majorities all show evidence of entrepreneurial activity and sustainable economic growth, it is important to view the proposed relationships critically. The proposed relationships may exist, but their impact and influence is probably small compared to the impact of economic policy. Christianity LO 5.2 Christianity is the most widely practised religion in the world. Approximately 30 per cent of the world’s people identify themselves as Christians. The vast majority of Christians live in Europe and the Americas, although their numbers are rapidly growing in Africa. Christianity grew out of Judaism. Like Judaism, it is a monotheistic religion. (Monotheism is the belief in one god.) A religious division in the 11th century led to the establishment of two major Christian organisations—the Roman Catholic Church and the Orthodox Church. Today, the Roman Catholic Church accounts for more than half of all Christians, most of whom are found in southern Europe and Latin America. The Orthodox Church, while less influential, is still of major importance in several countries (e.g. Greece and Russia). In the 16th century, the Reformation led to a further split with Rome; the result was Protestantism. The nonconformist nature of Protestantism has facilitated the emergence of numerous denominations under the Protestant umbrella (e.g. Baptist, Methodist, Calvinist). Economic implications of Christianity: The Protestant work ethic LO 5.3 222 PART 3 Several sociologists have argued that of the main branches of Christianity—Catholic, Orthodox and Protestant—Protestantism has the most important economic implications. In 1904, a German sociologist, Max Weber, made a connection between Protestant ethics and ‘the spirit of capitalism’ that has since become famous.28 Weber noted that capitalism emerged in Western Europe, where business leaders and owners of capital, as well as the higher grades of skilled labour, and even more the higher technically and commercially trained personnel of modern enterprises, are overwhelmingly Protestant.29 Weber theorised that there was a relationship between Protestantism and the emergence of modern capitalism. He argued that Protestant ethics emphasise the importance of hard work and wealth creation (for the glory of God) and frugality COUNTRY DIFFERENCES hiL23674_ch05_207-254.indd 222 08/06/19 07:50 PM (abstinence from worldly pleasures). According to Weber, this kind of value system was needed to facilitate the development of capitalism. Protestants worked hard and systematically to accumulate wealth. However, their ascetic beliefs suggested that rather than consuming this wealth by indulging in worldly pleasures, they should invest it in the expansion of capitalist enterprises. Thus, the combination of hard work and the accumulation of capital, which could be used to finance investment and expansion, paved the way for the development of capitalism in Western Europe and subsequently in the United States. In contrast, Weber argued that the Catholic promise of salvation in the next world, rather than this world, did not foster the same kind of work ethic. Protestantism may also have encouraged capitalism’s development in another way. By breaking away from the hierarchical domination of religious and social life that characterised the Catholic Church for much of its history, Protestantism gave individuals significantly more freedom to develop their own relationship with God. The right to freedom of form of worship was central to the nonconformist nature of early Protestantism. This emphasis on individual religious freedom may have paved the way for the subsequent emphasis on individual economic and political freedoms and the development of individualism as an economic and political philosophy. Islam LO 5.2 With more than 1.3 billion adherents, Islam is the second-largest of the world’s major religions. Islam dates back to AD 610 when the Prophet Muhammad began spreading the word, although the Muslim calendar begins in AD 622 when, to escape growing opposition, Muhammad left Mecca for the oasis settlement of Yathrib, later known as Medina. Adherents of Islam are referred to as Muslims. Muslims constitute a majority in more than 35 countries and inhabit a nearly contiguous stretch of land from the northwest coast of Africa, through the Middle East, to China and Malaysia. Islam has roots in both Judaism and Christianity (Islam views Jesus Christ as one of God’s prophets). Like Christianity and Judaism, Islam is a monotheistic religion. The central principle of Islam is that there is but the one true omnipotent God. Islam requires unconditional acceptance of the uniqueness, power and authority of God and the understanding that the objective of life is to fulfil the dictates of his will in the hope of admission to paradise. According to Islam, worldly gain and temporal power are an illusion. Those who pursue riches on earth may gain them, but those who forgo worldly ambitions to seek the favour of God may gain the greater treasure—entry into paradise. Other major principles of Islam include honouring and respecting parents, respecting the rights of others, being generous but not a squanderer, avoiding killing except for justifiable causes, not committing adultery, dealing justly and equitably with others, being of pure heart and mind, safeguarding the possessions of orphans, and being humble and unpretentious.30 Obvious parallels exist with many of the central principles of both Judaism and Christianity. Islam is an all-embracing way of life governing the totality of a Muslim’s being.31 As God’s surrogate in this world, a Muslim is not a totally free agent but is circumscribed by religious principles—by a code of conduct for interpersonal relations—in social and economic activities. Religion is paramount in all areas of life. The Muslim lives in a social structure that is shaped by Islamic values and norms of moral conduct. The ritual nature of everyday life in a Muslim country is striking to a Western visitor. Among other things, orthodox Muslim ritual requires prayer five times a day (business meetings may be put on hold while Muslim participants engage in their daily prayer ritual), requires that women should dress in a certain manner and forbids the consumption of pork and alcohol. CHAPTER 5 hiL23674_ch05_207-254.indd 223 DIFFERENCES IN CULTURE 223 08/06/19 07:50 PM ARC ARCTIC CTIC OCEAN OCE EAN ARCTIC OCEAN J J J Predominant Religions J J M J M ATLAN A NTIC ATLANTIC OCE O EAN N OCEAN Christianity (C)* Roman Catholic Protestant M C H Eastern churches HM H M Mixed sects Islam (M) Sunni PACIFIC ACIFIC OCEAN OC CEAN Shi’a Buddhism (B) Hinayanistic C M Hinduism (H) M H C C C M C PAC CIFIC C PACIFIC OC CEAN N OCEAN C IND DIAN INDIAN EAN EAN N OCEAN C J H Lamaistic M B Mormon (LDS) J Judaism (J) Sikhism Animism (tribal) Chinese complex (Confucianism, Taoism, and Buddhism) Korean complex (Buddhism, Confucianism, Christianity, and Chondogyo) Japanese complex (Shinto and Buddhism) Vietnamese complex (Buddhism, Taoism, Confucianism, and Cao Dai) Unpopulated regions * Capital letters indicate the presence of locally important minority adherents of nonpredominant faiths. 0 Scale: 1 to 190,080,000 0 1000 1000 2000 2000 Miles 3000 Kilometers MAP 5.1 Predominant world religions Source: ‘Map 14’, in J. L. Allen and C. J. Sutton, Student Atlas of World Politics, 10th ed. New York, NY: McGraw-Hill Companies, Inc., 2013. ANOTHER PERSPECTIVE RELIGIOUS FUNDAMENTALISM The past three decades have witnessed the growth of religious fundamentalism. While some may associate religious fundamentalism with a social movement often referred to as Islamic fundamentalism,32 religious extremism is not confined to Islam. For example, we have witnessed extreme Christian, Hindu and Buddhist movements such as the attacks directed against the 224 PART 3 Rohingya Muslims in Myanmar by so-called Buddhists, who hijacked the peace-loving religion to justify their violence. In the West, Islamic fundamentalism is associated with violence—with militants, terrorists and violent upheavals, such as the activities of Islamic State (IS) in COUNTRY DIFFERENCES hiL23674_ch05_207-254.indd 224 08/06/19 07:50 PM recent years, the 11 September 2001 attacks on the World Trade Center and the Pentagon in the United States, the 2002 and 2005 Bali bombings, the London attacks, the Nice attack in France and various terror attacks in Sri Lanka. However, this association is misleading. Islamic fundamentalism is perpetrated by a small minority of radical ‘fundamentalists’ who like other extremists have hijacked religion to further their own political and violent ends. The vast majority of Muslims point out that Islam teaches peace, justice and tolerance, not violence and intolerance, and that Islam explicitly repudiates the violence that radical minority groups such as the Taliban and IS followers practise. According to the well-known former Pakistani cricketer and prime minister Imran Khan, many Muslims are embarrassed by these extreme views and the practices of extremists.33 Indeed, many Muslims have been killed by these groups, sometimes in a very brutal manner. SOURCES: R. Ovendale review of ‘Islam in Revolution: Fundamentalism in the Arab World Second Edition’ by R. Hrair Dekmejian, Digest of Middle East Studies, 4(4), pp. 32–34; Enough Rope, with Andrew Denton, Episode 13, ABC TV, 13 October 2008, accessed via www.abc.net.au/tv/enoughrope/ transcripts/s2389924.htm; E. Dias, ‘Top Catholic Official in Myanmar Speaks Out on Treatment of Rohingya Muslims and the Risks of a Military Coup’, Time, 13 September 2017, accessed via http://time.com/4939946/myanmar-rohingya-muslims-pope-francis-envoy on 28 October 2018. Islamic fundamentalists demand a rigid commitment to traditional religious beliefs and rituals. The result has been a marked increase in the use of symbolic gestures that confirm Islamic values. In areas where fundamentalism is strong, women have resumed wearing floor-length, long-sleeved dresses and covering their hair; religious studies have increased in universities; the publication of religious tracts has increased; and the number of public religious orations has risen.34 The sentiments of some fundamentalist groups are increasingly anti-Western: rightly or wrongly, Western influence is blamed for a range of social ills and many fundamentalists’ actions are directed against Western governments, cultural symbols, businesses and even individuals. In several Muslim countries, fundamentalists have gained political power and have used this to try to make Islamic law (as set down in the Koran, the holy book of Islam) the law of the land. There are grounds for this in Islam. Islam is not just a religion: it is also the source of law, a guide to statecraft and an arbiter of social behaviour. Muslims believe that every human endeavour is within the purview of the faith—and this includes political activity— because the only purpose of any activity is to do God’s will.35 Muslim fundamentalists have been most successful in Iran, where a fundamentalist party has held power since 1979, but they have also had an influence in many other countries, such as Algeria, Afghanistan (where the Taliban established an extreme fundamentalist state until it was removed by the US-led coalition in 2002), Egypt, Pakistan, the Sudan and Saudi Arabia. Economic implications of Islam The Koran establishes some explicit economic principles, many of which are pro–free enterprise.36 The Koran speaks approvingly of free enterprise and of earning legitimate profit through trade and commerce. (The Prophet Muhammad was once a merchant.) The protection of the right to private property is also embedded within Islam, although Islam asserts that all property is a favour from God, who created and so owns everything. Those who hold property are regarded as trustees, rather than as owners in the Western sense of the word. As trustees they are entitled to receive profits from the property but are admonished to use it in a righteous, socially beneficial and prudent manner. This reflects Islam’s concern with social justice. Islam is critical of those who earn profit through the exploitation of others. In the Islamic view of the world, humans are part of a collective in which the wealthy and successful have obligations to help the disadvantaged. Put simply, in Muslim countries, it is fine to earn a profit, so long as that profit is justly earned and CHAPTER 5 hiL23674_ch05_207-254.indd 225 LO 5.3 DIFFERENCES IN CULTURE 225 08/06/19 07:50 PM not based on the exploitation of others for one’s own advantage. It also helps if those making profits undertake charitable acts to help the poor. Furthermore, Islam stresses the importance of living up to contractual obligations, of keeping one’s word and of abstaining from deception. Given the Islamic proclivity to favour market-based systems, Muslim countries are likely to be receptive to international businesses as long as those businesses behave in a manner that is consistent with Islamic ethics. For example, consider the Chapter 5 Closing Case; the managers of Cognition Consulting will have to be very mindful of the strong influence that Islam has within the business culture of country markets such as Dubai and the United Arab Emirates. The economic principle of Islam prohibits the payment or receipt of interest, which is considered usury. This is not just a matter of theology; in several Islamic states, it is also becoming a matter of law, as Emerging Markets: ‘Islamic banking in Malaysia’ illustrates. The rise of Islamic banking RIBA Arabic for ‘interest’ and/or ‘usury’ 226 PART 3 Financial experts from Islamic countries have argued that the Islamic banking system shielded them from the Global Financial Crisis. What is Islamic banking? How is it different from conventional banking? Islamic banking has a similar role to conventional banking, except that Islamic banking activity must comply with the principles of the Islamic rulings (Shari’ah), specifically Islamic rules on transactions known as Fiqh al-Muamalat. The Koran clearly condemns interest, which is called riba in Arabic, as exploitative and unjust. For many years, banks operating in Islamic countries conveniently ignored this condemnation, but starting about 30 years ago with the establishment of an Islamic bank in Egypt, Islamic banks started to open in predominantly Muslim countries. There are more than 200 Islamic financial institutions worldwide, and it is expected that assets managed by these institutions will grow to around US$4 trillion by 2020. Even conventional banks are entering the market—both Citigroup and HSBC, two of the world’s largest financial institutions, now offer Islamic financial services. While only Iran and the Sudan enforce Islamic banking conventions, in an increasing number of countries customers can choose between conventional banks and Islamic banks, such as in Malaysia and Pakistan. Conventional banks make a profit on the spread between the interest rate they have to pay to depositors and the higher interest rate they charge borrowers. Because Islamic banks cannot pay or charge interest, they must find a different way of making money. Islamic banks have experimented with two different banking methods—the mudarabah and the murabaha. A mudarabah contract is similar to a profit-sharing scheme. Under mudarabah, when an Islamic bank lends money to a business, rather than charging that business interest on the loan, it takes a share in the profits that are derived from the investment. Similarly, when a business (or individual) deposits money at an Islamic bank in a savings account, the deposit is treated as an equity investment in whatever activity the bank uses the capital for. Thus, the depositor receives a share in the profit from the bank’s investment (as opposed to interest payments) according to an agreed-on ratio. Some Muslims claim this is a more efficient and ethical system than the Western banking system, since it encourages both long-term savings and long-term investment. However, some believe that a mudarabah system is less efficient than a conventional Western banking system. The second Islamic banking method, the murabaha contract, is the most widely used among the world’s Islamic banks, primarily because it is the easiest to implement. In a murabaha contract, when a company wishes to purchase something using a loan—let’s say a piece of equipment that costs $1000—the company tells the bank after having negotiated the price with the equipment manufacturer. The bank then buys the equipment for $1000, COUNTRY DIFFERENCES hiL23674_ch05_207-254.indd 226 08/06/19 07:50 PM EMERGING MARKETS ISLAMIC BANKING IN MALAYSIA © Patrick Foto/Shutterstock In 1993 Malaysia became the first country to offer a dual banking system with the introduction of the Islamic Banking Scheme, allowing existing banks and other financial institutions to offer Islamic banking services. Nowadays, in multicultural Malaysia, Islamic banking is widely used by both Muslims and nonMuslims. In 2002 Malaysia pioneered the issuance of SUKUK Islamic bonds, called sukuk. A type of Islamic bond In the West, many US and British banks are setting up subsidiaries to offer Islamic banking, while Australian banks are also considering offering these services. Malaysia pioneered a dual banking system with the introduction of an Islamic Banking Scheme. SOURCES: ‘Forced devotion’, The Economist, 17 February 2001, pp. 76–7; ‘Islamic banking marches on’, The Banker, 1 February 2000; F. Bokhari, ‘Bankers fear introduction of Islamic system will prompt big withdrawals’, Financial Times, 6 March 2001, p. 4; ‘Islamic banking booms in Pakistan’, Agence France Presse, January 2005; D. Oakley, ‘BLME grows despite crunch’, Financial Times, 8 September 2008; and R. Brant, ‘Is Islamic finance the answer?’, BBC News, accessed via http://news.bbc.co.uk/2/hi/business/8025410.stm on 12 June 2009; AMEinfo.com, ‘Value of assets managed by global Islamic banks expected to touch Dhs14.6 trillion by 2020’, accessed via www.ameinfo.com/233174.html on 25 July 2012; The Economist online, Islamic Finance, 10 April 2012; E.M.R. Abdullah, ‘Development of Islamic banking in Malaysia’, KLRCA News Letter, accessed via www.ridzalaw.com.my/ downloads/2011-klrca_newsletter.pdf; Institute of Islamic Banking and Insurance, accessed via www.islamic-banking.com/what_is_ibanking.aspx on 10 March 2015; Daria Solovieva, ‘Get ready for corporate sukuk boom after sovereign rush’, accessed via www.bloomberg.com/news/articles/2015-01-05/ get-ready-for-company-boom-after-sovereign-rush-islamic-finance on 15 March 2015. and the borrower buys it back from the bank at some later date for, say, $1100, a price that includes a $100 mark-up for the bank. A cynic might point out that such a mark-up is functionally equivalent to an interest payment, and it is the similarity between this method and conventional banking that makes it so much easier to adopt. Hinduism LO 5.2 Hinduism has approximately 875 million adherents, most of them on the Indian subcontinent. Hinduism began in the Indus Valley in India more than 4000 years ago, making it the world’s oldest major religion. Unlike Christianity and Islam, its founding is not linked to a particular person. Nor does it have an officially sanctioned sacred book such as the Bible or the Koran. Hindus believe that a moral force in society, called dharma, requires the acceptance of certain responsibilities. Hindus believe in reincarnation, or rebirth into a different body, after death. Hindus also believe in karma, the spiritual progression of each person’s soul. A person’s karma is affected by the way he or she lives. The moral state of an individual’s karma determines the challenges he or she will face in CHAPTER 5 hiL23674_ch05_207-254.indd 227 DIFFERENCES IN CULTURE 227 08/06/19 07:50 PM the next life. By perfecting the soul in each new life, Hindus believe that an individual can eventually achieve nirvana, a state of complete spiritual perfection that renders reincarnation no longer necessary. Many Hindus believe that the way to achieve nirvana is to lead a severe ascetic lifestyle of material and physical self-denial, devoting life to a spiritual rather than material quest. One of the interesting aspects of Hindu culture is the reverence for the cow, which Hindus see as a gift of the gods to the human race. The sacred status of the cow created some unique problems for McDonald’s when it entered India in the 1990s, since devout Hindus do not eat beef (and many are also vegetarians). McDonald’s dealt with that challenge by adapting the original menu to create an Indian version of its Big Mac—the ‘Maharaja Mac’—created from mutton. Other additions to the menu also conform to local sensibilities—such as the ‘McAloo Tikki Burger’, which is made from chicken. All foods are strictly segregated into vegetarian and non-vegetarian lines to conform with preferences in a country where many Hindus are vegetarian.37 © Christopher Kerrigan/McGraw-Hill ANOTHER PERSPECTIVE ADAPTING TO SUIT THE LOCAL PALATE In Hong Kong, McDonald’s serves Rice Fan-tastic, substituting rice patties for buns. Food is an integral part of many cultures. Hindus in India do not eat the meat of the sacred cow. Muslims and Jews do not eat pork. McDonald’s responded to these cultural food dilemmas by adapting the menu to suit the local palate and other local sensibilities. In India, McDonald’s foods are strictly segregated into vegetarian and non-vegetarian lines to conform with preferences in a country where many Hindus are vegetarian. In predominantly Islamic countries such as Malaysia and Indonesia, foods are halal compliant. In Israel, around 50 of the McDonald’s restaurants are kosher in keeping with Jewish traditions. In Sri Lanka, where people have a taste for fiery hot chilli, locals can enjoy a ‘Seeni Sambol’ burger (with a filling of onions fried with chillies) or Curry N Rice. SOURCES: ‘About us’, McDonald’s, www.mcdonalds.co.il/About_McDonalds, accessed on 2 March 2015; McDonald’s India, www.mcdonaldsindia.com/ menu.html, accessed on 31 July 2012; McDonald’s delivery, www.mcdelivery.lk/lk/browse/menu.html, accessed on 29 October 2018. Economic implications of Hinduism LO 5.3 228 PART 3 Devout Hindus perceive the pursuit of material wellbeing as making the attainment of nirvana more difficult. Mahatma Gandhi, the famous Indian nationalist and spiritual leader, was certainly the embodiment of Hindu asceticism. It has been argued that the values of Hindu asceticism and self-reliance that Gandhi advocated had a negative impact on the economic development of post-independence India.38 But one must be careful not to read too much COUNTRY DIFFERENCES hiL23674_ch05_207-254.indd 228 08/06/19 07:50 PM into this argument. Modern India is a very dynamic, entrepreneurial society, and millions of hardworking entrepreneurs form the economic backbone of the country’s rapidly growing economy. Historically, Hinduism also supported India’s caste system. The concept of mobility between castes within an individual’s lifetime makes no sense to traditional Hindus. Hindus see mobility between castes as something that is achieved through spiritual progression and reincarnation. An individual can be reborn into a higher caste in his or her next life if he or she achieves spiritual development in this life. In so far as the caste system limits individuals’ opportunities to adopt positions of responsibility and influence in society, the economic consequences of this religious belief are somewhat negative. For example, within a business organisation, the most able individuals may find their route to the higher levels of the organisation blocked simply because they come from a lower caste. By the same token, individuals may get promoted to higher positions within a company as much because of their caste background as because of their ability. Buddhism LO 5.2 Economic implications of Buddhism The emphasis on wealth creation that is embedded in Protestantism is not found in Buddhism. However, Buddhism does not discourage ethical business practices, only the five forms of trades that are to be avoided: trading in arms, in living beings, flesh (breeding of animals for slaughter), intoxicating drinks and poisons.39 In addition, countries where Mahayana Buddhism is practised have been strongly influenced by local deities, ancestor worship and Confucian ethics, providing a more conducive environment for business. For example, at the Baolian Temple in the city of Xuzhou in southern China there is high patronage by local businesspeople praying for wealth and prosperity. CHAPTER 5 hiL23674_ch05_207-254.indd 229 © Rumintha Wickramasekera Buddhism is not a religion in the strict sense. Buddhism was founded in India in the 6th century BC by Siddhartha Gautama, an Indian prince who renounced his wealth to pursue an ascetic lifestyle and spiritual perfection. Siddhartha achieved nirvana but decided to spend the remainder of his life to teach his followers how they too could achieve this state of spiritual enlightenment. Siddhartha became known as the Buddha (which means ‘the awakened one’). Today, Buddhism has around 500 million followers. There are two main Buddhist sects, Theravada and Mahayana. Theravada Buddhism is practised predominantly in Sri Lanka, Cambodia, Thailand, Laos and Myanmar, while Mahayana Buddhism is practised in China, Taiwan, Korea and Japan. According to Buddhism, suffering originates in people’s desires for pleasure. Cessation of suffering can be achieved by following a path for transformation. The Buddha offered the Noble Eight-fold Path as a route for transformation. This emphasises right seeing, thinking, speech, action, living, effort, mindfulness and meditation. Unlike Hinduism, Buddhism does not support the caste system. Nor does Buddhism advocate the kind of extreme ascetic behaviour The Baolian Temple in Southern China is indicative of a that is encouraged by Hinduism. Nevertheless, like Hindus, fusion of beliefs. Buddhists stress the afterlife and spiritual achievement rather than involvement in this world. LO 5.3 DIFFERENCES IN CULTURE 229 08/06/19 07:50 PM Confucianism LO 5.2 Confucianism was founded in the 5th century BC by K’ung-Fu-tzu, more generally known in Western countries as Confucius. Until the 1949 Communist revolution, Confucianism was the official ethical system of China for more than 2000 years. While observance of Confucian ethics has been weakened in China since 1949, more than 400 million people still follow the teachings of Confucius (in conjunction with local beliefs and/or Buddhism),40 principally in China, Korea and Japan. Confucianism teaches the importance of attaining personal salvation through right action. Although not a religion, Confucian ideology has become deeply embedded in the culture of these countries over the centuries and, through that, has an impact on the lives of many millions more. Confucianism is built around a comprehensive ethical code that sets down guidelines for relationships with others. High moral and ethical conduct and loyalty to others are central to Confucianism. Unlike religions, Confucianism is not concerned with the supernatural and has little to say about the concept of a supreme being or an afterlife. Economic implications of Confucianism LO 5.3 230 PART 3 Some scholars maintain that Confucianism may have economic implications as profound as those Max Weber argued were to be found in Protestantism, although they are of a different nature.41 Their basic thesis is that the influence of Confucian ethics on the cultures of China, Japan, South Korea and Taiwan, by lowering the costs of doing business in those countries, may help to explain their economic success. In this regard, three values central to the Confucian system of ethics are of particular interest: loyalty, reciprocal obligations and honesty in dealings with others. In Confucian thought, loyalty to one’s superiors is regarded as a sacred duty—an absolute obligation. In modern organisations based on Confucian cultures, the loyalty that binds employees to the heads of their organisation can reduce the conflict between management and labour that we find in more class-conscious societies. Cooperation between management and labour can be achieved at a lower cost in a culture where the virtue of loyalty is emphasised in the value system. However, in a Confucian culture, loyalty to one’s superiors, such as a worker’s loyalty to management, is not blind loyalty. The concept of reciprocal obligations is important. Confucian ethics stress that superiors are obliged to reward the loyalty of their subordinates by bestowing blessings on them. If these ‘blessings’ are not forthcoming, then neither will be the loyalty. This Confucian ethic is central to the Chinese concept of guanxi, which refers to relationship networks supported by reciprocal obligations (which we discuss in the Management Focus: ‘DMG Entertainment’).42 Guanxi means ‘relationships’, although in business settings it can be better understood as ‘connections’. Today, Chinese will often cultivate a guanxiwang, or ‘relationship network’, for help. Reciprocal obligations are the glue that holds such networks together. If those obligations are not met—if favours done are not paid back or reciprocated—the reputation of the transgressor is tarnished and the person will be less able to draw on his or her guanxiwang for help in the future. Thus, the implicit threat of social sanctions is often sufficient to ensure that favours are repaid, obligations are met and relationships are honoured. In a society that lacks a rule-based legal tradition, and thus legal ways of redressing wrongs such as violations of business agreements, guanxi is an important mechanism for building long-term business relationships and getting business done in China. A third concept found in Confucian ethics is the importance attached to honesty. Confucian thinkers emphasise that, although dishonest behaviour may yield short-term benefits for the transgressor, dishonesty does not pay in the long run. The importance attached to honesty has major economic implications. When companies can trust each other not to break contractual obligations, the costs of doing business are lowered as expensive lawyers are not needed to resolve contract disputes. In a Confucian society, COUNTRY DIFFERENCES hiL23674_ch05_207-254.indd 230 08/06/19 07:50 PM people may be less hesitant to commit substantial resources to cooperative ventures than in a society where honesty is less pervasive. When companies adhere to Confucian ethics, they can trust each other not to violate the terms of cooperative agreements. Thus, the costs of achieving cooperation between companies may be lower in societies such as Japan relative to societies where trust is less pervasive. For example, it has been argued that the close ties between the automobile companies and their component parts suppliers in Japan are facilitated by a combination of trust and reciprocal obligations. These close ties allow the auto companies and their suppliers to work together on a range of issues, including inventory reduction, quality control and design. The competitive advantage of Japanese auto companies such as Toyota may in part be explained by such factors.43 Similarly, as we will see in the Management Focus, the combination of trust and reciprocal obligations is central to the workings and persistence of guanxi networks in China. Someone seeking and receiving help through a guanxi network is then obligated to return the favour and faces social sanctions if that obligation is not reciprocated when it is called upon. If the person does not return the favour, his or her reputation will be tarnished and he or she will be unable to draw on the resources of the network in the future. It is claimed that these relationship-based networks can be more important in helping to enforce agreements between businesses than the Chinese legal system. Some claim that guanxi networks are a substitute for the legal system.44 SUPERSTITIONS LO 5.2 Like religion, superstitions play an important role in the daily life of people as well as impacting on how business is conducted. The 5000-year-old Chinese culture is rich in traditions and superstitions. Numbers play a particularly important role for the Chinese, with their faith in lucky numbers influencing daily life, from choosing a car number plate, to a phone number, house or apartment number.45 MANAGEMENT FOCUS DMG ENTERTAINMENT In 1993, New Yorker Dan Mintz moved to China as a freelance film director with no contacts, no advertising experience and no Mandarin skills. By 2015, DMG, the company he subsequently founded in China in 2003, had emerged as one of China’s fastestgrowing advertising and entertainment agencies, with a multicultural staff of 800 and offices in Beijing, Shanghai, Changchun, Hangzhou, Chengdu and Los Angeles. DMG’s clients include Budweiser, Unilever, Sony, Nabisco, Audi, Volkswagen, Nike, Google, China Mobile and dozens of other Chinese brands. In recent years DMG facilitated multimillion-dollar co-productions between China and Hollywood such as Iron Man 3 and Valiant Entertainment’s suit of superheroes to be showcased in China and beyond. Mintz attributes his success to understanding the Chinese culture and in part to what the Chinese call guanxi. Guanxi literally means relationships, although in business settings it can be better understood as connections. Guanxi has its roots in the Confucian philosophy of valuing social hierarchy and reciprocal obligations. Confucian ideology has a 2000-yearold history in China. It stresses the importance of relationships, both within the family and between master and servant. Confucian ideology teaches that CHAPTER 5 hiL23674_ch05_207-254.indd 231 DIFFERENCES IN CULTURE 231 08/06/19 07:50 PM people are not created equal. In Confucian thought, loyalty and obligations to one’s superiors (or to family) are regarded as a sacred duty, but at the same time, this loyalty has its price. Social superiors are obligated to reward the loyalty of their social inferiors by bestowing ‘blessings’ upon them; thus, the obligations are reciprocal. Chinese people will often cultivate a guanxiwang, or ‘relationship network’, for help. There is a tacit acknowledgment that if you have the right guanxi, legal rules can be broken, or at least bent. Mintz, who is now fluent in Mandarin, cultivated his guanxiwang by going into business with two young Chinese associates who had connections, Bing Wu and Peter Xiao. Wu, who works on the production side of the business, was a former national gymnastics champion, which translates into prestige and access to business and government officials. Xiao comes from a military family with major political connections. Together, these three have been able to open doors that long-established Western advertising agencies could not. They have done it in large part by leveraging the contacts of Wu and Xiao and by backing up their connections with what the Chinese call shi li, the ability to do good work. A case in point was DMG’s campaign for Volkswagen, which helped the German company become ubiquitous in China. The ads used traditional Chinese characters, which had been banned by Chairman Mao during the cultural revolution in favour of simplified versions. To get permission to use the characters in film and print ads—a first in modern China—the trio had to draw on high-level government contacts in Beijing. They won over officials by arguing that the old characters should be thought of not as ‘characters’ but as art. Later, they shot TV spots for the ad on Shanghai’s famous Bund, a congested boulevard that runs along the waterfront of the old city. Drawing again on government contacts, they were able to shut down the Bund to make the shoot. Steven Spielberg had been able to close down only a portion of the street when he filmed Empire of the Sun there in 1986. DMG has also filmed inside Beijing’s Forbidden City, even though it is against the law to do so. Using his contacts, Mintz persuaded the government to lift the law for 24 hours. As Mintz has noted, ‘We don’t stop when we come across regulations. There are restrictions everywhere you go. You have to know how to get around them and get things done’. While it began as an advertising agency in 1993, the company started distributing non-Chinese movies in the Chinese market in the late 2000s as well as producing Chinese films, the first being The Founding of a Republic in 2009. This is a movie that marked the 60th anniversary of the People’s Republic of China. The company was split up in 2014. Today, DMG is a Chinese-based production and distribution company. The China component of DMG (renamed Yingin) retained the marketing, Chinese film distribution and other local activities. Later the company was listed on the Shenzhen Stock Exchange with co-founder Xiao appointed as chairman. However, Mintz could not hold an executive position in the company due to Chinese laws and returned to the United States to run DMG’s privately held unit based from Los Angeles. While strong connections and enjoying guanxi in China are important in facilitating business activities, there is a limit to what foreigners and Chinese nationals alike can achieve via guanxi. Businesspeople operating in China must be mindful of these limitations. SOURCES: J. Bryan, ‘The Mintz dynasty’, Fast Company, April 2006, pp. 56–62; M. Graser, ‘Featured player’, Variety, 18 October 2004, p. 6; C. Coonan, ‘DMG’s Dan Mintz: Hollywood’s man in China’, Variety, 5 June 2013, accessed 7 March 2014; S. Montlake, ‘Hollywood’s Mr China: Dan Mintz, DMG’, Forbes, accessed via www.forbes.com/sites/simonmontlake/2012/08/29/hollywoods-mr-china-dan-mintz-dmg/3 on 12 March 2015; ‘DMG and Valiant to Bring Largest Independent Superhero Universe to Movie Theaters Worldwide’, DMG, 9 March 2015, accessed via www.dmg-entertainment.com/ dmg-valiant-bring-largest-independent-superhero-universe-movie-theaters-worldwide on 14 March 2015; P. Brzeski, ‘DMG Entertainment’s Chinese Affiliate Crashes on Shenzhen Stock Exchange’, The Hollywood reporter, 20 August 2018, accessed via www.hollywoodreporter.com/news/dmgentertainments-chinese-affiliate-crashes-shenzhen-stock-exchange-1135580 on 28 October 2018. It is no coincidence that the Beijing Olympics started at 8pm on 8 August 2008 (8/8/08). The number eight is considered lucky or associated with wealth. (‘Eight’ in Chinese is pronounced in a similar manner to the word for making money, ba.) Other lucky numbers include six and nine; six is associated with things going smoothly or happiness, and nine conveys everlasting or long life. The meanings behind other numbers include: one—guaranteed; two—easy; three—life. In general, these numbers are considered good, and it is not surprising to find that some Chinese will value or pay a premium for items 232 PART 3 COUNTRY DIFFERENCES hiL23674_ch05_207-254.indd 232 08/06/19 07:50 PM containing lucky numbers. For example, a Hong Kong tycoon paid HK$13 million (AU$2.16 million) for a number ‘9’ for his car number plate,46 and a £50 bank note with the serial number AA01 000888 sold for over £800.47 In contrast, the number four is generally avoided. ‘Four’ sounds similar to the Chinese and Korean words for ‘death’ and is thus considered inauspicious. Superstitions are not confined to the Chinese; many cultures have these beliefs. Think of the number 13 in Australia and many Western countries—lucky for some, unlucky for others. To be successful, international businesses must become familiar with local beliefs and customs and endeavour to accommodate them. For example, Swiss watchmakers accommodate the belief in parts of Asia that the number four is unlucky by numbering a limited edition of five watches for that market 0, 1, 2, 3 and 5.48 LANGUAGE LO 5.2 One obvious way in which countries differ is language. By language, we mean both the spoken and the unspoken means of communication. Language is one of the defining characteristics of a culture. Spoken language Language does far more than just enable people to communicate with one another. The nature of a language also structures the way we perceive the world. The language of a society can direct the attention of its members to certain features of the world rather than others. The classic illustration of this phenomenon is that whereas the English language has just one word for snow, the language of the Inuit (Eskimos) lacks a general term for it. Instead, because distinguishing different forms of snow is so important in the lives of the Inuit, they have several words that describe different types of snow (e.g. powder snow, falling snow, wet snow, drifting snow).49 Because language shapes the way people perceive the world, it also helps to define culture. Countries with more than one language often have more than one culture. Canada has an English-speaking culture and a French-speaking culture. Tensions between the two can run quite high, with a substantial proportion of the French-speaking minority demanding independence from a Canada ‘dominated by English speakers’. The same phenomenon can be observed in many other countries. Belgium is divided into Flemish and French speakers, and tensions between the two groups exist; in Spain, a Basque-speaking minority with its own distinctive culture has been agitating for independence from the Spanish-speaking majority for decades; on the Mediterranean island of Cyprus, the culturally diverse Greek and Turkishspeaking populations of the island engaged in open conflict in the 1970s, and the island is now partitioned into two. While it does not necessarily follow that language differences create differences in culture and, therefore, separatist The fourth and thirteenth floors are missing pressures (witness the harmony in Switzerland, where four languages are from this hotel in Taiwan as patrons spoken), there certainly seems to be a tendency in this direction.50 consider them to be inauspicious numbers. Chinese (Mandarin) is the mother tongue of the largest number of people, followed by English and Hindi, which is spoken in India. However, the most widely spoken language in the world is English, followed by French, Spanish and Chinese (i.e. many people LINGUA FRANCA speak English as a second language). English is the lingua franca of international business. A language widely used by When Japanese and German businesspeople get together to do business, it is almost certain non-native speakers that they will communicate in English. Although English is widely used, learning the local CHAPTER 5 hiL23674_ch05_207-254.indd 233 DIFFERENCES IN CULTURE 233 08/06/19 07:50 PM © Rumintha Wickramasekera LO 5.3 © ILYA AKINSHIN/Shutterstock language yields considerable advantages. Most people prefer to converse in their own language, and being able to speak the local language can build rapport, which may be very important for a business deal. International businesses that do not understand the local language can make major blunders through improper translation. For example, the Sunbeam Corporation used the English words for its ‘Mist-Stick’ mistproducing hair curling iron when it entered the German market, only to discover after an expensive advertising campaign that mist means ‘excrement’ in German. General Motors was troubled by the lack of enthusiasm among Puerto Rican dealers for its new Chevrolet Nova. When literally translated into Spanish, nova means ‘star’. However, when spoken it sounds like ‘no va’, which in Spanish means ‘it doesn’t go’. General Motors changed the name of the car to Caribe.51 United States It’s fine Germany Lunatic Greece, Turkey An obscene symbol for a bodily orifice Unspoken language Unspoken language refers to non-verbal communication. We all communicate with each other by a host of non-verbal cues. The Japan Money, especially change raising of eyebrows, for example, is a sign of recognition in many cultures, while a smile is a sign of joy. Many non-verbal cues, however, FIGURE 5.2 are culturally bound. A failure to understand the non-verbal cues of Kinesics: gestures are not universal. This common gesture has different meanings internationally. another culture can lead to a communication failure. For example, as highlighted in Figure 5.2, making a circle with the thumb and the forefinger is a friendly gesture in the United States, but it is a vulgar sexual invitation in Greece and Turkey, and means ‘lunatic’ in Germany, ‘zero’ or ‘worthless’ in France, and ‘money’ or ‘change’ in Japan.52 Similarly, while most Americans and Europeans use the thumbs-up gesture to LO 5.2 indicate that ‘it’s all right’, in Greece the gesture is obscene. France Zero, or worthless Conducting research across cultural borders is difficult for many reasons. First, there are the more obvious issues connected to travel and building collaborative relationships in other countries, both of which are time-consuming and always full of surprises. One of the most difficult issues, though, is how to be certain that the concept about which you want to communicate has a similar meaning when it crosses a cultural border. This challenge is more than one of word translation; it is concept translation, which researchers term concept equivalence. Take the concept of bribery. Does it have the same meaning in the middle of Sydney, Auckland or Manhattan as it does in an underdeveloped, centralised economy such as North Korea? What do you think? 234 PART 3 © Ingram Publishing ANOTHER PERSPECTIVE STICKY PROBLEMS IN CULTURE RESEARCH COUNTRY DIFFERENCES hiL23674_ch05_207-254.indd 234 08/06/19 07:50 PM Another aspect of non-verbal communication is personal space, which is the comfortable amount of distance between you and someone you are talking with. In Australia and the United States, the customary distance apart adopted by parties in a business discussion is around two metres. In Latin America, it is around a metre to a metre and a half. Consequently, many Australians and North Americans unconsciously feel that Latin Americans are invading their personal space and can be seen backing away from them during a conversation. Indeed, Australians and Americans may feel that Latin Americans are being aggressive and pushy. In turn, Latin Americans may interpret such backing away as aloofness. The result can be a regrettable lack of rapport between two businesspeople from different cultures. EDUCATION LO 5.3 Formal education plays a key role in a society. Formal education is the medium through which individuals learn many of the language, conceptual and mathematical skills that are indispensable in a modern society. Formal education also supplements the family’s role in socialising the young into the values and norms of a society. Values and norms are taught both directly and indirectly. Schools generally teach basic facts about the social and political nature of a society. They also focus on the fundamental obligations of citizenship. In addition, cultural norms are taught indirectly at school. Respect for others, obedience to authority, honesty, neatness, being on time and so on are all part of the ‘hidden curriculum’ of schools. The use of a grading system also teaches children the value of personal achievement and competition.53 From an international business perspective, one important aspect of education is its role as a determinant of national competitive advantage.54 The availability of a pool of skilled and educated workers seems to be a major determinant of the likely economic success of a country. In analysing the competitive success of Japan since 1945, for example, Michael Porter notes that after the war, Japan had almost nothing except for a pool of skilled and educated human resources: With a long tradition of respect for education that borders on reverence, Japan possessed a large pool of literate, educated, and increasingly skilled human resources . . . Japan has benefited from a large pool of trained engineers. . . . A first-rate primary and secondary education system in Japan operates based on high standards and emphasises maths and science. Primary and secondary education is highly competitive . . . Japanese education provides most students all over Japan with a sound education for later education and training.55 Porter’s point is that Japan’s excellent education system is an important factor explaining the country’s postwar economic success. Not only is a good education system a determinant of national competitive advantage, but it is also an important factor guiding the location choices of international businesses. The recent trend to outsource information technology jobs to India, for example, is partly due to the presence of significant numbers of trained engineers in India, which in turn is a result of the Indian education system. By the same token, it would make little sense to base production facilities that require highly skilled labour in a country where the education system was so poor that a skilled labour pool was not available, no matter how attractive the country might seem on other dimensions. It might make sense to base production operations that require only unskilled labour in such a country. CHAPTER 5 hiL23674_ch05_207-254.indd 235 DIFFERENCES IN CULTURE 235 08/06/19 07:50 PM The general education level of a country is also a good index of the kind of products that might sell in a country and of the type of promotional material that should be used. For example, a country where more than 70 per cent of the population is illiterate is unlikely to be a good market for popular books. Promotional material containing written descriptions of mass-marketed products is unlikely to have an effect in a country where almost three-quarters of the population cannot read. It is far better to use pictorial promotions in such circumstances. CULTURE AND THE WORKPLACE LO 5.4 Of considerable importance for an international business with operations in different countries is how a society’s culture affects the values found in the workplace. Management processes and practices may need to vary according to culturally determined workrelated values. For example, if the cultures of Australia and China result in different workrelated values, an international business with operations in both countries should vary its management process and practices to account for these differences. Many researchers have focused on how cultures differ and the impact these differences have on business. Probably two of the most famous theories were proposed by Edward Hall and Mildred Hall,56 and by Geert Hofstede.57 Cultural context LOW-CONTEXT CULTURE A culture in which the speaker’s message is conveyed explicitly by the spoken words TABLE 5.1 Low- and high-context cultures SOURCE: E. Tuleja, ‘An overview of culture: ethnocentrism’, Intercultural Communication for Business, Mason, Ohio: South-Western Cengage Learning, 2009. Hall and Hall highlighted the cultural differences between countries by using the concept of context, where context equates to cues and other information present in a situation such as tone of voice and gestures. They divided the extremes of context into high and low context with a range in between (see Table 5.1). Most of the individualistic Western countries such as Australia, New Zealand, the United States, Canada and most of Western Europe tend to be low-context cultures (see Fig. 5.3). In these countries, explicit communication is preferred. Most countries in Asia, the Middle East, Latin America LOW-CONTEXT CULTURES HIGH-CONTEXT CULTURES Focus more on completing tasks than on maintaining relationships Maintain good relationships and the tasks will be completed Use objective data Subjective elements can be included Employees expect detailed information Employees expect superiors to handle details In general people are addressed informally, with notable exceptions such as in Germany People are addressed formally Executives tend to be given private office spaces Executives share open office space Employee’s position/status gives power and influence Meetings stick closely to a set agenda Low context High context FIGURE 5.3 Low- and high-context cultures SOURCE: Constructed by author based on E. Tuleja, ‘An overview of culture: ethnocentrism’, Intercultural Communication for Business, Mason, Ohio: South-Western Cengage Learning, 2009, pp. 13–16. 236 PART 3 an rm Ge US n via ina nd Sca ian lian nd n sh k a nad ustra tish lia i eal Bri Ita Span Gree Arab inese rean nese A Z w Ch Ko Japa e N an a dC COUNTRY DIFFERENCES hiL23674_ch05_207-254.indd 236 08/06/19 07:50 PM and Africa have high-context cultures. In these countries, people refrain from explicitly expressing feelings and thoughts, and important information is embedded in the context.58 What does this mean for undertaking business internationally? Australians, Americans and New Zealanders (low-context cultural background) tend to focus more on completing tasks than on maintaining relationships, whereas people from high-context cultures (such as Japanese, Chinese and Koreans) focus on forging and maintaining good relationships to facilitate the completion of tasks. (In Chapter 10 we will discuss the importance of forging long-term relationships in ensuring the long-term survival of companies and in reducing business costs.) In Germany and Switzerland, meetings start promptly, but not in Saudi Arabia or Mexico, where meetings often begin with lengthy socialising to establish rapport. Be careful how you say things: Australians, Americans and Western Europeans tend to speak plainly and in a straightforward manner, but Chinese, Japanese, Koreans, Arabs, Indians and some Latin Americans are indirect and rely on body language and context to make their point. And be careful what you say. American and Australian managers describe business in financial terms (or objective data), whereas in China and Japan subjective elements can be included in business discussions. A good rule of thumb: pay attention to cues and don’t assume that your customs are observed everywhere.59 It is good business practice to adapt to your clients’ needs. For example, the general manager of Jingzhi Co., a manufacturer of quality kitchen cabinets and wardrobes in the Chinese town of Ronggui,60 has adapted to the needs of his (low-context) Western clients. They have moved away from the traditional Chinese way of doing business, building relationships first and business later. ‘In the past we used to take time concluding business deals, including entertaining our Western business partners. We realised this hospitality seemed to annoy them. They were in China for a limited time and were keen to conclude as many deals as possible—“time is money”. Now we accommodate their needs by providing information prior to their arrival, including on our website. We no longer insist on socialising or hosting banquets for them.’ One of the most detailed studies of how culture relates to values in the workplace was undertaken by Geert Hofstede.61 As part of his job as a psychologist working for IBM, Hofstede collected data on employee attitudes and values for more than 100 000 individuals from 1967 to 1973. These data enabled him to compare dimensions of culture across 40 countries. Hofstede isolated four dimensions that he claimed summarised different cultures—power distance, uncertainty avoidance, individualism versus collectivism and masculinity versus femininity. Hofstede’s power distance dimension focused on how a society deals with the fact that people are unequal in physical and intellectual capabilities. According to Hofstede, highpower distance cultures were found in countries that let inequalities grow over time into inequalities of power and wealth. Low-power distance cultures were found in societies that tried to play down such inequalities as much as possible. The individualism versus collectivism dimension focused on the relationship between the individual and his or her fellows. In individualistic societies, the ties between individuals were loose and individual achievement and freedom were highly valued. In societies where collectivism was emphasised, the ties between individuals were tight. In such societies, people were born into collectives, such as extended families, and everyone was supposed to look after the interest of his or her collective. Hofstede’s uncertainty avoidance dimension measured the extent to which different cultures socialised their members into accepting ambiguous situations and tolerating uncertainty. Members of high uncertainty avoidance cultures placed a premium on job security, career patterns, retirement benefits, and so on. They also had a strong need for rules and regulations; the manager was expected to issue clear instructions, and subordinates’ initiatives were tightly controlled. Lower uncertainty avoidance cultures were characterised by a greater readiness to take risks and less emotional resistance to change. CHAPTER 5 hiL23674_ch05_207-254.indd 237 HIGH-CONTEXT CULTURE A culture in which the context of a discussion is as important as the actual words spoken POWER DISTANCE Extent to how much a society allows inequalities of physical and intellectual capabilities between people to grow into inequalities of power and wealth INDIVIDUALISM VERSUS COLLECTIVISM Extent to which a society teaches individuals either to prize personal achievement or conversely to look after the interests of their collective first and foremost UNCERTAINTY AVOIDANCE Extent to which cultures socialise members to accept ambiguous situations and to tolerate uncertainty DIFFERENCES IN CULTURE 237 08/06/19 07:50 PM MASCULINITY VERSUS FEMININITY Extent to which a society differentiates and emphasises traditional gender and work roles; a masculine characterisation means there is more differentiation, whereas a feminine level means there is less Hofstede’s masculinity versus femininity dimension looked at the relationship between gender and work roles. In masculine cultures, sex roles were sharply differentiated and traditional ‘masculine values’, such as achievement and the effective exercise of power, determined cultural ideals. In feminine cultures, sex roles were less sharply distinguished, and little differentiation was made between men and women in the same job. Hofstede created an index score for each of these four dimensions that ranged from 0 to 100 and scored high for high individualism, high-power distance, high uncertainty avoidance and high masculinity. He averaged the score for all employees from a given country. Table 5.2 summarises these data for 14 selected countries. Western nations such as Australia, the United States, New Zealand and Britain score high on the individualism scale and low on the power distance scale. At the other extreme are a group of Latin American and Asian countries that emphasise collectivism over individualism and score high on the power distance scale. Table 5.2 also reveals that Japan’s culture has strong uncertainty avoidance and high masculinity. This characterisation fits the standard stereotype of Japan as a country that is male dominant and where uncertainty avoidance exhibits itself in the institution of lifetime employment. Sweden stands out as a country that has both low uncertainty avoidance and low masculinity (high emphasis on ‘feminine’ values). TABLE 5.2 Work-related values for selected countries COUNTRY Australia POWER DISTANCE UNCERTAINTY AVOIDANCE INDIVIDUALISM MASCULINITY LONG-TERM ORIENTATION 36 51 90 61 31 Brazil 69 76 38 49 65 China 80 30 20 66 118 Germany 35 65 67 66 31 Great Britain 35 35 89 66 25 India 77 40 48 56 61 Japan 54 92 46 95 80 New Zealand 22 49 79 58 30 Nigeria 80 55 30 60 16 Russia 93 95 39 36 – Singapore 74 8 20 48 48 Sweden 31 29 71 5 33 Thailand 64 64 20 35 56 United States 40 46 91 62 29 SOURCES: G. Hofstede, ‘The business of international business is culture’, International Business Review, 3(1) (1994); data for Singapore and New Zealand derived from T.C. Garrett, D.H. Buisson and C.M. Yap, ‘National culture and R&D and marketing integration mechanisms in new product development: a cross-cultural study between Singapore and New Zealand’, Industrial Marketing Management, 35 (2006), pp. 293–307; G. Hofstede, G.J. Hofstede and M. Minkov, Cultures and Organizations: Software for the Mind, 3rd ed, New York, NY: McGraw-Hill Professional Publishing (2010). Hofstede’s results are interesting for what they tell us in a very general way about differences between cultures. Many of Hofstede’s findings are consistent with standard Western stereotypes about cultural differences. For example, many people believe Australians are more individualistic and egalitarian than the Japanese (Australians have a lower power distance), who in turn are more individualistic and egalitarian than Brazilians or Indians. Similarly, many might agree that Japanese place a higher emphasis on masculine values than the Nordic countries of Denmark and Sweden. However, one should be careful about reading too much into Hofstede’s research. It has been criticised on a number of points.62 First, Hofstede assumes there is a one-to-one 238 PART 3 COUNTRY DIFFERENCES hiL23674_ch05_207-254.indd 238 08/06/19 07:50 PM correspondence between culture and the nation-state but, as we saw earlier, many countries have more than one culture. Hofstede’s results do not capture this distinction. Second, the research may have been culturally bound. The research team was composed of Europeans and Americans. The questions they asked of IBM employees and their analysis of the answers may have been shaped by their own cultural biases and concerns. So, it is not surprising that Hofstede’s results confirm Western stereotypes, because it was Westerners who undertook the research. Third, Hofstede’s informants worked not only within a single industry, the computer industry, but also within one company, IBM. At the time, IBM was renowned for its own strong corporate culture and employee selection procedures, making it possible that the employees’ values were different in important respects from the values of the cultures from which those employees came. Also, certain social classes (such as unskilled manual workers) were excluded from Hofstede’s sample. Still, just as it should not be accepted without question, Hofstede’s work should not be dismissed either. It represents a good starting point for managers trying to figure out how cultures differ and what that might mean for management practices. Also, several other scholars have found strong evidence that differences in culture affect values and practices in the workplace, and Hofstede’s basic results have been replicated using more diverse samples of individuals in different settings.63 In addition, Hofstede’s work has evolved over time with the addition of further dimensions.64 Hofstede subsequently expanded his original research to include fifth65 and sixth66 dimensions that he argued captured additional cultural differences not brought out in his earlier work. He referred to the fifth dimension as ‘Confucian dynamism’, which is now referred to as ‘long-term orientation’. According to Hofstede, long-term orientation captures attitudes towards time, persistence, ordering by status, protection of face, respect for tradition, and reciprocation of gifts and favours. As might be expected, East Asian countries such as Japan, Hong Kong and Thailand scored high on long-term orientation, while nations such as Australia and New Zealand scored low (see Table 5.2). In countries scoring LONG-TERM ORIENTATION Extent to which a society adheres to values about time, persistence, ordering by status, protection of face, respect for tradition and reciprocation of gifts EMERGING MARKETS A TALE OF TWO COUNTRIES The two Asian countries in the spotlight for Western companies seeking to internationalise—via export or offshore production or offshore servicing—are India and China. India is best known for its IT-related services such as call centres, and China is better known for its lowcost manufacturing capabilities. Who has not received a marketing call from someone with an Indian accent or doesn’t own clothes marked ‘Made in China’? What are the similarities and differences between these two countries? Both countries have undergone major economic reforms and, as a result, are two of the fastest growing economies in the world. In 2015 both countries recorded growth rates of around 7 per cent. Both India and China have huge populations and pools of willing workers for production facilities, as well as a small but growing middle class with a sizeable disposable income for buying foreign goods. India’s and China’s scores are similar on some of Hofstede’s cultural value dimensions (see Table 5.2). The numbers in the table show that both countries are considered high power distance and collectivistic (although China is more collectivistic). China’s culture is considered more long-term oriented than India’s. Although there are similarities, it would be foolhardy for a Western manager to think of China and India in the same way. For Anglo-Westerners, doing business CHAPTER 5 hiL23674_ch05_207-254.indd 239 DIFFERENCES IN CULTURE 239 08/06/19 07:50 PM in India is ‘easier’ because English is widely spoken. In China, finding a good interpreter remains essential if you want to negotiate a complex business deal. The governments in the two countries are dissimilar: India’s government is a robust democracy; and although there are elections in China, the country has just one party—the Communist Party of China. China is officially atheist, although many Chinese practise Confucianism in conjunction with local beliefs and/or Buddhism. In India it is hard to miss the religious practices of the majority Hindu population (80.5 per cent) whose colourful temples are dotted throughout the cities. Muslims are also well represented among the Indian population (13.4 per cent). It is imperative that Western managers develop their cross-cultural literacy to understand how these similarities and differences play out in business behaviour. Western managers are often surprised about how long it takes to set up a business in these countries. The World Bank reported that starting a business in India took 89 days (on average). In China it takes 41 days for a business to be registered. Enforcing a contract also takes an extended time in both countries; in India it takes 425 days, compared to 241 days in China. Western companies wanting to set up business in either country have to navigate copious amounts of red tape. In India, companies have to be registered through the Office of the Registrar of Companies (ROC) in New Delhi. One Western company that wanted to establish a foothold in India, Uzanto Consulting, applied to register its company name in the last week of March, and it was not until 2 June that year that it received its registration certificate, and then had to wait a further two weeks for bank accounts to become operational. According to Amit Ranjan, Uzanto Consulting’s chief operating officer in New Delhi, the length of time it took the ROC was ‘due to bureaucratic red tape’. After originally applying to register the name ‘Uzanto Technologies’, the ROC wanted the company to change the second part of its name because ‘technologies’ was considered too generic. Concern in India over the use of the word ‘technology’ is ironic, given that the transformation from an impoverished, Soviet-inspired state in the 1980s to the global epicentre of communications technology is largely due to the technology revolution of the 1990s. Although Uzanto tried to reason with the ROC, it ‘soon realised that all such attempts were futile. In sheer exasperation and in an effort to get it over with’, the name Uzanto Consulting was suggested and the ROC agreed. Amit Ranjan writes in his blog that ‘wrangling over the name issue probably took up 20–25 days’. He goes on to comment that the role of his chartered accountant (CA) was crucial in the start-up process because some CAs can exert influence in the ROC office. The role of the CA might be related to the importance of personal relationships in India—some India watchers deem relationships the most effective form of communication in India. Recently, the ROC office has reduced the time it takes to register a company name by moving the process online. Approval of a company name can take as little as just a few minutes if companies apply online with all the necessary documentation. The time taken to craft a deal in a negotiation with Indians and Chinese can frustrate Westerners. The particular tactics used in China and India are different, but they can have the same outcome. In China it is common for negotiators to repeat their position over and over again. In India, ‘they have a tendency to badger one to the point of exasperation, when the average American or European business man will give in just to get rid of them or to move things along. Alternatively they will stall when things are not going their way, until the silence becomes unbearable and you give in.’ Silence is a commonly used tactic in China, too. Sometimes Chinese negotiators close their eyes and say nothing for extended periods. Coping with these behaviours is challenging for Western managers. Even if they are culturally literate, Western managers have to modify their responses to behaviours at the very least and, ideally, should modify their behaviours to achieve the goals they are seeking in China or India. SOURCES: M. Butcher, ‘India isn’t quite perfect but she has good opportunities for Australia’, On Line Opinion—Australia’s e-journal of social and political debate (2004), www.onlineopinion.com.au; CIA World Factbook, www.cia.gov/cia/publications/factbook; ‘India eyes white-hot economic growth’, cnn money.com, 7 February 2007, accessed via www.cnnmoney.com/2007/02/07/news/international/bc.india.economy.gdp.reut; J. Frederick, ‘Thriving in the Middle Kingdom: China’s middle class holds the key to the future of the country’, Time Asia (2002), www.time.com/time/asia/features/ china_cul_rev/middle_class.html; Itim International, www.geert-hofsted.com.hofsted_dimensions.php?culture1=42&culture2=18; R. Kumar, ‘Brahmanical idealism, anarchical individualism, and the dynamics of Indian negotiating behavior’, Cross Cultural Management, 4(1) (2004), pp. 39–58; A. Ranjan, ‘Time taken to incorporate a company in India falls from three months to one hour’ (2006), www.amitranjam.com/category/managing-itstartups; A. Ranjan, ‘Starting up business in India—beware of ROC red-tape’ (2005), www.amitranjan.com/2005/08/12/starting-up-a-business-in-india%e2%80%93-watch-out-for-the-roc-redtape; ‘India 89’, rediff.com (2005), rediff.com/money/2005/aug/10busi.htm; World development indicators database, http://dexdata.worldbank.org/external/CPProfile.asp?PTYPE=CP&CCode=IND. 240 PART 3 COUNTRY DIFFERENCES hiL23674_ch05_207-254.indd 240 08/06/19 07:50 PM high in long-term orientation, establishment of relationships comes before business, unlike in Western countries where relationships are secondary to business.67 The sixth dimension is based on the work of Michael Minkov. Hofstede and Minkov defined this dimension as ‘Indulgence versus restraint’ where indulgence is the human need to enjoy life and have fun, and restraint is the need to control indulgence via social norms. New Zealand and Australia are ranked 9 and 11 out of 93 countries.68 However, more empirical validation of the sixth dimension is needed prior to common usage. Two additional cultural values frameworks that have been examined and have been related to work-related and/or business-related issues are the Global Leadership and Organizational Behavior Effectiveness (GLOBE) Instrument and the World Values Survey (WVS). The GLOBE instrument is designed to address the notion that a leader’s effectiveness is contextual.69 It is embedded in the societal and organisational norms, values and beliefs of the people being led. The initial GLOBE findings from 62 societies involving 17 300 middle managers from 951 organisations build on findings by Hofstede and other culture researchers. The GLOBE research established nine cultural dimensions: power distance, uncertainty avoidance, humane orientation, institutional collectivism, in-group collectivism, assertiveness, gender egalitarianism, future orientation and performance orientation. (See Table 5.3 for a summary.) TABLE 5.3 GLOBE culture constructs CULTURE CONSTRUCT DEFINITIONS BRIEF DESCRIPTION OF GLOBE FINDINGS IN RELATION TO SOCIETAL ATTRIBUTES Power distance The degree to which members of a collective expect power to be distributed equally. In high-power-distance societies there is a divide between the rich and poor. Economic growth does not necessarily result in greater employment for the poor. Low score in the Human Development Index. Uncertainty avoidance The extent to which a society, organisation or group relies on social norms, rules and procedures to alleviate unpredictability of future events. Societies with high uncertainty avoidance have government support for economic activities and good infrastructure. Humane orientation The degree to which a collective encourages and rewards individuals for being fair, altruistic, generous, caring and kind to others. People in societies with high humane orientation tend to be hospitable, extend warm greetings and show others empathy. Institutional collectivism The degree to which organisational and societal practices encourage and reward collective distribution of resources and collective action. Countries with high institutional collectivism tend to be those countries influenced by Confucian values. Decisions are made by the group and economic systems are geared towards maximising the wellbeing of the society. In-group collectivism The degree to which individuals express pride, loyalty and cohesiveness in their organisations or families. Societies with high in-group collectivism have a strong distinction between in-groups and out-groups and an emphasis on relatedness with groups. Assertiveness The degree to which individuals are assertive, confrontational and aggressive in their relationships with others. In high-assertive societies competition and success is valued and communication is direct. In addition subordinates are expected to take initiatives. Gender egalitarianism The degree to which a collective minimises gender inequality. In high-gender-egalitarianism societies women can be in positions of authority and there is more gender equality. Future orientation The extent to which individuals engage in futureoriented behaviours such as delaying gratification, planning and investing in the future. High-future-oriented societies tend to achieve economic success and save for the future. The emphasis is on longterm success. Performance orientation The degree to which a collective encourages and rewards group members for performance improvement and excellence. Performance-oriented societies value training, development and value results over people with performance being rewarded. SOURCE AND ACKNOWLEDGMENT: This table attempts to summarise some of the key GLOBE study findings in relation to societal attributes based on R. House, P. Hanges, M. Javidan, P. Dorfman and V. Gupta, Culture, Leadership, and Organizations: The GLOBE Study of 62 Societies, Thousand Oaks, CA: Sage Publications, 2004. It is an incomplete list. CHAPTER 5 hiL23674_ch05_207-254.indd 241 DIFFERENCES IN CULTURE 241 08/06/19 07:50 PM COUNTRY FOCUS INDONESIA: CROSS-CULTURAL AND GEOPOLITICAL Indonesia is the world’s third largest democracy with the world’s largest Muslim population. It is also the largest economy in South-East Asia, the 16th largest economy in the world and one of Australia’s closest geographic neighbours. Australian mining equipment and agricultural products (mainly wheat and live animals) are among the major exports to Indonesia, while crude petroleum and manufactured goods are key imports. These trade flows are largely in primary and intermediate products, mainly business to business. As such, cross-cultural issues generally do not come into play since the parties on either end of the transaction are mainly focused on technical needs (e.g. the appropriateness or effectiveness of a machine) and relationships are typically purely business focused. A notable exception: changes had to be made to Australian live animal exports to Indonesia after 2016 when press reports indicated that some local Indonesian abattoirs were operating below the humane treatment standards that governed their Australian counterparts; indeed, the whole live animal trade is based on requirements for halal butchering of animals that meets Islamic law requirements acceptable in Indonesia. However, the bigger future growth potential is in trade and investment in services and goods marketed directly to consumers—and here cultural differences do have to be understood and navigated more closely. Tourism is already a major two-way relationship, as is education, but much more growth is possible. Indonesian students studying in Australia brought A$833 million into the Australian economy in 2017, while Australian tourists travelling in Indonesia contributed $3.1 billion to the Indonesian economy—large numbers but with much room to grow. Australia has had periodic hiccups with other nations over local treatment of foreign students but has been very responsive in addressing these (e.g. quickly making security improvements in response to periodic incidents where foreign students are victims of crime). Such events can momentarily upset diplomatic relations and cause a ruffle of media attention, but so far people from both Australia and Indonesia seem to show no let-up in wanting to visit one another’s countries. Both countries have an experience base to work from in navigating occasional serious disagreements and misunderstandings in these areas, something that bodes well for increasing growth in trade and investment. However, moves into other markets such as consumer goods, where a growing Indonesian urban middle class offers great possibilities for Australian companies, will require a new learning curve based on careful due diligence and in particular mutual respect for the differences between the dominant religious systems in the two nations. Geopolitics can often enter into this equation. For example, in 2018 the Australian government followed the US government in announcing that it would move its embassy in Israel from Tel Aviv to Jerusalem. This provoked a strong protest from the Indonesian government, which opposed the move because it suggested Israeli sovereignty over a city that Muslim nations believe should be more open given its significance to Christians and Muslims as well as Jews. Indonesia threatened to pull out of an upcoming bilateral free trade deal and the Australian government has since pulled back from its commitment. Geopolitics aside, Australia and Indonesia need each other economically. Increasing trade and investment relationships does not require constant agreement over cultural and religious concerns, but it does require mutual understanding and sometimes political compromise. As interdependency grows, so will the need for these considerations. Cameron Gordon Australian National University SOURCES: ‘Indonesia: Doing business’, Australian Government: Australian Trade and Investment Commission, www.austrade.gov.au/Australian/Export/ Export-markets/Countries/Indonesia/Doing-business, accessed February 2019; ‘Indonesia country brief’, Australian Government: Department of Foreign Affairs and Trade, https://dfat.gov.au/geo/indonesia/Pages/indonesia-country-brief.aspx, accessed February 2019; A. Smith, ‘A year of turmoil for live export industry’, Farm weekly, 31 December 2018, www.farmweekly.com.au/story/5824642/a-year-of-turmoil-for-live-export-industry/ accessed February 2019; ‘The World Bank in Indonesia’, The World Bank, www.worldbank.org/en/country/indonesia/overview, accessed February 2019; V. Asri, ‘Number of Indian students studying in Australia at a seven-year high’, SBS, 16 February 2018, www.sbs.com.au/yourlanguage/hindi/en/article/2018/02/16/number-indian-studentsstudying-australia-seven-year-high, accessed February 2019; R. Callinan, ‘Racial Attacks Trouble Indian Students in Australia’, Time, 6 June 2009, http:// content.time.com/time/world/article/0,8599,1903038,00.html, accessed February 2019; C. Sutton, ‘Left behind to rot: Bali ‘Five’ to die in jail’, news.com.au, 15 November 2018, www.news.com.au/national/crime/left-behind-to-rot-bali-five-to-die-in-jail/news-story/d66e41262452556d292cf8b708325630, accessed February 2019; K. Murphy, ‘Simon Birmingham says Indonesian trade deal critical amid Israel embassy spat’, The Guardian, 18 November 2018, www. theguardian.com/australia-news/2018/nov/18/simon-birmingham-says-indonesian-trade-deal-critical-amid-israel-embassy-spat, accessed February 2019. 242 PART 3 COUNTRY DIFFERENCES hiL23674_ch05_207-254.indd 242 08/06/19 07:50 PM The WVS is a research project spanning more than 100 countries that explores people’s values and norms, how they change over time and what impact they have on society and business.70 The WVS includes dimensions for support for democracy; tolerance of foreigners and ethnic minorities; support for gender equality; the role of religion and changing levels of religiosity; the impact of globalisation; attitudes towards the environment, work, family, politics, national identity, culture, diversity and insecurity; and subjective wellbeing. CULTURAL CHANGE LO 5.5 Culture is not a constant; it evolves over time. Changes in value systems can be slow and painful for a society. Change, however, does occur and can often be quite profound. In the 1960s, for example, Australian values relating to the role of women, love, sex and marriage underwent significant changes. Much of the social turmoil of that time reflected these changes. For example, at the beginning of the 1960s, the idea that women might hold senior management positions in major corporations or be a premier of a state or prime minister of the country was not widely accepted. Many scoffed at the idea. Today, few in mainstream Australian society question the development or the capability of women in the business world. However, although Australian culture has changed, it is still more New Zealand Prime Minister Jacinda Ardern is a role model difficult for women to gain senior management positions for other aspiring leaders. than men. According to the World Economic Forum Global Gender Gap Index (see Table 5.4), Australia is ranked 46th, below the United States at 45th and significantly below New Zealand ranked 9th. Regrettably, change is coming slowly: globally, it is estimated that it will take another 217 years to reach gender equality.72 TABLE 5.4 World Economic Forum Global Gender Gap Index RANK ECONOMY SCORE 1 Iceland 0.874 2 Finland 0.845 3 Norway 0.842 4 Sweden 0.815 5 Rwanda 0.8 6 Ireland 0.797 7 Philippines 0.786 8 Slovenia 0.786 9 New Zealand 0.781 45 United States 0.722 46 Australia 0.721 SOURCE: ‘Global Gender Gap Index 2016’, World economy forum, accessed via http://reports.weforum.org/globalgender-gap-report-2016/rankings/. Why is gender equality important for business? Apart from the ethical and moral imperative to stop discrimination, there is a significant economic benefit to gender equality. According to a McKinsey Global Institute report, advancing equality could result in more than US$12 trillion being added to the global GDP by 2025.73 CHAPTER 5 hiL23674_ch05_207-254.indd 243 DIFFERENCES IN CULTURE 243 08/06/19 07:50 PM © Hagen Hopkins/Stringer/Getty Images 71 The value systems of many former Communist states, such as Russia, are undergoing significant changes as those countries move away from values that emphasise collectivism and towards those that emphasise individualism. While social turmoil is an inevitable outcome of such a shift, the shift will still probably occur. Similarly, some claim that a major cultural shift is occurring in Japan and Japanese companies as highlighted in the opening case, with a move towards greater individualism.74 The model Japanese office worker, or ‘salaryman’, is characterised as being loyal to his boss and the organisation to the point of giving up evenings, weekends and vacations to serve the organisation, which is the collective of which the employee is a member. However, a new generation of office workers does not seem to fit this model. An individual from the new generation is likely to be more direct than the traditional Japanese. He acts more like a Westerner, a gaijian. He does not live for the company and will move on if he gets the offer of a better job. He is not keen on overtime, especially if he has a date. He has his own plans for his free time, and they may not include drinking or playing golf with the boss.75 Several studies have suggested that economic advancement and globalisation may be important factors in societal change.76 For example, there is evidence that economic progress is accompanied by a shift in values away from collectivism and towards individualism.77 Thus, as Japan has become richer, the cultural emphasis on collectivism has declined and greater individualism is being witnessed. One reason for this shift may be that richer societies exhibit less need for social and material support structures built on collectives, whether the collective is the extended family or the paternalistic company. People are better able to take care of their own needs. As a result, the importance attached to collectivism declines, while greater economic freedoms lead to an increase in opportunities for expressing individualism. The culture of societies may also change as they become richer, because economic progress affects a number of other factors, which in turn influence culture. For example, increased urbanisation and improvements in the quality and availability of education are both a function of economic progress, and both can lead to declining emphasis on the traditional values associated with poor rural societies. A 25-year study of values in 78 countries, known as the World Values Survey, coordinated by the University of Michigan’s Institute for Social Research, has documented how values change. The study linked these changes in values to changes in a country’s level of economic development.78 According to this research, as countries get richer, a shift occurs away from ‘traditional values’ linked to religion, family and country, and towards ‘secular rational’ values. Traditionalists say religion is important in their lives. They have a strong sense of national pride; they also think that children should be taught to obey and that the first duty of a child is to make his or her parents proud. They say abortion, euthanasia, divorce and suicide are never justified. At the other end of this spectrum are secular rational values. Another category in the World Values Survey is quality of life attributes. At one end of this spectrum are ‘survival values’, the values people hold when the struggle for survival is of paramount importance. These values tend to s
