LEVEL 5 INTERNATIONAL BUSINESS ECONOMICS AND MARKETS

Y o u r r o a d t o s u c c e s s

LEVEL 5 INTERNATIONAL BUSINESS ECONOMICS AND MARKETS

Your road to success

• ABE • OF

FIC

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L S T U DY GU

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ISBN: 978-1-911550-19-8

Copyright © ABE 2017 First published in 2017 by ABE 5th Floor, CI Tower, St. Georges Square, New Malden, Surrey, KT3 4TE, UK www.abeuk.com

All facts are correct at time of publication.

Author: Dr Bruce JohnstoneReviewer: Peter Rumble CertEd MCIM DipM

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Contents

Using your study guide iv

Chapter 1 Economic Principles 2

1.1 Why organisations engage in international trade 3

1.2 Arguments for and against free trade 9

1.3 The impacts of globalisation 16

Chapter 2 International Markets 20

2.1 How markets are selected 21

2.2 Assessing the main market entry methods 23

2.3 Conducting a structured analysis of a market 26

2.4 Marketing mix strategies for different contexts 35

Chapter 3 International Trading Blocs 40

3.1 Different types of economic co-operation and preferential trade arrangements 41

3.2 Evaluate the purposes and operations of intergovernmental bodies 45

3.3 The major trade blocs and regional groupings 48

Chapter 4 International Finance 54

4.1 Key international financial institutions in world trade 55

4.2 The impact of foreign currency exchange and interest rates on international business 57

4.3 A country’s balance of payments and balance of trade 60

Glossary 63

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Using your study guideWelcome to the study guide for Level 5 International Business Economics and Markets, designed to support those completing their ABE Level 5 Diploma.

Below is an overview of the elements of learning and related key capabilities (taken from the published syllabus).

Element of learning Key capabilities

Element 1 – Economic principles of international business

Awareness of the different economic and socioeconomic factors that affect how companies conduct business internationally and how the behaviours of customers and employees directly affect the workplace.

Analysis, justification, presenting reasoned arguments, communication

Element 2 – Markets from an international perspective

Ability to recognise and adapt to the impacts on products and markets arising from the availability of products, services and marketing communications from abroad.

Commercial awareness of cultural aspects and the direct impact of globalisation.

Analysis, commercial awareness, cultural awareness, decision-making, communication

Element 3 – International trading blocs and organisations

Ability to view the world not only in terms of an own country perspective, but to work within the wider sphere of global cooperation, treaties, and changing relationships.

Global perspective, relationships, communication

Element 4 – International financial aspects

Gaining an acceptance of the financial impacts and implications of being involved in global activity that are apparent in commercial activities of all businesses.

Financial awareness, analysis

This study guide follows the order of the syllabus, which is the basis for your studies. Each chapter starts by listing the syllabus learning outcomes covered and the assessment criteria.

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L5 descriptor

Knowledge descriptor (the holder…) Skills descriptor (the holder can…)

• Has practical, theoretical or technological knowledge and understanding of a subject or field of work to find ways forward in broadly defined, complex contexts.

• Can analyse, interpret and evaluate relevant information, concepts and ideas. Is aware of the nature and scope of the area of study or work.

• Understands different perspectives, approaches or schools of thought and the reasoning behind them.

• Determine, adapt and use appropriate methods, cognitive and practical skills to address broadly defined, complex problems.

• Use relevant research or development to inform actions. Evaluate actions, methods and results.

The study guide includes a number of features to enhance your studies:

’Over to you’: activities for you to complete, using the space provided.

Case studies: realistic business scenarios to reinforce and test your understanding of what you have read.

’Revision on the go’: use your phone camera to capture these key pieces of learning, then save them on your phone to use as revision notes.

’Need to know’: key pieces of information that are highlighted in the text.

Examples: illustrating points made in the text to show how it works in practice.

Tables, graphs and charts: to bring data to life.

Reading list: identifying resources for further study, including Emerald articles (which will be available in your online student resources).

Source/quotation information to cast further light on the subject from industry sources.

Highlighted words throughout denoting glossary terms located at the end of the book.

Note

Website addresses current as of August 2017.

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Introduction

We will begin our study of international business by looking at the economic principles that drive organisations to do business beyond their national borders; in the process, we will highlight the main arguments for and against free trade. Once we have understood those economic principles, we will be able to better appreciate how globalisation is changing economies, countries, cultures and the international business environment.

Learning outcomes

On completing this chapter, you will be able to:

1 Analyse economic principles associated with international business

Assessment criteria

1 Analyse economic principles associated with international business

1.1 Explain the reasons why organisations engage in international trade

1.2 Justify the arguments for and against free trade with reference to restrictions in trade

1.3 Demonstrate an awareness of the impact of international issues such as globalisation on organisations trading internationally

Economic Principles

Chapter 1

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1.1 Why organisations engage in international tradeTo compete successfully in sporting contests or artistic endeavours it is essential to have an advantage. This is also true of business, where having an advantage means being able to create more value compared to others; having an advantage supports economic success. Nations can also have different advantages that allow them to create value by trading internationally.

Our understanding of how nations can create wealth by trading with other nations has evolved over the centuries as a series of trade theories emerged; earlier ones are classed as classical trade theories and the more recent ones as modern trade theories. Let us begin by looking at the classical theories of mercantilism, absolute advantage and comparative advantage.

Mercantilism

Developed in the 1600s and 1700s, and associated with the French politician Jean-Baptiste Colbert, the theory of mercantilism sees international trade as a zero sum game where the goal is to secure as much wealth as possible. Wealth was valued in terms of gold, and there was only so much of it. According to the theory of mercantilism, if a country sells valuable goods and services to other countries, it gains gold and becomes richer at the expense of the country receiving those goods or services. A country succeeds over other countries by having more gold coming in than there is gold going out. If I have more gold, it means you must have less and vice versa. Mercantilism is a win-lose view of international trade.

The theory of mercantilism still exists today in the form of protectionism: the idea that governments should promote their country’s exports while they put up barriers against imports. This is justified through the protection of jobs and wealth in their own countries and is a view that opposes free trade.

Absolute advantage

The economist Adam Smith was an early advocate of the idea of free trade. In his 1776 book The Wealth of Nations, Smith explained that markets could work well without the interference of governments, as if controlled by an invisible hand. This applied to international markets as well as national markets.

Smith explained that a country could have an absolute advantage over other countries. For example, Portugal had an absolute advantage over England in producing grapes and wine because of its better climate and soil. However, England had an absolute advantage over Portugal in producing sheep and wool because of its climate.

Level 5 International Business Economics and Markets

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Chapter 1 Economic Principles

Absolute advantage

The theory of absolute advantage explained that Portugal should sell wine to England and that England should sell wool to Portugal. By specialising in what they were good at both countries could produce more. By trading with each other both could still have the goods they needed, including goods they could not produce efficiently themselves.

on the goREVISION

The mercantilism theory called for a country to import as little as possible and be self-sufficient, but the theory of absolute advantage explained that this would make a country worse off in the long run. Mercantilism saw international trade as win-lose, but Smith’s theory of absolute advantage recognised that free trade could be win-win.

Comparative advantage

But what should a country do if it does not have an absolute advantage? David Ricardo’s 1817 theory of comparative advantage demonstrated that a country could still benefit from exporting goods and services without having an absolute advantage, provided it has a relative or comparative advantage.


An importing country can be better off importing goods it could easily produce itself if by doing so it is able to concentrate its resources on other activities that produce more value.

NEED TO KNOW

To understand this, think about the many things you buy yourself even though you could make them. For example, you might purchase a knitted garment, even though you know how to knit. You might buy a burger, even though you could easily make one yourself. You make these choices because you know your resources of time and energy are better spent on the things you would rather do, such as studying in order to have a more successful career. You anticipate that in the long run your career will pay you more than you would earn by knitting or cooking burgers – even though you are also great at knitting and cooking.

Comparative advantage seems to offer another way for free trade to produce a win-win situation. Let us consider the case of Abeke and Barika below to understand how people, or countries, can benefit from a comparative advantage, even without an absolute advantage.

Abeke and BarikaAbeke is a lawyer who can also type, and Barika is a typist.

Abeke can sell her time at $100 per hour as a lawyer, and can type 100 words per minute.

Barika can type 50 words per minute and charges $20 per hour as a typist.

Abeke therefore has an absolute advantage over Barika in both legal work and typing.

CASE STUDY: COMPARATIVE ADVANTAGE

Economic Principles Chapter 1

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However, if Abeke hires Barika to do her typing, both Abeke and Barika are better off.

Barika earns $20 per hour for her typing and Abeke is able to charge her time at $100 per hour as a lawyer.

If Abeke did her own typing, she would save $40 per hour because she types at twice the speed of Barika, but she is able to create an even greater value by selling her time as a lawyer. After paying Barika $40 for two hours’ work, she still makes $60.


Name Abeke Barika

Occupation Lawyer Typist

Typing speed 100 wpm 50 wpm

Hourly rate $100/hour as a lawyer $20/hour as a typist

Value to Abeke of doing own typing

$20 × 2 = $40/hour

Value created by hiring Barika $100 − $40 = $60/hour $20/hour

Comparative advantage in services also exists between countries. For example, because they possess plentiful low-cost labour with English language skills and a good information communication technology (ICT) infrastructure, the Philippines and India have a comparative advantage over countries such as the UK, the United States of America (USA) or Australia in providing call centre services. Businesses in Australia could easily operate their own call centres, but many of them benefit from outsourcing their routine call centre tasks to the Philippines or India, as this allows them to concentrate their own resources on performing higher value work.

A telecommunications firm in Australia might use a call centre in the Philippines to handle calls from household customers, but maintain a smaller call centre in Australia to deal with its more valuable corporate customers. When an individual customer has a problem that the call centre in the Philippines cannot deal with, the call is simply transferred to a supervisor in Australia. In these ways, the Australian firm outsources simple work to where the Philippines have an advantage, while retaining the more complex client service work where Australia retains an advantage.

Activity 1: What is your country’s comparative advantage?

Can you think of goods that are imported into your own country, even though your country could grow or create those products itself?

OVER TO YOU

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Can you think of services that are provided from outside your country, even though your country could provide those services?

How can you explain the benefits of sourcing these goods or services from outside your country?

The factor endowment theory

David Ricardo saw comparative advantage as coming from differences in productivity between countries. He explained that a country gained a comparative advantage by applying more productive labour to its resources, but modern theorists realised this was not the whole story.

Swedish economists, Eli Heckscher and Bertil Ohlin, provided a more complete explanation in the twentieth century. The factor endowment (or Heckscher–Ohlin) theory held that countries derived comparative advantage from factor endowments. Factors might be: land, location or natural resources, such as minerals, energy, and labour or population size. This theory suggests countries will export goods that make use of factors they have inherited in abundance, and import goods that make use of factors that they lack. The factor endowment theory states that it is the relative abundance of these inherited factor endowments that counts.


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This theory explains why China, with a large low-cost labour force, exports manufactured electronic goods that are labour-intensive to produce. The USA lacks this low-cost labour force so the US company Apple has its popular iPhones manufactured in China, to take advantage of China’s factor endowment.

Trade theories and theorists

• Mercantilism – Jean-Baptiste Colbert

• Absolute advantage – Adam Smith

• Comparative advantage – David Ricardo

• Factor endowment theory – Eli Heckscher and Bertil Ohlin

NEED TO KNOW

New trade theory

During the 1970s, economists also noticed that being the first to innovate could be an important advantage for a country, especially if the world market was small. This is called a first-mover advantage. A good example is the manufacturing of large passenger aircraft, which require a large investment in manufacturing facilities and technology to produce a small number of very expensive aircraft every year, and the first country to develop this industry has a compelling advantage. Learning effects are cost savings that come from learning by doing. Once a manufacturer has built one aeroplane, the next one is much easier. This, combined with economies of scale, gives the first mover an almost unassailable advantage, and explains why there are only really two significant manufacturers of large passenger aircraft in the world: Boeing in the USA and Airbus in Europe.

Porter’s five factors

The factor endowment theory implies a passive approach can be adopted by governments and firms that simply make use of the factor endowments they have inherited. Management thinker, Michael Porter, pointed out that sustained industrial growth is rarely based on such inherited factor endowments. He noticed that sustained industrial growth tended to occur in “clusters”, which are groups of interconnected firms, suppliers, related industries and institutions that arise, or are created, in particular locations.

Michael Porter’s diamond model (Figure 1) explains how governments and firms can build export industries by creating competitive advantage. The four facets of the diamond are:

1 Firm strategy, structure and rivalry – direct competition between firms boosts innovation and productivity.

2 Demand conditions – demanding customers put pressure on firms to constantly innovate, improve quality and become more competitive.

3 Related and supporting industries – having these nearby helps with the communication of ideas, innovation and improvements.

4 Factor conditions – Porter argues that the key factors are created, not inherited. They are such things as skilled labour, capital and infrastructure.

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Factorconditions

Demandconditions

Related andsupportingindustries

Firm strategy,structure and

rivalry

Government

Figure 1: Michael Porter’s diamond model for creating competitive advantageon the goREVISION

A good example of a successful cluster is the area known as Silicon Valley in California, USA, where the factors in Porter’s diamond model have come together to create a hugely productive cluster containing many of the world’s most successful information technology and communication businesses.

There are examples around the world of smaller successful industry clusters. For example, the city of London in the United Kingdom can be seen as a financial services cluster. The Cape vineyards in South Africa is another good example of an industry cluster, as is the cluster of businesses involved in manufacturing ceramic tiles in Sassuolo, Italy. The Cape winemakers and Sassuolo tile makers make use of the factors in Porter’s diamond model to produce world-class merchandise.

Activity 2: Clustered competition

How do you think businesses in the Cape vineyards, Sassuolo, London’s financial district or Silicon Valley might benefit in practical terms from being clustered close to competitors, customers and suppliers?

OVER TO YOU


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What can governments do in the role of a catalyst and challenger to support clusters?

1.2 Arguments for and against free tradeThe theories of international trade tell us that trade between nations should be good for everyone, a win-win situation, and it would seem to follow that international trade should be as free as possible to capture those benefits. Many countries form a free trade area to make the most of the benefits of trade between each other. A very large free trade area, covering 450 million people, was formed by the USA, Canada and Mexico, who signed the North American Free Trade Agreement (NAFTA) in 1994. NAFTA’s stated purpose was to:

• eliminate barriers to trade in, and facilitate the cross-border movement of goods and services between the territories of the parties;

• promote conditions of fair competition in the free trade area;

• substantially increase investment opportunities in the territories of the Parties;

• provide adequate and effective protection and enforcement of intellectual property rights in each party’s territory;

• create effective procedures for the implementation and application of this agreement, for its joint administration and for the resolution of disputes;

• establish a framework for further trilateral, regional and multilateral cooperation to expand and enhance the benefits of this agreement.

Let us consider some of the positive things that come from free trade.

• Economic growth is boosted by free trade. NAFTA is estimated to have boosted the economic growth of the USA by 0.5% per year.

• Free trade increases jobs, with NAFTA being credited for creating five million new jobs in the USA.

• Free trade increases direct foreign investment that provides capital for businesses.

• Free trade creates a more dynamic business environment, challenging businesses to compete globally.

• Nations stop spending money to subsidise industries and put the funds to better use.

• Technology and expertise can be transferred to developing countries.

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However, it is not always that simple and there are a number of problems blamed on international trade:

• Well-paid workers in the developed world have to compete with low-paid workers in developing countries, potentially resulting in job losses and social problems.

• There is the potential for exploitation of workers in developing countries, including slave labour, child labour and people working gruelling jobs in unsafe conditions.

• People in developing countries are moved from rural areas to crowded cities, causing a breakdown of their social safety nets.

• In developing countries with little protection of the environment, natural resources can often be degraded or polluted as a result of international trade. For example, deforestation and strip-mining of natural environments.

• Indigenous cultures can be uprooted and destroyed as natural environments such as jungles are exploited.

• A country’s agricultural sector can struggle to compete with cheaper imports, resulting in job losses and the country losing the ability to produce its own food.

• Some countries export more value than they import and subsequently have a trade surplus, other countries import more value than they export and have a trade deficit. A trade deficit over a long period can lead to a high national debt.

• Defence technology from advanced nations might fall into the hands of oppressive regimes.

• A country might use subsidies, incentives or aid deals to gain an unfair trade advantage over other countries.

• An organisation might compete unfairly when it exports to another country. For example, by not meeting quality, health or safety standards, stealing intellectual property or dumping (selling goods below their cost to destroy competition).

These are all potential reasons why a nation might wish to control or restrict international trade.

Nations are said to have sovereignty, which means they can make their own rules and laws that they believe to be in their own national interests, and do not usually have to be concerned with how those rules and laws affect other nations. They can use this law-making power to gain a trade advantage, reduce a disadvantage or prevent some kind of harm to their people. Nations are able to control or restrict trade in the ways listed below.

Import tariffs or duty

A nation can impose a form of tax called an import tariff or duty on the goods that cross its borders. This provides an advantage to any local producers of the same goods as it increases the market price of imported goods compared to goods produced domestically. Tariffs can be so much per unit, or a percentage of the item’s value. They can be aimed at reducing imports overall, or targeted at particular products. A nation might decide some goods should have low or no tariffs, while other goods must face very high tariffs such as those imposed on imported luxury cars in India.

Currency manipulation

If a nation can lower the value of its currency, it makes its goods cheaper and more competitive in foreign markets while at the same time making foreign goods more expensive and less competitive in its home market. (See currency fluctuations in Section 4.2.)


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Non-tariff barriers

A nation might restrict trade by imposing a quota, so that only a certain quantity of a particular type of good can be imported or exported in a particular period. A quota becomes an embargo if all trade in a category of goods is stopped.

A government might require an importer or exporter to apply for a licence and receive specific permission for their imports or exports. Governments can then restrict trade by refusing or delaying the issue of a licence, or making the process lengthy or expensive.

Nations can raise barriers to trade in less obvious ways. For example, simply by subsidising their domestic industries or agriculture. Subsidies make it more difficult for foreign competitors to compete on price and may also give exporters a competitive advantage in foreign markets. Nations can also support their local industries by providing aid or loans to developing countries in exchange for large export orders.

Quality standards and labelling rules applied to local goods can become an effective barrier to imports by making it difficult, particularly for smaller enterprises, to sell into foreign markets.

Service industries also face non-tariff barriers in the form of licensing occupations and differing standards. Professionals such as engineers, lawyers, doctors, nurses and real estate agents generally need to be locally qualified and there is little mutual recognition of these qualifications between countries. For example, a tax accountant will usually have served experience requirements, spent time at a local university and belong to a local professional organisation. Outsourced accounting services in India often have staff who have gone through a lengthy process of qualifying as accountants in the United Kingdom, the USA or Australia, in order to offer their low-cost back-office services to accountants in those countries.

What is a tariff?

A tariff is a tax that a nation imposes on the value of goods that are imported. This makes the imported goods more expensive and gives local producers an advantage in their home market.

Tariffs are usually a percentage of the value of the goods, but can also be an amount per unit.

on the goREVISION

Activity 3: Could you overcome the non-tariff barriers to export your goods?

Imagine you have a small factory where you make delicious noodles that you sell in your local market and to restaurants. You decide to package your noodles in sealed plastic bags to sell in supermarkets, and export them to countries around the world.

What information about your noodles would you need to put on the label to meet the rules for sale in the USA, Europe or China? In which languages would it need to be written? Would you need to provide nutritional information as well as ingredients? Is there a special printed format you would need to follow for each country? Would your noodles have to pass tests? How would you find this information?

OVER TO YOU

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We can see that there are a number of rules and laws available to a sovereign nation that wants to restrict international trade. Let us now consider some of the reasons why a nation would want to do this.

Reducing unemployment

Unemployed people in a democracy are voters with lots of time on their hands to put pressure on politicians. Every country desires full employment and politicians can decide to put up trade barriers to protect an industry from foreign competition. This may appear to succeed in protecting jobs but comes at a cost to the country in the form of more expensive imported goods for consumers. Restricting imports might protect jobs for some people at the cost of higher prices for others.

Protecting emerging industries

Politicians may put up trade barriers to protect their nation’s infant industries, arguing that they need to be protected from more efficient foreign competition until their production costs decrease and they become competitive. They might argue that the new industry needs time for its workers to become more experienced and productive, as well as gaining the size and economy of scale to compete internationally. The risk is that this never happens and the industry remains inefficient and uncompetitive.

Promoting industrialisation

Developing nations with economies that rely on agriculture may restrict imports in order to develop an industrial base of their own. They want to attract foreign capital to build factories, employ people and boost the nation’s wealth by producing valuable industrial products, not just agricultural commodities that are often of fluctuating value. Import restrictions that aim to spur industrialisation may cause international companies to move some of their manufacturing into the country, boosting foreign direct investment (FDI), and subsequently providing jobs and technology.

Industrialisation of developing countries creates economic growth because people are moved from being under-employed in rural villages to being more productively employed when living in cities and working in factories. The downside is that people may lose the social safety net of their extended families and suffer harsh working and living conditions in cities.

Trade strategy reasons

A country may restrict imports from another country to balance levels of trade, perhaps to reduce a trade deficit. It may restrict imports to retaliate against restrictions from the other country, to seek to make trade access comparable or fair, or as a bargaining tool.


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Selling goods below cost is referred to as dumping. Companies might engage in this strategy to build new markets or because they receive government subsidies. If an industry believes foreign competitors are selling goods into their market at below cost, they might lobby their government to restrict trade. This is often difficult to prove and can lead to trade disputes.

An import tariff could be seen as an opportunity to tax the profits of foreign firms. This occurs when a foreign company lowers its prices to remain competitive because of a tariff.

Non-economic reasons

In addition to economic arguments for trade barriers, there are a number of non-economic reasons often used by governments to restrict or block imports. For example, a country, or group of countries, might wish to apply trade sanctions in order to put pressure on another country to improve its environmental standards or human rights, or to halt its development or use of chemical or nuclear weapons.

Protecting essential industries

Some industries are considered to be essential to a country for reasons of national security. This can include industries associated with defence, food security, key infrastructure and other capabilities that a country might need in a time of war. An industry might also be considered essential because other industries depend on it. A difficulty with this approach is that almost anything can be seen as essential and it can be difficult politically to remove protection once it is in place. For example, the USA continued the subsidy of mohair for 20 years after the military stopped using it to make uniforms.

Losers and winners of free trade

People who become unemployed because they worked in factories that could not compete with foreign imports can be seen as losers of free trade. A prominent example is the decline of the steel and heavy manufacturing industries in the USA. The formerly dominant industrial states of Illinois, Indiana, Michigan, Ohio and Pennsylvania are now referred to as the Rust Belt and have suffered from population loss and urban decay because the USA’s steel manufacturing industry could not compete with producers in China, India and Japan, even though worldwide demand for steel was still strong.

Winners of free trade are all the citizens of a country that enjoy a better quality of life as a result of their access to the best goods and services in the world at a fair price. These winners tend to be less vocal in pressing for free trade than the losers pressing for political protection. A closed down factory with thousands left unemployed makes headlines, whereas the fact that millions of people may now enjoy more economical and reliable motor vehicles may go unnoticed. The role of the government is to manage structural changes by initiatives such as the retraining of unemployed workers and incentivising start-ups in new industries, for example solar power.

Why do governments restrict trade?• Reducing unemployment

• Protecting emerging industries

• Promoting industrialisation

• Trade strategy – political reasons

• Protecting essential industries such as defence

NEED TO KNOW

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What caused the loss of jobs in the Rust Belt?

When Donald Trump was sworn in as the 45th President of the USA, his victory in the 2016 election was a surprise to many, and his success in the so-called Rust Belt was a predominant factor in helping him achieve it. Wisconsin, Michigan and Pennsylvania all went to Trump, something that had not happened for a Republican candidate since Ronald Reagan in 1984.

During his campaign, Donald Trump promised to boost US manufacturing and punish companies for moving jobs overseas. He threatened that any company that lays off American workers to move to another country will face a “substantial penalty” when trying to sell their products in the USA.

Unfortunately for America’s struggling working class, the majority of manufacturing jobs that have disappeared over the past few decades are never coming back, for one simple reason: they no longer exist. This reality is evidenced by a simple trend in manufacturing in America since the end of the Great Recession: while manufacturing output has increased more than 20% since 2009, manufacturing employment has grown by just 5%.

In other words, manufacturers have been returning to America in recent years, but they have not been bringing a whole lot of jobs with them, as Trump had initially expected. It has not been the Chinese or Mexicans who have been taking the majority of American manufacturing jobs, but machines. Of the millions of manufacturing jobs lost over the past decade, more than 80% have been replaced by automation technologies, not foreign workers. It is, of course, much easier to scapegoat (i.e. blame) foreigners and immigrants than to blame robots.

And so the “good old days” of American manufacturing, when hard-working Americans could reach the middle class by working in the same local factory for 30 years, are long gone. No president, not even a strongman like Trump, can reverse the tide of “creative destruction.” This process – which was first detailed in the writings of Karl Marx – is endemic to the capitalist system. Economist Joseph Schumpeter, who described creative destruction as a “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one,” called it the “essential fact about capitalism.”

Throughout the history of industrial capitalism, creative destruction has frequently caused social strife and recurrent economic crises, eliminating countless jobs and wiping out whole industries. (The Luddites famously responded to this in the early days of capitalism by destroying factory machinery, which, of course, proved futile.) In the long run, however, creative destruction has been a supremely positive force for humanity in transforming our standard of living. Moreover, technological advancements have created more jobs than they have destroyed by establishing new industries and expanding markets – resulting in globalisation.

With this in mind, one might assume that this historical trend will continue unabated, and new twenty-first-century technologies will end up creating even more jobs, while continuing to improve our lives.

However, this may not be the case, as new technologies – such as robotics, computerisation and artificial intelligence – are fundamentally different from past technologies, with the potential to emulate human labour itself, thus making human workers and their flaws obsolete. In a widely shared article published on BigThink.com, writer Phillip Perry warned of this possibility, which could ultimately produce a global crisis so devastating it would make the Great Recession look like a bad day at the stock market. Perry wrote:

CASE STUDY

BigThink.com


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“Unemployment today is significant in most developed nations and it is only going to get worse. By 2034, just a few decades [from now], mid-level jobs will be largely obsolete. So far the benefits have only gone to the ultra-wealthy, the top 1%. This coming technological revolution is set to wipe out what looks to be the entire middle class. Not only will computers be able to perform tasks more cheaply than people will, but they will be more efficient too.”

Perry cited a 2013 study at the University of Oxford that found as many as 47% of the jobs in the USA were at risk of being automated within the next two decades. “Accountants, doctors, lawyers, teachers, bureaucrats, and financial analysts beware: your jobs are not safe,” Perry insisted.

Sources:

https://www.forbes.com/sites/adammillsap/2017/01/09/the-rust-belt-didnt-adapt-and-it-paid-the-price/#b3f2227a3d6d

http://www.abc.net.au/news/2017-02-18/trump-threatens-to-punish-us-companies-for-moving-jobs-overseas/8282600

https://www.salon.com/2017/01/11/sorry-trump-voters-those-factory-jobs-arent-coming-back-because-they-dont-exist-anymore/

Activity 4: Rust Belt

Read these articles online:

https://www.forbes.com/forbes/welcome/?toURL=https://www.forbes.com/sites/adammillsap/2017/01/09/the-rust-belt-didnt-adapt-and-it-paid-the-price/&refURL=&referrer=#b3f2227a3d6d



What do YOU think caused the massive loss of American manufacturing jobs in the so-called Rust Belt? Which of these answers seem true?

• Free trade destroyed jobs in the Rust Belt.

• Jobs in US manufacturing have been replaced by robots and automation.

• Most traditional jobs will be replaced by automation.

• People left the Rust Belt because improved air-conditioning made it more desirable to live in Florida.

• American businesses should have bought American cars and steel, instead of foreign cars and steel.

• There was not enough US investment in new technology such as steel mini-mills.

• Unions prevented investment by demanding a share of the profits for workers.

• Businesses failed to innovate and ultimately could not compete with foreign firms.

• American workers could not compete with workers in Japan, China and Germany.

• American managers could not compete with workers in Japan, China and Germany.

OVER TO YOU

https://www.forbes.com/sites/adammillsap/2017/01/09/the-rust-belt-didnt-adapt-and-it-paid-the-price/#b3f2227a3d6d










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1.3 The impacts of globalisation

What is globalisation?

The world is divided into nations and we have examined the idea of sovereignty that empowers each nation to make its own rules and laws. Sovereign nations often create rules and laws in areas such as trade and immigration that exclude and disadvantage the people of other nations.

However, the people of the world have become increasingly connected to resources that lie outside of their own nation. Information flows much more freely from outside our own domain and connects us to new ideas about technology, goods, services and resources, and provides us with new ideas about how we should expect to live.

People have become more connected globally and nations have become more interdependent on other nations. In 1950, about 7% of the world’s production was sold outside its country of origin; today it is more like 25%.

Globalisation can be defined as an ongoing process by which societies, cultures and economies are becoming more joined together by the world’s developing networks of trade and communication. The economies of nations are brought closer together by trade, foreign direct investment, capital flows and the spread of technology; societies and cultures become more integrated as a result.

Key drivers of globalisation

Globalisation is driven by technology, trade liberalisation and co-operation between nations, and the development of services that support international business.

Developments in information and communication technology (ICT) have been a key driver of globalisation. The internet and the World Wide Web, faster microprocessors and technological improvements to telecommunications and transportation all continue to play a part.

Transportation of goods between countries has been made much more efficient – by air, through jumbo jets, on sea through specialised ships for bulk goods and items such as cars, and on land through improvements in road and rail infrastructure. All forms of transport have been made more efficient through technological advances in global positioning systems (GPS) and the adoption of containerisation, which allows cargo to move efficiently between sea, rail and road transport, and through ports and warehousing.


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Major investment in new rail and sea corridors between China and Europe was announced in 2015 by the government of China. Referred to as the Belt and Road Action Plan and the New Silk Road, this will continue the process of globalisation and boost global trade by developing transportation infrastructure and building economic activity and trade between the 68 countries along the routes.

How does globalisation affect organisations trading internationally?

Advances in technology and communications make it easier for businesses to operate globally. Businesses have a much greater ability to source components, ingredients and specialised skills from different parts of the world, and this is true of businesses large and small. Technology platforms such as PayPal, Alibaba, eBay, Amazon, Etsy and Shopify make it possible for tiny businesses to trade globally.

Beads by Bheka

Bheka lives in Malawi where she runs a small home business making unique and attractive designer jewellery out of beads, using her own designs. She is able to purchase a dazzling selection of beads online direct from manufacturers in China using Alibaba.com, an online platform that connects buyers with sellers in China, which has become the world’s largest retailer.

Bheka photographs her designer bead creations, sets a price and sells them globally using selling platforms such as eBay, Amazon, Etsy and Shopify. She ships her creations direct to clients almost anywhere in the world and accepts payment in most currencies via PayPal or Stripe payment platforms.

Beads by Bheka is a micro global business that would have been impossible a few decades ago. Because it has always shipped its goods and sourced its supplies worldwide it can be described as a born global firm, and this has been made possible by technology, trade liberalisation and the development of services that support international business.

CASE STUDY

Activity 5: Starting up a micro business

What sort of micro business could you start that would make use of buying, selling and payment platforms that support global business?

OVER TO YOU

Alibaba.com

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Globalisation of markets

Formerly distinct world markets are tending to merge and integrate into single world markets. For example, the types and styles of clothing worn by young people largely follow global fashions that cut across different cultures and societies. Markets become more globalised when people from different societies and cultures find common preferences and tastes, and establish norms. The jeans and t-shirts adopted by students and the suits worn by business people are examples of common preferences, tastes or norms that have spread globally. Markets for popular entertainment are also increasing globally.

It is important to note that some distinctions between national and regional markets exist, even in markets that have become quite globalised. Global businesses often need to adjust their marketing strategies to suit local conditions and differences in local markets as they compete with local businesses as well as other global businesses.

The globalisation of markets is enabled by the mass production of goods and the desire of companies to globalise markets in order to increase profits and achieve company goals. Companies will often move into a market to cater for a demand for their products. While entering a foreign market often increases the risk of doing business, selling into a number of different markets can also increase the chances of success for the product or service.

Activity 6: Globalising markets

Think about your everyday clothing choices. Are they different from those of a person your age and gender living in other cities – such as Lilongwe, Nairobi, Beijing or London?

Other than clothing, can you think of more markets that are increasingly globalised?

OVER TO YOU

Globalisation of production

The factors that influence the location of manufacturing facilities include access to labour (which might be plentiful or skilled), capital and raw materials, and being close to supporting businesses, suppliers and markets. All these factors differ from country to country and a multinational corporation or global business weighs up the advantages and risks, and then looks for the best combination when it comes to deciding the most beneficial place in the world to locate production.

Government support, or lack of support, might also be a factor. Subsidies, taxes and tariffs, along with quotas and other restrictions, can drive the globalisation of production by encouraging firms to invest in establishing manufacturing in a different country.


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Globalisation to some extent takes some power away from nations and gives it to global businesses who can now decide where they will produce and market their products and services, and where they will invest, provide jobs and pay tax.

Multinational brands such as Zara and Adidas take advantage of the ability to shift their production to countries such as Bangladesh where labour costs are low and worker rights are not as strong. These companies operate factories without many of the regulations that apply in their home countries and are challenged to act ethically in managing their employees and the environment.

What drives globalisation?

The rise of free trade, better transportation, the internet and World Wide Web, and new information and communication technology that better connects people around the world has led to the phenomenon called globalisation.

on the goREVISION

• Obadic’, A. (2013), “Specificities of EU cluster policies”, Journal of Enterprising Communities: People and Places in the Global Economy, Vol. 7 Issue: 1, pp. 23–35. (This article will be available in your online student resources.)

• Mutalemwa, D. K. (2015), “Does globalisation impact SME development in Africa?”, African Journal of Economic and Management Studies, Vol. 6 Issue: 2, pp.164–182. (This article will be available in your online student resources.)

• Alberti, F. G., Pizzurno, E. (2015), “Knowledge exchanges in innovation networks: evidences from an Italian aerospace cluster”, Competitiveness Review, Vol. 25 Issue: 3, pp. 258–287. (This article will be available in your online student resources.)

• Expósito-Langa, M., Tomás-Miquel, J., Molina-Morales, F. X. (2015), “Innovation in clusters: exploration capacity, networking intensity and external resources”, Journal of Organizational Change Management, Vol. 28 Issue: 1, pp. 26–42. (This article will be available in your online student resources.)

• O’Dwyer, M., O’Malley, L., Murphy, S., McNally, R. C. (2015), “Insights into the creation of a successful MNE innovation cluster”, Competitiveness Review, Vol. 25 Issue: 3, pp. 288–309. (This article will be available in your online student resources.)

• Spich, R. S. (1995), “Globalization folklore problems of myth and ideology in the discourse on globalization”, Journal of Organizational Change Management, Vol. 8 Issue: 4, pp. 6–29. (This article will be available in your online student resources.)

READING LIST

SummaryAfter working through this first chapter you will now understand something about the economic principles that underpin international business. You will have knowledge of the theories that explain why firms engage in international trade, and this will have provided you with insights into the potential benefits of free trade and globalisation. You will also be able to discuss some of the potential negative impacts of free trade and globalisation, and understand why governments might want to restrict imports from other countries.

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Introduction

Companies begin to engage in international business when they start doing business in another country. In this chapter, we will look at how companies use a process of decision-making to decide which international markets they should enter, and how they should go about entering those markets.

Learning outcomes


2 Evaluate markets from an international perspective

Assessment criteria

2 Evaluate markets from an international perspective

2.1 Evaluate the methods and criteria by which markets are selected

2.2 Assess the characteristics and applicability of the main market entry methods across a range of industry sectors

2.3 Conduct a structured analysis of a country/market from both external and internal perspectives

2.4 Recommend appropriate marketing mix strategies for different contexts

International Markets

Chapter 2

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2.1 How markets are selectedLet us begin by considering the reasons a business might want to establish itself in a foreign country.

• Resource seeking – the country has resources that make it attractive to the business.

• Efficiency seeking – there is an opportunity to reduce costs.

• Innovation seeking – the business can access new ideas and technologies.

• Market seeking – the country has potential customers for the business.

Resource seeking

Firms that work with natural resources such as oil or minerals, or renewable resources such as agricultural produce or timber, are very keen to secure access to them. They will often seek them out in foreign countries and enter those markets because they are rich in the resources they need. This is why oil companies operate all over the world; they depend on having access to resources of oil.

Efficiency seeking

Firms can make their operations more efficient by reducing labour costs, the costs of raw materials or the cost of getting their goods to market. They may enter a foreign market to take advantage of lower costs for resources or higher availability of those resources. Economies of scale might also be created by the higher capacity of suppliers or higher demand from local consumers. Being close to customers also creates efficiencies. For example, a British law or accounting firm might open an office in Hong Kong to be close to the many head offices that are based there.

Innovation seeking

Innovation seeking firms are looking for new ideas and technologies that will give them an advantage. They want to stay in touch with the latest developments in their industry and develop their own innovations as quickly as possible. For example, a South African technology firm might open an office in California’s Silicon Valley in the USA in order to have a better ability to innovate.

Market seeking

Many firms invest in a foreign country to take advantage of bigger markets for their goods or services. Sure, they could just export their goods, but setting up production locally will save the costs of serving the market from a distance. The firm can more easily adapt their goods to local


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Chapter 2 International Markets

tastes or needs, and their presence in the market might overcome tariff and non-tariff barriers and transport costs they faced as exporters. The firm may also be keen to establish themselves and dominate the market to discourage competitors from entering.

Growth markets

Growth markets are particularly attractive to multinational enterprises (MNEs) because the economic growth going on in those countries can translate into growing sales and profits for the business. A feature of growth markets is that they have rapidly growing middle classes. As more people in a country move out of poverty, those people start consuming more household goods, clothing, food, motorbikes, cars and trucks, and this further drives growth in demand for manufactured goods. Let us look at where this growth is going on.

BRICS countries

Brazil, Russia, India and China, collectively known since 2001 as the BRIC countries, are considered the world’s main emerging economies. South Africa was later invited to join the group (renamed BRICS) in 2010. Together, these five countries are home to 40% of the world’s population (nearly 3.6 billion people in 2015), and cover a quarter of the world’s land area.

In economic terms, the BRICS are currently about 30% of the world’s gross domestic product (GDP).

Speaking at a 2015 meeting of the BRICS Trade Ministers, Russian Minister of Economic Development Alexei Ulyukayev said, “Our countries accounted for over 17% of global trade, 13% of the global services market and 45% of the world’s agricultural output and the combined GDP of the five BRICS countries surged from US $10 trillion in 2001 to US $32.5 trillion in 2014.”1 He also pointed out that trade between the BRICS countries in 2014 was up by more than 70% to US $291 billion.

The economic growth powerhouses within the BRICS group are China, with an estimated growth of 6.5%, and India, with an estimated growth of 7.2% in 2017.

MINT/MIST countries

Mexico, Indonesia, Nigeria and Turkey are referred to as the MINT countries, while Mexico, Indonesia, South Korea and Turkey are referred to as MIST countries. Both these terms were created by Jim O’Neill of the investment bank Goldman Sachs, who created the BRIC acronym. MINT/MIST countries are relatively smaller emerging economies with growing populations that are likely to experience economic growth at different rates.

Less developed countries (LDCs)

Less developed countries (LDCs), also known as developing countries, have an industrial base that is less developed than other so-called developed countries. LDCs generally have faster growth rates than developed countries and their people are often transitioning from traditional lifestyles towards the modern lifestyles led by people in the developed world. This move towards development brings benefits such as longer life expectancy, higher literacy rates and incomes. However, development and industrialisation is not always good for people and it is often difficult to say if a particular country is developed or undeveloped. Organisations such as the World Bank now

1 BRICS (2015) BRICS reach 30 percent of global GDP [online]. Retrieved from: http://en.brics2015.ru/news/20150707/277026.html [Accessed on 24 July 2017]

http://en.brics2015.ru/news/20150707/277026.html

http://en.brics2015.ru/news/20150707/277026.html

International Markets Chapter 2

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prefer to classify countries by their gross national income (GNI) per person, rather than referring to them as either developed or undeveloped.

Researching markets – sources of information

Any organisation planning to invest directly into a foreign country will want to conduct thorough research to understand the potential risks and rewards of doing so.

Much of the information we need to conduct research into an international market is available to us through the internet, published documents or by communicating with people via email or over the telephone. This research can be carried out from a desk and is referred to as desk research.

Good desk research is more than just a search of the open internet and will include academic and commercial databases for peer-reviewed academic journal articles, official reports from government and non-government organisations and news articles from reputable sources. Useful information sources include The Economist, CIA and UNCTAD.

Field research usually involves going to the country to observe, ask questions or conduct experiments such as test marketing products or services. If you are planning to sell a particular type of product, it is a good idea to talk to the people that you hope will be your customers and ask them questions such as:

• Would you buy this product?

• How many would you buy and how often?

• How would you use this in your home or business?

• How could this be changed to better suit your needs?

• What would you expect to pay for this?

• Whom would you expect to buy this from?

Do not expect that consumers in different countries will all use your product in the same way.

For example, while a student in South Africa may use a mobile phone for social networking and news, a farmer in Uganda may use it to manage mobile money micropayments and find out the best time to plant and harvest.

Answers to the last question (Whom would you expect to buy this from?) can be especially useful in identifying the industry systems and distribution channels being used, and the particular firms that are respected by locals.

2.2 Assessing the main market entry methods When a business decides to enter a foreign market, it must decide its means of market entry. There are many options that might be chosen, all with their pros and cons. Selecting the best method requires considering the unique combination of factors relating to the home country and host country, the industry sector, competition and the resources of capital and management available, as well as the business, appetite for risk. Let us consider the main options for market entry.

Direct export

A company can simply pack its goods into a shipping container and ship that container to a customer in a foreign country. That makes them a direct exporter and this is a simple way to enter a foreign market. An advantage of this approach is that it can increase production in your factory,

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because it is now supplying an additional market. The company might introduce a night shift to make the extra goods, which can mean more sales and profits without having to invest in new factories and equipment.

The direct exporter or its customers must pay the cost of shipping its goods and any tariffs that are charged by the foreign government, and direct exporters are also subject to any quotas and other non-tariff barriers.

The company is also likely to need sales representatives to look after its customers in the foreign market and may need to operate a sales office in the country.

Agents and distributors

An alternative to directly exporting is to work with intermediaries in the foreign country, referred to as agents or distributors. As locals, these intermediaries know their local market well and may be much better at making sales. This means the business can avoid the cost of having a sales office and its own sales people in the market. Agents represent the business in the foreign market and make sales on its behalf. Distributors usually import goods in bulk into their own warehouse, and distribute smaller quantities to their customers.

Agents and distributors make money out of handling imported goods in the form of a fee, commission, discount or mark-up.

Sometimes a company takes advantage of a distribution network set up by another company in the foreign market. This arrangement is called “piggyback marketing” and usually occurs when the two companies have products that complement each other, but do not directly compete.

Licensing

A business can enter a foreign market by allowing a business in that market to manufacture its goods and sell them in the foreign country. The business provides the rights to use its intellectual property, such as designs, patents and copyrights, and transfers knowledge and technology to the foreign manufacturer. In exchange, it receives a licence fee or royalty payment for all the goods produced under the arrangement.

The advantage of licensing is that the goods are manufactured inside the foreign country and this provides a way to get around the costs of shipping, tariffs and non-tariff barriers.

Another advantage of licensing is that the business receives extra revenue without having to manufacture or distribute the goods itself, and it has less risk as it does not have to make a big investment to enter the market itself. The local business may do a better job of selling the goods in its home market.

A disadvantage of licensing is having to share profits with a local manufacturer. There is also the risk that once the local business has learned how to make the product, it will end the licensing arrangement, then produce and sell its own similar product instead.

Franchising

Franchising is like licensing but usually refers to a branded service business rather than a manufactured product. Fast food restaurant chains, hotels and retail brands are often run as a franchise and operate under strict rules so that the quality standards of the business are maintained. It can be difficult to set up and run a business in a foreign country, and some governments do not allow foreign ownership of certain businesses. Franchising to a local business operator overcomes this.


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Turnkey contracts

A business can enter a foreign market by building and equipping a new factory in that market, and selling it to new owners in that market. This is called a “turnkey contract” because the new owners take delivery of a factory that is ready to have its doors opened and start producing goods. A business agrees to build and then hand over a new operational factory that incorporates its technology.

The business can expect to be paid for providing its technology and knowledge in the form of a working factory. It might also transfer technology that has become obsolete in its home market, or dismantle a disused manufacturing facility and ship it to another country, where a new factory is built to continue production. By doing this, the business extracts value from its old technology without giving away the competitive advantage it derives from its new technology. An example of this is the Volkswagen Beetle car, which became no longer viable to manufacture in Germany. The ageing equipment to make it was moved to Brazil and Mexico where the model was still in demand.

The disadvantage for the business providing a turnkey factory is that it probably now cannot export its goods to that country in the future, so it would only do this if more attractive alternatives were not available. There is always the danger that it will be setting up a business that might become a competitor in other markets in the future.

Contract manufacturing

Hiring a local business to manufacture goods in a foreign market can be a better option than direct exporting, licensing or turnkey contracts. Import costs and restrictions are overcome and the contract manufacturer produces goods in the foreign market for the business to sell to its local customers. The contract-manufactured goods might also be exported to other countries.

The business should be able to capture more of the profits, compared to licensing arrangements, and may be able to rationalise its global manufacturing operations and make them more efficient.

There is a risk that its technology and knowledge will leak out to other manufacturers in the foreign market and it may find that similar or even counterfeit products soon start to appear.

Joint ventures

Forming a joint venture with a foreign business can allow a business to set up in a new market without having to take all the risks on their own. This can make the joint venture an attractive option in volatile emerging markets. The joint venture partner can potentially contribute valuable local knowledge, manufacturing, distribution and investment. Of course, both joint venture partners will expect to share in the profits.

In some countries, it may even be necessary to form a joint venture to overcome legal or political barriers. For example, entering China in a type of business controlled by the Chinese government usually requires establishing a joint venture with a Chinese firm.

Strategic alliances

Strategic alliances occur when businesses co-operate to achieve a goal. A business entering a market can form strategic alliances with its suppliers or customers for short, medium or long periods. To be successful, a strategic alliance must be a win-win situation in which both partners receive a benefit. Benefits would include access to customers or natural resources, or operational efficiencies of some kind. Innovation can also be an important strategic goal and businesses often form alliances with universities and innovative organisations to have access to new technologies they can exploit.

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Foreign direct investment

A business can enter a market by making a foreign direct investment (FDI) in that market. For example, buying land, building a factory, installing equipment, hiring local people and producing goods in the foreign country. FDI can also take the form of buying agricultural land, farming operations, office buildings or existing businesses producing goods or services.

FDI without a local partnership of any kind results in a wholly owned subsidiary, entirely under the control of the business making the investment. While this promises greater returns than other forms of market entry, it also comes with the highest risk as the business is committing all the capital and is going it alone in the foreign market without a joint venture partner, strategic alliance, agent or distributor.

Direct marketing

Direct marketing is when a business sells its goods direct to consumers in a market. For example, a South African firm might sell its goods on the internet and ship them direct to customers worldwide. It might reach customers in the USA by advertising on television shopping networks.

Methods of market entry

• direct export

• agents and distributors

• licensing/franchising

• turnkey contracts

• contract manufacturing

• joint ventures

• strategic alliances

• foreign direct investment

• direct marketing

NEED TO KNOW

2.3 Conducting a structured analysis of a market

Macro analysis – based upon political, economic, social/cultural, technological, ecological and legal factors

One strategic tool for understanding a market is to conduct a PESTLE analysis, which covers political, economic, social, technological, legal and environmental factors. These are the environmental factors likely to have an impact on business and are referred to as macro environmental factors.

Political – for example, how stable is the government and does it intervene in the economy using tax, labour laws, trade restrictions and tariffs? How does it manage health, education and infrastructure?


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Economic – for example, what is the GDP? What is the distribution of incomes? What are the interest rates, exchange rates and rates of inflation and growth? How do people spend their incomes?

Social – for example, how will the local culture affect doing business? How is the population changing? Is it growing or ageing? What are the differences between urban and rural living? What are people’s attitudes to health and safety? Marketers are keen to understand what drives buyer behaviour in the market.

Technological – for example, how good is information communication technology infrastructure such as fixed and mobile networks? How many people have internet access or mobile devices? Technological factors can allow for new ways to produce or deliver goods and services, and new ways to communicate with customers.

Legal – a business must understand how the legal environment of a country might affect its operations. Laws covering consumers, employment, discrimination, health and safety, and anti-trust are all relevant. Global businesses have to comply with the different laws that apply in all the different jurisdictions in which they operate. Laws in places like Australia and the USA may apply to the whole country, but some are made at state level, making compliance quite complicated.

Environmental – factors such as weather, climate and climate change can have a big impact on how a business operates its expenses and the customer demand for its goods. Consumers are demanding higher standards of sustainable sourcing of raw materials and ethical behaviour from businesses.

A PESTLE analysis helps a business understand opportunities and threats in the market. These, together with strengths and weaknesses, allow an analysis of strengths, weaknesses, opportunities and threats (SWOT).

P

E

S

T

L

E

Political

Economic

Social

Technological

Legal

Environmental

Figure 1: The PESTLE model used to review the macro factors in an environment

on the goREVISION

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Political

The Federal Parliament of Somalia is the national parliament that contains the national bicameral legislature. It consists of House of Representatives (lower house) and senate (upper house), whose members are elected to serve four-year terms. The parliament elects the president, speaker of parliament and deputy speakers, and has the authority to pass and veto laws.

Economic

Somalia is classified by the United Nations as a less developed country. Despite experiencing two decades of civil war, the country has maintained an informal economy, based mainly on livestock, remittance/money transfers from abroad, and telecommunications. In 2014, the International Monetary Fund (IMF) estimated economic activity to have expanded by 3.7%, primarily driven by growth in the primary sector and secondary sector. Currency: Somali shilling.

Social

Somalis are predominantly Muslims, the majority belonging to the Sunni branch of Islam and the Shafi`i school of Islamic jurisprudence, although some are also adherents of the Shia Muslim denomination.

The clan groupings of the Somali people are important social units, and clan membership plays a central part in Somali culture and politics. Clans are patrilineal and are divided into sub-clans and sub-sub-clans, resulting in extended families.

Technological

Technological help is sourced from various parts of the world, as it is one of the least developed countries.

Legal

The Provisional Constitution of the Federal Republic of Somalia is the supreme law of Somalia. It provides the legal foundation for the existence of the Federal Republic and source of legal authority. It sets out the rights and duties of its citizens, and defines the structure of government.

Environment

Somalia is a semi-arid country with about 1.64% arable land. From 1971 onwards, a massive tree-planting campaign on a nationwide scale was introduced by the Siad Barre government to halt the advance of thousands of acres of wind-driven sand dunes that threatened to engulf towns, roads and farmland.

Source: Gupta, S. K. (2016), “Pestel of Somalia”, Retrieved from: http://www.sachdevajk.in/2016/12/19/pestel-of-somalia/ [Accessed on: 19 September 2017]

CASE STUDY: A PESTLE ANALYSIS OF SOMALIA

Porter’s Five Forces

In 1979, management thinker Michael Porter put forward the idea that there were five forces that should be considered in analysing an industry’s likely profitability and attractiveness: competitive rivalry, supplier power, buyer power, the threat of substitution and the threat of new entry by a rival.

http://www.sachdevajk.in/2016/12/19/pestel-of-somalia/


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Bargaining powerof suppliers

Bargaining powerof buyers

Threat ofsubstitute

products orservices

Threat ofnew entrants

Threat of new entrants

• Time and cost of entry• Specialist knowledge• Economies of scale• Cost advantages• Technology protection• Barriers to entry

Rivalry among existing competitors

• Number of competitors• Quality differences• Other differences• Switching costs• Customer loyalty

Bargaining power of suppliers

• Number of suppliers• Size of suppliers• Uniqueness of service• Your ability to substitute• Cost of changing

Bargaining power of buyers

• Number of customers• Size of each order• Differences between competitors• Price sensitivity• Ability to substitute• Cost of changingThreat of substitute products

or services

• Substitute performance• Cost of change

Rivalry amongexisting

competitors

Source: Adapted from Porter, M. E. (1979) “How Competitive Forces Shape Strategy.” Harvard Business Review 57, no. 2 (March–April): 137–145

Figure 2: Porter’s Five Forces modelon the goREVISION

Let us look at Porter’s Five Forces to understand their importance:

Rivalry among existing competitors is the number and strength of the organisation’s rivals. How many competitors does it have, how good are they and how does the quality of their products and services compare? If competitive rivalry is low, the organisation is in a strong position to make good profits. If, on the other hand, the organisation has strong rivals, it is likely to have to cut price and advertise aggressively to attract customers.

Bargaining power of suppliers is determined by how easy it is for suppliers to increase their prices. Ideally, the business buys readily-available inputs and has many alternative suppliers. The more choices the business has, the greater its power to negotiate lower prices. The more special and unique the product being supplied, the more power the supplier has to increase prices, and this cuts into the potential of the business to make profits.

Bargaining power of buyers is high when buyers have the ability to negotiate lower prices. This tends to occur when there are only a few large buyers. An example would be a small farmer who sells to one or two large supermarkets that are able to dictate prices and terms. The buyers hold all the power and the farmer is not able to make big profits.

Threat of substitute products or services is a force that weakens a business’ ability to raise prices and boost profits. For example, let us imagine a business that operates the only hotel at a tourist destination. The hotel might seem to have no competition, but people going on holiday can choose a completely different destination for their holiday, or perhaps go on an ocean cruise. The hotel must compete with substitutes and this keeps it from being able to put its prices up.

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Threat of new entrants also constrains pricing and profits. A sector that is highly profitable is likely to attract the attention of other businesses who might move into the market to get a piece of the action. Threat of new entry is reduced when the barriers to a new entrant are high. These barriers might be the need for a big investment, special technology, intellectual property or a government licence.

Michael Porter stressed that these five forces are the fundamental and structural sources of competitive pressure in an industry. Other factors such as new technology, government intervention or industry growth rate are likely to be temporary.

The Five Forces model gives a way of understanding competition in a market or an industry that can be used from the point of view of a business in the market, a business contemplating entering the market, market regulators, suppliers and customers. Once the structure of competition in a market is understood, we can begin to identify ways to improve our competitive position.

Activity 1: Porter’s Five Forces

Think about a business or industry in your own country that you know something about. Look at each of the forces in turn; what observations are you able to make?

Competitive rivalry

Buyer power

Supplier power

OVER TO YOU


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Threat of substitution

Threat of new entry

Is this business in a competitive position that is strong or weak?

SWOT analysis

Following on from an analysis using tools such as PESTLE and Porter’s Five Forces, an analysis of strengths, weaknesses, opportunities and threats (a SWOT analysis) is a great next step in developing a strategic plan. Originated by Albert S. Humphrey in the 1960s, it is a tool that can be applied to any business and you too can make use of it to plan your personal career strategy.

Strengths and weaknesses are internal factors – we must normally look inside our business or ourselves to identify these. Opportunities and threats are external factors that we must look outside our business to identify. It is also sometimes referred to as an internal/external, IE analysis or matrix.

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Here are some useful questions that could help you conduct a SWOT analysis for a business.

Strengths• What advantages does your business have?

• What do you do better than anyone else?

• What unique or lowest-cost resources can you draw upon that others cannot?

• What do people in your market see as your strengths?

Weaknesses• What could you improve?

• What should you avoid?

• What are people in your market likely to see as weaknesses?

• What factors lose you sales?

Opportunities• What good opportunities can you spot?

• What interesting trends are you aware of?

• Useful opportunities can come from changes:

• Have there been changes in technology, markets or government policy related to your field?

• Have there been changes in social patterns, population profiles, lifestyle changes, etc.?

Threats• What obstacles do you face?

• What are your competitors doing?

• Are quality standards or specifications for your job, products or services changing?

• Is changing technology threatening your position?

• Could any of your weaknesses seriously threaten your business?

SWOT analysis for Beko Consultants

Beko Consultants is a small start-up engineering consultancy in South Africa.

Strengths

We are able to respond very quickly as we have no red tape, and no need for higher management approval.

We are able to give great customer care, as our current small amount of work means we have plenty of time to devote to customers.

CASE STUDY


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Our lead consultant has a strong reputation in the market.

We can change direction quickly if we find that our marketing is not working.

We have low overheads, so we can offer good value to customers.

Weaknesses

Our company has little market presence or reputation.

We have a small staff, with a shallow skills base in many areas.

We are vulnerable to vital staff being sick or leaving.

Our cash flow will be unreliable in the early stages.

Opportunities

Our business sector is expanding, with many future opportunities for success.

Local government wants to encourage local businesses.

Our competitors may be slow to adopt new technologies.

Threats

Developments in technology may change this market beyond our ability to adapt.

A small change in the focus of a large competitor might wipe out any market position we achieve.

As a result of its analysis, the consultancy may decide to specialise in rapid response, good value services to local businesses and local government.

Conclusions

Marketing would be in selected local publications to get the greatest possible market presence for a set advertising budget, and the consultancy should keep up-to-date with changes in technology where possible.

As a result of their analysis, the consultancy may decide to specialise in rapid response, good value services to local businesses and local government.

Activity 2: A SWOT analysis for a market in your country

Can you think of a market within your own country in which you would like to start a business? Imagine you have financial backing to start this business and operate in this market. Conduct an analysis of what would be the strengths, weaknesses, opportunities and threats for your new business.

What would be the strengths of your new business in this market and how can you make the most of them?

OVER TO YOU

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What would be the weaknesses of your new business in this market, and how can you minimise their effect or become stronger?

What would be the opportunities for your new business in this market? How can you seize them?

What would be the threats to the success of your new venture? How can you avoid or overcome them?

Conducting a structured analysis of a market

We conduct market analysis when we want to understand how a particular market is structured, how attractive it is now, and how that might change.

We are likely to want information about the size of the market now, and how that might change in the future. Market trends, growth rate and profitability would be important and we would want to understand the industry systems operating in the market, for example cost structures, distribution channels and the practices followed by the successful players. We would want to identify the key success factors and details to which the market’s successful firms pay attention.


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2.4 Marketing mix strategies for different contexts

The marketing mix

The term “marketing mix” describes the many decisions a business has to make in the process of bringing a product or service to market.

The 4Ps, originated in the 1960s by E.J. McCarthy, is perhaps the most popular way of categorising the elements that make up a marketing mix. The 4Ps are:

• product (or service)

• place

• price

• promotion.

Product:

• Quality• Design• Features• Brand name• Packaging• Services

Promotion:

• Advertising• Public relations• Sales promotion• Sponsorships• Direct marketing

Place:

• Coverage• Location• Channels• Inventory• Logistics

Price:

• List price• Discounts• Credit terms• Payment periods

Marketing mix

Figure 3: The marketing mix, made up of product, place, price and promotion

on the goREVISION

To create a marketing mix, decisions must be made about each of these categories. Here are some of the questions a business needs to carefully consider and answer for each of the 4Ps.

Product/service• What customer needs does the product satisfy?

• What problems does it solve for customers?

• What features does it need to meet these needs?

• Are you adding any unnecessary features customers do not value?

• How and where will your customers use it?

• Do different demographics of market segments use it differently?

• What does it look like? How will customers experience it?

• What options are available, such as size or colour?

• What is the name and brand and how is it branded?

• How is it different from what your competitors offer?

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Place• Where will buyers expect to find your product or service? Will they look in a store, if so, what

kind? A specialist shop or a supermarket, or both? Will they buy online, or respond to an advertisement or infomercial?

• What are the right distribution channels, and how can you access them? Do you need sales people or telemarketers?

• What do your competitors do? How can you be better?

Price• What is the value of your product or service to your customers?

• What are the normal price points for products or services like yours?

• How much do your customers care about price? Will they care if the pack is smaller or if there is a price increase?

• Will you need different prices for different customers, such as resellers, trade customers, and bulk buyers?

• Will your process be cheaper or more expensive than your competitors?

Promotion• How will you communicate your sales messages to your target market?

• What mix of advertising media will you use?

• Is your product promoted at certain times of the year?

• How do your competitors promote their products? How can you be different and better?

Many more questions can be added to the above and the 4Ps are sometimes extended to 7Ps with the addition of categories for people, processes and physical layout decisions.

An alternative approach is Lauterborn’s 4Cs, which consider the elements of the marketing mix from the buyer’s point of view. It is made up of customer needs and wants (the equivalent of product), cost (price), convenience (place), and communication (promotion).

The important point to note is that successful marketing requires a mixture of marketing that all works together to achieve the best possible result.

Developing a marketing strategy for foreign markets

A business entering a foreign market is usually already successfully marketing its products or services in its home market, and is possibly already successfully marketing in other foreign markets. Even global businesses that may see themselves as marketing to the whole world have to consider if and how their strategy will need to change to get the best result in each market.

On the one hand, it is efficient to standardise products and services as much as possible across different markets, but it is also often necessary to adapt to local conditions.

McDonald’s is a powerful global brand that standardises its business systems and many of its menu items worldwide, but it is also necessary for it to adapt its products to meet local conditions in different foreign markets (see case study).


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How McDonald’s both standardises and adapts

The global success of McDonald’s fast food restaurants is based on the standardisation of their products and services offered around the world. Certainly, it is possible to walk into a McDonald’s in any of the countries in which they operate and purchase an almost identical Big Mac hamburger. Economists are able to use a tool called the Big Mac Index to compare the purchasing power of different currencies. McDonald’s official company history shows that they do not modify their business systems and processes in order to adapt to cultures across national boundaries but instead seek to impose their approach to fast food onto local cultures to meet their own needs – seeming to ignore differences between places.

McDonald’s seem to standardise the name and presentation of their main menu items in the majority of markets, but there are also examples of decisions to adapt in order to meet customer expectations in markets outside of the USA.

Examples of McDonald’s adaptations

Of the standard USA burger selection, only the McChicken and the Filet-o-Fish are also offered in India.

Wine is offered in France, beer is offered in Germany and tea is offered in England.

In the Netherlands, fries are served with mayonnaise dip instead of ketchup.

A burger with egg and beetroot is offered in New Zealand and Angus beef burgers are sold in Canada.

Conclusion

Even a powerful global brand like McDonald’s, that sets out to standardise as much as possible, will adapt to differences in cultures and customs. This is because failing to do so would reduce or jeopardise the performance and profits of the business in those markets.

CASE STUDY

A multinational enterprise (MNE) operates in multiple countries and has to adapt its operations to local conditions. Distribution systems for goods can vary considerably between countries and are entwined with the local economic, cultural and legal environments. For example, the cost of paying retail workers and their conditions of employment, the efficiency of delivery systems and consumer preferences.

Cosmetics giant Avon Products, Inc. has a strategy of selling directly through independent representatives but has had to adapt its approach to distribution in order to adjust to local conditions in a number of countries.

For example, Avon operates a thriving mail-order business in Japan, where mail order is popular, and has beauty counters in China because of regulations on house-to-house sales. The firm operates franchise centres in the Philippines because of infrastructure inefficiencies and beauty centres in Argentina, where many customers want services together with cosmetic purchases.

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Another example of how distribution systems can vary between countries is to compare supermarkets in the USA with those in Hong Kong. Hong Kong stores are much smaller and closer together and carry a higher proportion of fresh foods. A company from the USA selling packaged foods products will find there is much less demand per store. They will have to make many smaller deliveries and have a harder time fighting for shelf space.

Activity 3: Distribution of goods in your country

Think about the way international companies sell their goods in your country. Can you give an example of how have they adapted to your local conditions?

OVER TO YOU

Marketing mix – 4Ps

• Product (or service)

• Place

• Price

• Promotion

NEED TO KNOW

These websites provide useful additional reading:

• https://www.wto.org

• http://www.export.org.uk

• http://www.worldbank.org

• http://reports.weforum.org

READING LIST

www.chinaskinny.cn

https://www.wto.org

http://www.export.org.uk

http://www.worldbank.org

http://reports.weforum.org


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• http://www.oecd.org

• http://www.bankofengland.co.uk

• https://www.cia.gov/library/publications/the-world-factbook

• http://www.un.org/en

• http://en.unesco.org

• https://www.mckinsey.com

• http://knowledge.wharton.upenn.edu

• https://www2.deloitte.com/global/en.html?icid=site_selector_global

• https://dupress.deloitte.com

• https://www.accenture.com/gb-en

• https://home.kpmg.com/uk/en/home.html

• http://marketingsherpa.com

• https://www.mindtools.com

• https://hbr.org

• https://www.forbes.com

• https://www.economist.com

Summary

Completing this chapter will have helped you to evaluate markets from an international perspective and understand how firms decide which international markets they will enter, and which method of market entry they will use. You now have some insights into how international markets can be analysed and marketing strategies can be created.

http://www.oecd.org

http://www.bankofengland.co.uk

https://www.cia.gov/library/publications/the-world-factbook

http://www.un.org/en

http://en.unesco.org

https://www.mckinsey.com

http://knowledge.wharton.upenn.edu

https://www2.deloitte.com/global/en.html?icid=site_selector_global

https://dupress.deloitte.com

https://www.accenture.com/gb-en

https://home.kpmg.com/uk/en/home.html

http://marketingsherpa.com

https://www.mindtools.com

https://hbr.org

https://www.forbes.com

https://www.economist.com

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Introduction

The world of international trade can be viewed as a patchwork of overlapping trade agreements between countries and groups of countries. In this chapter, we examine different types of economic co-operation and some of the more important trading blocs.

Learning outcomes


3 Evaluate the significance of international trading blocs and organisations

Assessment criteria

3 Evaluate the significance of international trading blocs and organisations

3.1 Assess the characteristics of different types of economic cooperation and preferential trade arrangements

3.2 Evaluate the purposes and operations of intergovernmental bodies

3.3 Evaluate the international market in terms of the major trade blocs and regional groupings

International Trading Blocs

Chapter 3

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3.1 Different types of economic co-operation and preferential trade arrangementsTrade within trade blocs accounted for about half of the world’s trade in 2014. The major trade blocs of the world include:

• The European Union (EU), which is made up of 28 countries.

• The European Free Trade Association (EFTA), which includes the EU and adds a further four countries.

• EU preferential trade agreements with 58 countries (including the EFTA).

• The three countries of the North American Free Trade Agreement (NAFTA): Canada, Mexico and the USA.

• Trade agreements Mexico has with the EU, EFTA and Chile, Costa Rica, Columbia, El Salvador, Guatemala, Honduras, Israel, Japan, Nicaragua, Peru and Uruguay, in addition to its membership in NAFTA.

• The seven countries of the Central American Free Trade Area (CAFTA-DR).

• The freetrade areas that the USA has with Australia, Bahrain, Chile, Colombia, Israel, Jordan, South Korea, Morocco, Oman, Panama, Peru and Singapore, in addition to its memberships in NAFTA and CAFTA-DR.

• The five countries of MERCOSUR (with a sixth country, Bolivia, in the process of acceding to full membership) and its trade association agreements with Chile, Colombia, Ecuador, Guyana, Peru and Suriname.

• The trade agreements that Turkey has with the EU, EFTA and 16 other countries.

There are now more than 250 preferential trade agreements in force and together they cover most of the world in what can perhaps be described as a tangled web. In fact, only four countries that are members of the World Trade Organisation (WTO) are not members of any trade bloc: Congo, Djibouti, Mauritania and Mongolia.

Trade discrimination

There are two kinds of trade barriers that are designed to discriminate:

1 Trade blocs – each member country can import from other member countries freely, or at least cheaply, while imposing barriers against imports from outside countries. The European Union (EU) has done this, allowing free trade between members while restricting imports from other countries.

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Chapter 3 International Trading Blocs

2 Trade embargoes – some countries discriminate against certain other countries, usually because of a political dispute. They prevent the outflow of goods, services, or assets to a particular country while allowing exports to other countries, discriminate against imports from the targeted country, or block both exports to and imports from the target.

When countries create a trade bloc or embargo, they are enacting a form of discrimination by deciding to favour trade with certain countries over trade with others. Whether this is a good or a bad thing depends on your point of view.

We have already understood that, while there are losers, in general the world benefits from free trade. Forming trade blocs and embargos can be seen as bad because it means restricting free trade to certain countries and putting up or maintaining barriers that discriminate against imports from other countries.

Alternatively, we can see a trade bloc as a good thing for the world if it creates more free trade than there was before. It at least removes barriers between some countries, so is a step in the right direction. The problem is that a trade bloc encourages imports from higher cost suppliers within the bloc and discourages imports from countries outside, with goods that may be more efficiently produced and less expensive. Consumers may pay more for the things they buy to support inefficient producers within the trade bloc.

Less developed countries in particular may be disadvantaged by being outside of the world’s major trade blocs and facing tariff barriers that restrict their exports and their opportunity for economic growth.

Another problem with trade blocs is that they can cause international friction, especially when countries find they are being discriminated against by being left out of the bloc.

Because of this, the WTO is opposed to trade discrimination in principle. A basic WTO rule is that trade barriers should be lowered equally and without discrimination for all foreign trading partners. The WTO follows the Most Favoured Nation (MFN) principle that says that any concession given to any foreign nation must be given to all nations having MFN status.

How then is it possible to form a trade bloc without breaking WTO rules? Other parts of WTO rules permit deviations from MFN under specific conditions. Trade blocs involving industrialised countries are allowed if the trade bloc removes tariffs and other trade restrictions on most of the trade among its members, and if its trade barriers against non-members do not increase on average.

WTO rules also allow special treatment for developing countries, which can exchange preferences among themselves and receive preferential access to markets in the industrialised countries.

In practice, the WTO has applied its rules loosely and no trade bloc has ever been ruled in violation.

Types of trade blocs

Trade blocs can be simple arrangements between neighbouring countries, or represent strong arrangements of insiders discriminating against outsiders, and acting almost like states within a single country. Let us look at the different types of trade blocs that exist in the world.

Economic co-operation

Regional economic integration takes the form of an agreement between countries within a geographic region. Neighbouring countries tend to ally because of their proximity to one another, somewhat similar regional tastes, the relative ease of establishing channels of distribution and a

International Trading Blocs Chapter 3

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willingness to co-operate with one another for the greater benefit of all allied parties. An example is the Association of Southeast Asian Nations (ASEAN), which exists to promote co-operation between 10 states in the Southeast Asia region.

Bilateral or multinational trade agreements

A trade agreement (also sometimes calls a treaty or a pact) is a tax, tariff and trade agreement that often includes investment arrangements. The most common trade agreements are of the preferential and free trade types, and are concluded in order to reduce (or eliminate) tariffs, quotas and other trade restrictions on items traded between the sides that sign the agreement. A trade agreement is classified as bilateral (BTA) when it is between two sides. Each side could be a country, group of countries or a trade bloc of some kind. A trade agreement signed between more than two sides is referred to as multilateral.

Preferential trade agreement

A preferential trade agreement (PTA) is a trading bloc that gives preferential access to certain products from the participating countries. This is done by reducing tariffs but not abolishing them completely. A PTA is often the first stage of economic integration. The line between a PTA and a free trade area (FTA) may be blurred, as almost any PTA has a main goal of becoming a FTA in accordance with the General Agreement on Tariffs and Trade.

PTAs create departures from the normal trade relations rule that World Trade Organisation (WTO) members should apply the same tariffs to imports from all other WTO members.

An example of a PTA is the Global System of Trade Preferences among Developing Countries (GSTP). This has operated since 1988 with the aim of increasing trade between developing countries. Original member states, participating since 1989, are: Bangladesh, Cuba, Ghana, India, Nigeria, Singapore, Sri Lanka, Tanzania and Zimbabwe. Members that have been added since then are: Algeria, Argentina, Benin, Bolivia, Brazil, Cameroon, Chile, Colombia, Ecuador, Egypt, Macedonia, Guinea, Guyana, Indonesia, Iran, Iraq, North Korea, South Korea, Libya, Malaysia, Mexico, Morocco, Mozambique, Myanmar, Nicaragua, Pakistan, Peru, Philippines, Sudan, Thailand, Trinidad and Tobago, Tunisia, Venezuela, Vietnam and the trade bloc of MERCOSUR. Applicants are (at 2014): Burkina Faso, Burundi, Haiti, Madagascar, Mauritania, Rwanda, Suriname, Uganda and Uruguay.

Free trade area

A free trade area (FTA) is formed when members remove trade barriers among themselves but keep their separate national barriers against trade with the outside world. Most trade blocs operating today are FTAs. One example is the North American Free Trade Area (NAFTA), which formally began at the start of 1994.

Customs union

A customs union is formed when members remove barriers to trade among themselves and adopt a common set of external barriers. The European Economic Community (EEC) from 1957 to 1992 included a customs union along with some other agreements. The Southern Common Market (MERCOSUR), formed by Argentina, Brazil, Paraguay and Uruguay in 1991, is an example of a customs union.

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Common market

In a common market, members allow full freedom of movement for people, goods, services and capital among themselves, in addition to having a customs union. Despite its name, the European Common Market (EEC, which became the European Community, EC, and is now the European Union, EU) was not a common market through the 1980s because it still had substantial barriers to the international movement of labour and capital. The EU became a true common market at the end of 1992.

Economic union

Full economic union is said to occur when member countries unify all their economic policies, including monetary and fiscal policies, as well as policies toward trade and migration of people and investment. Belgium and Luxembourg have had such a union since 1921 and the EU is on a path toward economic unity.

Political union/federation

A political union, or federation, occurs when countries join together politically. For example, Australia is made up of member states (New South Wales, Victoria, Queensland, Tasmania, South Australia, Western Australia and the Northern Territory) that make most of their own laws, but are part of a federal system that binds them together as a single country.

Types of trade blocs

• Economic co-operation

• Bilateral or multilateral trade agreement

• Preferential trade agreement

• Free trade area

• Customs union

• Common market

• Economic union

• Political union/federation

NEED TO KNOW

on the goREVISION

Activity 1: What trade blocs does your country belong to?

Do some research online and find out what trade blocs and free trade areas your country belongs to.

OVER TO YOU


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3.2 Evaluate the purposes and operations of intergovernmental bodiesGovernments of individual countries need to work together, and in this section we will look at the purposes and operations of the key intergovernmental bodies that help to make this possible.

World Trade Organisation (WTO)

When trade between nations operates smoothly and predictably, and follows a system of basic rules that all countries have agreed, the world is a more peaceful and stable place as a result. This is the objective of the World Trade Organisation (WTO): to provide legal rules for international trade and a system for international commerce.

The WTO was formed in 1995, taking the place of the General Agreement on Tariffs and Trade (GATT), which had begun in 1947. As the world recovered economically from the Second World War, the objective of GATT was to facilitate trade between nations by reducing tariffs. Under GATT, countries could give each other the status of most favoured nation (MFN), which meant it had privileged trading rights. GATT aimed to help countries obtain MFN status.

The Uruguay round of GATT negotiations ran from 1986 to 1994, and created the rules about trade between countries in goods that the WTO still upholds. These include how trade in agriculture operates and anti-dumping policies.

Trade in services was also covered in the Uruguay round, resulting in the General Agreement on Trade in Services (GATS). This agreement covered protection for intellectual property rights in the form of copyright and patents.

There are more than 140 member countries in the WTO, covering 97% of the world’s trade. Member countries adopt the WTO regulations by ratifying them, effectively making those rules part of their legal system, as well as agreeing that they will not pass other laws that do not follow the WTO rules. This means that a business can invest in another member country, perhaps setting up an office there, and rely on the protection of the WTO rules.

The WTO Ministerial Committee meets in Switzerland to make decisions, usually by consensus rather than a vote. There are WTO councils that make recommendations on goods trade, services trade or intellectual property rights, and a general council, as well as a number of committees and working groups. The WTO can resolve disputes between nations, usually through negotiation, although it can also impose sanctions on countries that break the rules.

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Nevertheless, a critic of the WTO, international law scholar Steve Charnovitz, points out that countries are prevented from passing laws that might protect workers, industries or the environment because of the requirement to follow WTO rules.

The sovereignty of countries is compromised in the name of free trade and this can make it unable to act in the best interests of its people. An example is when the governments of less developed countries in Africa want to allow the manufacture of generic versions of drugs to treat HIV/AIDS, because they simply cannot afford the expensive patented drugs. Because WTO rules on intellectual property protection for the rights of drug companies that own the patents, governments that allow generic drugs face the possibility of WTO trade sanctions.

Another critic of the WTO, Martin Khor, pinpoints that, by protecting investment, the WTO gives an advantage to rich countries as most investment flows from rich countries to poor countries. There are also those who criticise the ideas of free trade on which the WTO is based upon and call for protectionist trade policies. The election of Donald Trump as president of the USA was due, at least in part, to a rising call for the USA to put its own interests first when it comes to trade.

The Organisation for Economic Co-operation and Development (OECD)

Established in 1961, the Paris-based Organisation for Economic Cooperation and Development (OECD) provides a forum in which governments can work together to share experiences and seek solutions on common problems. The OECD provides independent research and analysis to help improve the lives of people in its member countries and globally, but has no ability to make or enforce rules and relies on negotiation and consensus to influence governments.

Members of the OECD are Australia, Austria, Belgium, Canada, Chile, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Japan, South Korea, Latvia, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the USA.

The G8 and G20

The G8 and G20 are groups of nations that come together to discuss and decide on important world issues. They have replaced the G7 – a group of seven countries that came together in 1975 over the conflict between the Arab world and Israel.

The USA and the United Kingdom backed Israel with military aid, while the USSR supported the Arab nations – an action that kept it from being invited to join the G7.

Officially called the Group of Seven Industrialised Nations, the G7 consisted of the United Kingdom, the USA, France, Canada, Japan, Italy and Germany. It was renamed the G8 in 1997 when Russia joined after the dissolution of the USSR in 1991.

The main role of the G8 is to work towards political and economic stability, whilst also achieving the interests of its members on the world stage, tackling issues such as climate change.

Formed in 1999 as an extension of the G8, the G20 is a larger club, which includes the nations of Brazil, China, Saudi Arabia, South Korea, France, Australia, China, Canada, Germany, Indonesia, Argentina, Turkey, India, Russia, South Africa, Mexico, Japan, the United Kingdom, the USA and the European Union. The G20 does not make any decisions that are binding on


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its members but provides an international forum for discussions between the governments and central bank governors from these major economies. The G20 has the goal of promoting balanced and sustainable economic development and reducing the world’s imbalances and poverty. It also wrestles with such issues as transnational corporate tax evasion and corruption.

Organisation of Petroleum Exporting Countries (OPEC)

The Organisation of Petroleum Exporting Countries (OPEC) represents 12 of the world’s major oil-exporting nations. Founded in 1960, OPEC has this stated mission:

To co-ordinate and unify the petroleum policies of its Member Countries and ensure the stabilization of oil markets in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers, and a fair

return on capital for those investing in the petroleum industry.

In fact, OPEC is a cartel that manages the supply of oil in an effort to set the price of oil on the world market, aiming to keep prices high and maximise the revenues and profits their members receive for their oil exports. Most countries have laws that prevent companies forming price price-fixing cartels, but the existence of OPEC suggests there is nothing much to stop sovereign states doing this.

OPEC’s founding members were Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. They have since been joined by Qatar, Indonesia, Libya, the United Arab Emirates, Algeria, Nigeria, Ecuador, Gabon and Angola. Together, its members hold around 80% of the world’s crude oil reserves and half of its natural gas.

Russia, China and the USA are also major oil producers, but not members of the OPEC club. Fracking technology, especially in the USA, has unlocked new sources of oil and weakened OPEC’s control over the global market.

The World Economic Forum (WEF)

The World Economic Forum (WEF) is a Swiss non-profit foundation, based in Cologny, Geneva. It summarises its mission statement as being:

… committed to improving the state of the world by engaging business, political, academic, and other leaders of society to shape global,

regional, and industry agendas.

The WEF is best known for its annual meeting at the end of January in Davos, a mountain resort in Graubünden, in the eastern Alps region of Switzerland. The meeting brings together business leaders, politicians, economists and journalists for a four-day discussion of the most pressing global issues.

There are also annual regional meetings each year in Africa, East Asia and Latin America, as well as annual meetings in China and the United Arab Emirates. The WEF publishes a series of research reports and co-ordinates initiatives involving its members.

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Activity 2: What does the OECD say about your country?

The OECD publishes reports about countries and regions of the world, many of them available online. Find an OECD paper or report that relates to your country or region. What does it say about your country?

OVER TO YOU

WTO rules

The World Trade Organisation (WTO) has over 140 member countries and sets regulations that govern 97% of the world’s trade. When member countries ratify WTO regulations, they make them part of their own legal system. These regulations provide some certainty to firms doing business in other countries.

on the goREVISION

3.3 The major trade blocs and regional groupingsIn this section, we will review the international market in terms of the major trade blocs and regional groupings.

Europe’s single market

The European Coal and Steel Community (ECSC) was formed in 1952 as an alliance of six European countries involved in the production of iron and steel. This was a first step in a growing economic co-operation that led to the European Union.

When the European Customs Union was formed in 1958, it was the world’s first major trade bloc in modern times. While the people of Europe benefitted from free trade in goods, they had to carry the cost of the common agricultural policy, which was an expensive system to provide welfare for farmers.

In the 1980s, European countries progressed from being a customs union and became a single common market. The Single European Act in 1992 eliminated many national product standards


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that had been non-tariff barriers, which protected high cost local producers from more efficient competitors in other European countries. Belgium could no long apply strict rules on chocolate ingredients, Germany could no longer restrict imports of beer that did not meet strict brewing standards and Italy could no longer keep out imported pasta. The shift to become a common market also meant that workers could move between countries and financial investments could flow freely across European borders.

In 1999, the EU took the further step of establishing a single currency for Europe: the euro. At first, European countries retained their own currencies and the euro was simply an overarching currency that made it much easier to conduct financial transactions across borders. It became possible to compare prices of goods within Europe without having to make currency calculations, and the risk of currency fluctuations was eliminated.

Within three years, the euro was adopted by most European countries as their only domestic currency (the United Kingdom was a notable exception and retained its own currency: the pound sterling). Countries that adopted the euro had to give up the ability to manipulate the value of their currency to meet their own economic objectives. The European Central Bank manages the euro, so its value cannot be controlled by any one country.

The EU became a lot larger from 2003 to 2013 when 13 additional countries joined. The EU population grew by 27%, although these were poorer former Eastern Bloc countries, meaning they only added 6% to the size of the EU economy. The new member countries needed to be democratic market economies that would commit to respect for human rights and agree to meet exact EU standards, described in 80,000 pages of documents.

People in the new member nations did not enjoy the same farm subsidies and freedom of movement immediately, but did have access to a greater variety of imported goods and opportunities to grow their economies.

Still possibly to join at some time in the future are the Balkan countries of Serbia, Montenegro, Bosnia, Macedonia and Albania. In a more distant future, Ukraine, Moldova and Georgia may be able to join. Turkey would like to join but it is considered unlikely that such a large and relatively poor country could make the necessary political changes and be successfully integrated.

North American Free Trade Area

The North American Free Trade Area (NAFTA) began to emerge in 1989 with the formation of the Canada–US Free Trade Area (CUSFTA). Talks between the USA and Mexico began in 1990 and, in 1991, became talks to create a free trade area that would include Canada. CUSFTA was later replaced with NAFTA in 1994.

NAFTA removed nearly all tariffs and some non-tariff barriers within the three North American countries. Barriers to investment across the two borders were removed, along with rules restricting US and Canadian businesses in Mexico, but an important difference compared to the EU is that NAFTA does not allow free movement of labour.

Critics of NAFTA in the USA, such as the American Federation of Labor and Congress of Industrial Organizations, say that their jobs are lost to cheaper Mexican labour and that it supports a corrupt political system in Mexico. Mexican critics of NAFTA fear a loss of sovereignty, as the USA uses NAFTA rules to force changes to policies in Mexico. NAFTA is also blamed for environmental pollution in industrial border towns and increasing inequality between rich and poor people in Mexico.

However, Mexico benefits from investment from foreign businesses that can manufacture goods cheaply in Mexico to sell into the huge US market. It is estimated that NAFTA has boosted foreign

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investment in Mexico by 40%. Market and political reforms in Mexico are making life better for its people and making it a better neighbour and ally for the USA.

NAFTA improves productivity in the three countries in two main ways. Firstly, the increased competition from within the larger market drives innovation as manufacturers come under pressure to improve production methods and design better products.

Secondly, because a factory in one of the three countries can now supply a larger market, economies of scale can be created as factories can have longer production runs – making a smaller range of goods in higher quantities is more efficient.

Mexico’s plentiful low-cost labour gives it a comparative advantage over the USA and Canada. This makes it good at manufacturing clothing, furniture and other product assembly work, as well as growing fruit and vegetables to export to the USA. It sells huge quantities of these goods to the USA while at the same time buying more from the USA in areas where they have a comparative advantage, such as financial services, chemicals and technology.

It is difficult to calculate the overall benefits of NAFTA. Trade has certainly increased but much of this is diverted from other trade relationships rather than created by it. Economists mostly agree that NAFTA has been modestly good for all three countries, adding a tenth of 1% to the US economy, 1% to Canada and 2% to Mexico.

It is important to note that economists have not observed the massive loss of US jobs that many predicted would occur as a result of NAFTA.

NAFTA rules of origin

Under NAFTA, the USA imposes no tariffs on clothing manufactured in Mexico, but retains tariffs on other countries such as China. What is to stop a business bypassing US tariffs by shipping their goods in through Mexico?

The answer is the rules of origin that are part of the NAFTA agreement and rigorously enforced by the US authorities.

NAFTA rules of origin have to guard against all the different ways importers might try to beat the system, such as making 90% of a garment in China, then finishing it in Mexico and sewing on the “Made in Mexico” label.

The NAFTA rules of origin have thousands of rules to guard against this sort of thing in different industries, covering 200 pages. For example, clothing manufacturers must prove they actually made the fabric in Mexico to qualify for duty-free shipping. Many of the rules are so strict and require so much documentation that they act as protectionist non-tariff barriers. The fabric rule protects US fabric manufacturers but harms much lower cost fabric producers in Asia, along with the US consumers who pay more for clothing.

Asia-Pacific Economic Co-operation (APEC)

The Asia-Pacific Economic Cooperation (APEC) forum was established to “further enhance economic growth and prosperity for the region and to strengthen the Asia-Pacific community”, and sets out to be “the premier forum for facilitating economic growth, co-operation, trade and investment in the Asia-Pacific region.”

Established in 1989, APEC now includes 21 economies that mostly have a Pacific Ocean coastline. APEC refers to member economies, not countries, as this allows both China and Taiwan to be members, even though China does not recognise Taiwan as a country. Hong Kong is also a member


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although it is officially part of China. Other members are Australia, Brunei Darussalam, Canada, Indonesia, Japan, South Korea, Malaysia, New Zealand, the Philippines, Singapore, Thailand, the USA, Mexico, Papua New Guinea, Chile, Peru, Russia and Vietnam.

Member economies make voluntary commitments and decisions are reached by consensus. Representatives are not all politicians – business leaders from the member economies also take part in the APEC Business Advisory Council (ABAC). The idea is to make doing business between the member economies easier by reducing the cost of trading across borders, providing access to trade information and simplifying processes, and investing and doing business behind the borders of different economies.

Member economies take turns hosting an annual APEC meeting and the APEC secretariat is based in Singapore.

Contemporary developments in a dynamic world

International markets change and shift over time as alliances between nations are formed and reformed. Recent developments have included the proposal for a Regional Comprehensive Economic Partnership that will cover half of the world’s population, the last minute rejection by the USA of the proposed Trans-Pacific Partnership and Britain’s decision to exit from the EU. These three developments are detailed below.

Regional Comprehensive Economic Partnership (RCEP)

The Regional Comprehensive Economic Partnership (RCEP) is a proposal that emerged in 2012 for a regional free trade area, which would initially include the ten ASEAN member states and those countries that have existing FTAs with ASEAN: Australia, China, India, Japan, South Korea and New Zealand.

The 16 RCEP participating countries account for almost half of the world’s population, almost 30% of the global GDP and over a quarter of world exports.

The objective of the RCEP is to bring together a patchwork of trade deals that exist between nations in the region to achieve a modern, comprehensive, high quality and mutually beneficial economic partnership agreement. RCEP will cover trade in goods, trade in services, investment, economic and technical co-operation, intellectual property, competition, electronic commerce and dispute settlement.

Trans-Pacific Partnership (TPP)

The TPP is an ambitious proposed free trade agreement between 12 countries that aimed to establish a more seamless trade and investment environment by setting commonly agreed rules and promoting transparency of laws and regulations. The TPP aimed to provide greater certainty for businesses, reduce costs and red tape, and facilitate in regional supply chains.

The proposed members were Australia, Brunei Darussalam, Canada, Chile, Japan, Mexico, New Zealand, Malaysia, Peru, Singapore, Vietnam and the USA, with the possibility of more countries joining in the future.

Unfortunately, the TPP was derailed when incoming US President Donald Trump refused to agree to it. Without the participation of the world’s biggest economy, many of the trade advantages were lost to the other proposed members and the future of the TPP was cast into doubt. At time of writing, it seems possible it will go ahead in an amended form without the USA.

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Britain’s exit from the EU – “Brexit”

In a controversial referendum in 2016, the people of the United Kingdom voted by a narrow margin to leave the EU – a process referred to as Brexit. At the time of writing, the terms of Brexit are still being negotiated and people in both the UK and the EU are still coming to terms with the implications for their economies.

While still part of the EU, the UK can have no trade agreements of its own with any other countries. If and when a separation from the single European market takes place, the UK will need to work quickly to secure access to markets for its goods and services to minimise economic damage.

The free movement of people between Europe and the UK is expected to end, causing problems for people who have moved across borders to live and work, potentially harming the UK economy by cutting the flow of both highly skilled and less skilled workers.

UK-based businesses, such as motor vehicle manufacturers that rely on supplying the single EU market, or need to move goods, services and skilled people across borders, now face uncertainty about what the future might hold. In particular, London’s financial services and banking industry is likely to find it harder to do business in the EU.

Activity 3: What problems will Brexit cause for UK businesses?

What problems will UK businesses face if they can no longer be part of the EU single market, which allows free movement of goods, services and labour between member countries?

OVER TO YOU

NAFTA has produced gains

The North America Free Trade Agreement (NAFTA) has proved modestly good for all three countries. Economists calculate it has added a tenth of 1% to the US economy, 1% to Canada and 2% to Mexico. The major loss of US jobs predicted by labour unions did not occur.

on the goREVISION


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• http://reports.weforum.org

• http://www.oecd.org

• http://www.un.org/en

• http://en.unesco.org

• http://www.economist.com

READING LIST

on the goREVISION

Summary

After completing this chapter, you should be able to discuss the significance of international trading blocs and organisations, and the characteristics of different types of economic co-operation and preferential trade arrangements. In addition, you now have some insights into the purposes and operations of intergovernmental bodies, and understand how the international market is divided into a patchwork of overlapping trade blocs and regional groupings.


http://reports.weforum.org

http://www.oecd.org

http://www.un.org/en

http://en.unesco.org

http://www.economist.com

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Introduction

International trade could not operate smoothly without international financial systems and the institutions that maintain them. In this chapter, we will gain some insights into the world of international finance.

Learning outcomes


4 Discuss the key aspects of international finance

Assessment criteria

4 Discuss the key aspects of international finance

4.1 Analyse the aims and roles of key international institutions in the financial aspects of world trade

4.2 Evaluate the impact of foreign currency exchange and interest rates on international business

4.3 Analyse the trading position of a country with reference to balance of trade/payments

International Finance

Chapter 4

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4.1 Key international financial institutions in world trade

World Bank

The World Bank is an international organisation dedicated to providing financing, advice and research to developing nations to aid their economic advancement. It is headquartered in Washington D.C., USA, and has more than 10,000 employees in over 120 offices worldwide.

Created out of the United Nations’ Bretton Woods conference at the end of the Second World War, the World Bank was originally needed because many European and Asian countries needed finance to pay for reconstruction. Today, the Bank mostly attempts to fight poverty by providing development aid to low income countries.

The World Bank is really five organisations:

1 International Bank for Reconstruction and Development (IBRD) – an institution that provides debt financing to governments that are considered middle income.

2 International Development Association (IDA) – a group that gives interest-free loans to governments of poor countries.

3 International Finance Corporation (IFC) – focuses on the private sector and provides developing countries with investment financing and financial advisory services.

4 Multilateral Investment Guarantee Agency (MIGA) – an organisation that promotes foreign direct investments in developing countries.

5 International Centre for Settlement of Investment Disputes (ICSID) – an entity that provides arbitration on international investment disputes.

The World Bank aims to end extreme poverty by reducing the number of people living on less than $1.90 a day to less than 3% of the world population. It also wants to increase income growth in the bottom 40% of the world’s population.

It provides governments with low-interest loans, zero-interest credits and grants to help with education, health care, public administration and development. The World Bank also helps governments with policy advice, research, analysis, and technical assistance.

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Chapter 4 International Finance

International Monetary Fund

The International Monetary Fund (IMF) works hand-in-hand with the World Bank. While the World Bank focuses on long-term economic solutions and the reduction of poverty, the IMF is more focused on economic policy solutions and providing shorter-term loans. The IMF also aims to stabilise financial relations and exchange rates and economically strengthen its member countries. It was created with these aims:

1 Promoting global monetary and exchange stability.

2 Facilitating the expansion and balanced growth of international trade.

3 Assisting in the establishment of a multilateral system of payments for current transactions.

The IMF played a large role in the economic restructuring of the post-Second World War world. After the war, some countries were in economic distress, and others were reluctant to trade with certain other countries after the fighting. The Fund helped smooth over the economic post-war transition period and re-stabilise the world economy.

A system of fixed exchange rates, established by the IMF, operated until 1971. Since then, the IMF has promoted floating exchange rates, which allows the value of a currency to change relative to the value of another.

The 188 countries that belong to the IMF contribute money in the form of quotas based on the size of their economies. The IMF pools these funds and uses them to make loans to countries in need and impose a code of conduct on its members. It requires countries that are seeking to borrow to meet that code of conduct too, and sometimes even stricter rules.

The financial crisis in Greece was an example of how the IMF gets involved to help economies that are in trouble by contributing funds, helping to decide how to handle the debt and the changes needed to return stability to the economy.

European Central Bank (ECB)

The European Central Bank (ECB) formulates monetary policy, conducts foreign exchange, holds currency reserves and authorises the distribution of euro bank notes and coins. It began in 1999, when members of the EU (not including the UK, Sweden and Denmark) created the euro as a common currency. The ECB was a new central bank that was established to manage the new currency and with it the monetary system of the EU.

Before the introduction of the euro, EU finances were managed by the European Monetary System (EMS), which was an arrangement between European countries, set up in 1979, to link their currencies and stabilise the exchange rate. The UK withdrew from the EMS in 1992 and later refused to join the Eurozone along with Sweden and Denmark. The European Economic and Monetary Union (EMU), which created the euro, later replaced the EMS.

The introduction of the euro and the ECB was a step towards European political unity, and supported efforts by Eurozone nations to reduce debt, curb excessive public spending and attempt to tame inflation.

The European sovereign debt crisis

The global economic crisis of 2008 exposed weaknesses in the EU’s finances. Greece, Ireland, Spain, Portugal and Cyprus had high national deficits that created a European sovereign debt crisis. The UK, having stayed outside the euro, simply saw the value of its currency devalue, but the troubled

International Finance Chapter 4

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Eurozone countries did not have this option. Instead, the value of assets inside those countries, such as houses, plummeted.

The idea of bailing out troubled EU countries was not popular with people in the wealthier EU countries such as Germany, but bailouts finally went ahead. In 2012, the European Stability Mechanism provided further bailouts while forcing austerity measures in the afflicted countries. Ireland, Portugal and Spain have managed a tentative recovery, but Greece remains in economic recession with political strife, very high unemployment and an uncertain future.

Aims of the World Bank

The World Bank has the aim of ending extreme poverty in the world. It wants to increase income growth for the poorest 40% of the world’s people and cut the number who live on less than $1.90 a day to less than 3%.

on the goREVISION

4.2 The impact of foreign currency exchange and interest rates on international businessCurrencies can be bought and sold like any product. Buying a currency with another currency means the currencies are being traded for one another. But how do we know what our buying and selling currencies are worth relative to each other? Most industrialised countries allow the value of their currency to fluctuate. Setting exchange rates for these currencies is the function of banks that create exchange rates by trading currencies between each other.

Foreign exchange markets and rates are relevant to all businesses that buy, sell or invest in more than one currency. Simply buying goods that come from another country with a different currency involves the risk that the price you pay could rise due to a change in the rate of exchange. If you are buying goods in one currency and selling them in another, you face exchange risk.

Exchange risk also occurs if you are investing in a foreign business or security, and interest rates can also rise or fall differently from those at home, possibly a further risk.

Financial managers have to be concerned with exchange risk even if they do not do business internationally. Exchange rate changes could change the price of any imported raw materials or other inputs the business uses, and increased costs spell reduced profits. Exchange risk is even more of a problem if a business is doing business across borders and buying, selling, investing or borrowing money in more than one currency.

For example, investing in a US dollar account that pays 5% per year is better than investing in a Swiss franc account that pays 10% per year if, during the year, the franc devalues by 6%.

Exchange risk can be eliminated or reduced in a number of ways. These alternatives fall into four categories:

• risk avoidance

• risk adaptation

• risk transfer

• diversification.

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Risk avoidance

You can try to avoid exchange risk by only selling and buying in your local currency. This may not be an effective strategy as your business can still be affected by the price of imported goods you need to buy, such as vehicles, machinery, steel or chemicals.

Risk adaptation

Exchange risk adaptation involves hedging the risk. You can protect liabilities denominated in foreign currency with equal-value, equal-maturity assets denominated in that foreign currency.

For example, let us imagine you have agreed to buy machinery from Germany at a cost of €100,000 to be paid in 180 days. To fix the cost at today’s rate you could purchase an asset in euros, such as a certificate of deposit, that will also be worth €100,000 in 180 days. When the time comes to pay for your German machinery, you sell the asset and, no matter how much your currency has changed against the euro, you have exactly the amount you need to complete the purchase.

Even simpler, deposit the €100,000 in a euro-denominated bank account. An alternative approach might be to agree to sell a shipment of your company’s products for €100,000 in 180 days.

Risk transfer

Another strategy for reducing exchange risk is exchange risk transfer. This involves a guarantee or insurance contract that transfers the risk to a guarantor or insurer. A business can insure against exchange risk and, in some countries, the central bank offers exchange risk guarantees to importers and exporters.

Diversification

If your business holds assets in a variety of different currencies this provides some protection against exchange risk. This is referred to as currency diversification. If you hold half your assets in US dollars and the other half in euros, changes in the exchange rate between these two currencies will not be a problem for you. While one asset will be worth less, the other is worth more.

Exchange risk makes the profit disappear at a $2 Store

Amara has a variety store called The $2 Store that sells everything for $2 in her local currency.

She buys goods from another country for an average landed cost per item of US$1, and needs 75 cents from each sale to cover the overhead costs of her business. This leaves her with a profit of 25 cents for each item she sells.

Amara’s local currency had been worth the same as the US dollar and her business had been profitable until bad economic news about her country’s prospects caused her local currency to drop in value against the US dollar by 20%.

The average landed cost of Amara’s goods is still US.$1, but this is now $1.25 in her local currency. Her overhead costs are still 75 cents so she can no longer make any profit from operating The $2 Store.

CASE STUDY


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Activity 1: Managing exchange risk for your own $2 Store

What could you theoretically do to minimise the exchange risk at your $2 Store?

Choose one of the solutions below, or one of your own, and explain why.

• Insist that you purchase from your supplier in China using your local currency.

• Sell everything in your store for the local currency equivalent of US $2 dollars so the price goes up and down with the exchange rate.

• Buy a forward contract from your bank to cover the foreign exchange needed for each order you place.

• Change the name of your store to The $3 Store.

OVER TO YOU

Hedging exchange risk

Exchange risk adaptation involves hedging the risk. You can protect liabilities denominated in foreign currency with equal-value, equal-maturity assets denominated in that foreign currency.

NEED TO KNOW

on the goREVISION

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Currency devaluation

If the currency of your country devalues, it becomes more expensive to import goods, so of course you will have to pay more to buy imported goods. At the same time, the goods that your country exports become less valuable. This initially makes your country’s balance of trade less favourable.

However, because the devaluation has made the goods your country produces less expensive in other countries, demand for those goods soon rises and the value of your exports starts to increase. At the same time, people in your country start buying less imported goods, because they are now more expensive. They may start replacing some of those imported goods with local products.

So your country may become initially worse off after a devaluation but then exports rise, imports reduce, and the position of the country improves. If you drew a graph of the country’s balance of payments after a devaluation it would show a dip followed by a rise. Economists describe this as a J curve.

The opposite occurs if your currency appreciates in value. Exports fall, because your country’s goods now cost more in other countries, and imports increase because the strong currency makes it cheaper to buy imported goods. The result of a currency appreciation can be a reverse J curve.

4.3 A country’s balance of payments and balance of tradeThe balance of payments (BOP) is a record of transactions that take place between the people, organisations and government of one country and the people, organisations and governments of all other countries. Double entry bookkeeping is used so for all value that flows out as a payment, some corresponding value flows in as a receipt, therefore there cannot be a deficit.

A BOP records transactions rather than actual payments, which is important because some transactions are exchanges that do not involve actual payment of money. BOP transactions are classified as current account (mostly goods and services) or capital account (mostly financial instruments). This information is used by governments to see trade imbalances or how much foreign investment is taking place.

Governments formulate economic policy, perhaps deciding to lower their exchange rate to stimulate exports and build up cash reserves, or perhaps seeking to attract investment in certain sectors. The BOP is used to measure the success of such economic policies.

Balance of trade

Balance of trade is different from balance of payments and can show a surplus or a deficit. A surplus in the balance of trade occurs when exports exceed imports and a deficit occurs when imports are greater than exports. The balance of trade shows the amount of visible trade and is the major component of a country’s balance of payments.

Visible trade is the exchange of physically tangible goods between countries, involving the export, import, and re-export of goods at various stages of production and includes equipment used directly in the production of goods.

Invisible trade is the exchange of physically intangible items between countries and is primarily services or transactions when physical goods do not change hands. Invisible trade includes income from foreign investment in the form of interest, profits, and dividends; private or government transfers of monies from one country to another; and intellectual property and patents.


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Balance of trade

The balance of trade shows the amount of visible trade that has taken place. It is the major component of a country’s balance of payments.

When exports exceed imports there is a surplus, however, when the opposite occurs, imports are more valuable than exports, and a deficit in the balance of trade is created.

NEED TO KNOW

on the goREVISION

Current account deficits

A deficit in the current account of the balance of payments occurs when the value of the goods and services a country imports exceeds the value of the goods and services it exports.

Developed countries, such as the USA, often run current account deficits, as do countries that are very poor. Emerging economies often run current account surpluses.

Is a current account deficit a bad thing? It depends. If it means that a country is simply living beyond its means, it is risking insolvency, but if the country is using debt to finance investments that have a higher rate of return than the cost of the debt, it can run a current account deficit and remain solvent.

A country can attempt to reduce its current account deficit by increasing the value of its exports relative to the value of imports. It can do this by placing restrictions on imports, promoting exports or seeking to improve the global competitiveness of its exporters. It can also use devaluation of its currency to make its exports less expensive.

The UK is an example of a country that runs a current account deficit. It has high levels of imports financed by borrowings and much of what it exports are commodities that have declined in value, resulting in lower earnings for UK companies.

The UK currency declined in value dramatically after the Brexit vote in 2016. UK firms that sold goods priced in US dollars, or held cash reserves in the USA, were suddenly much more wealthy in UK pounds and the devaluation also meant that the UK’s current account deficit unexpectedly decreased.

Activity 2: What about your country?

Does your country run a current account deficit? How big is it and what do politicians say about it? Go online and see what you can find out.

OVER TO YOU

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Current account deficit

When the value of the goods and services a country imports exceeds the value of the goods and services it exports, this creates a deficit in the current account of the balance of payments.

NEED TO KNOW

on the goREVISION



• http://www.bankofengland.co.uk

• http://www.mckinsey.com

• http://knowledge.wharton.upenn.edu

• https://www2.deloitte.com/global/en.html?icid=site_selector_global

• https://dupress.deloitte.com

• https://www.accenture.com/gb-en

• https://home.kpmg.com/uk/en/home.html

• http://www.economist.com

READING LIST

on the goREVISION

Summary

This final chapter has covered the key aspects of international finance and has provided you with an understanding of the aims and roles of key international institutions in the financial aspects of world trade. You should now have an insight into the impact of foreign currency exchange and interest rates on international business, and can understand how the trading position of countries is measured by balance of trade and balance of payments.


http://www.bankofengland.co.uk

http://www.mckinsey.com

http://knowledge.wharton.upenn.edu

https://www2.deloitte.com/global/en.html?icid=site_selector_global

https://dupress.deloitte.com

https://www.accenture.com/gb-en

https://home.kpmg.com/uk/en/home.html

http://www.economist.com

Glossary

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Glossary

Absolute advantage A trade theory which holds that nations can increase their economic well-being by specialising in goods that they can produce more efficiently than anyone else.

Born global firms Business organisations that, from inception, seek to derive significant competitive advantage from the use of resources and the sale of outputs in multiple countries.

BRICS Five countries considered the world’s main emerging economies: Brazil, Russia, India, China and South Africa.

Common market A form of economic integration characterised by the elimination of trade barriers among member nations, a common external trade policy, and mobility of factors of production among member countries.

Comparative advantage A trade theory which holds that nations should produce those goods for which they have the greatest relative advantage.

Containerisation The use of standardised shipping containers that can be simply loaded onto a carrier and then unloaded at their destination without any repackaging of the contents of the containers.

Currency diversification An exchange risk management technique through which the firm places activities or assets and liabilities into multiple currencies, thus reducing the impact of exchange rate change for any one of them.

Customs union A form of economic integration in which all tariffs between member countries are eliminated and a common trade policy toward non-member countries is established.

Decision-making The process of choosing from alternatives.

Distribution The course that goods take between production and the final consumer.

Dumping The selling of imported goods at a price below cost or below that in the home country.

Economic integration The establishment of transnational rules and regulations that enhance economic trade and cooperation among countries.

Economic union A form of economic integration characterised by free movement of goods, services, and factors of production among member countries, and full integration of economic policies.

Embargo A quota set at zero, thus preventing the importation of those products that are involved.

European Coal and Steel Community (ECSC) A community formed in 1952 by Belgium, France, Italy, Luxembourg, the Netherlands and West Germany for the purpose of creating a common market that would revitalise the efficiency and competitiveness of the coal and steel industries in those countries.

European Economic and Monetary Union (EMU) The agreement among, initially, 11 of the European Union countries to eliminate their currencies and create the euro. European Union countries do not necessarily have to join the EMU.

European Free Trade Association (EFTA) A free trade area currently consisting of Iceland, Liechtenstein, Norway and Switzerland – past members included the UK (before it joined the EU).

European Union (EU) A treaty-based institutional framework that manages economic and political co-operation among its 27 member states: Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, and the United Kingdom.

Exchange rates The value of one currency in terms of another. For example, $US 2.00/€1.

Exchange risk The risk of financial loss or gain due to an unexpected change in a currency’s value.

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Glossary

Exchange risk adaptation An exchange risk management technique through which a company adjusts its business activities to try to balance foreign-currency assets and liabilities, and inflows and outflows.

Exchange risk transfer An exchange risk management technique through which the firm contracts with a third party to pass exchange risk onto that party, via such instruments as forward contracts, futures and options.

Exports Goods and services produced by a firm in one country and then sent to another country.

Factor conditions Land, labour and capital.

Factor endowment theory A trade theory which holds that nations will produce and export products that use large amounts of production factors that they have in abundance and will import products requiring a large amount of production factors that they lack.

Foreign direct investment (FDI) Equity funds invested in other nations.

Foreign exchange Foreign-currency-denominated financial instruments, ranging from cash-to-bank deposits to other financial contracts payable or receivable in foreign currency.

Free trade area An economic integration arrangement in which barriers to trade (such as tariffs) among member countries are removed.

Globalisation The production and distribution of products and services of a homogeneous type and quality on a worldwide basis.

Gross domestic product (GDP) A monetary measure of the market value of all final goods and services produced in a period (quarterly or yearly). Nominal GDP estimates are commonly used to determine the economic performance of a country.

Heckscher–Ohlin theory A trade theory that extends the concept of comparative advantage by bringing into consideration the endowment and cost of factors of production, and helps to explain why nations with relatively large labour forces will concentrate on producing labour-intensive goods, whereas

countries with relatively more capital than labour will specialise in capital-intensive goods.

Hedging A strategy to protect the firm against risk, in this case against exchange rate risk.

Imports Goods and services produced in one country and brought in by another country.

Import tariff A tax levied on goods shipped into a country.

Industry clusters Geographic concentrations of interconnected businesses, including suppliers, specialist contractors and associated institutions.

Innovation The renewal and enlargement of the range of products and services and the associated markets; the establishment of new methods of production, supply and distribution; the introduction of changes in management, work organisation, and the working conditions and skills of the workforce.

International Monetary Fund (IMF) The international organisation that includes most countries of the world and offers balance of payments support to countries in crisis along with financial advising to Central Banks.

International trade The exchange of goods and services across international borders.

Licence A contractual arrangement in which one firm (the licensor) provides access to some of its patents, trademarks or technology to another firm in exchange for a fee or royalty.

Mercantilism A trade theory which holds that a government can improve the economic well-being of the country by encouraging exports and stifling imports to accumulate wealth in the form of precious metals.

MERCOSUR A sub-regional free trade group formed to promote economic cooperation; the group consists of Argentina, Brazil, Paraguay and Uruguay.

MINT countries Mexico, Indonesia, Nigeria and Turkey.

MIST countries Mexico, Indonesia, South Korea and Turkey.

Glossary

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Multinational enterprises (MNEs) A company headquartered in one country but having operations in other countries.

Non-tariff barriers Rules, regulations and bureaucratic red tape that delay or preclude the purchase of foreign goods.

North American Free Trade Agreement (NAFTA) A very large free trade area, covering 450 million people, formed by the USA, Canada and Mexico.

Organisation for Economic Co-operation and Development (OECD) A group of 30 relatively wealthy member countries that facilitates a forum for the discussion of economic, social and governance issues across the world.

PESTLE analysis A market analysis that covers political, economic, social, technological, environment and legal factors.

Political union An economic union in which there is full economic integration, unification of economic policies and a single government.

Promotion The process of stimulating demand for a company’s goods and services.

Quota A quantity limit on imported goods.

SWOT analysis An analysis of strengths, weaknesses, opportunities and threats.

World Bank The world’s largest development bank, formed along with the IMF at Bretton Woods in 1944. Its original name was the International Bank for Reconstruction and Development (IBRD). The World Bank assists developing countries with loans and economic advising for economic development.

World Trade Organisation (WTO) An international organisation that deals with the rules of trade among member countries. One of its most important functions is to act as a dispute-settlement mechanism.

Documents

LEVEL 5 INTERNATIONAL BUSINESS ECONOMICS AND MARKETS