Concept Notes On International Business

International Business
Concept Notes
Contents
Concept Notes
Sl.No.
Title
Pages
1.
International Business and Globalization ......................................... 1-20
2.
International Trade Theories and Application ................................ 21-66
3.
Entry Strategy and Strategic Alliances ........................................... 67-94
4.
International Monetary System..................................................... 95-120
5.
Foreign Exchange Markets ....................................................... 121-130
6.
Global Marketing and Supply Chain ........................................... 131-144
7.
Global Human Resource Management ...................................... 145-156
8.
Global Research and Development ........................................... 157-168
9.
Accounting in the International Business ................................... 169-180
10. Financial Management in International Business....................... 181-192

11. Global Internet and E-Commerce............................................... 193-212
12. Ethics in International Business ................................................. 213-226
Concept Note - 1
International Business and Globalization

1. Introduction
Countries operating in international markets function in a highly competitive
environment. As such, they require a strategy to manage the conflicting pressures that
force them to differentiate their products on the one hand and expect them to enhance
their perceived value and reduce production costs on the other. Pressures from local
competition for customization and price competition from international competitors with
low-cost production bases pose a challenge to international companies. Such companies,
therefore, have to frame a strategy that strikes a balance. When choosing a location, they
have to consider various aspects like labor costs, tax rates, infrastructure, distribution
systems, patent laws, suppliers, and government support. They should also identify the
extent to which customers are willing to pay for customization.
In modern times, globalization has become a key buzzword. While globalization may have
different meanings for different people, its manifestations are found around everyone.
Globalization of business is seen as a creator of wealth that will benefit nations and
individuals worldwide. International business, by forming a network of global links
around the world, engages in international trade and investment.
This unit will discuss the concept of globalization and its importance. It will go on to
talk about the benefits and threats of globalization. The unit will explain the link
between globalization and international business. Finally, it will take a look at the
motives for carrying out international business.
2. Concept of Globalization
For consumers, globalization may mean more choices, reduced prices, and an
indistinct national identity for products and services. For instance, a consumer who
buys a General Motors or Ford car may find that the car is made either in Canada or
Mexico or contains several foreign components. In the service sector, similar trends
can be observed. For instance, the mortgage on a residents US property might be
underwritten by Dutch bank ABN Amro; a persons retirement benefits might be
managed by Germany-based Deutsche Bank or invested in Switzerland-based Nstle.
Globalization also has an impact on the career choices and progression of people. For
instance, a student upon graduation may work for many of the foreign companies in
the US or work in another country for a US, local, or foreign firm.
3. The Face of Globalization

3.1 Benefits from Globalization
In general globalization is higher among the G-7 nations (the G-7 nations are the
industrialized nations of France, Canada, the UK, the US, Italy Japan, and Germany)
than in the developing and emerging economies. Nevertheless, some developed
nations such as Japan are ranked below some of the highly globalized developing and
emerging economies such as Botswana and the Czech Republic.
In 2000, the share of developing countries in world merchandise trade reached the
highest level in 50 years. The trade growth of the 49 least developed countries (LDCs)
surpassed the global average.
Often, the signs of globalization in wealthy nations end up helping poorer economies.
For instance, when a Singaporean tourist visits Laos, he/she is increasing the export
sales of the country by buying services such as hotel stays and tours. Finally, around
95 percent of the 78 million new births every year take place in developing nations.
This indicates that sooner or later the developing nations will provide the bulk of
consumption and production, profiting more from international trade and investment.
3.2 Globalization and the Monopoly Power of Corporations

A common complaint against globalization is that it deprives nations of their
sovereignty. This may occur because of the growing stature of international
organizations such as the World Trade Organization (WTO) whose officials are not
elected by popular vote, and because to some people, globalization only means
Americanization or westernization and therefore a threat to their values and identity.
The WTO may have assumed the role of conflict resolution that was earlier the
domain of bilateral negotiations, but international trade is very much a government-togovernment domain.
3.3 Globalization and the Environment

Another criticism against globalization is that it comes at the expense of the
environment. Environmentalists often complain that firms relocate their operations
mainly to escape the tough rules of pollution in their home country, an argument titled
lowest common denominator or the race to the bottom. This argument too is only
partially true. Though some firms focus on lowering costs regardless of their
environmental responsibilities, others adhere strictly to the codes of environmental
protection. For instance, Dow Chemical, have been credited with environmental
cleanup in Eastern Europe and former East Germany. Further, the truth is that for
most organizations, environmental standards are just one the many criteria used in
determining their location and investment decision.
3.4 Striking a social balance with globalization

Globalization has its set of threats and promises and has both winners and losers at the
regional, national, individual, and organizational levels. For instance, it is felt that
trade benefits all participants and globalization is correlated with higher economic
growth. This, however, may not console an employee who loses his/her job as a result
of foreign competition. Globalization is not the only factor that influences wage levels
and job loss. Research indicates that technology puts downward pressure on the wages
of unskilled labor. The challenge of globalization is to maintain a balance between
public interest and the interest of those who could be suffering its consequences in the
short range.
Globalization is linked with other potential negative repercussions. Global capital
flow makes less regulated emerging economies such as Argentina, Thailand, and
Mexico vulnerable to the volatilities of the foreign exchange markets or international
capital.
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Globalization also exposes national economies to the global economic uncertainties.

Ironically, it is the open economies that are most vulnerable to a global slowdown.
However, the global economies also have the most even income distribution.
Therefore, the benefits and hardships are shared by all segments of the society.
To derive constructive solutions to the debate on foreign trade and investment, what is
needed is a balanced view of globalization that acknowledges both its bright and dark
sides. If the globalization infrastructure is developed in the proper way, globalization can
offer advantages to participating economies, rich or poor. Globalization infrastructure
concerns market efficiency and institutional frameworks that support fair transactions of
product or services and streamline flows of capital labor, commodities, knowledge, and
information. The WTO, World Bank, and the International Monetary Fund (IMF) play a
major role in facilitating the globalization infrastructure.
Finally, a balanced view of globalization needs recognition that is just one of the
factors that affect the well-being of a population.
4. Globalization and International Business

4.1 International Business
International business refers to business activities that involve the transfer of
resources, goods, services, knowledge, skills, or information across national
boundaries. The parties involved may include individuals, company clusters,
international institutions, and government bodies. Of these, the dominant players are
the companies. Their international transactions are evident largely in international
trade and international investment. International trade takes place when a company
exports goods or services to buyers (importers) in another country. International
investment occurs when the company invests resources in business activities outside
its home country.
4.2 International versus Domestic business

International business is the outgrowth of domestic business. In fact, most of the
major organizations active in the international arena started their operations in the
domestic market. Leading Japanese automakers such as Mitsubishi, Toyota, and
Honda started their operations in the domestic market before they began to export to
other countries. As their operations grew in magnitude they decided to set up their
facilities in other countries, mostly in the US.
Companies or individuals that actively invest and operate in another country without
a home base are called international entrepreneurs. They may set up new
international ventures abroad and operate them using their experience, expertise,
flexibility, and networks. For instance, many investors in Hong Kong do not have any
home base in Hong Kong but are active in mainland China where they have their trade
and investment activities.
Though international business is often considered as an extension of domestic
business, it differs significantly from the latter due to differences in operations and
environmental dynamics. Environmentally, the diversity existing between countries
with regard to their interest rates, currency, inflation, cultures, customs, accounting
practices, business practices, political stability, laws, and government regulations are
among the many reasons for the complexity of international business. Hence
international business is perceived to be riskier than domestic business. For instance,
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the variations in currency, interest rates, taxation, and inflation among different
nations have an impact on the profitability of an international firm. For a firm that
borrows and invests in a foreign country, higher tax rates, interest rates, and inflation
rates mean high operation costs and low profitability. On the other hand, for a firm
that deposits money in a foreign bank, high rates of interest mean a high return. The
clash of cultures is not rare in international business. For instance, US-based
companies have a very different corporate culture and understanding of how society
works compared to Japanese companies. Therefore when either of these companies
ventures to globalize across the Pacific, they first need to understand and reconcile
differences in cultures.
International firms also have to face different industrial environments compared to
domestic firms. For instance, Coca-Cola receives money in different currencies and
has to convert and protect its values; it has to decide upon effective tax strategies in
environments with different accounting methods; select an effective human resource
for each market, etc. These issues are indicative of challenges which other
international companies as well as their employees, consumers, regulators, and
competitors face while operating globally. Conditions related to market demand and
supply in a foreign country inevitably differ from those of the home country. These
differences and complexities create more opportunities with risks and uncertainties for
international firms than domestic firms. However, if a firm is concerned about
diversification of the product portfolio or financial portfolio, a presence abroad may
help mitigate risks for firms or investors. Risk refers to unpredictability of
operational and financial outcomes. Uncertainty refers to the unpredictability of
environmental or organizational conditions that affect firm performance. Uncertainty
about organizational or environmental conditions increases the unpredictability of
corporate performance and hence increases risk.
Operationally, international business is more difficult and costly to manage than
economic activities in a single country. If an international firm does not succeed in
leading a complex business effectively, it may not realize the benefits. Local
employees and expatriates may face difficulties in getting along with each other due to
cultural and language differences. The cultural diversity encountered while carrying
out operations in different countries may create problems of coordination,
communication, and motivation. The managerial philosophies and organizational
principles often differ among nations thus increasing the complexity of operation and
management of international business.
5. International Expansion
In general, the motivations for carrying out international business include market
motives, economic motives, and strategic motives. The motives vary from one
business activity to another, producing several motivations for the international firm
with a wide scope of activities in different parts of the world.
5.1 Market Motives

Market motives can be offensive or defensive. An offensive motive seizes market
opportunities in foreign countries through investment or trade. Mary Kall, Amway,
and Avon entered China in the early 1990s in search of opportunities in direct
marketing business in China. Besides being the fastest growing economy with the
largest population in the world, Chinas strong culture of personal connections and
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pervasiveness of closely knit families and friends helped the country become the
biggest direct selling market.
A defensive motive protects and holds the market power or competitive position of a
firm from threats such as domestic rivalry or changes in government policies. Dell
made investments in Europe, Africa, Asia, and Latin America due to the strong
competition in the US.
5.2 Economic Motives

Firms go in for international expansion to increase their return through lower costs
and higher returns. International trade or investment enables companies to benefit
from differences in costs of capital, natural resources, and labors as well as differences
in the regulatory treatments such as taxation, between international and domestic
countries. Many companies have expanded into Asia in search of cheap labor or
resources. For instance, Fossil, a wrist watch manufacturer, has chosen to locate its
headquarters in east Asia rather than its home country, the US.
5.3 Strategic Motives

Firms participate in international business for strategic reasons. They may aim to
capitalize on their distinctive capabilities or resources already developed at home. By
deploying these capabilities or resources in foreign markets or by increasing their
production through international trade, firms may be able to increase their cash flows.
They may also go international to have a first mover advantage before any competitor
takes that position. This results in strategic benefits for the company such as
technological leadership, competitive position, brand image, and customer loyalty.
Firms could have further advantages from vertical integration involving different
countries. For instance, a firm in the oil exploration and drilling business may
integrate downstream by building or acquiring an oil refinery in a foreign country that
has a market for refined products.
Another strategic motive is for a company to follow its major customers abroad. For
instance, Bridgestone, the Japanese tire maker, landed up in the US market when its
customers, the Japanese car makers, exported their cars to the US with tires supplied
by Bridgestone. Because product adaptation and responsiveness are becoming critical
for business success, proximity to foreign customers is an important driver of foreign
investment.
6. Summary
For consumers, globalization may mean more choices, reduced prices, and an
indistinct national identity for products and services. Globalization has its
winners and losers, and it is often accused of coming at the cost of poorer nations.
A common complaint against globalization is that it deprives nations of their
sovereignty. The globalization challenge is to maintain a balance between public
interest and interest of those who are suffering its consequences in the short range.
International business refers to business activities that involve the transfer of
resources, goods, services, knowledge, skills, or information across national
boundaries.
In general, the motivations for carrying out international business include market
motives, economic motives, and strategic motives.
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Example: Globalization and its effect on the German Economy

Globalization seems to have hit Germany, especially its labor market. any
automakers like General Motors (GM), Volkswagen, and DaimlerChrysler, had
been hinting at reducing labor costs. On October 19, 2004, thousands of workers of
GM in Germany marched through the streets of Russelsheim to protest the
companys proposal to cut 12,000 jobs across Europe. The US-based GM had been
incurring losses in its European operations since 2000 and its total losses were
estimated at around US$ 2 billion. The firm, which had about 63,000 employees in
11 factories across Germany, the United Kingdom, Belgium, Poland, and some
other countries, had been seriously contemplating cutting down its costs to make up
for the losses. Workers, who previously had resorted to strikes for wage hikes,
were now more worried about protecting their jobs. The German workforce sought
job security beyond 2010 but GM was unlikely to agree to that.
M
German carmaker, Volkswagen, also planned to cut labor costs by 30 percent by

2011. Apart from automakers, other companies had also planned to reduce the
number of employees.
Germany was once a major economic power in Europe with a huge domestic
market that offered business opportunities to many countries and contributed to
nearly one third of the European Unions economic growth. However, after 1980,
its economy started to decline and its GDP grew by only 1.6 percent during the
latter half of the 1990s. According to the German economy minister, the economic
turmoil was the result of globalization. The reforms initiated by the government
were not bringing in the expected results and the GDP growth for 2005 was
forecast at a low of 1.5 percent as against 2.3 percent for the European Union. The
German economy had hardly grown since 2000. In fact, the economy shrank by 0.1
percent in 2003.
Domestic demand did not increase as much as the industry had expected. Low
wage growth and an uncertain future led to heavy savings, thus creating lower
demand. Further, the proposed reforms by the government had seriously affected
the long-term unemployed.
The German companies that gained profits especially from exports had not shown
much interest in re-investing in Germany. The prime reason for this was high taxes,
which accounted for around 52 percent of the cost of labor as against 30 percent in
the United States during 2001. Also, the German bureaucracy and a rigid labor
market had not only forced many companies to shift their operations from
Germany but also restricted many foreign investors from investing in Germany.
Germany overvalued its currency, the deutsche mark, when it adopted the euro as
its official currency. One euro was equal to 1.95 deutsche marks and this resulted
in high prices and cost structures.
Already, globalization had seen a decrease in the production of cars in Spain and
France as production had shifted to Central European countries where production
costs were lower. It was believed that this might provoke Germany to try and step
into the shoes of Britain, which had converted itself into a service economy.
Compiled from various sources.
Example: India & China- Threat to the US Economy

Globalization, which was expected to benefit the US economy enormously, was
posing a major threat to the US economy as a whole. The countrys trade deficit
had continued to increase and thousands of American workers had lost their jobs.
The trend of lost jobs was at all-time high for the entire period following the Great
Depression of the 1930s, and the losses were especially high in the manufacturing
sector.
Three decades ago, during the initial stages of globalization, many economists
termed it 'a boon' for the US economy. Though there was a shift of certain jobs
from the US to countries with cheap labor, economists explained that since laborintensive works could be undertaken using low skilled workers in less developed
countries, those countries would in turn buy higher-value goods manufactured by
Americas skilled workers. Though some jobs would be lost through globalization,
Americans would still benefit as they would be more than compensated through
low-priced imported goods and increased exports of higher-value goods.
But this theory was rapidly losing ground. China and India were fast emerging as
major economic forces, and many economic relationships were getting realigned.
Most of the foreign direct investments (FDI) in the world were going to China, and
China was ahead of the US in attracting FDI due to its large potential consumer
market. Many US-based multinational companies were outsourcing not only their
blue-collar jobs but also some high-skilled jobs such as programming, engineering,
etc. to India, due to the availability of cheap and skilled labor in India. India and
China produced a larger number of qualified students than the US, so some
economists felt that the competitive advantage in human capital had shifted to these
countries. The present trend of high-end jobs in the US moving to developing
countries like China and India had made many reverse their views on the benefits
of unrestricted international trade for the US. It was felt that the growing
availability of highly skilled as well as cheap workers around the world might
reduce the wages of the highly skilled American workers and increase competition.
Some economists still felt that off-shoring jobs to countries with cheap labor, apart
from being cost effective, would compensate the employers with regard to a drop in
revenues due to the price of exports. Also, the US could overtake countries like India
in still more specialized fields such as drug research and nanotechnology, with their
highly skilled workers and capital investments. However, others believed that in this
globalized world, where there was free flow of technology, countries like China
could easily compete with US in any field. US firms were investing huge amounts in
Asia, and their key advantage, namely technology (IT) was transferred freely to
Asian countries. Basically, for the theory of comparative advantage to work, a
countrys labor, capital, and technology must not move offshore.
Most US-based companies had gained considerably due to globalization but the
US economy as a whole had suffered. Some experts said that the claimed GDP
growth was merely due to unadjusted inflation. The trade deficit of the US had
been negative since 1992 and there was expected to be no change even in the
coming years. Experts opined that the huge trade deficits were mainly due to the open
Contd
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economy of the US, and certain flawed trade policies made with North American
Free Trade Agreement (NAFTA) and the World Trade Organization (WTO), which
had resulted in reduced incomes, job losses, and a rise in poverty. Nevertheless,
imposing new trade barriers, would mean nothing but a disaster.
What was thought would be a boon to the US economy, had gradually turned into a
nightmare, and many political leaders were reconsidering their further support to
globalization in the coming years.
Appendix - 1
Country Differences
Introduction
Culture plays an important role in international business. It not only affects employee
interaction but the overall strategy adopted by a business. The different layers of
culture affect the strategy and operations of an MNE in both the home and the host
country.
The political-legal environment is crucial for an MNE at home as well as abroad. The
political environment identifies key constituencies and the legal environment sets the
rules of the game as well as the range in which a legitimate business can be
conducted.
This unit defines culture and its significance in international business. It then explains
correlates of culture. It takes a look at the key classifications of national cultures. The
unit defines corporate culture and explains other layers of culture. It also discusses
key cultural issues. The unit then explains the political environment in which the
MNE operates and the MNEs relationship with the governments of the home country
and the host country. The unit finally discusses the legal environment in which the
MNE carries out its operations.
Culture and International Business

The Oxford Encyclopedia English Dictionary defines culture as the art and other
manifestations of human intellectual achievement regarded collectively; the customs,
civilization, and achievement of a particular time or people; the way of life of a
particular society or group.
Anthropologists Herskovits and Harris define culture as the man-made part of the
environment and the learned patterns of thought and behavior characteristic of a
population or society.
Modern management scholars such as Hofstede define culture as the collective
programming of the human mind, whereas Trompenaars and Hampden-Turner define
culture as the way in which people solve problems and recognize dilemmas.
The significance of culture to international business cannot be overestimated. For
instance, culture is considered as a key ingredient in the liability of foreignness. At
the firm level, the impact of culture ranges from strategy formulation to FDI and
organization design. Culture has an influence on organizational behavior processes
such as perception, leadership, and motivation, as well as human resource
management, and negotiations, decision making, and management style. Marketing,
supply chain management, and accounting and all other functions are virtually
influenced by culture. Culture also plays a crucial role in international alliances and
mergers.
Correlates of Culture
Culture is correlated with other variables that vary cross-nationally. Culture, however,
cuts across linguistic and religious boundaries and the latter cut across national
boundaries. For instance, Belgium, Nigeria, and Switzerland are countries which have
multiple official languages. South Korea and Lebanon have a large Christian minority
while Northern Ireland has both Catholic and Protestant communities.
Language
Websters dictionary defines language as a systematic means of communicating
ideas or feelings by the use of conventionalized signs, gestures, marks, or especially
articulate vocal sounds. Language is one of the defining expressions of culture. It
determines how norms and values are expressed and communicated.
As there are fundamental differences in the structure of languages and the use of
dialects and slang, language blunders are common. For instance, Coca-Cola is
translated into Chinese as bite the wax tadpole while PepsiCos jingle Pepsi comes
alive means brings your ancestors from the burial place.
The differences in structural and grammatical formats produce different types of
discourse.
Non-verbal language, which is considered to be an important means of
communication, varies across cultures and languages. It is more important in some
cultures than in others. The gestures also vary from one culture to another and their
meanings may lead to embarrassing blunders. For instance, in western cultures, the
hand gesture is used to implore someone to come over. In Korea, it is used for pets
and is not taken as a positive expression if used for a Korean executive.
Religion
Religion contains norms and key values that are reflected in the life of an adherent.
Globally, Christianity claims to have the most adherents while Islam is the fastest
growing. De Blij and Murphy term Christianity, Islam, and Buddhism as global
religions whereas religions dominating a single national culture are termed as cultural
religions.
International business is influenced by religions in many ways. Business firms and
national institutions try to adopt practices that satisfy religious decrees without
undermining modern business practices. For instance, as bank interest is prohibited
under Islamic law, banks in Moslem countries issue shares to depositors and the
borrowers are charged fees and commissions to maintain profitability without any
interest being charged.
National Culture Classifications

Though culture and nation are not similar, cultural and national boundaries partially
overlap. The key classifications of national cultures are described here:
Hofstedes Dimensions of Culture
A survey conducted by Hofstede yielded four underlying assumptions power
distance, uncertainty avoidance, individualism/collectivism, and masculinity/feminity.
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Power distance
Power distance is the extent to which hierarchical differences are accepted in society
and articulated. Power distance should not be confused with power and actual
distribution of wealth in a nation. For instance, Israel is low on power distance though
its income equality is the highest in the developed world. MNEs from cultures
characterized by a high power distance (e.g. Cemex, Mexican cement maker) are less
likely to delegate more authority to their subsidies compared to MNEs from cultures
characterized by a low power distance.
Uncertainty avoidance
Uncertainty avoidance refers to the extent to which uncertainty and ambiguity are
tolerated. According to Hofstede, uncertainty avoidance is the most critical dimension
for foreign investment due to its implication for risk taking and investment. For instance,
MNEs with high uncertainty avoidance are likely to take an incremental approach to
internationalization. For instance, Nissan, the Japanese car manufacturer, lagged behind
its US and European counterparts in establishing production facilities in China.
Individualism/collectivism
Individualism/collectivism refers to the extent to which the self or the group
constitutes the center point of identification for the individual. MNEs from high
collectivist cultures e.g. Taiwans Acer tend to show paternalism i.e. they are less
likely to lay off an employee during a downturn.
Masculinity-Feminity
Masculinity-Feminity describes the extent to which masculine values such as
assertiveness and aggressiveness are emphasized. MNEs from feministic cultures, e.g.
carmakers Saab and Volvo (now owned by General Motors and Ford respectively),
have the tendency to emphasize social rewards and benefits at the workplace that are
viewed as excessive by their parent companies.
Long-term orientation
Long-term orientation (LTO) was originally termed as Confucian Dynamism due to
its being anchored in the Confucian value system. LTO represents values such as
persistence, thrift, and traditional respect for social obligations. In cultures with high
LTO, organizations are likely to adopt a longer planning horizon. Organizations with
such deeply rooted cultures may face difficulties in changing the traditions and
practices.
The LTO is not originally a dimension of Hofstede. Rather, it results from his
cooperation with Michael Bond and his associates.
Schwarts Classification
This framework originated in psychology and has been used to a limited extent in
literature. Schwartz and his associates identify three polar dimensions of culture
which are described here:
Embeddedness versus autonomy
Embeddedness implies emphasis on tradition and social relationships. Autonomy
implies being encouraged to express ones own attributes and finding meaning in
ones own uniqueness.
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Autonomy is of two kinds intellectual autonomy (creativity, self-direction) and

affective autonomy (the pursuit of self-indulgence and stimulation).
Hierarchy versus egalitarianism
Hierarchy means legitimacy of resource allocation and hierarchical role.
Egalitarianism means promoting the welfare of others and transcendence of selfinterests.
Mastery versus harmony
Mastery implies mastering the social environment through ambition, success, etc.
Harmony implies living in peace with nature and society.
Trompenaars and Hampden-turners Classification
Trompenaars and Hampden-Turners classification is drawn largely from the previous
literature but is validated by the authors.
Universalism versus particularism: In universal cultures, legal solutions are
prominent and rules can be applied in all situations. The US, the UK, Canada,
Germany, the Netherlands, and the Scandinavian countries are high on universalism.
Countries high on particularism as for instance, Arab countries, offer more benefits to
employees in return for commitment.
Communitarianism versus individualism:
In individual cultures, people see
themselves chiefly as individuals whereas in communal cultures they see themselves
as group members. Countries high on individualism are Nigeria, Romania, Israel,
Canada, the US, Denmark, and the Czech Republic. Egypt, Mexico, India, Japan, and
Nepal are high on communitarianism.
Neutral versus emotional: In neutral cultures, interactions are objective and
impersonal; in emotional cultures, interactions are laden with emotions. Countries
with high neutral expression are Poland, Ethiopia, Japan, and New Zealand. Countries
high on emotional expression include Oman, Kuwait, Egypt, and Spain.
Diffuse versus specific: In diffuse cultures such as in France, Japan, and Mexico, there
is no clear separation between different life domains. In specific cultures such as in
the US and Germany, interaction is narrowly confined and private life is separated
from work.
Achievement versus ascription: In achievement cultures, people are evaluated on their
performance and status is based on achievement. In ascriptive cultures, status is
bestowed on kinship, birth, and age. Countries high on achievement are the US and
Canada. Countries high on ascription include Saudi Arabia and Kuwait.
Attitudes to time: Countries such as the US, Brazil, and Ireland plan for a shorter time
horizon whereas those like Portugal and Pakistan plan for a longer time horizon.
Attitudes toward the environment: Countries such as the US, Spain, and Israel control
the environment whereas Russia, Nepal, and Venezuela are not geared toward such
control.
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Corporate Culture
Corporate culture is the culture adopted, developed, and disseminated by a
company. It is crucial for an MNE that adopts a global strategy and adopts corporate
culture to integrate its various units. According to Hofstede, corporate culture is more
superficial than the national culture because the imprints on the national culture reside
in deeply embedded values.
Laurent proposed that corporate culture plays a major role in modifying behavior and
artifacts, and beliefs and values but the underlying assumptions can be found deeply
in national culture.
Other Layers of Culture
Ethnicity
In many countries, significant ethnic communities exist. For instance, in the US,
various Asian and Hispanic communities have been growing rapidly, creating a
subculture within the culture of the US. These variations are recognized by the MNE
as they affect many issues from employee relations to consumption patterns.
Industry
Industry is an important layer of culture. For instance, the high-tech industry is
considered to be innovative, informal, and flexible. Common norms and values shared
by marketers where MNEs operate help in facilitating global integration.
Demographics
Hofstede et.al. found that age, education, seniority, and hierarchical level have a
strong affect on differences in values. For instance, Ralston et.al. found that the new
generation of Chinese managers were more individualistic than the previous
generation.
Ideology
Ideology is an important layer of culture. For instance, Maoist ideology provided
many of the beliefs and values in China from the mid-1950s to the mid-1970s.
Key Cultural Issues

A culture distinguishes itself from others based on its beliefs, values, and norms.
Cultural or business etiquette is the manners and behavior that are expected in a
given situation, be it business negotiations, a supervisor-subordinate discussion of
raise, or the behavior expected outside the workplace and after business hours.
Violating business culture is considered to be more offensive in some cultures,
especially those that emphasize realistic behavior and are high on uncertainty
avoidance.
Cultural Stereotypes
Stereotypes are the beliefs about others, their attitudes, and behavior. Auto-stereotypes
are how people see themselves as more distinguished than others. Hetero-stereotypes
are how people are seen by others.
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Stereotypes are important because they affect how MNE staff at headquarters and
other locations perceive other MNE employees.
Cultural Distance
Cultural distance is a measure of the extent to which cultures differ from each other.
It plays a key role in MNE strategies and foreign investment. It also affects alliance
performance and the entry mode.
Convergence and Divergence
The convergence hypothesis assumes that technology and economics combine to
make countries more alike and with the diffusion of MNC practices and global
integration of markets, convergence will accelerate. The divergence hypothesis
assumes that countries will maintain their distinctive characteristics and that those
differences may even become accentuated over time.
The Political Environment

Political behavior is defined as the acquisition, development, securing, and use of
power in relation to other entities, where power is viewed as the capacity of social
actors to overcome the resistance of other actors. The political processes faced by an
MNE, though not unique to international business, are problematic and more complex
than is usually the case with domestic operations.
Economists view political processes as constraints that impede the free flow of
production factors, intermediary and final goods which leads to distortion of demand
and supply.
Political constraints and political agenda are influenced by the nature of international
business activity. For instance, exporters may seek to reduce limitations on hightechnology exportation while importers focus on activities such as tariff reduction, etc.
The Institutional Context
The crucial layer of the political environment is constituted by the historical landscape
of political relations and institutions between and within countries. For instance, after
nearly 40 years of the French colonial rule, former western Africa colonies continue to
import their needs from France.
Affinity or animosity between nations reflects how nations are aligned or estranged
based on their history and political reality. Countries with high political affinity and
historical bonds such as the US and the UK tend to have high levels of mutual trade
and investment. In contrast, trade and investment are prohibited among hostile
countries.
Political considerations often have an influence over third countries. For instance, the
US administration warned the Israeli government to cancel the sale of airborne aircraft
warning systems to China, and threatened Israel with cancellation of aid if it entered
into a deal with China.
14
The Mne-Government Relationship

An important political challenge faced by MNEs is their relationship with the
governments of the host and the home country. The government also affects the legal
and economic environment in which the MNE carries out its operations. Governments
are also responsible for trade and investment policies, transfer-pricing policies, and
capital and exchange controls.
MNE Relationship with the Host Country
Three models that analyze the MNE-government relationship are sovereignty at bay,
dependency, and no-mercantilism. The sovereignty at bay models consider an MNE as
a threat to the national sovereignty of the host country. The dependency model sees a
cooperative relationship only between the MNE and the government of the home
country.
The nature of the relationship between the MNE and host governments is termed as
coopetition a combination of cooperation and competition. From the view of the
government, increasing pressure of global integration, decelerated economic growth,
heightened competition for inbound FDI, and stronger needs for upgrading economic
structure encourage coopetition with MNEs. From the viewpoint of an MNE,
increasingly foreign operations are depending on industrial, educational,
technological, and financial structures built by host governments.
The key political goal of an MNE in a host country is to establish a favorable trade
and investment environment. The MNEs aim to face as few regulatory hurdles as
possible and strive to remove limits on foreign ownership and open access to local
markets. Another important goal for an MNE is to obtain legitimacy. Legitimacy is
the acceptance of the MNE as a natural organ in the local environment.
The aim of the host governments is to protect their national interests as the security of
the nation is concerned. Local governments are also concerned about protecting their
environment from pollution, unsustainable logging, and the like.
The bargaining power of a nation is high when it offers an attractive environment that
is unmatched by other locations. The bargaining power of an MNE is high when it
offers a differential and technologically advanced product which others cannot
provide. Governments compete with each other and are willing to bargain with an
MNE over provisions for investment incentives. The incentives can be used for
preferential tax treatment, infrastructure development, interest subsidies, and loans
and loan guarantees.
MNE and its Home Government
The home government plays a major role in facilitating the political objectives of an
MNE. For instance, when Saudi Arabia was deciding to buy a new aircraft from
Airbus or Boeing, the then US president, Bill Clinton called the king on behalf of
Boeing. The intervention of the government is only to preserve jobs and protect the
interests of the nation. Political pressure is also applied to close the home market to
foreign competition. For instance, US car manufacturers imposed a limit on Japanese
imports to the US in the late 1970s and 1980s.
15
Political Risk
Political risk is the probability of disruption to an MNEs operation from political
forces and events and their correlates. Political risks narrow down the decisionmaking span of the foreign investor, in effect transferring the decision-making power
to the host government. This restrains an MNE from investing or makes it seek a
higher premium to compensate for the risk. Political risk can be measured using
qualitative approaches, scenario approaches, aggregates of expert opinions, decisiontree methods, and quantitative techniques.
Political risks are of three types ownership, operational, and transfer. Ownership risk
represents a threat to the MNEs ability to select or shift to a given governance
structure or the current ownership structure. Operational risk includes changes to the
rules of the game under which the firm carries out its operations. Transfer risk
involves impediments to the transfer of production factors.
The Legal Environment

The Institutional Context
A common law system that originated in England was followed by the US and former
British colonies such as New Zealand and Australia. A civil law system that
originated in the Roman Empire was used by Latin America and Continental Europe.
Civil law is considered to be less flexible than the common law system as the former
follows a legal code which is applied universally.
Another legal system is theocratic law, which is a system that relies on religious code.
For instance, countries such as Saudi Arabia and Iran rely on Islamic law as the basis
of their legal system.
Legal Jurisdiction
Legal jurisdiction is the legal authority under which a legal case can be adjudicated.
It is often difficult to determine legal jurisdiction in international business. The MNE
is mainly subjected to home country and host country laws and less often to third
country laws.
A firm is subject to international regulatory system and international law at the
international jurisdiction level. A firm is subject to laws and regulations of a regional
entity such as the European Union or trade framework such as the ASEAN, at the
regional-global jurisdiction level. The most importation jurisdiction level for an MNE
is at the national level, whether at the home, host, or a third country.
Of late, the WTO has been proactive in deciding jurisdiction and contradictory laws
matters.
Regional Jurisdiction
Regional bodies are also increasingly taking responsibility for enacting and enforcing
laws. At times, uncertainty prevails as to whether regional jurisdiction supersedes
national jurisdiction.
16
National Jurisdiction
The MNE has to comply with domestic jurisdiction at home and foreign jurisdiction
abroad. For instance, the Foreign Corrupt Practices Act in the US is responsible for
bribery and related activities in foreign operations of MNEs.
Legal Issues
Legal issues concerning MNEs include protection of individual and corporate
property, restriction on foreign asset ownership, and contract law.
Rule of Origin Laws
Measuring local content or determining duties is important for knowing product
origin, which is also a frequent requirement in trade and foreign direct investment
(FDI). In developing economies, local content is an important issue. For instance,
India requires local content for domestic production of cars by foreign manufacturers.
Competition Laws
Antitrust legislation and enforcement
The US anti-trust legislation is the most advanced of legislation and has been
emulated by several countries. In recent years, the European Commission (EU) has
been aggressively enforcing anti-trust legislation. For instance, the EU was
investigating Coca-Colas sales and distribution practices as PepsiCo. alleged that the
former had paid retail outlets not to stock Pepsis products.
Subsidies
EU rules prohibit subsidies from the government that give an edge to a firm from one
country over another. However, the EC is less concerned with infringements
detrimental to non-EU firms.
Marketing and Distribution Laws
National laws determine the practices that are allowed in advertising, distribution, and
promotion. For instance, advertising cigarettes on TV is prohibited in many countries.
Product Liability Laws
Product liability laws are stringent in the EU, the US, and many other developed
countries. The laws are, however, lax or not enforceable in many developing
economies.
Treaties
Treaties are agreements signed by two (bilateral) or more (multilateral) nations. A
multilateral treaty that is ratified by many countries with a joint interest in the issue at
hand is called a law-making treaty. Treaties of Friendship, Commerce, and
Navigation (FCN) offer the same rights and privileges enjoyed by domestic businesses
in the other country to firms from signatory countries. Most of the treaties include a
Most Favored Nation (MFN) clause that entitles the signatory state to receive the
same favorable treatment enjoyed by other countries.
Other important treaties include the ones that involve protection of intellectual
property rights.
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Patent Laws
Patent registration is based on nationality a patent issued in the US cannot be
protected from infringement in other countries. A first to invent system grants
patent protection to an entity or a person inventing the product or the technology.
A first to file principle means that the first to file a patent in any country will be
awarded a patent without having to prove that he/she had invented the product or
technology.
Two international treaties that govern patent protection are the Paris Convention for
Protection of Industrial Property and the Patent Cooperation Treaty.
Summary
Culture refers to the art and other manifestations of human intellectual
achievement regarded collectively; the customs, civilization, and achievement of
a particular time or people; the way of life of a particular society or group.
Culture is correlated with other variables that vary cross-nationally. Culture,
however, cuts across linguistic and religious boundaries and the latter cut across
national boundaries.
A survey conducted by Hofstede yielded four underlying assumptions power
distance,
uncertainty
avoidance,
individualism/collectivism,
and
masculinity/feminity.
Schwartz and his associates identify three polar dimensions of culture:
embeddedness versus autonomy, hierarchy versus egalitarianism, and mastery
versus harmony.
Trompenaars and Hampden-Turners classification includes key dimensions such
as universalism versus particularism, communitarianism versus individualism,
neutral versus emotional, diffuse versus specific, achievement versus ascription,
attitudes to time, and attitudes toward the environment.
According to Hofstede, corporate culture is more superficial than national culture
because the imprints on the national culture reside in deeply embedded values.
A culture distinguishes itself from others on the basis of its beliefs, values, and
norms. Key cultural issues include cultural etiquette, cultural stereotypes, cultural
distance, and convergence and divergence.
Political behavior is defined as the acquisition, development, securing, and use
of power in relation to other entities, where power is viewed as the capacity of
social actors to overcome the resistance of other actors.
The crucial layer of the political environment is constituted by the historical
landscape of political relations and institutions between and within countries.
An important political challenge faced by MNEs is their relationship with the
governments of the host and the home country. The government also affects the
legal and economic environment in which the MNE carries out its operations.
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Example: The Goodyear Sumitomo Alliance

In 1999, Goodyear, the Ohio-based tire manufacturer acquired a major stake in
Sumitomo, Japanese tire manufacturer. Goodyear projected the deal as an alliance
of equals rather than calling it a takeover though it took control of Sumitomos
assets. Experts said that by calling it an equal deal, Goodyear prevented Sumitomo
from losing face, which would have meant that Sumitomo was acknowledging its
failure in the market.. Moreover, letting Goodyear be in charge of the whole
operations would have embarrassed the Japanese firm, especially as Japanese
culture lays emphasis on hierarchy.
Industry observers pointed out that culture plays a significant role in international
business. Some observers cited instances where Japanese buyers if not interested in
buying a product said they will think about it rather than saying we are not
interested in buying. In contrast, Americans interpreted the response from the
Japanese as not being straightforward.
Example: Microsofts Illegal Trade Practices

On December 22, 2004, a European Union (EU) court upheld the sanctions
imposed by the European Unions Executive Commission (EC) on Microsoft
Corporation (Microsoft), thus dismissing Microsofts appeal for the suspension of
the sanction. The sanction had been imposed on the US software giant by the EC
on March 24, 2004. The EC concluded its five-year-long investigation into
Microsofts alleged monopolistic behavior by imposing a fine of 497 million euros
($613m; 331m) on Microsoft.. Further, the EC ordered Microsoft to ensure the
availability of a version of Windows without the Windows Media Player (WMP)
and also to share its intellectual property with other competitors in the server
industry so as to enable competitors to sell software which was compatible with
PCs and servers based on Windows. In fact, the EU Commissioner, Mario Monti
also insisted that Microsoft disclose all the codes and related information of its
Windows software, which was used in around 90 percent of the worlds PCs.
The Windows Media Player issue was not an isolated case. There were strikingly
similar issues with regard to the Internet Explorer and Java when Microsoft
breached its contractual obligation to deliver products that were compatible with
Sun Microsystems (Sun) Java technology. All these issues culminated in the antitrust proceedings against Microsoft.
The legal anti-trust battle between the EU and the American software giant started
when Sun filed a case in December 1998 with the EU. Prior to this, on October 7,
1997, Sun had sued Microsoft in a US District Court stating that Microsoft had
refused to provide interface information, which was required by Sun to develop
products compatible with the Windows operating system. The plaintiff further
alleged that by refusing to provide the required intellectual property, Microsoft was
preventing the move to create a conducive and competent platform where all the
players could compete on an equal footing. After five and a half years of enquiry
and three communications to Microsoft, the EU concluded that Microsoft had
broken the European Union competition law and was close to attaining a market
monopoly. The EU investigation also revealed certain facts.
Contd
19
Contd
The decision of the EU on March 24, 2004, represented a milestone in EU history.

Even though this decision was not the first in the field of information technology
(three years earlier, EU had fined Nintendo heavily for abuse of position in the
market of console videogaming), it was the first such in the field of operating
systems for desktop computers and servers. Apart from imposing a huge fine, the
EC also ordered Microsoft to disclose complete and accurate interface
documentation, which would allow non-Microsoft work group servers to achieve
full interoperability with Windows PCs and servers within 120 days from the time
of sentence, and to offer PC manufacturers a version of its Windows client PC
operating system without the Windows media player within 90 days from the time
of sentence.
Apple Computer Inc and Real Networks (Real), competitors of Microsoft,
welcomed the ruling and Real said that the ruling would allow the company to
increase its market share provided conditions for fair competition in the software
market prevailed. Real went to the extent of claiming that the predatory practices of
Microsoft had resulted in a severe loss of revenue for the company and even filed a
lawsuit of US$ 1 billion against Microsoft for loss of revenue.
Microsoft filed an appeal with the European Court of First Instance (CFI) against
the ECs decision on June 7, 2004. On June 25, 2004, it requested the CFI to
suspend the remedies set out by the EC. The CFI issued an order on procedural
matters on July 26, 2004. A two-day hearing regarding Microsofts request for
suspension of the ECs orders before the CFI, started on September 30, 2004.
Finally on December 22, 2004, the CFI dismissed the appeal and said that
Microsoft had not shown that it might suffer serious and irreparable damage as a
result of implementing the ECs decision.
20
Concept Note - 2
International Trade Theories and Application

1. Introduction
There are two schools of thought on international trade. One school favors free trade
while the other advocates protectionism. Advocates of protectionism argue that it is
necessary to protect the home industry from foreign competition. Under protection, it
would be easy to establish an industry in a country. If the industry is at an infant stage,
it needs to be protected from well-established competitors who are already producing
on a large scale. But according to free trade advocates, free trade allows the growth of
exports in a country.
This unit discusses the major theories of international trade. It also describes the
different types of trade barriers.
2. International Trade Theories

International trade is the exchange of goods and services across borders.
2.1 The Mercantilist Doctrine

Mercantilism emerged in the mid-sixteenth century in England as the first theory of
international trade. The doctrine set immense faith in the governments ability to
improve the residents well-being using a system of centralized controls. Under
mercantilism, the government set two goals in foreign economic policy. The primary
goal focused on acquiring gold to increase the nations wealth. Mercantilists identified
the national wealth with the size of the reserves of the precious metals in the nation.
The second policy goal was to extract trade gains from foreigners through controls
and regulations in order to achieve a surplus in balance of trade by minimizing
imports (e.g., tariffs and quotas) and maximizing exports (e.g., subsidies).
However, in a modern economy, gold reserves are simply prospective claims against
goods on foreigners. Moreover, as demonstrated by David Hume in 1752, an influx of
gold would boost the price of exports and increase the domestic price levels.
Therefore, the country with which the gold is held would lose its competitive edge in
price which had enabled it to acquire gold earlier by exporting more than it had
imported. In contrast, the gold lost in the foreign nation would reduce prices and
reinforce its exports. Gold reserves signify a minor portion of the foreign exchange
reserves. These reserves are often used by the government to intervene in foreign
exchange markets in order to influence foreign exchange rates.
Mercantilism overlooks other sources of wealth accumulation of a country such as
workforce skills, quantity of its capital, and the strength of other production inputs
such as natural resources and land.
2.2 Absolute Advantage Theory

The doctrine of laissez-faire in international trade was introduced by Adam Smith in
his 1776 landmark treatise, An Inquiry into the Nature and Causes of Wealth of
Nations. The literal meaning of laissez-faire means freedom of enterprise and
freedom of commerce or let make freely. The keystone of the 19th century
liberalism was elimination of the ubiquitous regulation. According to Smith, all
nations would benefit from free and unregulated trade that would allow individual
countries to specialize in goods that they could best produce due to their natural and
acquired advantages. Smiths trade theory came to be known as the theory of absolute
advantage. The theory states that a nations imports should consist of goods made
more efficiently abroad while exports should include goods that are made efficiently
at home. For instance, Caribbean countries should export bananas since they have an
absolute advantage at home and import apples from Washington which has an
absolute advantage in the US.
According to the absolute advantage theory, the market reaches an efficient end by
itself. The intervention of government in the nations economic life and trade relations
among nations is counterproductive. Free trade would benefit a nation as imports
would cost less than the domestic products it would otherwise produce. In absolute
advantage theory, both the countries would gain from global allocation of national
resources unlike the mercantilist doctrine where the nation could gain from trade only
when the trading partner lost.
2.3 Comparative Advantage Theory

The absolute advantage theory could not explain some situations where, for instance,
one country has an edge over another in producing all goods efficiently. In this
situation would it pay for both the countries? This question was answered by a 19 th
century English economist, David Ricardo in his 1817 book On the Principles of
Political Economy and Taxation. According to him, both the countries would benefit
from trade even if one was more efficient in the production of all goods. Thus, this is
the comparative advantage of a nation in producing a good relative to other nation
that determined international trade flows.
The concept of opportunity cost can be introduced in the theory of comparative
advantage. If the opportunity cost of producing a piece of goods is lower in the home
country than in the other country, the country has a comparative advantage in
producing the goods.
It is also vital to understand the sources of comparative advantage. The immediate
source of trade is the price difference of the same commodity between different
countries; hence the difference in opportunity costs. The difference in price is
determined by the interaction of supply and demand. Therefore, the price differential
is derived from differences in demand conditions, supply conditions, or both. On the
demand side, differences in demand patterns are caused by differences in tastes and
incomes, and thus differences in prices. When two countries share similar consumer
tastes and income levels, income is unlikely to be a major source of differences in
demand. Similarly, differences in tastes may not result in significant demand
differences and thus for trade between countries belonging to the same socio-cultural
matrix. On the supply side, differences in supply patterns are a result of differences in
the patterns of production costs.
Hence, in todays world economy, comparative advantage should be explained by a
reference to comparative production cost differences, which further depends on the
production process of the commodity and on the prices of production factors such as
land, capital, labor, and natural resources. In turn, the factor prices are related to the
factors available in the national economy. The inputs to the production process are
referred to as production factors by economists. The conditions (availability and cost)
of production factors are referred to as the countrys factor endowment. In todays
22
global economy, quality levels of production factors become more crucial for
improving the exports of a country or attracting foreign investment. Thus, factor
endowment should also include the quality level of production factors in todays
international business environment. However, in the 19 th century, because intercountry differences in technology were minor, international variations in comparative
advantage were attributed to different national endowment in terms of cost and
availability. This forms the theoretical root for the Heckscher-Ohlin theorem.
2.4 Heckscher-Ohlin Theorem

The Hecksher-Ohlin theorem was propounded by Swedish economists, Eli Heckscher
ad Bertil Ohlin. The theorem explains the link between the comparative advantage of
nations and national factor endowments. The theorem states that a country has a
comparative advantage in commodities whose production is intensive in its relatively
abundant factor, and will hence export those commodities. Meanwhile, a country
would import commodities whose production was intensive in the countrys relatively
scarce factor of production. Therefore the differences in comparative advantage can be
attributed to the differences in the structure of the economy. A country is considered
to be more relatively efficient in activities suiting its economic structure.
There are several assumptions underlying the Heckscher-Ohlin theorem. First, it
assumes that countries differ in the availability of different factors of production.
Second, while each commodity has its own specific production function, the
production function is assumed to be identical anywhere in the world. The production
function shows the amount of output that can be produced by using a given quantity
of capital and labor. In other words, the theorem assumes that the same amount of
input will produce the same amount of output in any country. Third, the theorem holds
that the technology is constant in all trading countries and that the same technology is
used in all countries. Finally, it assumes that the conditions of demand for factors of
production are the same in all countries. With identical demand conditions,
differences in the relative supply of production factors will lead to differences in the
relative price of that factor between the two countries.
The Heckscher-Ohlin theorem also implies international equalization of prices of
factors of production under free trade the so-called Heckscher-Ohlin law of factor
price equalization. It argues that the exchange of goods between agricultural and
industrial countries would result in an increase in the previously relatively low levels
of land rents and a drop of the high level of industrial wages in the agricultural
country. However, in the industrial country, the opposite change in factor prices
occurs an increase in industrial wages and a decrease in land rents. In addition to
similar factors of production across different countries, the theorem assumes other
conditions under which free commodity trade equalizes factor prices: (1) free
competition in every market; (2) absence of costs of transportation; and (3) after the
beginning of free trade, all commodities continue to be produced in both countries.
The implications of the Heckscher-Ohlin theorem are described here:
1.
Trade in addition to trade gains should be highest among countries with the
highest economic structure differences.
2.
Trade should enable countries to specialize more in the production and export of
goods that are distinct from imports.
23
3.
Trade policy rather than taking the form of trade simulation should take the form
of trade restrictions.
4.
Countries should be exporting goods making use of their relatively abundant

factors.
5.
Free trade should equalize factor prices not between countries with markedly
different factor endowments but between countries with fairly similar relative
factor endowments.
6.
Factor prices should be almost equal between countries with liberal mutual trade.
7.
The differences in factor endowments stimulate international investment and

international investment should be negatively correlated to international trade.
2.5 The Leontief Paradox

The central notion of the Heckscher-Ohlin theorem is that a country exports goods
making use of the abundant factor in the country and imports goods making use of the
scarce factor in the country. This proposition was tested in 1953 in the US by Wassily
Leontief, winner of the 1973 Nobel Prize in Economics. Using the trade figures of
1947 and input-output tables covering 200 industries, he found that US imports were
capital-intensive and exports were labor-intensive. Because these results contradicted
the Heckscher-Ohlin theorem predictions, it has come to be known as the Leontief
Paradox. The study by Leontief motivated further empirical research. The empirical
evidence collected since then shows several paradoxical results and contains serious
challenges to the general applicability of factor endowment explanations in other
countries such as Japan, Canada, India, and Germany.
The Leontief paradox stimulated a search for explanations:
Demand bias for capital-intensive goods: The US demand for capital-intensive
goods is extremely strong that it could reverse the US comparative cost advantage
in such goods.
Existence of trade barriers: The labor-intensive imports were reduced by trade
barriers that were imposed to protect and save jobs in America.
Importance of natural resources: Leontief took into consideration only labor and
capital inputs leaving out natural resource inputs. As natural resources and capital
are often used together in production, a country importing capital-intensive goods
may actually be importing natural resource-intensive goods. For instance, the US
imports crude oil, which is capital-intensive.
Prevalence of factor-intensity reversals: A factor-intensity reversal occurs when the
relative prices of capital and labor change over time, which results in changing the
relative mix of capital and labor in the commodity production process from being
labor-intensive to capital-intensive (or vice versa).
2.6 Human Skills and Technology-based Views

Several scholars have challenged the conventional trade theory which assumed that
there was equivalence in technology and human skills among different nations. The
technology-based and human skills view is regarded as a refinement of the
conventional trade theory. To explain the sources of comparative advantage, the
theory has added two new production factors -- human skills and technology gaps.
24
The human skills theorists explain the source of comparative advantage in terms of the
comparative abundance of high-level human skills and professional skills. According
to Donald B Keesing, these include (1) scientists and engineers; (2) draftsmen and
technicians; (3) skilled manual workers; (4) managers; and (5) other professionals.
Technology theorists argue that certain countries have a special advantage as new
product innovators. According to them, there is an imitation lag that prevents other
countries from instantly duplicating the new products of the innovating country. These
conditions lead to technology gaps in those products that afford an export monopoly
for the innovating country during the period of imitation lag. Similarly, when a firm
comes up with a different and advanced production technique, it will enjoy cost
advantage and lead the world market for some time.
2.7 The Product Life-Cycle Model

The product life-cycle model was proposed by Raymond Vernon in the mid-1960s.
The imitation-gap approach was further developed by Vernon where he suggested that
changes take place in the input requirements of a new product as soon as it becomes
established in a market and becomes standardized in production. As there is a
development in the product cycle, the cost advantage changes accordingly and a
comparative advantage in innovative capacity could be offset by a cost disadvantage.
Vernon developed a four-stage model to explain the behavior of US exports of
manufactures, assuming that the export effects of product innovation are undermined
by lower costs and technological diffusion abroad. This life-cycle model includes four
stages. They are:
1.
The US has an export monopoly in a new product;
2.
Foreign production of this product begins;
3.
The foreign production of the new product becomes competitive in export

markets;
4.
The US becomes an importer of this product which is no longer a new product.
According to Vernon, the US producers may be the first to exploit market

opportunities for a new product that is technology-intensive. The producers will be the
first to produce this new product in the US regardless of the cost of production inputs
in other countries due to their close proximity to suppliers and customers. In this first
stage, the US producers have a monopoly in export markets and focus on building up
sales with no concern for foreign competition. In the second stage, the producers of
other industrialized countries begin manufacturing the product whose production and
design are now standardized. As a consequence of this, the overall growth rates of
exports in the US decline. In the third stage, foreign producers displace US exports in
other export markets. Finally, foreign producers succeed in achieving sufficient
competitive strength arising from lower labor costs and economies of scale to export
to the US market itself.
Vernons theory also states that the product life-cycle model of international trade
associates itself with the life-cycle stage of the product itself. As the product moves
through its life-cycle, the international trade life cycle also changes. The theory
explains changes in trade and production in new product lines.
25
2.8 Linders Income-Preference Similarity Theory

The Hecksher-Ohlin theorem states that the trade incentive is greatest among nations
which have radically different factor endowments. This means that trade chiefly takes
place between developed manufacturing countries and developing countries that
produce labor-intensive goods and primary products such as natural resource
commodities like oil and petroleum.
Staffan B Linder, a Swedish economist, divided international trade into two different
categories -- primary products and manufactures. Linder states that the factor
endowment differences explain trade in natural resource-intensive products but not in
manufactures. According to him, the range of manufactured exports of a country can
be determined by internal demand. International trade in manufactures takes place
primarily among developed nations as nations export only those goods that are
manufactured at home and they will manufacture at home only those goods for which
there is a strong domestic demand.
Linder also asserts that the more similar the preferences in demand for manufactured
goods in two countries, the more intensive will be the potential trade in manufactures
between them. If two countries have the same or similar demand structures, then the
investors and consumers will have the same demand for goods with similar degrees of
sophistication and quality, a phenomenon known as preference similarity. The
similarity results in boosting trade between two industrialized countries. Linder argues
that the determinants of the demand structure can be explained by average per capita
income. Countries that have high per capita income demand high-quality luxury
consumer goods and sophisticated capital goods while countries with low per capita
income demand low quality necessity consumer goods. Consequently, a rich country
that has a comparative advantage while producing high-quality advanced
manufactures will discover their big export markets in other affluent countries where
there is a demand for such products. Similarly, manufactured exports of poor
countries will find their best markets in other poor countries having similar demand
structures. Linder also acknowledges that the effect of per capita income levels on
trade in manufactures may be distorted or constrained by cultural and political
differences, entrepreneurial ignorance, transportation costs, and legislative
obstructions such as tariffs.
2.9 The New Trade Theory

The new trade theory was expounded by Dixit and Norman, Lancaster, Krugman,
Helpman, and Ethier. According to these theorists, countries not only specialize and
trade solely to take advantage of their differences; they also trade due to the increasing
returns, which make specialization beneficial per se. The new trade theory makes
several contributions in understanding international trade.
First, the theorists of the new trade theory introduce the view of an industrial
organization in the trade theory, and include real-life imperfect competition in
international trade. They argue that increasing returns to specialization in many
industries are a result of economies of scale. Economy of scale is reduction of
manufacturing cost per unit as a result of increased production quantity during a given
time period.
26
Second, the theory suggests that inter-industry trade continues to be determined by the
Heckscher-Ohlin theory. In contrast, intra-industry trade is mainly driven by
increasing returns that result from specialization within the industry. This suggests
that comparative advantage from increasing returns that result from industry
specialization and factor endowment differences can coexist since they vary in the
application of inter-industry versus intra-industry trade.
Finally, the new trade theory comprehends the significance of externality in
international trade and specialization. Externality takes place when the action of one
agent has a direct effect on the environment of another agent. In international trade,
externalities include political relations between two countries; government policies;
history of the importing and exporting country; consumption differences between
different cultures, etc. The theorists of new trade theory contend that these
externalities could be the alternatives to comparative advantage as factors that
influence actual patterns of international trade.
The new trade theory has several implications. First, it helps in explaining the
Leontief paradox by bringing in the concept of economies of scale. According to the
theory, a firm engages in trade as it expects increasing returns from larger economies
of scale. These economies may not essentially associate with factor endowment
differences between exporting and importing countries. Scale economies are likely to
lead countries to specialize and trade with a country which is similar in terms of
consumption preferences and income levels. Second, the new trade theory helps in
explaining the intra-industry trade, which is a two-way trade that is carried out with
goods belonging to the same industry. Trade is carried out with the intent to realize
economies of scale, and may not be correlated with factor endowment differences.
Finally, this theory goes on to explain intra-firm trade, which takes place when import
and export activities are carried out between the subsidiaries of the same multinational
enterprise (MNE). MNEs consider intra-firm trade as a facilitator that globally
integrates upstream and downstream activities.
2.10 Theory Assessment

Though no single theory can explain the entire range of motives of international trade,
they collectively offer invaluable insights into why international trade takes place. The
differences in factor endowments are the most general explanation of the pattern of
old trade. Despite its diminishing power in explaining todays international trade, the
comparative advantage theory still has the capability of explaining international trade
in natural resource products. When the factor endowments are extended to include
skilled labors and technologies, the Heckscher-Ohlin theorem can be applied to
current import and export activities between developed and developing nations.
The product life cycle theories and the technological gap (e.g. technology-based views
and human skills) emerge as powerful explanations of trade in new products, i.e.
products made by a skilled workforce using technologies. These technologies and
skills can be used to improve the terms of trade of a country, which is a major concern
of both developed and developing countries. The terms of trade refer to the relative
price of exports, that is, the unit price of exports divided by the unit price of imports.
The terms of trade will improve if the country exports more goods associated with
technologies and human skills. In this case, the foreign trade contribution to the
economic growth of the nation will be stronger. Though the product life-cycle model
27
is not as applicable today as it was at the time it was conceptualized, it still explains
key patterns in the international trade evolution. The import and export structures of a
nation change over time. Similarly, every new product has life stages in the global
marketplace.
The theories which provide insights into the triggers of international trade on trade
between regions with similar levels of income and consumption patterns and
sophisticated manufacturing products are the Leontief Paradox and Linders incomepreference similarity theory. According to these theories, market demands are viewed
as an important parameter for international trade. In reality, international trade today
is driven not only by national differences in factor endowments but also by national
differences in market demand. Intra-regional trade accounts for a high proportion of
the world trade due to similarities in demand structures and income levels, in addition
to efficiencies arising from reduced transaction costs and uncertainty. The limitation
of these theories is that they could not enlighten how trade activities would take place
between nations having similar levels of income with different consumption preferences.
Due to this drawback, the increasing trade between developed countries and industrialized
countries (e.g. Hong Kong, Singapore, South Korea, and Taiwan) or emerging markets
(e.g. India, China, Brazil, Mexico, and Russia). The key driver of this trade phenomenon
seems to be the elevated purchasing power and rising income levels.
Finally, the new trade theory helps in understanding the intra-industry and intra-firm
trade. For explaining international trade, it links national factor endowments with firm
behavior and firm incentives. This link was crucial since firms rather than countries
conduct international trade and investment. The international trade efficiency can be
maximized if economies-of-scale advantages of firms and national factor endowment
differences can be combined and simultaneously realized. The limitation of this theory
is that it overlooks other incentives and focuses only on increasing returns from
economy of scale.
3. Types of Trade Barriers

Trade barriers are divided into two types tariff barriers and non-tariff barriers. Tariff
barriers are official constraints on the importance of certain goods and services in the
form of a total or a partial limitation or in the form of a special levy. Non-tariff
barriers are indirect measures that discriminate against foreign manufacturers in the
domestic market or otherwise distort and constrain trade. While tariff barriers were
reduced during the General Agreement on Tariffs & Trade (GATT) regime, some of
the non-tariff barriers such as subsidies have been reduced. Together tariff and nontariff barriers pose obstacles to international trade.
3.1 Tariff Barriers

Tariff barriers chiefly include tariffs and quotas as their derivatives, in addition to
export controls and anti-dumping laws.
Tariffs
Tariffs are surcharges that an importer must pay above and beyond taxes levied on
domestic goods and services. Tariffs are considered to be transparent and ad valorem
i.e. based on the product or service value. In the 19th century, tariffs were widely used
but were reduced over time. This trend was reversed by the Smooth-Hawley Act of
1930 which pushed tariffs to 60 percent level of the import value.
28
In the following decades, tariffs in the US and other nations substantially declined.
However, tariffs on some products in the US as, for instance, sugar, remained high.
Over the years, remarkable progress has been made toward tariff reduction or
elimination. Some companies make efforts to circumvent tariffs. For example,
Heartland By-Products, a Michigan-based firm, circumvents the tariff on sugar by
buying sugar molasses from its sister company in Canada which makes it from sugar
bought at world prices. The process is then reversed and the molasses is turned into
sugar syrup which is sold to makers of candy, ice cream, and cereals in the US.
Due to low tariffs, governments try to shift products in the high tariff category while
firms develop strategies to benefit from the lower tariff category.
Optimal Tariff
The optimal tariff theory assumes that by imposing tariffs, governments can capture a
significant portion of the profit margin of manufacturers. In other words, assuming
that the exporter cannot willingly raise prices, domestic customers will not have to
pay a higher price, and the government manages to obtain the proceeds that would
have been otherwise obtained by the exporter. The optimal theory also assumes that
the exporter will not absorb the lower prices and will not shift its efforts to other
markets. The theory does not take into consideration the fact that higher tariffs could
trigger smuggling that would eventually end in reducing government revenues.
Infant Industries
The infant industry for tariffs argues that an industry which is new to a developing
country needs protection through tariff walls or it risks being squeezed by global
players before it begin to grow and develop. This argument was raised vigorously by
the US throughout the 19th century, by Japan after World War II, and by Korea in the
1960s. These countries aimed to encourage domestic industry development while
generating revenues for the state at the expense of foreign manufacturers. Consumer
interests were not taken into consideration as demonstrated by international trade
theories. For instance, when US motor vehicles were kept out of Korea and Japan by
the imposition of high tariffs and other barriers, this resulted in higher local prices.
Quotas
Quotas are quantitative limitations on the importation of goods typically spelled in terms
of units. Some quotas allow for an increase that is preset, for instance, an annual increase
of 4 percent, while some quotas allow for a decrease that is preset as contained in the
North America Free Trade Agreement (NAFTA). Quotas can also be established in terms
of market share beyond which cessation of imports or tariffs are triggered.
Quotas hold the quantifiable, definitive protection of domestic producers unlike
tariffs. However, they may lead to unintended consequences. In contrast to tariffs,
quotas do not have the needed potential that could trigger efficiencies arising from the
need to remain competitive with the domestic producers.
Rule of Origin
Tariffs and quotas are administered on the basis of the country of origin, the default
for which is the importing country. The terms for rule of origin differ between types
of tariffs and supports.
29
Rule of origin is usually an issue of contention, however, because the value added to
the product in the country which is transient could be debatable. For instance, the
French government once returned a shipment of cars of US-based Honda saying that
the cars were Japanese and hence fell under the Japanese car imports quota, which had
already been exceeded.
As a remedy to the problems accruing from rule of origin, the World Trade
Organization (WTO) issued a first ever agreement on rules of origin. It required that
the rules be applied in a consistent way, that they are transparent, that they are based
on positive standards, and that they will not distort, restrict, or disrupt trade.
Export Controls
Most of the countries impose a limit on the number of products that can be exported to
other countries especially those nations that are considered an enemy or where the
security of the exporting nation is at risk. Export controls are activated against
products with a national security potential, but also to so-called dual-use products
such as computers and trucks that can have both security and civilian uses.
During emergencies, export controls are used to prevent the export of goods that are
vital to armed forces and the domestic industry, as for example, oil. Export controls
differ from other trade barriers in the sense that they are placed by the exporting country
rather than the importing country. Companies which export goods often pressure their
government to ease export controls by arguing that the importing country will receive
products from competitors where export controls are not strict. Finally, export controls
affect manufacturers in the home country and in the third country. This has relevance
especially in countries such as the US which have substantial surplus in technology
balance of payments. For instance, the US warns Israel to ensure that it does not use
sensitive technologies of the US in its sales to China.
Dumping and Anti-dumping
Dumping is defined by the WTO as selling a product at an unfairly low price, with
the fair price defined as the domestic price, the price charged by an exporter in
another market, or a calculation of production costs. Dumping interferes with the free
flow of trade as it distorts pricing. It also undermines the principle of comparative
advantage as it may cause the exporting country to specialize in any product or service
in which it will not have any advantage over the importing country.
Due to the adverse impact of dumping on trade, the WTO allows remedies against it
but only if material injury has been demonstrated to the domestic industry. In theory,
the extra duties that could be added up to 40 percent of the price of the product can be
brought down to realistic levels, permitting the efficient producers to sell their goods.
The problem arises when retaliation is used in the form of anti-dumping duties for the
protection of inefficient domestic producers.
In 1999, 28 nations had initiated 1,200 anti-dumping measures which are now applied
by developing and developed nations.
3.2 Non-Tariff Barriers

Non-tariff barriers are obstacles to trade, not anchored in laws and official
regulations and therefore are not transparent. It is difficult to deal with a non-tariff
barrier as the offending party will not admit that there is a barrier and will refuse to
30
enter into negotiations for its removal. Some barriers are difficult to detect and
monitor. There are many non-tariff barriers whose combined effect can be substantial.
3.3 Administrative Barriers

Administrative barriers are often used by governments to block the entry of products
even as they argue that the barrier does not exist. An example of an administrative
barrier is labeling. Most countries require product labels to be in local languages,
which is considered to be a reasonable requirement but one that puts an additional
burden on the small exporter who may not find it economically feasible to do.
3.4 Production Subsidies

Subsidies are payments provided by a government or its agencies to domestic
companies in order to make them more competitive vis--vis foreign competitors at
home and/or abroad.
Subsidies bring in an artificial incentive into the production equation of domestic
manufacturers by funneling resources away from their optimal deployment. However,
subsidies, in contrast to tariffs, do not distort the decisions of consumers because they
do not increase prices beyond the global level. According to the WTO, subsidies can
be prohibited, actionable, and non-actionable. Prohibited subsidies require the
recipient to make use of domestic goods rather than using foreign goods or to meet
export targets. Actionable subsidies are disallowed when damage is demonstrated to
the national interests of the company which is complaining. Non-actionable subsidies
include offering support to disenfranchised regions to enable companies to comply
with stringent employment laws and R&D assistance not exceeding one quarter or one
half of the total R&D cost. Countervailing duties cannot be imposed on nonactionable subsidies. These duties are set to counter the impact of subsidies.
3.5 Emergency Import Protection

The WTO recognizes remedies against a surge in imports, defined as a sudden and
dramatic increase in imports or in market share that can cause material damage to the
domestic industry. Though the remedies cannot be targeted at a particular country,
they can set a quota formula for allocating supply among different exporting
countries. A variation of emergency restrictions could be seen while setting voluntary
quotas. For instance, the quotas imposed by the US government to stem the rising
tide of Japanese auto imports are voluntary as the importing country threatens other
measures if no heed is paid to the quotas.
Although emergency import protection is seen to disrupt free trade flow, it can be
justified in that it can safeguard competition by preventing existing players from
making an exit from the market.
3.6 Foreign Sales Corporation

In February 2000, the WTO gave a ruling in response to a complaint by the European
Union that the US makes use of a foreign sales corporation which represents subsidy
to exports. It ruled that the US firms had to face sanctions due to this practice by its
corporations or had to remedy the situation. Such sanctions take the form of
retaliatory tariffs on products in the US, producing an additional barrier to trade in the
opposite part of the trade flow.
31
Foreign sales corporations are offshore corporations that market the products and/or
services of firms in foreign countries. Firms benefited as part of the income
generated by foreign sales corporations as it was excluded from taxes in the US. For
instance, Boeing saved US$ 230 million in 1999 through this mechanism of selling
through foreign sales corporations.
3.7 Embargoes and Boycotts

Embargoes and boycotts halt trade by interfering with the free flow of trade. Both
make an attempt to damage a country by withdrawing international trade benefits. An
embargo is the prohibition on exportation to a designated country. A boycott is the
blank prohibition on importation of all or some goods and services from a designated
country. Boycotts are considered to be non-tariff barriers as firms deny their
existence. They are initiated by national governments. For instance, the US embargo
on Cuba. They are also sometimes initiated by non-government organizations (NGOs)
such as consumer groups and business associations.
Finally, buy local campaigns make efforts to curtail all imports, regardless of the
origin of the country.
3.8 Technical Standards

Technical standards refer to provisions made by government agencies in various
countries that pertain to a large array of areas, for example, safety, pollution, technical
performance, and the like. Companies wishing to sell their products in a country need
to show that that their products meet the standards of the country where they plan to
sell their products. A group appointed by the US National Research Council and
headed by Gary Hufbauer, concluded:
(1) Standards that differ from international norms are employed as a means to protect
domestic producers; (2) restrictive standards are written to match the design features
of domestic products, rather than essential performance criteria; there remains unequal
access to testing and certification systems between domestic producers and exporters
in most nations; (3) there continues to be a failure to accept test results and
certifications performed between domestic producers and exporters in most nations;
(4) there continues to be a failure to accept test results and certifications performed by
competent foreign organizations in multiple markets; and (5) there is significant lack
of transparency in the system for developing technical regulations and assessing
conformity in most countries.
3.9 Corruption
Corruption is another trade barrier. For instance, the US which has anti-bribing
legislation, may refrain from doing business in countries where bribes are expected.
Some exporters also refrain from selling in markets where intellectual property (IP) is
not respected. Trebilcock and Howse argue that IP protection is of interest to
innovating countries such as the US but not of economies such as Taiwan and Korea
which imitate knowledge developed elsewhere.
Ironically, the efforts to fight corruption may also serve as barriers to trade. For
instance, a pres-shipment inspection is carried out in many countries to prevent tax
evasion, fraud, and capital flight by subjecting incoming imports to continuous
inspection by private companies which are contracted. In many cases, such
inspections delay or block imports for protecting domestic producers that may be
associated with the inspectors.
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3.10 Barriers to Service Trade

Barriers to service trade differ from those which affect merchandise trade. As
knowledge plays a major role in a service economy, any limitations on free
information flow, including constraints related to individual mobility e.g. immigration
controls, signify barriers to trade in services. Some of the barriers to trade in services
are identical to tariff barriers in nature.
According to Trebilcock and Howse, in the absence of global regulations and
standards, free trade in services may result in reducing global welfare. For instance,
lax regulation in the banking industry of a country may affect depositors in another
country, resulting in net reduction in global welfare.
4. Summary
Mercantilism emerged in the mid-sixteenth century in England as the first theory
of international trade. The doctrine set immense faith in governments ability to
improve the residents well-being using a system of centralized controls.
The theory of absolute advantage states that imports in a nation should consist of
goods made more efficiently abroad while exports should include goods that are
made efficiently at home.
The concept of opportunity cost can be introduced in the theory of comparative
advantage. If the opportunity cost of producing a piece of goods is lower in the
home country than in the other country, the country has a comparative advantage
in producing the goods.
The Hecksher-Ohlin theorem states that a country has a comparative advantage
in commodities whose production is intensive in its relatively abundant factor,
and will hence export those commodities.
Wassily Leontief found that US imports were capital-intensive and exports were
labor-intensive.
The technology-based and human skills view is regarded as a refinement of the
conventional trade theory. To explain the sources of comparative advantage, the
theory has added two new production factors -- human skills and technology
gaps.
The product life-cycle model was proposed by Raymond Vernon in the mid1960s. The imitation-gap approach was further developed by Vernon where he
suggested that changes take place in the input requirements of a new product as
soon as it becomes established in a market and becomes standardized in
production.
Staffan B Linder, a Swedish economist, divided international trade into two
different categories -- primary products and manufactures. Linder stated that the
factor endowment differences explain trade in natural resource-intensive products
but not in manufactures.
The new trade theory was expounded by Dixit and Norman, Lancaster, Krugman,
Helpman, and Ethier. According to these theorists, countries not only specialize
and trade solely to take advantage of their differences; they also trade due to the
increasing returns, which make specialization beneficial per se.
33
Tariff barriers chiefly include tariffs and quotas as their derivatives, in addition to
export controls and anti-dumping laws.
The optimal tariff theory assumes that by imposing tariffs, governments can
capture a significant portion of the profit margin of manufacturers.
Non-tariff barriers include administrative barriers, production subsidies,
emergency import protection, foreign sales corporations, embargoes and boycotts,
technical standards, and corruption.
Example: China Eliminating its Trade Barriers

In the last two decades, China experienced rapid growth in foreign trade and
investment. Chinas entry into the WTO further strengthened this growth and the
country transformed itself into a market-based economy. China was one of the
worlds leading exporters, and also the biggest single destination for foreign
investment among developing countries. It was likely to play a major role in the
coming multinational trade negotiations around the world. China had also lifted its
trade barriers. It had also reduced tariffs on a range of goods entering the country,
from agricultural products to engineering goods. Some sectors of the Chinese
economy, such as textiles, footwear, and electronics, were likely to benefit from
free trade. The Chinese economy was flexible enough to meet the fast-changing
needs of the global consumer goods market.
According to analysts, India would have to accelerate the pace of its economic
reforms and liberalization to meet the competitive challenge posed by Chinas
entry into the WTO. Chinas entry into the WTO would have both a positive and a
negative impact on India. On the positive side, there would be more transparency in
Chinas rules and regulations on trade, because under the WTO it was mandatory
for trading nations to provide information regarding rules and regulation on trade
and investment to the WTOs general council. If any trade-related problem arose
between China and a trading partner, a dialogue could be initiated under the
WTOs dispute settlement mechanism.
Greater transparency would lead to easier market access for Indian companies,
which were currently hesitant to export to China. On the negative side, the high
transparency of the Chinese system would also give other countries a competitive
edge (such as those in Southeast Asia) in accessing the Chinese market. For similar
reasons, the flow of foreign direct investment to China was likely to increase. This
would prove costly for India. Even now, China attracted the highest amount of FDI
in the world as much as US$ 45 billion annually. With the entry of China into the
WTO, a rule-based trading system would come into operation, paving the way for
even larger amounts of global capital to flow into the country. Being a member of
the WTO, China would have MFN (most favored nation) status, giving it access to
all WTO member countries. Under the WTO rules, China would be guaranteed
non-discriminatory access to the markets of all major industrial countries, which
were members of the WTO. Quid pro quo, foreign companies would be given the
right to trade and invest in China, with the confidence that any concessions granted
by the Chinese government could not be reversed.
Contd
34
Contd
With MFN status, China would move to an even more advantageous position.
According to analysts, the challenge before India was to undertake macroeconomic reforms to step up overall growth. Reforms should include reducing the
fiscal deficit and high borrowings. To compete with China for FDI, India needed to
improve its infrastructure.
Example: Impact of Protectionism on the US Steel Industry

The US steel industry had been in existence since the late 19th century. After
World War II, the US steel industry continued to retain its leadership position
globally. There was hardly any import of steel into the US as the steel firms in
Germany and Japan had been destroyed during the War. The US steel industry
exported a significant amount of the steel it produced. However, by the late 1950s,
Japanese and European steel industries had recovered from the War and started
exporting to the US. While the domestic production of steel increased by 48 percent
between 1950 and the end of the twentieth century, imports grew substantially
during the same period.
Since the late 1960s, the US steel industry had been asking for protection from
imports and subsidies to help alleviate its troubles. The dominance of the US steel
industry seemed to be over by 1970, and domestic steel consumers became
increasingly dependent on cheap imports. During the same time, the development
of electric furnace technology reduced the barriers to entry in the steel industry and
the dominant position of the integrated steel players was challenged for the first
time. In the 1980s, the government imposed quotas limiting imports to 20 percent
of the US market. The industry was also protected by voluntary restraint
agreements on imports. In the late 1990s, the Clinton administration imposed a 12point plan to protect the domestic industry from the dumping of Japanese steel.
In the late 1990s, US steel companies and trade unions came together in a show of
solidarity to curb imports. According to George Becker, president of the United
Steelworkers of America (USWA), the US steelworkers were suffering because of
economic failures in other countries, notably in Russia, Japan, and Brazil. Another
problem was that despite increasing domestic competition in the steel industry,
there was no increase in demand for steel. The mini-mills with their cost-effective
production techniques increased competition in the industry. There was also an
increase in productivity. Output increased from 400 tons in 1990 to 600 tons in
2000. However, since there was no increase in demand, the steel manufacturers had
to cut their labor force.
The Clinton administration faced pressure from the US Congress and the steel
companies backed by trade unions, to take steps to curb imports. The Clinton
administration also hinted at offering relief to the steel industry under Section
201(which allows the government to impose tariffs or quotas on a temporary basis
provided it was proved that imports were harming the domestic industry). The
industry also began lobbying the government to fund its legacy costs, i.e. pension
benefits to employees, and to provide healthcare benefits for employees who had
lost their jobs after the companies filed for bankruptcy and shut down plants.
According to analysts, the estimated cost of funding the legacy costs would be
between US$10 billion and US$ 13 billion.
Contd
35
Contd
In June 2001, former president of the Unites States, George W Bush (Bush),
announced his Steel Program. In March 2002, the president imposed tariff measures
to help domestic producers compete with imported steel. These tariff and quota
measures were not applicable to Canada, Mexico, Israel, and Jordan, USs free
trade partners. Most developing countries were also excluded from these measures
provided their share of the total imports during 1996-97 was less than 3 percent. In
August 2002, the government decided against imposing anti-dumping duties on
cold-roll steel from five countries (Japan, Australia, India, Sweden, and Thailand).
This decision was based on the finding by the US International Trade Commission
(USITC) that the import of cold-roll steel was not harming the domestic industry.
Further, the government also announced that it would increase the number of steel
products that were exempted from the tariffs imposed in March 2002 to 178.
However, supporters of free trade and industries using steel hailed the decision
saying that steel companies were already benefiting from higher prices because of
the earlier announced tariffs. Bushs tariff measures to protect the domestic steel
industry were hailed by supporters of protectionism but were vehemently criticized
by proponents of free trade. Some analysts felt that the US steel industry should be
protected not only because of the pride associated with it but also because of its key
role in the US economy. The importance of steel as a commodity in the US
economy was next only to oil. Steel was a source of political and economic strength
for the country. Some of these analysts added that major steel producing countries
such as Japan and Korea were not dependable trading partners as they had in the
past resorted to unfair trade practices such as dumping and predatory pricing. Thus
it made sense for the US steel industry to be protected. Some analysts also believed
that without protection, the US steel industry would find it difficult to reorganize
and become more competitive. They argued that protection from foreign
competition had allowed the industry in the1980s to cut down 60 percent of its
workforce and to spend US$ 23 billion on modernizing facilities. Because of
protection, the industry was able to regain its leadership position in quality and
productivity, and in 1991 experienced its highest level of exports since 1970.
Another justification was the legacy costs of the industry. In the early 2000s, the
industry was finding it difficult to fund these legacy costs, which included healthcare
and pension benefits to around 600,000 retirees and their dependents. In 2002, the
number of employees in the industry was 142,000, 60 percent down from its peak in
the early 1970s. With this number, the industry was not able to finance the legacy
costs of the large number of retirees. The government could use the funds generated
from higher tariffs to help the industry meet its healthcare and pension costs.
The governments protectionist policies had adversely affected market efficiency
and innovation in the industry some experts observed. Imposition of Section 201
tariff measures would increase government intervention in an industry that was
already protected, they felt. Statistics show that 80 percent of imports into the US
were already subject to tariffs under the US anti-dumping laws. These laws allowed
the government to impose tariffs on steel products that were subsidized by the
foreign governments and dumped in the US. But these measures did not seem to be
helping the still-struggling industry.
Contd
36
Contd
These analysts felt that the industry was struggling on account of homegrown
problems. Before the government started protecting the domestic steel industry in
the late 1960s, the average compensation in the industry was almost equal to the
average compensation in the manufacturing sector. In the early 2000s, the average
compensation was more than 50 percent higher than that in the manufacturing
sector as a whole. This was mainly because the steel industry was highly unionized
and the strong trade unions without any threat of foreign competition could
negotiate high compensation packages. Thus, far from being of benefit,
protectionism was actually responsible for many of the ills of the industry in the
early 2000s.
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Appendix-2
The Strategy of International Business

Introduction
International business managers increase the performance of their firm by expanding
into foreign markets. They also deal with competitive pressures for competing in the
global marketplace. Firms pursue different strategies when competing internationally.
This unit discusses the strategies pursued by firms for competing in international
markets. It then goes on to explain how firms increase their profitability by expanding
globally. It discusses the pressures faced by firms in global markets related to cost
reductions and local responsiveness. Finally, the unit takes a look at how firms choose
their strategies when competing internationally.
Strategy and the Firm

The strategy of a firm can be defined as the actions that managers take to attain the
goals of the firm. For most firms, the major goal is to maximize their value for their
owners, the shareholders. The value of a firm can be maximized by pursuing strategies
that increase the profitability of the firm and its rate of profit growth over time.
Profitability is the rate of return that the firm makes on its invested capital (ROIC).
ROIC is calculated by dividing the firms net profits by total invested capital. Profit
growth can be measured by the percentage increase in net profits over time. Higher
profitability and profit growth help in maximizing the value of a firm and thus the
returns acquired by the owners and shareholders.
To maximize a firms profitability, managers pursue strategies that lower costs or add
value to the firms products, which enable the firm to increase prices. Managers can
increase the profit growth rate by pursuing strategies to sell more products in existing
markets or by entering new markets.
Value Creation
By creating more value, firms can increase their profitability. The value created by a
firm is measured by the difference between its cost of production and the value
perceived by the consumers in its products. However, the price charged by a firm for a
product or a service is less than the value placed by the consumer. This is because
consumers capture some of that value in the form of consumer surplus. The consumer
is able to do this because the firm competes with other firms for the customers
business, so the firm has to charge a lower price than it could have if it was the only
supplier.
The strategy that focuses on lowering production costs is called low-cost strategy. The
strategy that focuses chiefly on increasing the product attractiveness is called
differentiation strategy. Michael Porter argues that low cost and differentiation are
two strategies that create value and help a firm attain competitive advantage in an
industry. According to Porter, firms that create superior value get superior
profitability. Superior value could be created by driving down the cost structure of the
business and/or differentiating its product so that the consumers value it more and are
ready to pay a premium.
38
Strategic Positioning
According to Porter, a firm has to be explicit about its choice of strategic emphasis
with regard to value creation and low cost. A firm should also be clear about
configuring its internal operations for supporting that strategic emphasis.
Porter emphasizes that it is crucial for management to decide where the firm wants to
be positioned with regard to cost and value and accordingly configure its operations
and manage them efficiently.
Operations
The firms operations can be thought of as a value chain consisting of distinct value
creation activities including production, marketing and sales, materials management,
research and development, human resources, information systems, and the firm
infrastructure. The operations or value creation activities can be categorized as
primary activities and support activities. For a firm to implement its strategies
efficiently, it should manage these strategies effectively.
Primary activities
Primary activities deal with the design, creation, delivery, marketing, support, and
after-sales service of a product. The primary activities are divided into four functions
such as research and development, production, marketing and sales, and customer
service.
Research and development (R&D) is concerned with the product design and the
production process. R&D increases the products functionality through superior
design making it attractive for the customers to buy the product. In addition, R&D
also results in a more efficient production process, thereby cutting the costs of
production. Either way, R&D creates value.
Production is concerned with the creation of a product or service. For physical
products, production means manufacturing processes and their output. An example of
physical production could be production of an automobile in an assembly line. For
services such as healthcare or banking, production occurs when the service is
delivered to the customers. The production activity of a firm creates value by carrying
out its activities efficiently so that it results in lower costs of production or a product
of high quality, or both.
The marketing and sales functions create value in several ways. Marketing through
brand positioning and advertising, increases the value the customers perceive to be
contained in the product. If these create a favorable impression in the minds of the
consumers, the firm can charge a premium.
The marketing and sales function also creates value by discovering the needs of the
consumers and communicating them back to the R&D function, which can then
design products that will suit the needs of the consumers.
The role of the service activity is to offer after-sales service and support. By offering
support and solving the problems of consumers, this function creates a perception of
superior value in the consumers minds.
39
Support activities
The support activities of the value chain provide inputs for the primary activities to
take place. For a firm to attain competitive advantage, the support activities are as
important as the primary activities. The transmission of physical materials through the
value chain, from procurement through production to distribution is controlled by the
logistics function. The efficiency with which these functions are carried out can
significantly lower costs, thereby creating more value.
The human resource (HR) function creates value by ensuring that the firm has the
right mix of people to perform its value creation activities efficiently. The HR also
ensures that the people are adequately trained, motivated, and compensated to carry
out the value creation activities efficiently.
Information systems are electronic systems that track sales, manage inventory, price
and sell products, deal with customer service queries, etc. Information systems
coupled with the communication features of the Internet can help in altering the
efficiency and effectiveness with which the firm manages its value chain activities.
Firm infrastructure is the final support activity. The infrastructure includes the control
systems, organizational structure, and culture of the firm. As the top management
exerts significant influence in shaping these aspects of a firm, it is also viewed as part
of the firms infrastructure. The top management shapes the firms infrastructure
through strong leadership, thereby enhancing the performance of all the value chain
activities.
Global Expansion and Profitability

Global expansion helps firms increase their profitability and profit growth rate. Firms
operating internationally can:
Expand the market for their local products by selling them in international
markets.
Realize location economies by dispersing individual value creation activities to
those locations across the globe where they can be carried out effectively and
efficiently.
Realize greater cost economies by serving the global market from a central
location, thus reducing the value chain costs.
Leverage valuable skills developed in foreign operations to earn greater return by
transferring them to other entities within the global network of operations of the
firm.
Market expansion: Leveraging products and competencies
A firm can increase its growth rate by taking goods or services developed
domestically and selling them internationally. For instance, automobile companies
such as Toyota and Volkswagen grew by developing products at home and later
selling them worldwide. The returns from such a strategy can be significant if the
competitor in nations which a country enters lacks comparable products.
The success of multinational companies that expand in this manner not only depends
on the product or services offered by them in the international markets but also on the
core competencies that underlie the production, development, and marketing of those
40
goods or services. Core competencies refer to skills within the firm that competitors
cannot easily match or imitate. These skills may be present in any of the value
creation activities of the firm production, marketing, R&D, human resources,
logistics general management, etc. Such skills are expressed in product offerings that
other firms cannot imitate or find it difficult to imitate. Core competencies form the
basis for the firms competitive advantage. They allow a firm to reduce the value
creation costs and/or create a value so that their products can be premiumly priced.
For instance, Proctor & Gamble has a core competency in developing and marketing
name brand consumer products.
Location Economies
Countries differ in different dimensions such as economic, political, legal, and cultural
and these differences can either lower or raise the costs of doing business in those
countries. According to the theory of international trade, certain countries have a
comparative advantage in the production of certain factors due to factor cost
differences. For instance, Japan excels in the production of automobiles and consumer
electronics and the US excels in the field of biotechnology, pharmaceuticals, software,
and financial services.
For a firm that tries to survive in a competitive global market ( a market where the
trade barriers and transportation costs are negligible), the firm can benefit by basing
its value creation activities at the location where political, cultural, and economic
conditions including relative factor costs are conducive to the performance of that
activity.
Firms pursuing such strategies realize location economies which can be defined as
the economies that arise from performing a value creation activity in the optimal
location of that activity, wherever in the world that might be. Locating a value
creation activity in the optimal location can have one of two effects. It can lower value
creation costs and help the firm to achieve a low-cost position and/or enable a firm to
differentiate its products from those of competitors.
Experience Effects
The experience curve refers to systematic reductions in production costs that have
been observed to occur over the life of a product. Some studies have observed that
production costs decline by some quantity each time the cumulative output doubles.
This was observed in the aircraft industry where each time the cumulative output of
airframes doubled, the unit costs declined by 80 percent of their previous level.
Learning Effects
Learning effects are savings in cost that come from learning by doing. For instance,
labor learns more efficiently by repeating how to carry out a task, such as assembling
airframes. The productivity of labor is enhanced over time as the laborers learn to
perform the tasks more efficiently. Similarly, in production facilities, management
learns to manage new operations efficiently over time. Thus the increasing efficiency
and management and labor productivity result in a decline in production costs, which
in turn enhances the profitability of the firm.
Learning effects become more significant when technologically complex tasks are
repeated, because there is more to be learned about the task. Thus learning effects are
noteworthy in an assembly process involving 1,000 complex steps than in just 100
41
simple steps. However, the learning effects are important only during the start-up
period and disappear after two to three years. Any decline in the experience curve
after such a point is attributed to economies of scale.
Economies of Scale
Economies of scale refer to the reductions in unit costs achieved by producing a large
volume of a product. Attaining economies of scale helps in lowering unit costs of a
firm and increases its profitability. There are a number of sources for economies of
scale. First, the ability to spread fixed costs over a large volume. Fixed costs are costs
incurred in a setting up a production facility, developing a new product, etc. Second, a
firm may not be able to attain efficient scale of production unless it serves the global
markets.
Finally, as global sales increase the firms size, its bargaining power increases. This
may allow it to barrage down its cost of inputs, helping it boost its profitability.
Leveraging on Subsidiary Skills
Valuable skills are developed by a firm in its home market and are then transferred to
foreign operations. For instance, Wal-Mart developed its retailing skills in the US and
then transferred them to its foreign operations. However, for mature multinationals
that already have a network of subsidiary operations in foreign markets, valuable
skills can be developed in foreign subsidiaries as well.
Leveraging on the skills developed within subsidiaries and applied to the firms other
operations under the firms global network may create value. For instance,
McDonalds finds in its foreign franchisees a source of valuable ideas. Due to low
growth in France, McDonalds franchisees experimented with the menu as well as the
layout and theme of restaurants. Following the change, the increase in same stores
sales grew from 1 percent to 3.4 percent in 2002. Impressed by the idea, executives at
McDonalds adopted similar changes at other McDonalds restaurants where same
stores sales growth was sluggish, including in the US.
This phenomenon creates new challenges for managers of multinational enterprises.
First, they should have the humility to recognize that valuable skills that lead to
competencies can arise anywhere within the global network of the firm and not just at
the corporate center. Second, they should establish an incentive system that
encourages local employees to acquire new skills. Third, managers should have a
process to identify when valuable skills have been created in a subsidiary. Finally,
managers have to act as facilitators for transferring the valuable skills within the firm.
Pressures for Cost and Local Responsiveness

Firms competing in a global marketplace face two types of competitive pressures that
have an effect on their ability to realize location economies and experience effects, for
leveraging on products and transferring competencies and skills within the firm. They
face pressures for cost reduction and pressures for local responsiveness. These
pressures place competitive demands on a firm. For responding to cost pressures, a
firm has to minimize its unit costs. For responding to pressures of local
responsiveness, a firm has to differentiate its marketing strategy and product offering
from one country to another in a bid to accommodate diverse sets of demands that
42
arise due to national differences in consumer tastes and preferences, distribution

channels, business practices, competitive conditions, and government policies. As
differentiation across countries may involve significant duplication and a lack of
standardization of products, it may increase costs.
Cost Reduction Pressures
International business often faces cost pressures in competitive global markets. For
responding to cost pressures, a firm has to lower its value creation costs. For instance,
a manufacturer may mass-produce a product at an optimal location in the world and
may outsource certain functions to low-cost suppliers in a bid to reduce costs.
Cost reduction pressures can be intense in industries where commodity-type products
are produced, where differentiation on non-price factors is difficult, and price is the
major competitive weapon. This is the case with products that serve universal needs.
Universal needs exist when tastes and preferences of consumers in different nations
are similar if not identical. Examples are conventional commodity products such as
petroleum, sugar, steel, etc. It is also the case with several industrial and consumer
products such as personal computers, liquid crystal display screens, handheld
calculators, and semiconductor chips.
Cost reduction pressures are also intense in industries where major competitors are
based in low-cost locations, where consumers are powerful and face low switching
costs, and where there is persistent excess capacity. The liberalization of the world
trade and investment environment by facilitating greater international competition has
resulted in an increase in cost pressures.
Local Responsiveness Pressures
Local responsiveness pressures arise from national differences in consumer tastes and
preferences, infrastructure, business practices, distribution channels, and from the
demand of the host-government. To respond to these pressures, a firm has to
differentiate its products and marketing strategy across countries to accommodate
these factors, all of which tend to raise the cost structure of the firm.
Differences in consumer tastes and preferences
Consumer tastes and preferences differ significantly across countries due to deeply
rooted historic or cultural reasons. In such cases, a multinationals marketing message
should be customized to appeal to the local consumers. This creates pressures for a
firm to delegate production and marketing functions and responsibilities to the
overseas subsidiaries of a firm. For instance, consumers in North America have a
strong demand for pickup trucks whereas the European consumers consider pickup
trucks as utility vehicles because of which these are purchased mostly by firms as
opposed to individuals.
Some commentators argue that consumer demands for localization are on the decline
worldwide. This has been highlighted by the fact that modern communication and
transport technologies have created conditions for convergence of consumer tastes and
preferences from different nations. This has resulted in the emergence of several
global markets with standardized consumer products. For instance, companies and
products such as Coca-Colas soft drinks, McDonalds burgers, Nokias cell phones,
and Sonys PlayStations have gained worldwide acceptance.
43
However, significant differences in consumer tastes and preferences still exist across
nations and cultures. International business managers do not yet have the luxury to
ignore such differences.
Differences in infrastructure and traditional practices
The local responsiveness pressures that arise from differences in infrastructure and
traditional practices create a need for product customization. This requires a firm to
delegate its manufacturing and production functions to its foreign subsidiaries. For
example, in North America, electrical systems are based on 110 volts whereas in
European countries, the standard is 240 volts. Thus, domestic electrical appliances are
required to be customized for this difference in infrastructure. The traditional practices
also differ among nations. For instance, people in Britain drive left-hand cars thus
creating a demand for left-hand cars whereas in France, people drive right-hand drive
cars and hence want right-hand drive cars.
Differences in distribution channels
The marketing strategies of a firm have to be responsive to differences in distribution
channels among countries, which may demand delegation of the marketing functions
to national subsidiaries. For instance, in the pharmaceutical industry, the Japanese and
the British systems are radically different from the US system. Japanese and British
doctors do not respond to a high-pressure sales force. Thus, pharmaceutical companies
have to adopt different marketing practices in Japan and Britain compared with what
they follow in the US.
Host-government demands
Political and economic demands imposed by governments of the host country may
require local responsiveness. For example, pharmaceutical companies are subject to
registration procedures, local clinical testing, and pricing restrictions, all of which
make it essential that the manufacturing and marketing of a drug should meet local
requirements. As governments and government agencies control a significant
proportion of the healthcare budget in most of the countries, they are in a powerful
position to demand a high level of local responsiveness.
In general, threats of protectionism, local content rules, and economic nationalism
dictate that international businesses manufacture locally. For example, Canada-based
manufacturer of railcars, jet boats, and aircraft, Bombardier, has 12 railcar factories in
Europe. Critics argue that the resulting duplication of manufacturing facilities leads to
high costs and helps explain why Bombardier makes lower profit margins on its
railcar operations than on its other line of businesses. In reply, Bombardier managers
argue that in Europe, informal rules with regard to local content favor people using
local workers. For selling railcars in Germany, they claim manufacturing should be
done in Germany. For addressing its cost structure in Europe, Bombardier has
centralized its engineering and purchasing functions but has no plans to centralize
manufacturing.
Choosing a Strategy
When competing internationally, firms typically select from one of the four strategies
global standardization strategy, localization strategy, transnational strategy, and
international strategy. The appropriateness of each strategy varies given the extent of
cost reduction and local responsiveness pressures.
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Global Standardization Strategy

Firms pursuing a global standardization strategy focus on increasing profitability and
profit growth by making use of the reductions in cost arising from location economies,
learning effects, and economies of scale -- that is, the strategic goal of a firm is to
pursue a low-cost strategy on a global scale. The marketing, R&D, and production
activities of a firm that pursues a global standardization strategy are concentrated in
some favorable locations. Such firms do not make any attempt to customize their
product offering and marketing strategy to local conditions as customization involves
shorter production runs and the duplication of functions, which may increase costs.
Instead, firms prefer to market a standardized product worldwide to reap the
maximum benefits from learning effects and economies of scale. They may also make
use of their cost advantage for supporting aggressive pricing in world markets.
The global standardization strategy makes a lot of sense when the demand for local
responsiveness is minimal and there are strong pressures for cost reductions. These
conditions are prevalent in many industrial goods industries, whose products serve
universal needs. For instance, in the semiconductor industry, global standards have
emerged, creating a huge demand for standardized global products. Accordingly,
companies such as Texas Instruments, Intel, and Motorola pursue a global
standardization strategy. However, these conditions are not found in consumer goods
markets, where the demand for local responsiveness is high.
Localization Strategy
A localization strategy focuses on increasing the profitability of a firm by customizing
its goods or services so that they offer a good match to tastes and preferences in
different national markets. Localization can be appropriate when cost pressures are
not too intense and when there are substantial differences across nations with regard to
consumer tastes and preferences. By customizing a product to suit local demands, a
firm increases the product value in the local market. However, as customization
involves duplication of functions and smaller production runs, it limits the ability of a
firm to capture the cost reductions that are associated with mass-producing of a
standardized product for global consumption. MTV is a good example of a company
that has adopted the localization strategy. If it had not localized its programs, it would
have lost its market share to local competitors; its advertising revenues would have
fallen, and its profitability would have declined.
Transnational Strategy
When a firm simultaneously faces strong cost pressures and pressures for local
responsiveness, it is advisable for it to pursue a transnational strategy.
According to researchers Christopher Bartlett and Sumantra Ghoshal, in todays
global environment, competitive pressures are so intense that to survive, firms need to
do anything to respond to pressures for cost reductions and local responsiveness.
Firms should realize experience effects and location economies for leveraging on
products internationally, for transferring core competencies and skills within the
company, and for paying attention to local responsiveness pressures. Bartlett and
Ghoshal note that in a modern multinational enterprise, core competencies and skills
do not reside just in the home country but can also be developed in any of the firms
operations worldwide. Thus, they maintain that product offerings and skills should not
45
just flow from home country to foreign subsidiary but also from foreign subsidiary to
home country and foreign subsidiary to foreign subsidiary. In other words,
transnational enterprises should focus on leveraging on the skills of the subsidiary.
In essence, firms pursuing a transnational strategy make attempts to simultaneously
achieve low costs from location economies, learning effects, and economies of scale;
differentiate their product offerings across geographic markets to account for local
differences; and foster a multidirectional flow of skills between different subsidiaries
of the firm. The transnational strategy is not easy to pursue as it places conflicting
demands on the company. Differentiating the product in different geographic markets
to suit local demands may increase costs, which is in contrast to the firms goal of
reducing costs.
International Strategy
Some multinationals find themselves in a fortunate position where they confront low
cost pressures and low pressures for local responsiveness. Such firms pursue an
international strategy where products are produced in the domestic market and are
then sold in international markets with minimal localization. The distinguishing
feature of such firms is that they sell products that serve universal needs but do not
face significant competitors and thus, unlike firms pursuing a global standardization
strategy, are not confronted with pressures to reduce their cost structures. Xerox found
itself in such position in the 1960s after it invented and commercialized a photocopier.
The technology was protected by patents so Xerox had no competition and had a
monopoly. The product served universal needs and was highly valued in many
developed nations. Thus, Xerox sold the same basic product worldwide, charging a
relative high price. Since Xerox did not face any direct competitor, it did not have to
deal with strong pressures to minimize its cost structure.
Firms pursuing an international strategy have followed a similar developmental
pattern as they have expanded into foreign markets. They tend to centralize product
development functions such as R&D at home. However, they may also make attempts
to establish manufacturing and marketing functions in each major geographic region
or country where they conduct their business. The resulting duplication can increase
costs, but this is not a major issue if a firm does not face strong pressures to reduce
costs. Though the firms may undertake some local customization of marketing
strategy and product offering, this may be limited in scope. Eventually, in most of the
firms that pursue an international strategy, the head office retains tight control over
product and marketing strategy.
Summary
The strategy of a firm can be defined as the actions that managers take to attain
the goals of the firm.
The value created by a firm is measured by the difference between its cost of
production and the value perceived by the consumers in its products.
The operations or value creation activities can be categorized as primary activities
and support activities. For a firm to implement its strategies efficiently, it should
manage these strategies effectively.
46
after-sales service of a product. The primary activities are divided into four
functions -- research and development, production, marketing and sales, and
customer service.
The support activities of the value chain provide inputs for the primary activities
to take place.
Global expansion helps firms increase their profitability and profit growth rate.
Firms operating internationally can expand the market for their local products by
selling them in international markets, by realizing location economies, by
realizing greater cost economies, and by leveraging on valuable skills developed
in foreign operations.
Firms competing in a global marketplace face two types of competitive pressures
pressures for cost reduction and pressures for local responsiveness. These
pressures have an effect on their ability to realize location economies and
experience effects, for leveraging products and transferring competencies and
skills within the firm.
When competing internationally, firms typically select from one of the four
strategies global standardization strategy, localization strategy, transnational
strategy, and international strategy.
Example: Innovation as a Core Competency at Whirlpool

All through the 1990s, Whirlpool Corporation (Whirlpool) had focused on having
quality and cost reduction as its core competency. David R. Whitwam (Whitwam),
chairman and CEO of Whirlpool, believed that only innovative products could
command premium prices and build customer loyalty. He emphasized the need to
develop a culture that would spur Whirlpools growth through consumer-focused
innovation. This would be a part of the companys competitive strategy. In fact,
Whitwam wanted to make innovation a core competency at Whirlpool. Moreover,
he did not want creativity to be limited to a few people in the organization; he
wanted all the employees to be creative.
The practical aspect of such an initiative was also overwhelming. Whirlpool had to
first figure out what it meant by innovation, how to measure success or failure, and
how to inculcate creativity in its people.
Initially, Whirlpool had trouble deciding on its definition of innovation. The top
management decided that for any idea to be considered innovative, it had to meet
three criteria innovative
it had to create a competitive advantage, it had to be
unique and differentiating, and it had to create shareholder value. However, after
working for about three years on those metrics, the management realized that these
criteria alone would not be sufficient. Measuring the results was equally difficult.
Linking the results of an innovation to revenues was another problem. The
management at Whirlpool also had to consider what should be the measure of
success or failure: the number of employees trained in innovation or the revenue
generated from innovation? What should the goal for revenue generated from
innovation in a year be: should it be US$500 million, or should it be US$1 billion?
Contd
47
Contd
There was also the aspect of training the employees in creativity, giving them
access to expertise and small amounts of seed funding, the freedom to work on
their ideas, and a way to share information. In short, Whirlpool needed to set up a
formal framework to bring about a culture change and supporting infrastructure
like IT to support this change initiative. Another challenging aspect was that
everything had to be built up from scratch.
While the core groups were being trained, Nancy T Snyder (Snyder), vice president
of leadership and strategic competency development at Whirlpool, focused on
getting the rest of the companys global workforce involved in the initiative
through the Internet and innovation fairs. Strategos, a US-based management
consultancy firm, helped Whirlpool to put the necessary infrastructure in place and
to use Information Technology (IT) to facilitate the objective. Whirlpool reengineered management processes that slowed down innovation and used IT to
improve and accelerate the innovation chain from idea to final product. Instead of
going in for a few big projects, it encouraged many low-cost stratlets (also
known as small strategies).
Snyder put a leadership team in place. The team included a global director of KM,
three regional vice presidents of innovation, and regional innovation boards (IBoards) to set goals, allocate resources, and review ideas for funding. Executive Iboards in each region strove to keep the companys innovation pipeline full. They
were responsible for building innovation capability, identifying the next generation
of innovation consultants (I-consultants), coordinating innovation-related
programs, and keeping innovation at the top of Whirlpools corporate agenda. Iconsultants were full-time staff that helped divisions adopt and implement
innovation techniques. They also facilitated individuals, groups, or business units
to come up with new ideas and put these ideas into action.
Later, each major business unit also established an I-Board. Twenty-five people
from each region were trained to serve as in-house I-consultants and I-mentors. Imentors were people specially trained to facilitate innovation projects and to help
people with their ideas. I-consultants hired their own team of I-mentors.
A knowledge management system called the Innovation E-Space was started which
provided a course in innovation. It started with the fuzzy front end of innovation
where random insights were systematically generated and shared to spark ideas. If
an employee had a concept, he/she could go to the knowledge management system
and post the idea on a bulletin board. The home page linked employees to all the
tools and resources they needed, from insight libraries and innovation templates to
I-mentors. According to Snyder, this provided an informal social system enabled
by technology that worked across the hierarchy level.
All the projects that were in the pipeline were listed on the I-Pipe on the website.
The I-Pipe gave a dashboard view of the innovation pipeline adapted from
Strategos. It tracked ideas from concept to scale-up and provided project details
as well as the big picture, enabling management to focus on areas that needed
Contd
48
Contd
attention. According to Gary Hamel (a visiting professor of Strategic and

International Management at the London Business School, chairman of Strategos,
and director of the Woodside Institute), the I-Pipe helped innovators to create
strategy and top managers to edit it so as to fit the companys requirements. He
also acknowledged that using IT to support innovation sessions was challenging.
The Innovation E-Space was cost-effective and did not require a big investment.
On the front end, Whirlpool used a Lotus Notes-based intranet and added new
capabilities using collaboration tools like QuickPlace and Sametime from Lotus.
For the I-Pipe, the company built a platform on its SAP infrastructure using SAPs
xApps for project resource management. Organizing tactical training was
complemented by a significant amount of e-learning technology. Some courses
were put online using LearningSpace of IBM Mindspan Solutions. Using such selfpaced courses freed up Whirlpool resources for assignment tp other products and
significantly reduced costs.
Whirlpool also hosted innovation fairs to felicitate inventors and encourage the
flow of ideas. At these fairs, proud employees demonstrated their new designs and
discussed their proposals.
Instead of waiting for employees to come out with ideas, the I-mentors helped
employees reflect on customer needs, industry trends, and their own experience to
come up with insights on formal innovation sessions.
The insight gained from the cross-fertilization of ideas between people from
various disciplines such as marketing and engineering also helped. For the
employees, the thrill of achievement was its own reward, and innovators received
no bonuses or perks for their ideas. According to Tammy Patrick, global director of
knowledge management, the innovators got charged up by the opportunity for
exposure and the fact that someone was listening to their idea.
Though initially Whirlpool got very few ideas out of the process, the rank-and-file
employees were happy that their participation was being sought on important
matters. However, the immediate superiors of the people who were engaged in this
process and senior managers were not happy as they thought that this initiative was
a distraction from their regular work. Moreover, in the absence of concrete goals
and this initiative not being tied to their performance in any way, the middle level
management had little incentive to support the initiative. The hardest part for
Whirlpool was to change the way leaders saw their roles as this required a huge
shift in thinking. According to Snyder, only leaders could change an environment
and allow an innovator the freedom to pursue different things.
Example: Localization Strategies of MTV in India

MTV Networks International (MTVI) adopted the policy of Think Globally, Act
Locally, in the mid-1990s and began to launch separate channels in its different
regions. Although many programs were adapted from American originals, the
channels were presented in a localized format. MTVI tried to establish MTV as a
global brand with a local outlook.
Contd
49
Contd
MTVI built its base outside the US by not only launching the MTV channel but
also by acquiring local music channels. It followed the practice of tying up with a
local company for the initial launch and acquiring the channel from the company
after some time.
MTVI entered India in the early 1990s in a tie-up with STAR TV but exited the
country in 1994 after differences erupted between the partners in the tie-up. By the
time it re-entered India in 1995, STAR TV had launched Channel [V], a 24-hour
music channel, which was available in many parts of South-Asia. Channel [V]
became very popular, especially in India, because it aired programs in Hindi.
On its re-entry, MTV Asia tied up with Indias national television service
Doordarshan (DD). Initially, MTV Asia was aired for two hours every day on DD
Metro, one of the channels of DD, before becoming a 24-hour channel. MTV India
was later launched as a separate channel in 1996.
Taking its cue from Channel [V], MTV India began broadcasting Hindi film songs.
Officials at MTV Asia were confident that the channel would become successful in
India.
By the late 1990s, MTV India had launched a variety of programs with Indiaspecific content. Most of the programs were film based and were targeted at the
youth. The VJs, many of whom were picked through VJ hunts conducted across the
country, became very popular. Some Indianized programs like MTV Bakra (a
reality prank show), Fully Faltoo (a spoof show on Hindi films and songs), and
MTV Roadies (based on the US reality show Road Rules) also gained popularity.
MTV India also co-sponsored many music events and began merchandising
products like clothes and perfumes under the MTV banner in 2001.
Though the programming format of MTV India was more or less similar to that of
MTV in America, the content was localized to suit the preferences of Indian
viewers. By 2004, MTV India had become the leading Indian music channel in
terms of advertising revenues, with a 35% market share. MTV Asia also launched
VH1 and Nickelodeon in a localized format in India.
50
Appendix-3
The Organization of International Business

Introduction
International businesses use organizational architecture to manage and direct their
global operations. For a firm to ensure profitability, the elements of the organizational
architecture should be consistent internally; the strategy must fit the organization
architecture; and finally the strategy and architecture should not only be consistent
with each other, but should also be consistent with the competitive conditions
prevailing in the market.
This unit defines organizational architecture and explains its various components. It
then goes on to explain the different dimensions of organizational structure. It
discusses different types of control systems and incentives. The unit defines processes
and how they are managed in international business. It also discusses how an
organizational culture is created and maintained and how it influences the
performance of a multinational in international business. It takes a look at the
synthesis of organizational architecture and strategy. The unit finally talks about
organizational change and the strategies and tactics used for implementing
organizational change.
Organizational Architecture
Organizational architecture refers to the totality of a firms organization, including
formal organizational structure, control systems and incentives, organizational culture,
processes, and people.
Organizational structure includes three things: first, the formal organization division
into subunits such as product divisions, national operations, and functions. The second
aspect of the organizational structure is the location of decision making roles and
responsibilities within that structure. Its third feature is the establishment and
integration of a mechanism to coordinate different activities of the subunits in the
organization, including cross-functional teams and/or pan-regional committees.
Control systems are metrics that measure the performance of the subunits and make
judgments about how well the managers are running those subunits. For instance,
Unilever measured the performance of its national operating subsidiaries by setting
profitability as the metric. Incentives are devices used for rewarding appropriate
managerial behavior. For instance, a manager of a unit may receive a bonus if the
performance targets are achieved.
Processes are the manner in which work is carried out and how decisions are made in
an organization. Examples of processes are strategy formulation and resource
allocation.
Organizational culture refers to the norms and value systems that are shared among
the employees of an organization. Organizations are composed of societies of
individuals who come together to perform tasks collectively. They have their
distinctive cultural and sub-cultural patterns. Finally, people refers not just to the
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employees in an organization but also the strategy for recruiting, compensating, and
retaining those employees and the kind of people they are in terms of values, skills,
and orientation.
The various components of organizational architecture are not independent of each
other. Each component is shaped by another component. To maximize its profitability,
a firm should pay attention to achieving internal consistency between the various
components of its architecture. Some inconsistencies do exist in the design of the
organization architecture. Though perfection cannot be achieved in the design, it can
be minimized through intelligent design.
Consistency between architecture and strategy is required because architecture must
fit strategy. It is relatively easy for senior managers to announce a change in strategy
but is harder to put into action. A change in strategy also requires a change in the
architecture, and changing architecture is much more difficult than changing strategy.
Even with internal consistency and a fit between strategy and architecture, high
performance cannot be guaranteed. The firm has to ensure that the fusion of strategy
and architecture is consistent with the demands of the market in which the firm
competes.
Organizational Structure
Organizational structure can be understood in terms of three dimensions (1) vertical
differentiation, which refers to the location of decision making responsibilities within
a structure; (2) horizontal differentiation, which refers to the formal organizational
division into subunits; and (3) establishing integrating mechanisms, which are
mechanisms to coordinate the subunits.
Vertical Differentiation
Vertical differentiation in a firm determines where the decision making power is
concentrated in the hierarchy. There are arguments for centralization and
decentralization.
Arguments for centralization
There are four main arguments for centralization. First, it facilitates coordination.
Second, it ensures that decisions are consistent with the organizational objectives.
Third, it gives top-level managers the means to bring about the needed organizational
changes by concentrating power and authority in one individual or a management
team. Fourth, it avoids duplication of activities that occurs when similar activities are
carried on by various subunits within the organization.
Arguments for decentralization
There are five main arguments for decentralization. First, top management becomes
overburdened when the decision making authority is centralized and this can result in
poor decisions being taken. Decentralization gives time to top management to focus
on critical issues by delegating routine tasks to lower-level managers. Second,
motivational research favors decentralization. Third, decentralization allows for
flexibility. Fourth, decentralization results in better decision making. Fifth,
decentralization can increase control.
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Centralization and strategy in international business

It usually makes sense for firms to centralize some decisions and decentralize others,
depending on the strategy of the firm and the type of decision. Decisions related to the
firms overall strategy, financial objectives, major financial expenditure, and legal
issues are typically centralized at the headquarters of the firm. However, operating
decisions such as those related to marketing, production, R&D, and human resource
management may or may not be centralized depending on the strategy of the firm.
Firms pursuing a global standardization strategy should decide how to disperse the
value creation activities around the globe so that the experience curve and location
economies are realized. The head office must make decisions about where to locate
production, R&D, marketing, etc. In addition, the globally dispersed value creation
activities facilitating a global strategy should also be coordinated. All of this creates
pressure to centralize some of the operating decisions.
In contrast, firms pursuing a localization strategy face strong pressures to decentralize
operating decisions to foreign subsidiaries. Firms that pursue an international strategy
maintain centralized control over their core competency and decentralize other
decisions to foreign subsidiaries.
The situation in firms pursuing a transnational strategy is more complex. The
realization of location and experience curve economies requires some degree of
centralized control over global production centers. However, the need for local
responsiveness dictates decentralization of many operating decisions to foreign
subsidiaries. Thus in such firms, some decisions are centralized and some are
decentralized. In addition, global learning based on multidirectional transfer of skills
between subsidiaries and between subsidiaries and the corporate center is a key
feature of a firm pursuing a transnational strategy. The concept of global learning is
predicated on the belief that foreign subsidiaries within a multinational firm have
significant freedom to develop their own competencies and skills. These can then be
leveraged on to benefit other parts of the organization. To avail of this freedom, a
degree of centralization is required. For this reason, firms pursuing a transnational
strategy require a high degree of decentralization.
Horizontal Differentiation
Horizontal differentiation relates to how the firm decides to divide itself into subunits.
The decision is made on the basis of function, type of business, or geographical area.
One of these predominates in many firms but in some firms, more complex solutions
are adopted.
Structure of domestic firms
Most firms begin with no formal structure and are run by an entrepreneur or a small
group of individuals. As they grow, the management demands become too great for an
individual or a small team of individuals to handle. At this point, the organization is
split into functions reflecting the value creation activities of the firm. These functions
are coordinated and controlled by the top management. Decision making in this
function is centralized.
Horizontal differentiation may be needed if the firm significantly diversifies its
product offering, which takes it into different business areas. In such
circumstances, the functional structure becomes too clumsy. Problems of
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coordination and control arise when different business areas are managed within
the functional structure framework. It becomes difficult to ide ntify the
profitability of each distinct business area. Supervising value creation activities of
several business areas is also difficult.
To solve the problems of coordination and control, firms move to the product
divisional structure from the functional structure.
The international division
Firms that expand abroad initially often group their international activities into an
international division. This is in case of firms organized on the basis of functions and
on the basis of product divisions. Despite the firms domestic structure, its
international division tends to be organized on geography.
Though the international division is widely used, it can give rise to some problems. Its
dual structure contains the potential for conflict and coordination problems between
domestic and foreign operations. One problem with the international division structure
is that the heads of foreign subsidiaries are not given as much as voice as the heads of
domestic functions or divisions. Rather, the head of the international division is
assumed to have the ability to represent the interests of all countries to headquarters.
This effectively demotes managers of each country to the second tier of the firms
hierarchy, which is inconsistent with a strategy of trying to expand internationally and
build a multinational organization.
The lack of coordination between domestic operations and foreign operations can
inhibit worldwide introduction of new products, the transfer of core competencies
between domestic and foreign operations, and the consolidation of global production
at key locations for realizing experience curve and location economies.
Due to these problems, many firms that expand internationally abandon this structure
and adopt one of the worldwide structures.
Worldwide area structure
A worldwide structure is favored by firms with a low degree of diversification and a
domestic structure based on functions. Under this structure, the world is divided into
geographic areas. An area is a country or group of countries. Each area is a selfcontained, largely autonomous entity with its own set of value creation activities.
Strategic decisions and operations authority related to these activities are
decentralized to each area, with headquarters retaining the authority for financial
control and overall strategic direction of the firm.
The worldwide structure facilitates local responsiveness. As decision-making
responsibilities are decentralized, each area can customize marketing strategy, product
offerings, and business strategy to the local conditions. However, this structure
encourages fragmentation of the organization into highly autonomous activities. This
makes realization of experience curve and location economies and transfer of core
competencies and skills between areas difficult. In other words, the worldwide area
structure is consistent with a localization strategy but it makes it difficult to realize
gains associated with global standardization.
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Worldwide product divisional structure

A worldwide product division structure is adopted by firms that are reasonably
diversified and originally had domestic structures based on product divisions. In a
domestic product divisional structure, each division is a self-contained, largely
autonomous entity with total responsibility for its value creation activities. The
headquarters retains the responsibility for the financial control and overall strategic
development of the firm.
Underpinning the organization is a belief that the value creation activities of each
product division should be coordinated by that division worldwide. Thus, the
worldwide product divisional structure is designed to overcome the problems related
to coordination that arise with the international division and worldwide area
structures. The worldwide product division structure enhances the consolidation of
value creation activities at key locations essential for the realization of experience
curve and location economies. It also facilitates the transfer of core competencies
within the worldwide operations of the division and the concurrent worldwide
introduction of new products. The major problem with this structure is that it gives
limited voice to country or area managers, since they are seen as docile to product
division managers. This may result in lack of local responsiveness and can lead to
performance problems.
Global matrix structure
Some firms have made attempts to cope with the conflicting demands of a
transnational strategy by using a matrix structure. In a global matrix structure,
horizontal differentiation proceeds along two dimensions -- product division and
geographic area. The responsibility of operating decisions related to a particular
product should be shared by the product division and various areas of the firm. It is
believed that the dual decision making responsibility enables a firm to achieve its
objectives. In a classic matrix structure, the idea of dual responsibility can be
reinforced by giving product divisions and geographical areas equal status within the
organization. Thus individual managers belong to two hierarchies a divisional
hierarchy and an area hierarchy and have two bosses a divisional boss and an area
boss.
In practice, the global matrix structure is clumsy and bureaucratic. It may require so
many meetings that work does not get done. The area and product division may slow
down the decision making process and may produce an inflexible organization that
will be unable to respond to market shifts or to innovate. The dual hierarchy may also
lead to conflicts and power struggles between the area and product divisions. The
most difficult thing in this structure would be ascertaining accountability as one side
may always blame the other. Thus firms pursuing a transnational strategy build
flexible matrix structures based on enterprise-wide management knowledge networks,
and a shared vision and culture.
Integrating Mechanisms
A firm has to identify some means for coordinating the subunits. One way to achieve
coordination is through centralization. However, centralization will not be effective if
the coordination task is complex. Higher-level managers who are responsible for
achieving coordination can get overwhelmed by the volume of work required to
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coordinate the activities of several subunits, especially when the subunits are large,
diverse, and/or geographically dispersed. In this case, firms look toward integrating
both formal and informal mechanisms to achieve coordination.
Strategy and coordination in international business
The need for coordination between subunits varies with the firms strategy. The need
for coordination is lowest in firms pursuing a localization strategy, is higher in
international companies, still higher in global companies, and highest of all in
transnational companies. Firms pursuing a localization strategy are chiefly concerned
with local responsiveness and are likely to adopt a worldwide area structure in which
each has considerable autonomy and its own set of value creation functions. As each
area is set up as a stand-alone entity, the need for coordination between areas is
minimized.
Firms pursuing an international strategy have a higher need for coordination and they
try to profit from transferring core competencies and skills between units at home and
abroad. Coordination is essential to support the transfer of skills and product offerings
between units. The need for coordination is also high in firms pursuing a global
standardization strategy. Achieving experience and location economies involves
dispersing value creation activities to different locations around the globe. The
resulting global web of activities needs to be coordinated for ensuring the smooth flow
of inputs into the value chain, the smooth flow of semi-finished goods through the
value chain, and the smooth flow of finished goods to markets worldwide.
The need for coordination is greatest in transnational firms, which simultaneously
pursue experience curve and location economies, local responsiveness, and
multidirectional transfer of skills and core competencies among their all sub-units. A
transnational strategy also requires coordination between foreign subsidiaries and the
globally dispersed value creation activities of the firm to ensure that any marketing
strategy and product offering is customized to local conditions.
Impediments to coordination
Managers of various subunits have different orientations, partially because they have
different tasks. For instance, marketing managers are concerned with issues related to
marketing such as pricing, promotion, distribution, and market share whereas
production managers are concerned with issues related to production such as capacity
utilization, cost control, and quality control. These differences may inhibit
communication between managers.
Differences in the orientation of sub-units also arise from differing goals, which may
often lead to conflict.
Such impediments to coordination are not unusual in any firm, but can get
problematic in the multinational enterprise with abundant subunits at home and
abroad. Differences in the orientation of subunits are often reinforced in
multinationals by differences in time zones and nationality and distances between
managers of the subunits.
Formal integrating mechanisms
The formal mechanisms used for integrating subunits differ in complexity from simple
direct contact and liaison roles, to teams, to a matrix structure. Generally, the greater
the need for coordination, the more complex the formal integrating mechanisms need
to be.
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The simplest integrating mechanism is the direct contact between subunit managers.
In this mechanism, the managers of various subunits contact each other whenever they
have a common concern. However, direct contact may not be effective if the managers
belong to differing orientations.
Liaison roles are a bit more complex. When the volume of contacts between subunits
increases, coordination can be improved by giving a person in each subunit the
responsibility for coordinating with another subunit on a regular basis. Through these
roles, the people involved establish a permanent relationship. This helps in attenuating
the impediments to coordination.
When the need for coordination is greater, firms tend to use temporary or permanent
teams consisting of individuals from the subunits that need to achieve coordination.
These teams typically coordinate product development and introduction but they are
also useful when any aspect of strategy or operations requires coordination of two or
more subunits. Product development and introduction teams include personnel from
R&D, marketing, and production. The resulting coordination aids product
development tailored to the needs of the consumers that can be produced at reasonable
cost.
When the need for integration is very high, firms may institute a matrix structure in
which all roles are viewed as integrating roles. The matrix structure is designed to
facilitate maximum integration among subunits. The most common matrix in
multinational firms is based on worldwide product divisions and geographical areas.
This results in the achievement of a high-level of integration between the product
divisions and the areas, that is, in theory, the firm pays close attention to the pursuit of
location and experience curve economies as well as local responsiveness.
In some multinationals, matrix structures are complex as they structure the firm into
geographical areas, worldwide product divisions, and functions, all of which directly
report to headquarters. Such a matrix structure, in addition to facilitating local
responsiveness and experience curve and location economies, fosters the transfer of
core competencies within the organization.
Matrix structures tend to be bureaucratic, inflexible, and characterized by conflict. For
such a structure to work it needs to be a little flexible and should be supported by
formal integrating mechanisms.
Informal integrating mechanisms
To avoid problems associated with formal integrating mechanisms, firms with a high
need for integration have experimented with an informal integrating mechanism
knowledge networks that are supported by an organizational culture that values
teamwork and cross-unit cooperation. A knowledge network is a network for
transmitting information within an organization that is based not on formal
organization structure, but on informal contacts between managers within an
enterprise and on distributed information systems. The strength of a knowledge
network is that it can be used as a non-bureaucratic channel for flow of knowledge
within a multinational enterprise. Managers at different locations need to be linked
indirectly for a network to exist.
Networks can be established using two techniques information systems and
management development policies.
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For providing the foundation for informal knowledge networks, firms use their
distributed computer and telecommunications information systems. Electronic mail,
video conferencing, and web-based search engines are spread out over the globe to get
to know each other, to publicize and share best practices, and identify contacts that
might help in solving a particular problem. For instance, Wal-Mart used an intranet
system for communicating ideas related to its merchandising strategy between stores
located in different locations.
Some firms develop informal networks by using management development programs.
Managers are regularly rotated through various subunits to build their informal
networks and management education managers bring managers of subunits together at
a single location so that they can get acquainted with each other.
Knowledge networks themselves cannot achieve coordination if the managers of
subunits persist in pursuing sub-goals that are at variance with the goals of the firm.
Thus managers should share a commitment to the same goals for a knowledge
network to function properly. To eliminate this flaw, firms should have a strong
organizational culture that promotes cooperation and teamwork.
Control Systems and Incentives

A major mission of a firms leadership is to control the various subunits of a firm
whether they are defined on the basis of function, geographic area, or product division
to ensure that their actions are consistent with the overall strategic and financial
objectives of the firm. This can be achieved with the help of various control and
incentive systems.
Types of Control Systems
Multinational firms use four different types of control personal controls,
bureaucratic controls, output controls, and cultural controls.
Personal controls
Personal controls are controlled by personal contact with subordinates. This is widely
used in small firms where subordinates actions are under direct supervision. IThis
approach also structures the relationships between managers at different levels in the
multinational enterprise. For instance, Jack Welch, former CEO of General Electric,
had one-to-one meetings with the heads of all GEs major businesses. He used these
meetings to probe the strategy, structure, and financial performance of their
operations. In doing so, he exercised control over these managers as well as on their
strategies.
Bureaucratic controls
Bureaucratic control is control through rules and procedures that directs the actions of
subunits. The most important bureaucratic controls in subunits are capital spending
rules and budgets. Budgets are essentially a set of rules for allocating a firms
financial resources. The budget specifies how much the subunit may spend. Capital
spending rules require the management at the headquarters to approve any capital
expenditure by a subunit that surpasses a certain amount.
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Output controls
Output controls involve setting goals for subunits for achieving and expressing those
goals in terms of relatively objective performance metrics such as productivity,
market share, profitability, growth, and quality. The performance of managers of the
subunits is judged on their ability to achieve these goals. If goals are met or exceeded,
the managers of the subunits are rewarded. If the goals are not met, top management
usually intervenes to find out why and takes appropriate corrective action. Thus
control is achieved by comparing actual performance against targets and taking
corrective action when needed.
Cultural controls
Cultural controls exist when employees buy into the value systems and norms of the
firm. Employees tend to control their own behaviors, which reduces the need for
direct supervision. In a firm with a strong culture, self-control reduces the need for
other control systems.
Incentive Systems
Incentives refer to the devices used to reward appropriate employee behavior.
Employees receive incentives in the form of annual bonus. Incentives are tied to the
performance metrics used for output controls. For instance, setting targets linked to
profitability might be used to measure the subunits performance. Incentives vary
depending on the type of employees and their tasks. Incentives for employees working
on the factory floor would vary from the incentives given to senior managers. The
basic principle is to ensure that the incentive scheme for an employee is linked to the
output target that he/she has control over and can influence.
The successful execution of a strategy in a multinational often requires significant
cooperation between managers in different subunits. The managers can be encouraged
to cooperate with each other by linking incentives to performance at higher levels in
the organization.
The incentive systems in a multinational often have to be adjusted to account for
national differences in institutions and culture. Incentive systems used in one country
might not be allowed or even work in other countries.
It is important for managers to recognize that incentive systems have unintended
consequences. They have to carefully think through exactly what behavior certain
incentives will encourage.
Control Systems, Incentives, Strategy in the International Business
Performance ambiguity is the key to understanding the relationship that exists
between international strategy, control systems, and incentive systems. Performance
ambiguity exists when the causes for poor performance of a subunit are not clear. This
occurs when there is a high degree of interdependence between subunits within an
organization.
In firms pursuing a localization strategy, each national operation is a stand-alone
entity and can be judged on its own merits. The level of performance ambiguity is
low. In firms pursuing an international strategy, the level of interdependence is
somewhat higher. In firms pursuing a globalization strategy, many of the activities are
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interdependent and thus performance ambiguity is high. The level of performance

ambiguity is highest in transnational firms. The high level of integration within
transnational firms implies a high degree of joint decision making and the resulting
interdependencies leads to poor performance.
Processes
Processes can be defined as the manner in which decisions are made and work is
performed within the organization. Processes are found at different levels of the
organization. There are processes for formulating strategy, allocating resources,
evaluating new product ideas, handing customer inquiries and complaints, improving
product quality, evaluating employee performance, etc. Often, valuable skills or core
competencies of a firm are embedded in its processes. Efficient and effective
processes lower the costs of value creation and add additional value to a product. For
instance, General Electrics process of Six Sigma is used for quality improvement.
Many processes cut across functions or divisions, and require cooperation between
individuals in different subunits. For instance, product development processes require
employees from R&D, manufacturing, and marketing to work in a cooperative manner
to ensure that new products are developed with market needs in mind and are
designed in such a way that they are manufactured at a low cost.
Many processes in a multinational enterprise cut across not only organizational
boundaries but also across national boundaries. For instance, designing a new product
may require R&D personnel from California, production people located in Taiwan,
and marketing personnel located in Asia, America, and Europe.
It is important for a multinational enterprise to recognize that valuable new processes
that might lead to a competitive advantage can be developed anywhere within the
firms global network of operations. It is also important to leverage on valuable
processes. This requires both formal and informal integrating mechanisms such as
knowledge networks.
Organizational Culture
Culture refers to a system of values and norms that are shared among people.
Values are abstract ideas about what a group believes to be good, right, and
desirable. Norms mean the social rules and guidelines that prescribe the appropriate
behavior in particular situations. Values and norms are the behavioral patterns in an
organization that new employees are encouraged to follow.
Creating and Maintaining an Organizational Culture
The culture of an organization comes from several sources. First, the founders or
leaders have a profound impact on the organizational culture often imprinting their
own values on the culture. An example is Lincoln Electric, a US-based wielding
equipment manufacturer, where the values of James Lincoln, the company founder,
became the core values.
Another important influence on organizational culture is the broader social culture of
the nation where the organization is founded. For instance, many American firms
reflect the values of the American culture. Thus organizational culture is influenced
by national culture.
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A third influence on organizational culture is the history of the enterprise, which

shapes the value of the organization. For instance, at Philips NV, the culture was
shaped by the history of the company. The company operated with a culture that
placed high value on the independence of national operating companies.
Culture can be maintained by a variety of mechanisms such as the hiring and
promotional practices of the organization, socialization processes, reward strategies,
and communication strategy. The goal is to recruit people whose values are consistent
with those of the organization. To reinforce values, a company may promote
individuals whose behavior is consistent with the core values of the organization.
Socialization can be both formal and informal. Formal socialization includes training
programs that educate employees about the core values of the organization. Informal
socialization may include friendly advice from peers and bosses. Merit review
processes are linked to the company values, which further reinforces cultural norms.
As for communication strategy, companies with a strong culture devote a lot of
attention to communicating key values in corporate mission statements,
communicating them to employees, and using them as a guide in the taking of difficult
decisions.
Organizational Culture and Performance in International Business
A culture that leads to high performance in the home nation may not be imposed on its
foreign operations. An organization has to establish values in the new enterprise rather
than imposing the values of an established enterprise. Another solution is for the firm
to devote a lot of time and attention to transmitting its organizational culture to its
foreign operations. A third solution is to recognize that it is essential to change some
aspects of the firm so that it fits in better with the culture of the host nation.
The need for a common organizational culture that is the same across a
multinationals global network of subsidiaries varies probably with a firms strategy.
Shared values and norms can facilitate coordination and cooperation between
individuals belonging to different subunits. A strong common culture may lead to goal
congruence and can attenuate problems arising from performance ambiguities,
interdependence, and conflict among managers of different subsidiaries.
Synthesis: Organizational Architecture and Strategy

Firms pursuing a transnational strategy focus on local responsiveness and operate with
worldwide area structures where the operating decisions are decentralized to
subsidiaries that are functionally self-contained. The need for coordination between
subunits is low. In such firms there is no need for high integrating mechanisms. The
lack of interdependence implies that the level of performance ambiguity in such firms
is low, as are the cost of controls. Thus headquarters can manage foreign operations
by relying on bureaucratic and output controls and a policy of management by
exception. Incentives can be linked to performance metrics at the level of country
subsidiaries. As the need for coordination and integration is low, the need for common
organizational culture and processes is also quite low.
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Firms pursuing an international strategy attempt to create value by transferring core
competencies from home to foreign subsidiaries. If they are diverse, most firms
operate with a worldwide product division structure. Headquarters maintains
centralized control over the core competency of the firm. Other operating decisions
are decentralized within the firm to subsidiary operations in each country.
The need for coordination is moderate in such firms. The integrating mechanisms are
not that extensive. The low level of interdependence results in a low level of
performance ambiguity. These firms get bureaucratic and output controls with
incentives that focus on performance metrics at the level of country subsidiaries. The
need for a common organizational culture and common processes is not that great. An
exception is that when the core competencies or skills of the firm are embedded in
process and culture, the firm needs to pay close attention to transferring those
processes and culture from the corporate center to the country subsidiaries. The level
of complexity in such firms is not that great.
Firms pursuing a global standardization strategy focus on the realization of experience
curve and location economies. If they are diversified, these firms operate with a
worldwide product division structure. To coordinate the firms globally dispersed
value creation activities; headquarters maintains control over most of the operating
decisions. The need for integration in such firms is high. Thus these firms operate
with formal and informal integrating mechanisms. The resulting interdependencies
can lead to significant performance ambiguities. Such firms stress on building a strong
organizational culture that facilitates coordination and cooperation. They use incentive
systems that are linked to performance metrics at the corporate level. The integration
of such firms is more complex than that of firms pursuing a localization or
international strategy.
Firms pursuing a transnational strategy focus on achieving location and experience
curve economies, local responsiveness, and global learning. These firms may operate
with a matrix structure in which both geographic areas and product divisions have
significant influence. The need to coordinate a globally dispersed value chain and to
transfer core competencies creates pressures for centralizing some operating
decisions. The need to be locally responsive creates pressures for decentralizing some
operating decisions to national operations. Consequently, these firms tend to mix high
degrees of centralization for some operating decisions with high degrees of
decentralization for other operating decisions.
The need for coordination is high in transnational firms. This is reflected in the use of
formal and informal integrating mechanisms, including formal matrix structures and
informal management networks. Such integration results in high interdependence
among subunits and this may cause significant performance ambiguities, which
increases the cost of control. This can be reduced by cultivating a strong culture and
establishing incentives that promote cooperation between subunits.
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Environment, Strategy, Architecture, and Performance

For a firm to achieve high performance, a fit between strategy and architecture is
essential. To succeed in this, two conditions have to be met. First, the firms strategy
should be consistent with the environment in which it operates. Second, the
organizational architecture of the firm must be consistent with its strategy.
If the strategy does not fit the environment, the firm may face performance problems.
If the architecture does not fit the strategy, the firm will again face performance
problems. Thus for a firm to survive, it has to find a fit with its environment, strategy,
and its organizational architecture.
Organizational Change
Multinationals alter their architecture periodically to conform to the changes in the
environment in which they compete and the strategy they pursue.
Organizational Inertia
Within most organizations are strong inertia forces. These forces come from many
sources. The distribution of influence and power in an organization is one source of
inertia. The power and influence enjoyed by individual managers is part of their role
in the organizational hierarchy, as defined by the structural position. Most of the
substantive changes in the organization require a change in structure and a change in
power and influence within the organization. As a result of organizational changes,
some individuals see an increase in their power and influence and vice versa.
The existing culture is another source of inertia expressed in norms and value systems.
Value systems reflect beliefs that are deeply held and are hard to change.
Organizational inertia also arises from the preconceptions of senior managers about
the appropriate business model or paradigm to be used. When a given paradigm has
worked well in the past, mangers may have trouble accepting that it may no longer be
appropriate.
Institutional constraints may also be a source of inertia. Individual nations regulations
including local rules and policies pertaining to layoffs may make it difficult for
multinational firms to alter their global value chain.
Implementing Organizational Change
Though all organizations suffer from inertia, the complexity and global spread of
multinationals might make it difficult for them to change their strategy and structure
to match new organizational realities. Yet globalization in many industries has made it
critical that multinationals do that. Declining trade barriers to cross-border trade and
investment have led to changes in the nature of the competitive environment.
Increasing cost pressures have required multinationals to respond by streamlining
their operations to realize the economic benefits associated with experience curve and
location economies and with transfer of skills and competencies within the
organization. At the same time, local responsiveness remains an important source of
differentiation. To survive in this competitive environment, multinationals change
their strategy as well as their architecture. The basic principles for successful
organizational change can be summarized as follows: (1) unfreeze the organization,
(2) move the organization though a new state, and (3) refreeze the organization into
the new state.
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Unfreezing the Organization

Due to forces of inertia, incremental change often means no change. Those whose
power is threatened by change can also resist change easily. Thus the theory of change
maintains that effective change requires unfreezing the established culture of an
organization and changing the distribution of influence and power. Shock therapy to
unfreeze the organization might include closure of a plant deemed uneconomic or the
announcement of some striking changes in organizational structure. It is also
important to realize that change does not take place unless senior managers are
committed to it. Senior managers must articulate the need for change so that
employees understand why it is being pursued and the benefits that can be reaped
from successful change.
Moving to the New Site
Once an organization is unfrozen, it should be moved to a new state. Movement
requires taking some action such as closing operations; reorganizing the structure;
reassigning responsibilities; changing control, incentive and reward systems;
redesigning processes; and letting go of people who act as impediments to change.
The movement is successful when it is done with sufficient speed. For rapid
movement, employees can be involved in the change effort.
Refreezing the Organization
Refreezing the organization takes a longer time. It may require a new culture to be
established while the old one is being dismantled. Thus refreezing requires that
employees be socialized into the new way of doing things. For achieving this,
companies use management education programs. However, these programs are not
enough; hiring policies should also be changed to reflect the new realities where such
individuals are hired whose own values are consistent with the new culture the firm is
trying to build. Similarly, control and incentive systems should also be consistent with
the new realities of the organization. Else change will not take place.
Summary
Organizational architecture refers to the totality of a firms organization,
including formal organizational structure, control systems and incentives,
organizational culture, processes, and people.
Organizational structure can be understood in terms of three dimensions (1)
vertical differentiation, which refers to the location of decision making
responsibilities within a structure; (2) horizontal differentiation, which refers to
the formal organizational division into subunits; and (3) establishing integrating
mechanisms, which are mechanisms to coordinate the subunits.
Multinational firms use four different types of control personal controls,
bureaucratic controls, output controls, and cultural controls. Incentives are
devices used to reward appropriate employee behavior.
Processes are found at different levels of the organization. There are processes for
formulating strategy, allocating resources, evaluating new product ideas, handling
customer inquiries and complaints, improving product quality, evaluating
employee performance, etc.
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The culture of an organization comes from several sources. First, the founders or
leaders have a profound impact on the organizational culture, often imprinting
their own values on the culture. Another important influence on organizational
culture is the broader social culture of the nation where the organization is
founded. A third influence on organizational culture is the history of the
enterprise, which shapes the values of the organization.
Firms pursuing a transnational strategy focus on local responsiveness and operate
with worldwide area structures where the operating decisions are decentralized to
subsidiaries that are functionally self-contained.
Firms pursuing an international strategy attempt to create value by transferring
core competencies from home to foreign subsidiaries. If they are diverse, most
firms operate with a worldwide product division structure.
Firms pursuing a global standardization strategy focus on the realization of
experience curve and location economies. If they are diversified, these firms
operate with a worldwide product division structure.
Firms pursuing a transnational strategy focus on achieving location and
experience curve economies, local responsiveness, and global learning. These
firms may operate with a matrix structure in which both geographic areas and
product divisions have significant influence.
Within most organizations are strong inertia forces. The existing culture is
another source of inertia expressed in norms and value systems. Organizational
inertia also arises from the preconceptions of senior managers about the
appropriate business model or paradigm to be used. Institutional constraints may
also be a source of inertia.
The basic principles for successful organizational change can be summarized as
follows: (1) unfreeze the organization, (2) move the organization though a new
state, and (3) refreeze the organization into the new state.
Example: Wal-Marts International Division

In the early 1990s, US-based retail giant Wal-Mart started its international
expansion. The company set up an international division for overseeing its several
processes. The international division was established at the company headquarters
at Arkansas. The division was split into three regions Europe, Asia, and the
Americas, with the Chief Executive Officer (CEO) of each region reporting to the
CEO of the international division who in turn reported to the CEO of Wal-Mart.
The managers at Wal-Mart ensured that the international stores copied the store
format, merchandising, and operations of the US operations. They believed that
centralized control over the merchandising strategy and operations was the way to
ensure success in its global operations. However, the managers at Wal-Mart later
found that centralized control slowed down the decision making process. They felt
the need for a decentralized approach that would enable international managers to
adapt their merchandising strategy and operations to suit local conditions.
Though the company benefited globally by decentralizing its international division,
it faced problems such as managing global procurement. The company felt the need
for a global procurement strategy so that it could negotiate with its key suppliers on
a global basis and introduce new merchandise to all its stores worldwide.
Contd
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Contd
According to Wal-Mart, the international division had helped the company identify
best practices and transfer them between countries.
Example: Organizational Culture and Incentives at Lincoln

The success at Lincoln Electric (Lincoln), a wielding equipment company, was
attributed to its organizational culture and a piecework-based incentive scheme.
The organizational culture at the company dates back to 1907 when James Lincoln
(James) joined a company established by his brother. The company had an
ingrained culture that respected an individuals ability and believed that motivated
people could achieve extraordinary performance. James emphasized that people at
the company should be rewarded for their individual effort. He ensured that all
employees received equal treatment. The company shared its productivity gains
with the customers in terms of offering products at lower prices, with employees in
the form of higher pay, and with shareholders in the form of higher dividends.
The organizational culture that resulted from Jamess beliefs was reinforced by the
companys incentive system. Production workers were paid according to the
number of pieces they produced as opposed to receiving a base salary. These
workers were awarded semiannual bonuses based on their merit ratings. The
incentives motivated employees to work hard and generate innovations that
boosted the productivity at the company.
While this culture worked well in the companys US operations, the success could
not be replicated in its European and Latin American operations as each country in
these regions had their individualistic culture. The managers in other countries
could not impose Lincolns strong organizational culture. However, they
introduced the incentive systems. This also met with several roadblocks as
piecework was viewed as an exploitive compensation system that forced
employees to work harder. Thus, Lincoln could not (?) replicate the high level of
employee productivity that it had achieved in its US operations in other countries.
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Concept Note - 3
Entry Strategy and Strategic Alliances

1. Introduction
Firms considering international expansion need to take some basic decisions such as
which foreign market to enter, when to enter it, on what scale, and what entry mode to
choose. The decision on which foreign markets to enter is driven by an assessment of
long-run growth and profit potential. Choosing the entry mode is another major issue
which firms engaging in international businesses need to consider. The various entry
modes for serving foreign markets include exporting, licensing, franchising,
establishing joint ventures or wholly-owned subsidiaries, or acquiring an established
enterprise in the host nation.
This unit discusses the basic decisions a firm has to consider for foreign expansion. It
goes on to explain the various modes of entering a foreign market. It talks about how
an entry mode is selected. Moving on, the unit discusses the Greenfield strategy, and
the advantages and disadvantages of acquisitions and Greenfield ventures. The unit
finally discusses strategic alliances, its advantages and disadvantages, and how to
make the alliances work.
2. Basic Entry Decisions

A firm has to contemplate three basic decisions for foreign expansion which markets
to enter, when to enter those markets, and on what scale.
2.1 Which Foreign Markets to Enter?

How attractive a country is as a potential market for an international business depends
upon the efficient balancing of benefit, costs, and risks associated while doing
business in that country.
The long-run economic benefits of doing business in a country depends on factors
such as market size, the purchasing power of consumers in that market, and the likely
future wealth of consumers, all of which depends on the economic growth rate. The
markets should be seen in terms of economic growth and living standards when
measured by the number of consumers. For instance, China, and to a lesser extent,
India, are relatively poor compared to other developed nations. Yet they are attractive
targets for inward investment. On the other hand, the weak growth in Indonesia makes
it a less attractive target for inward investment.
The costs and risks associated with doing business in a foreign country are lower in
economically advanced and politically stable democratic nations and greater in less
developed and politically unstable nations.
Other things being equal, the benefits-cost-risk trade-off is likely to be most favorable
in politically stable developing and developed nations that have free market systems,
and where there is no upsurge in either private-sector debt or inflation rates. The
trade-off is least favorable in politically unstable developing nations that operate with
a command or mixed economy or in developing nations where financial bubbles that
are speculative have led to excess borrowing.
Another crucial factor is the value an international business can create in a foreign
market. This depends on the suitability of the product offering to that market and the
nature of the local competition. If the international business offers a product that is not
widely available in that market and one that satisfies an unmet need, the value of that
product will be greater than if it offers the same type of product that local competitors
and other foreign entrants are already offering. Greater value translates into an ability
to charge higher prices and to build volume of sales more rapidly.
By taking into consideration such factors, a firm can rank countries in terms of their
attractiveness and profit potential in the long run.
2.2 Timing of Entry

Having identified attractive markets, it is important for a firm to consider the timing of
entry. An entry is said to be early when the firm enters an international market before
other foreign firms and the entry is said to be late when the firm enters after other
foreign firms have established themselves. The advantages associated with entering a
market early are called first-mover advantages. One first-mover advantage is the
ability to preempt rivals and capture demand by establishing a strong brand name.
Another advantage is the ability to build sales volume in the country and ride down
the experience curve ahead of rivals, giving a cost advantage to the early entrant
before the late entrants. The cost advantage may enable the early entrant to cut prices
to below that of the late entrants, thus driving them out of the market. A third
advantage is the ability of early entrants to create switching costs that bind customers
to their products and services. Such switching costs make it difficult for late entrants
to win business.
Some disadvantages are also associated with entering a foreign market before other
international businesses enter. These are referred to as first-mover disadvantages.
These disadvantages may give rise to pioneering costs that an early entrant has to bear
but a late entrant can avoid. Pioneering costs include the costs of business failure if
the firm makes some major mistakes due to its ignorance of the foreign environment.
The late entrant may also benefit from observing and learning from the mistakes made
by early entrants. An early entrant may also face a severe disadvantage relative to the
late entrant, if regulations diminish the value of investments made by the early entrant.
This is a serious risk faced by early entrants in developing nations where the rules
governing business practices are still evolving.
2.3 Scale of Entry and Strategic Commitments

Entering a market on a large scale involves commitment of significant resources. It
also implies rapid entry. However, some firms enter on a small scale as they do not
have the resources essential to enter on a large scale.
The consequences of entering on a significant scale entering rapidly are associated
with the value of ensuing strategic commitments. A strategic commitment has a longterm impact which is difficult to reverse. A major strategic commitment is when a
firm decides to enter a foreign market on a significant scale. Strategic commitments
such as rapid large scale entry into a market can have an important influence on the
nature of competition in the market.
Strategic commitments that are significant are either good or bad. Rather, they tend to
alter the competitive playing field and unleash several changes, some of which will be
desirable and some which will not. A firm has to consider the implications of entering
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a large-scale market and act accordingly. For instance, a firm has to identify how
actual and potential competitors react to the large-scale entry into a market. Also a
large-scale entrant is more likely to be able to capture first mover advantages
associated with scale economies, and demand preemption and switching costs.
The value of the commitments that flow from rapid large-scale entry into a foreign
market must be balanced against the risks that will result and the lack of flexibility
associated with strategic commitments. But strategic inflexibility also has value.
The benefits of a small-scale entry include balance against the value and risks of the
commitments associated with large-scale entry. A small-scale entry allows a firm to
learn about the foreign market while limiting its exposure to that market. It also
reduces the risks associated with large-scale entry. But the lack of commitment
associated with a small-scale entry may make it difficult for the firm to build market
share and capture first-mover advantages.
3. Entry Modes
Once a firm decides to enter a foreign market, it has to consider the mode of entry.
Firms can use various entry modes such as exporting, turnkey project, licensing,
franchising, establishing joint ventures with a host firm, or setting up a wholly-owned
subsidiary in the host country. Each mode of entry has its advantages and
disadvantages.
3.1 Exporting
Many manufacturing firms commence their global expansion as exporters and later
switch to another mode for serving a foreign market.
Advantages
Exporting has two advantages. First, it avoids the substantial costs associated with
establishing manufacturing operations in the host country. Second, it helps firms
achieve location and experience curve economies. The firm can realize substantial
scale economies from its global sales volume by manufacturing the product in a
centralized location and exporting it to other national markets.
Disadvantages
Exporting has its drawbacks as well. First, exporting from the home base of the firm
may not be appropriate if lower-cost manufacturing locations are found abroad.
Second, the high costs associated with transportation make exporting uneconomical,
particularly for bulk products. Thus, firms should manufacture bulk products
regionally as it enables them to realize some economies from large-scale production
and also limits their transportation costs.
Another drawback is that tariff barriers make exporting uneconomical. A fourth
drawback is that when a firm delegates its sales, marketing, and service to another
company as its local agent, often the local agent carries products of competing firms
and so has divided loyalties. In such cases, a firm can carry off its marketing job itself
better than any local agent. This problem can be solved by setting up wholly-owned
subsidiaries in foreign nations to handle local marketing, sales, and service. This
enables the firm to exercise tight control over marketing and sales in the country while
reaping the cost advantages of manufacturing the product in a single location.
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3.2 Turnkey Projects

Firms specializing in construction, design, and start-up of turnkey plants are common
in some industries. In a turnkey project, the contractor handles every project detail for
a foreign client, including training of operating personnel. After the contract is
completed, the foreign client is handed the key to the plant that is ready for full
operation hence, the term turnkey. This is a mode of exporting process technology
to other countries. Turnkey projects are common in industries such as pharmaceutical,
chemical, and petroleum refining where complex, expensive technologies are used.
Advantages
The know-how required to run a technologically complex process is a valuable asset.
Turnkey projects earn greater returns from these assets. The strategy is useful
especially where FDI is limited by regulations of the host government. A turnkey
strategy can also be less risky than conventional FDI. In a country with unstable
economic and political environments, a longer-term investment might expose the firm
to unacceptable economic and/or political risks.
Disadvantages
Three drawbacks are associated with a turnkey strategy. First, the firm entering a
turnkey deal will have no long-term interest in the foreign market. This can be a
disadvantage if that country proves to be a major market for the output of the process
that has been exported. Second, the foreign enterprise with which a firm enters into a
turnkey project may turn out to be a competitor. Third, if the process technology of a
firm is the source of competitive advantage, then selling this technology through a
turnkey project is like selling competitive advantage to actual or potential competitors.
3.3 Licensing
A licensing agreement is an arrangement wherein a licenser grants the rights to
intangible property to a licensee or another entity for some specific period, and in
return, the licensor receives a royalty fee from the licensee. Intangible property
includes patent, trademarks, copyrights, formulas, inventions, designs, and processes.
Advantages
A primary advantage of licensing is that the firm does not have to incur the
development costs and risks associated with opening a foreign market. Licensing is
attractive to firms lacking capital to develop overseas operations. It is also attractive to
firms unwilling to commit substantial financial resources to an unfamiliar or
politically volatile foreign market. Licensing is often used when a firm wishes to enter
a foreign market but is unable to do so due to barriers to investment. Licensing is
frequently used when a firm has some intangible property that may have some
business applications, but it does not want to develop those applications itself.
Disadvantages
Licensing involves each licensee setting up their own production facilities and
operations. It does not give a firm the tight control over marketing, manufacturing,
and strategy that is required to realize the experience curve and location economies.
When these experiences and economies are important, licensing may not be the best
way for overseas expansion.
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Second, licensing limits a firm from using the profit earned in one country to support
a different licensee in another country.
A third problem with licensing is the risk associated with licensing technological
know-how to foreign companies.
The risks associated with licensing can be reduced by entering into a cross-licensing
agreement with a foreign firm. Under this agreement, a firm might license some
invaluable tangible property to a foreign partner, but the firm can request the foreign
partner to license some of its valuable know-how to it, in addition to a royalty
payment.
Another way of reducing risk is to link an agreement to license know-how with the
formation of a joint venture in which the licensor and the licensee have equal stakes.
3.4 Franchising
Franchising is a specialized form of licensing in which the franchiser sells the
intangible property to the franchisee and also insists that the franchisee agrees to abide
by the strict rules of conducting a business. The franchiser also assists the franchisee
to run the business on an ongoing basis. Franchising receives a royalty payment like
licensing. Franchising is employed by service firms. For instance, McDonalds uses a
franchising strategy where the franchisees follow strict rules of operating a restaurant,
and the control is extended to menu, cooking methods, design, location, and staffing
policies.
Advantages
The firm is relieved of the costs and risks of opening in a foreign market on its own.
Instead, the franchisee assumes these risks and costs.
Disadvantages
Franchising inhibits the ability of a firm to take out profits earned in one country to
support competitive strategies in another country. A significant disadvantage of
franchising is quality control. The foundation of a franchising agreement is that the
brand name of a firm conveys a message to consumers about the firms product
quality. This disadvantage can be overcome by setting up a subsidiary in each country
in which the firm expands. The subsidiary can be a joint venture with a foreign
company or can be wholly owned. The subsidiary assumes the rights and obligations
to establish franchises throughout the particular region or country. The proximity and
smaller number of franchisees to oversee reduces the challenges of quality control.
3.5 Joint Ventures

A joint venture entails establishment of a firm that is jointly owned by two or more
otherwise independent firms. For instance, Fuji Xerox set up a joint venture between
Xerox and Fuji Photo. The most typical joint venture is a 50/50 venture, in which two
parties hold a 50 percent ownership stake each and contribute a team of managers for
sharing operating control. However, in some joint ventures, one firm has a majority
stake and thus has tighter control.
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Advantages
Joint ventures have many advantages. First, firms benefit from the local partners
knowledge about the competitive conditions, language, business systems, and political
systems of the host country. Second, they gain by sharing the development costs and
risks associated with entering a foreign market. Third, in many countries, political
considerations make joint ventures the only possible mode of entry.
Disadvantages
There are major disadvantages with joint ventures. First, a firm entering a joint
venture risks giving control of its technology to its partner. However, joint venture
agreements can be constructed to minimize risks. One option is to hold majority stake
in the joint venture so that the dominant partner can exercise greater control. Another
option is to wall off from a partner technology that is central to the core competence
of the firm.
A second disadvantage is that a joint venture does not give a firm the kind of tight
control over its subsidiaries that it may need to realize location and experience curve
economies. Nor does it give the firm any control over a foreign subsidiary that it
might need to engage in its global strategies to coordinate against its competitors.
A third disadvantage with joint ventures is that the shared ownership arrangement can
lead to conflicts and battles for control between the investing firms if their objectives
and goals change or if they have different views over what the strategy should be.
3.6 Wholly-owned Subsidiaries

In a wholly-owned subsidiary, a firm owns 100 percent of the stock. A wholly-owned
subsidiary can be established in a foreign market in two ways. The firm can either set
up a new operation in that country, called a Greenfield venture, or it can acquire an
established firm in the host nation and use the firm for promoting its products.
Advantages
There are several advantages of having wholly-owned subsidiaries. First, when the
competitive advantage of a firm is based on technological competence, a whollyowned subsidiary will often be the preferred mode of entry as it reduces the risk of
losing control over that competence. Second, a wholly-owned subsidiary gives a firm
tight control over operations in different countries. This is essential for engaging in
global strategic coordination.
Third, a wholly-owned subsidiary may be required if a firm wants to realize
experience curve and location economies. When cost pressures are intense, it may pay
a firm to configure its value chain in such a way that the value added at each stage is
maximized.
Disadvantages
Establishing a wholly-owned subsidiary is the costliest method of serving the foreign
market from the standpoint of capital investment. Firms have to bear the full capital
costs and risks of setting up foreign operations.
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4. Selecting an Entry Mode

Trade-offs are inevitable when an entry mode is being selected. For instance, when a
firm is considering entering an unfamiliar country with a track record of
discriminating against foreign-owned enterprises, it might favor a joint venture with a
local enterprise. Its rationale might be that the local partner would help it establish
operations in an unknown environment and to earn contracts from the government.
However, if the core competency of the firm is in proprietary technology, entering
into a joint venture might mean the risk of its losing control of that technology to the
joint venture partner. Despite such trade-offs, it is possible to make some
generalizations about the optimal choice of entry mode.
4.1 Core competencies and Entry Mode

Firms expand internationally to earn greater returns from their core competencies,
skill transfer, and products derived from their core competencies in foreign markets
where indigenous competitors lack those skills. The optimal mode of entry for such
firms depends on the nature of the core competency to some extent. A distinction can
be made between firms whose core competency is in technological know-how and
those whose competency is in management know-how.
Technological Know-how
If the competitive advantage of a firm is based on control over proprietary
technological know-how, joint venture and licensing arrangements should be avoided
if possible in order to minimize the risk of its losing control over that technology.
Thus if a high tech firm establishes its operations in a foreign country to profit from a
core competency in technological know-how, it should go through a wholly-owned
subsidiary. However, sometimes a joint venture and licensing arrangement can be
structured to reduce the risk of the licensee or joint venture partner imitating its
technological know-how. Another exception exists when a firm perceives its
technological advantage to be transitory, when it expects imitation of its core
technology by competitors. In such cases, the firm might want to license its
technology rapidly so that it gain global acceptance for its technology before any
imitation occurs. This strategy has some advantages. By licensing its technology to
competitors, the firm may dissuade them from developing their own, superior
technology. Further, by licensing its technology, the firm may establish its technology
as the dominant design in the industry. This ensures a steady stream of royalty
payments.
Management Know-how
The competitive advantage of many service firms depends on the management knowhow. For such firms, the risk of losing control over the management skills to jointventure partner or franchisees is not great. The valuable asset of these firms is the
brand name, which is protected by international laws pertaining to trademarks. Many
issues arising in the case of technological know-how are of less concern here. Thus,
many service firms favor a combination of subsidiaries and franchising to control the
franchisee within particular countries or regions. The subsidiaries can be whollyowned or joint ventures. A joint venture is more acceptable politically and brings a
degree of local knowledge to the subsidiary.
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4.2 Pressures for Cost reductions and Entry Mode

The greater the cost reduction pressures, the more likely a firm will want to pursue a
combination of exporting and wholly-owned subsidiaries. By manufacturing in
locations where factor conditions are optimal and then exporting to the world, a firm
may realize substantial experience curve and location economies. The firm might then
want to export the finished product to marketing subsidiaries based in various
countries. Typically, these subsidiaries will be wholly-owned and have the
responsibility to oversee distribution in their particular countries. Establishing a
wholly-owned marketing subsidiary is preferred to a joint venture arrangement or
foreign marketing agents because it gives the firm tight control that could be required
to coordinate a globally dispersed value chain. The firm can also use the profits it
achieves in one market to improve its competitive position in another market. In other
words, firms pursuing a transnational or global standardization strategy prefer setting
up wholly-owned subsidiaries.
5. Greenfield Acquisition or Venture

A Greenfield strategy is one where a firm can establish a wholly-owned subsidiary in
a country by building a subsidiary from the ground-up.
5.1 Pros and Cons of Acquisitions

Acquisitions have many advantages. First, acquisitions are quick to execute. By acquiring
an established enterprise, a firm can rapidly build its presence in the foreign market.
Second, firms use acquisitions to preempt their competitors. The need for preemption
is great in markets that are rapidly globalizing, such as telecommunications. An
example is the US$ 60 billion acquisition of Air Touch Communications in the US by
British telecom company, Vodafone.
Third, managers may believe acquisitions to be less risky than Greenfield ventures. In
an acquisition, a firm buys a set of assets that are producing a known revenue and
profit stream. In contrast, the revenue and profit stream a Greenfield venture might
generate is uncertain as it does not exist yet.
Reasons for Failure of Acquisitions
Acquisitions fail for a number of reasons. First, the acquiring firm may overpay for
the assets of the acquired firm. The price of the target firm could be bid up if many
firms are interested in purchasing it. In addition, the management of the acquiring firm
is usually optimistic about the value that can be created through an acquisition and is
thus willing to pay a significant premium over market capitalization of the target firm.
This is known as the hubris hypothesis of why acquisitions fail. According to this
hypothesis, top managers typically overestimate their ability to create value from an
acquisition, chiefly because rising to the top of a corporation has given them an
overstated sense of their own abilities.
Second, many acquisitions fail due to cultural clashes between the acquired and the
acquiring firm. Many companies also experience employee turnovers as the
employees do not fit in with the culture of the acquiring firm. The loss of expertise
and management talent can harm the performance of the acquired unit. This may be a
problem in international business, where the management of the acquired firm has
valuable local knowledge that is difficult to replace.
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Third, many acquisitions fail as attempts to realize synergies by integrating the

operations of the acquiring and the acquired entities often run into roadblocks. The
slow integration of operations is attributed to differences in management philosophy
and company culture. These problems can be exacerbated by differences in national
culture. The process can also get complicated due to bureaucratic haggling.
Finally, inadequate pre-acquisition screening also results in the failure of many
acquisitions. Many firms decide to acquire other firms without making a thorough
analysis of the potential benefits and costs.
Reducing the Risks of Failure
These problems can be overcome if the firm is careful about its acquisition strategy.
The foreign enterprise to be acquired should be screened including a detailed auditing
of the financial position, operations, and management culture. This helps ensure that
the firm does not pay too much for the acquired firm, does not uncover any nasty
surprises post acquisition, and acquires a firm whose organizational culture is not
opposite to that of the acquiring company. It is also important for the acquiring firm to
alleviate any concerns the management of the acquired enterprise would have. The
objective should be to reduce unwanted attrition in management after the acquisition.
Finally, after the acquisition, the management should rapidly put an integration plan
into place and should act on the plan.
5.2 Pros and Cons of Greenfield Ventures

The biggest advantage of setting up a Greenfield venture in a foreign country is that it
gives the firm a greater ability to build the kind of subsidiary company that it desires.
For instance, it is easier to build the organizational culture from scratch than it is to
change the organizational culture of the acquired unit. Similarly, it is much easier to
establish a set of operating routines in a new subsidiary than it is to convert the
operating routines of the acquired firm. This is a very crucial advantage for many
international businesses where transferring competencies, products, skills, and knowhow from the firms established operations to the new subsidiary are principal ways
for creating value.
Despite the advantages, there are several disadvantages of a Greenfield venture. They
are slower to establish and are risky. A degree of uncertainty is also associated with
future revenue and profit prospects. A final disadvantage is the possibility of being
preempted by aggressive global competitors who enter through acquisitions and build
a market presence that limits the market potential of the Greenfield venture.
5.3 Greenfield or Acquisition?

It is not easy to make a choice between acquisitions or Greenfield ventures. Both have
their advantages and disadvantages. In general, the choice depends on the
circumstances confronting the firm. If a firm wishes to enter a market where there are
already-established enterprises, and in which global competitors are also interested in
establishing their presence, an acquisition route is a viable option. If a firm wishes to
enter a country where there are no incumbent competitors for acquisition, the
Greenfield venture may be the only mode. Even if incumbents exist, a Greenfield
venture is still preferable if the firms competitive advantage is based on the transfer
of organizationally embedded skills, routines, competencies, and culture.
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6. Strategic Alliances
Strategic alliances refer to cooperative agreements between potential or actual
competitors. Strategic alliances range from formal joint ventures in which two or
more firms have equity stakes, to short-term contractual agreements in which two
companies agree to cooperate on a particular task.
6.1 Advantages of Strategic Alliances

One of the biggest advantages of a strategic alliance is that it facilitates entry into
foreign markets. For instance, if a firm is considering making a successful entry into
the Chinese market, it needs a local partner who understands business conditions and
has good connections in China.
Second, strategic alliances allow firms to share the fixed costs of developing new
products or processes. For instance, an alliance between Boeing and a number of
Japanese companies to build the commercial jetliner, the 7E7, was motivated by
Boeings desire to share the estimated US$ 8 billion investment required for
developing the aircraft.
Third, an alliance brings together complementary skills and assets that neither
company could develop easily on its own. For instance, in 2003, Microsoft
Corporation (Microsoft) and Toshiba entered into an alliance for developing
embedded processors. To the alliance, Microsoft brought its software engineering
skills and Toshiba brought its skills in developing microprocessors.
Fourth, it makes sense to form an alliance that helps the firm establish technological
standards for the industry that would benefit the firms. For instance, in 1999, Palm
Computer, the leading Personal Digital Assistant (PDA) maker, entered into an
alliance with Sony under which Sony would license and use Palms operating system
in Sony PDAs. The alliance focused on establishing Palms operating system as the
industry standard for PDAs, as opposed to rival Microsofts Windows operating
system.
6.2 Disadvantages of Strategic Alliances

Some commentators have criticized strategic alliances saying that competitors get
access to a low-cost route to new markets and technology. The critics also point out
that alliances have risks. A firm may give its partner more than it receives in an
alliance.
6.3 Making Alliances Work

The success of strategic alliance depends on three main factors partner selection,
alliance structure, and managing the alliance.
Partner Selection
The key to managing a strategic alliance is to select the right partner. A good partner
has three characteristics. First, a good partner helps the firm in achieving its strategic
goals, whether it includes sharing of costs and risks associated with product
development, market access, or accessing critical core competencies. The partner
should have the capabilities lacked by the firm. Second, a good partner shares the
vision of the firm for the purpose of alliance. If the two firms entering an alliance do
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not share the same vision, the relationship will not be harmonious and will not
flourish. Third, a good partner does not exploit the firm opportunistically, that is, it
does not expropriate the technological know-how of the firm while giving away little
in return.
To select a partner with these characteristics, a firm needs to conduct comprehensive
research on potential alliance partners. Thus a firm should collect publicly available
information on potential partners, gather data from third parties, and get to know the
potential partner prior to committing itself to an alliance.
Alliance Structure
Having selected a partner, an alliance should be so structured that the risk associated
with a firm giving too much to its partner is reduced to an acceptable level. First,
alliances can be so designed as to make it difficult to transfer technology that should
not be transferred. The design, development, manufacture, and service of a product
created by an alliance can be structured to separate sensitive technologies to prevent
their leakage to the other participant. For instance, in an alliance between General
Electric and Snecma for building commercial aircraft engines, GE reduced the risk of
transferring in excess by walling off certain sections of the production process.
Second, contractual safeguards can be written into an agreement of the alliance to
guard against the risk of opportunism by a partner.
Third, parties in an alliance can agree in advance to swap skills and technologies to
ensure that both have an equitable gain. This goal can be achieved through crosslicensing agreements.
Fourth, the risk of opportunism can be reduced if the firm extracts in advance a
significant commitment from its partner.
Managing the Alliance
Once a partner has been selected and an alliance structure agreed on, the task facing
the firm is to maximize its benefits from the alliance. In all international business
deals, an important factor is sensitivity to cultural differences. Most of the differences
in management styles are attributed to cultural differences, and managers need to
make allowances for these in dealing with their partner. Beyond this, maximizing the
benefits from an alliance involves building trust between partners and learning from
them.
Successful management of an alliance requires the building of interpersonal
relationships between the managers of the firm -- what is referred to as relational
capital. For instance, Ford and Mazda set up a framework of meetings within which
managers discussed matters pertaining to the alliance and also had the time to get to
know each other better. The belief is that the resulting friendships help in building
trust and facilitating harmonious relations between the alliance partners. Personal
relationships also foster an informal management network between the firms. This
network can be used to solve problems arising in formal contexts.
Academics have argued that a major determinant of how much acquiring knowledge a
company gains from an alliance is its ability to learn from its partner. For example,
Gary Hamel, Yves Doz, and C K Prahalad conducted a five-year study on 15 strategic
alliances between major multinationals and focused on a number of alliances between
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Japanese companies and Western partners. In every case in which the Japanese
company emerged stronger than its Western partner, it had made a great effort to
learn.
Firms can maximize the benefits from an alliance by trying to learn from their partner
and then applying the knowledge to their own organization. It has been suggested that
the operating employees should be briefed on the strengths and weaknesses of the
partners and should understand how acquiring particular skills will bolster the
competitive position of the firm.
7. Summary
A firm has to contemplate three basic decisions for foreign expansion which
markets to enter, when to enter those markets, and on what scale.
Firms can use various entry modes such as exporting, turnkey project, licensing,
franchising, establishing joint ventures with a host firm, or setting up a whollyowned subsidiary in the host country.
Firms expand internationally to earn greater returns from their core competencies,
skill transfer, and products derived from their core competencies in foreign
markets where indigenous competitors lack those skills.
A Greenfield strategy is one where a firm can establish a wholly-owned
subsidiary in a country by building a subsidiary from the ground-up.
Strategic alliances refer to cooperative agreements between potential or actual
competitors.
Example: McDonalds Franchising Practices

McDonalds Corporation (McDonalds) is one of the largest food service
organizations in the world. It has a significant market share in the restaurant service
segment in almost all the countries where it has a presence. McDonalds is
considered one of the most renowned brands in the fast food segment. Its history
can be traced back to 1955 when its founder Ray A. Kroc started the first
McDonalds restaurant in Des Plaines, Illinois, USA. Within a very short time,
McDonalds extended its operations throughout the world. McDonalds fast
expansion into international markets can be attributed to its franchisee model.
McDonald's chose franchising as the best method of doing business in international
markets and is regarded as a premier franchising company around the world. In
fact, 70 percent of its restaurant businesses is owned and operated by franchisees.
McDonalds strongly believes that its success depended upon the success of its
franchisees. Therefore, it is very particular with regard to choosing its franchisees
and follows a distinct procedure in doing so.
The franchisees are selected on the basis of certain parameters such as highly
qualified individuals in terms of education, overall business experience, past
business and personal history of the individual, ability to lead the people, high
interpersonal relationships, and full dedication to the success of the business. The
franchisee has to pay an initial fee to McDonalds at the time of opening a new
restaurant. The choice of site location lies with the franchiser and it also takes the
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responsibility of acquiring the property and constructing the building. But the
responsibility of furnishing the building lies with the franchisee. Every franchisee
has to attend training programs conducted by McDonalds. However, McDonalds
allows its franchisees the freedom to manage their business and does not interfere
in their day-to-day operations.
The franchisees receive support from the parent company in areas like operations,
training, advertising, marketing, real estate, construction, and purchasing
equipment. Thus, even after setting up its own business, the franchisee is offered
support by the franchiser. Generally, the training program lasts for nine months,
and is provided to the franchisees free of cost. The training starts with teaching
basic restaurant operations like cooking, serving, cleaning, etc. Once the trainees
have gained knowledge in these, the training is conducted at regional training
centers. Here, the emphasis is on various areas such as business management,
leadership skills, team building, and handling customer enquiries. In the final part
of the training program, the franchisees are given coaching in controlling the stock
and ordering, recruiting of people, and maintaining of accounts. In 1961,
McDonalds established the Hamburger University, a world-wide management
training center in Oak Brook, Illinois, USA, to train its employees and franchisees.
It also set up ten international training centers in England, Japan, Germany, and
Australia.
The franchisees benefit from McDonalds various activities such as national marketing,
which is carried out to analyze consumer attitudes and perceptions in different
respective countries. The research findings help the franchisees to predict the market for
a particular product, thereby reducing their risk in the business. McDonalds gives
utmost importance to quality and has laid down certain standards to be followed by its
franchisees all over the world. To satisfy customers, the company relies on quality
service, cleanliness, and providing value for money. McDonalds also believes in
customizing the menu to suit the tastes of the local customers and in constant
improvisation of the menu to meet customers changing needs.
Example: The Tata Teleservices-DoCoMo Joint Venture

On June 10, 2009, Tata Teleservices Limited (Tata Teleservices), a CDMA mobile
service provider in India, and NTT DoCoMo Inc. (DoCoMo), a Japan-based
mobile phone operator, unveiled a new brand identity for their GSM service Tata
DoCoMo. The new branding followed months after the joint venture (JV) was
formed between the two companies in November 2008.
DoCoMo was founded in August 1991 as a subsidiary of Nippon Telegraph and
Telephone Corporation (NTT). To reduce its monopoly in the telecom sector,
NTTs mobile communication network was spun-off in 1992 to form DoCoMo.
The new division targeted the mobile cellular service market in Japan. As of March
2008, DoCoMo had a customer base of 53 million users covering more than half of
Japans cellular market. However, since 2006, the company had been losing its
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market share due to the aggressive strategies adopted by low cost competitors,
primarily SoftBank Mobile Corp., that sparked a price war in the market. When mobile
number portability (MNP) was introduced in Japan in 2006, DoCoMo was adversely
affected by a drop in the companys market share to 49.7 percent. DoCoMo was also
unable to compete with its rivals in terms of new customer acquisition.
Tata Teleservices was incorporated in 1996 as the telecom division of the Tata
Group led by Tata Sons. It provided a CDMA service in India under the brand
Tata Indicom. Its array of telephony services included mobile services, wire-line
services, public booth services, and wireless desktop phones. As of 2009, it catered
to around 37 million customers across 320,000 towns and villages of India.
In November 2008, Tata Teleservices announced that it was entering into a JV with
DoCoMo. Under the JV, DoCoMo bought a 26 percent stake in Tata Teleservices
for US$ 2.7 billion. Subsequently, DoCoMo made an open offer for 20 percent of
the outstanding equity of Tata Telecom Maharashtra Limited (TTML). In addition
to this, DoCoMo acquired 6 percent of additional shares in the company from the
Tata Group.
The JV was headed by a Business and Technology Cooperation Committee.
This committee consisted of senior personnel from both the companies. Their
mission was to identify the key areas where the companies could work together.
The JV gave Tata Teleservices a presence in the GSM market. After it clinched the
deal with DoCoMo, Tata Teleservices received a pan-India license to offer its GSM
services in 19 telecom circles and received allotments for spectrums in 18 telecom
circles from the Department of Telecommunications. The company planned to
invest US$ 2 billion for offering the GSM services across India.
While the JV marked the entry of Tata Teleservices into the GSM market, it
offered DoCoMo an opportunity to tap the Indian telecom market. DoCoMo
planned to introduce several services for the Indian consumers such as i-mode,
location-based services, and mobile payments. Moreover, the company also
planned to launch advanced technologies such as 3G and Long Term Evolution
(LTE) in India. DoCoMo expected the JV to earn profits within three years and was
ready to increase its stake in Tata Teleservices subsequently.
The Tata DoCoMo service was commercially launched on June 24, 2009, after
approval was received from the Securities Exchange Board of India (SEBI) and the
Foreign Investment Proposal Board (FIPB). The company launched an advertising
campaign consisting of print ads, radio, and outdoor advertising. The campaign was
reportedly well received by the public. Within three weeks of its launch, Tata DoCoMo
had completed its South India rollout covering Andhra Pradesh, Kerala, Karnataka,
Tamil Nadu, and Chennai. The company had also launched the service in Orissa and
Maharashtra, and had plans to have a pan-India presence by the end of 2009.
The unique selling proposition highlighted by Tata DoCoMo was the pay-as-youuse scheme under which the subscriber would be charged one paisa per second
and only for the duration of use. Based on this concept, the company formed its
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tagline Do the new. The pay-as-you-use benefit was extended to most of the
value added services which Tata DoCoMo offered. These services were voice chat,
24-hour music, cricket commentary, etc. In addition to this, the service for missed
calls alerts was complimentary. All subscribers of Tata DoCoMo could also avail
of voice mail functions without paying any monthly rentals, retrieval charges, or
deposits. In September 2009, Tata DoCoMo introduced the Diet SMS plan under
which it would charge only 1 paisa per character in an SMS.
The company received an overwhelming response from consumers. In just 45 days
of its launch, nearly 600,000 connections were sold. The demand was still
increasing and resulted in a supply crunch which led to black marketing of the
connections at higher prices.
Though the pay-as-you-use scheme offered by Tata DoCoMo received
encouraging response from the customers, some subscribers were not satisfied with
the service. They complained of inadequate customer service and poor network.
Tata DoCoMo responded to the consumer complaints and defended itself by saying
that the massive response received for its service had led to the problem of
congestion. It assured the complainants that they would be compensated for the
losses incurred.
Many analysts were of the opinion that this venture heldbig promises for both
sides. Industry observers believed that the Indian telecom market offered both
Indian and foreign operators huge scope for growth. As of July 2009, the
teledensity in India stood at 41 percent with an estimated 479 million subscribers,
and the number was poised to reach 770 million by 2013.
However, some analysts were not too optimistic about the JV since the Indian
telecom market was already overcrowded with established players like Bharti
Airtel Ltd., Vodafone Essar Ltd., and Reliance Communications Ltd. Some experts
also felt that the business model adopted by Tata DoCoMo could be easily
emulated by its competitors. Some experts opined that if the competitors followed
the pay-as-you-use scheme offered by Tata DoCoMo, the telecom sectors
revenue would be reduced by 10-15 per cent.
However, Tata DoCoMo remained optimistic about its future in the Indian telecom
sector. The company also contended that after the introduction of MNP it would be
able to wean away a significant number of subscribers from its rivals.
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Appendix -4
The Strategy of International Business

Introduction
International business managers increase the performance of their firm by expanding
into foreign markets. They also deal with competitive pressures for competing in the
global marketplace. Firms pursue different strategies when competing internationally.
This unit discusses the strategies pursued by firms for competing in international
markets. It then goes on to explain how firms increase their profitability by expanding
globally. It discusses the pressures faced by firms in global markets related to cost
reductions and local responsiveness. Finally, the unit takes a look at how firms choose
their strategies when competing internationally.
Strategy and the Firm

The strategy of a firm can be defined as the actions that managers take to attain the
goals of the firm. For most firms, the major goal is to maximize their value for their
owners, the shareholders. The value of a firm can be maximized by pursuing strategies
that increase the profitability of the firm and its rate of profit growth over time.
Profitability is the rate of return that the firm makes on its invested capital (ROIC).
ROIC is calculated by dividing the firms net profits by total invested capital. Profit
growth can be measured by the percentage increase in net profits over time. Higher
profitability and profit growth help in maximizing the value of a firm and thus the
returns acquired by the owners and shareholders.
To maximize a firms profitability, managers pursue strategies that lower costs or add
value to the firms products, which enable the firm to increase prices. Managers can
increase the profit growth rate by pursuing strategies to sell more products in existing
markets or by entering new markets.
Value Creation
By creating more value, firms can increase their profitability. The value created by a
firm is measured by the difference between its cost of production and the value
perceived by the consumers in its products. However, the price charged by a firm for a
product or a service is less than the value placed by the consumer. This is because
consumers capture some of that value in the form of consumer surplus. The consumer
is able to do this because the firm competes with other firms for the customers
business, so the firm has to charge a lower price than it could have if it was the only
supplier.
The strategy that focuses on lowering production costs is called low-cost strategy. The
strategy that focuses chiefly on increasing the product attractiveness is called
differentiation strategy. Michael Porter argues that low cost and differentiation are
two strategies that create value and help a firm attain competitive advantage in an
industry. According to Porter, firms that create superior value get superior
profitability. Superior value could be created by driving down the cost structure of the
business and/or differentiating its product so that the consumers value it more and are
ready to pay a premium.
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Strategic Positioning
According to Porter, a firm has to be explicit about its choice of strategic emphasis
with regard to value creation and low cost. A firm should also be clear about
configuring its internal operations for supporting that strategic emphasis.
Porter emphasizes that it is crucial for management to decide where the firm wants to
be positioned with regard to cost and value and accordingly configure its operations
and manage them efficiently.
Operations
The firms operations can be thought of as a value chain consisting of distinct value
creation activities including production, marketing and sales, materials management,
research and development, human resources, information systems, and the firm
infrastructure. The operations or value creation activities can be categorized as
primary activities and support activities. For a firm to implement its strategies
efficiently, it should manage these strategies effectively.
Primary activities
after-sales service of a product. The primary activities are divided into four functions
such as research and development, production, marketing and sales, and customer
service.
Research and development (R&D) is concerned with the product design and the
production process. R&D increases the products functionality through superior
design making it attractive for the customers to buy the product. In addition, R&D
also results in a more efficient production process, thereby cutting the costs of
production. Either way, R&D creates value.
Production is concerned with the creation of a product or service. For physical
products, production means manufacturing processes and their output. An example of
physical production could be production of an automobile in an assembly line. For
services such as healthcare or banking, production occurs when the service is
delivered to the customers. The production activity of a firm creates value by carrying
out its activities efficiently so that it results in lower costs of production or a product
of high quality, or both.
The marketing and sales functions create value in several ways. Marketing through
brand positioning and advertising, increases the value the customers perceive to be
contained in the product. If these create a favorable impression in the minds of the
consumers, the firm can charge a premium.
The marketing and sales function also creates value by discovering the needs of the
consumers and communicating them back to the R&D function, which can then
design products that will suit the needs of the consumers.
The role of the service activity is to offer after-sales service and support. By offering
support and solving the problems of consumers, this function creates a perception of
superior value in the consumers minds.
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Support activities
The support activities of the value chain provide inputs for the primary activities to
take place. For a firm to attain competitive advantage, the support activities are as
important as the primary activities. The transmission of physical materials through the
value chain, from procurement through production to distribution is controlled by the
logistics function. The efficiency with which these functions are carried out can
significantly lower costs, thereby creating more value.
The human resource (HR) function creates value by ensuring that the firm has the
right mix of people to perform its value creation activities efficiently. The HR also
ensures that the people are adequately trained, motivated, and compensated to carry
out the value creation activities efficiently.
Information systems are electronic systems that track sales, manage inventory, price
and sell products, deal with customer service queries, etc. Information systems
coupled with the communication features of the Internet can help in altering the
efficiency and effectiveness with which the firm manages its value chain activities.
Firm infrastructure is the final support activity. The infrastructure includes the control
systems, organizational structure, and culture of the firm. As the top management
exerts significant influence in shaping these aspects of a firm, it is also viewed as part
of the firms infrastructure. The top management shapes the firms infrastructure
through strong leadership, thereby enhancing the performance of all the value chain
activities.
Global Expansion and Profitability

Global expansion helps firms increase their profitability and profit growth rate. Firms
operating internationally can:
Expand the market for their local products by selling them in international
markets.
Realize location economies by dispersing individual value creation activities to
those locations across the globe where they can be carried out effectively and
efficiently.
Realize greater cost economies by serving the global market from a central
location, thus reducing the value chain costs.
Leverage valuable skills developed in foreign operations to earn greater return by
transferring them to other entities within the global network of operations of the
firm.
Market expansion: Leveraging products and competencies
A firm can increase its growth rate by taking goods or services developed
domestically and selling them internationally. For instance, automobile companies
such as Toyota and Volkswagen grew by developing products at home and later
selling them worldwide. The returns from such a strategy can be significant if the
competitor in nations which a country enters lacks comparable products.
The success of multinational companies that expand in this manner not only depends
on the product or services offered by them in the international markets but also on the
core competencies that underlie the production, development, and marketing of those
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goods or services. Core competencies refer to skills within the firm that competitors
cannot easily match or imitate. These skills may be present in any of the value
creation activities of the firm production, marketing, R&D, human resources,
logistics general management, etc. Such skills are expressed in product offerings that
other firms cannot imitate or find it difficult to imitate. Core competencies form the
basis for the firms competitive advantage. They allow a firm to reduce the value
creation costs and/or create a value so that their products can be premiumly priced.
For instance, Proctor & Gamble has a core competency in developing and marketing
name brand consumer products.
Location Economies
Countries differ in different dimensions such as economic, political, legal, and cultural
and these differences can either lower or raise the costs of doing business in those
countries. According to the theory of international trade, certain countries have a
comparative advantage in the production of certain factors due to factor cost
differences. For instance, Japan excels in the production of automobiles and consumer
electronics and the US excels in the field of biotechnology, pharmaceuticals, software,
and financial services.
For a firm that tries to survive in a competitive global market ( a market where the
trade barriers and transportation costs are negligible), the firm can benefit by basing
its value creation activities at the location where political, cultural, and economic
conditions including relative factor costs are conducive to the performance of that
activity.
Firms pursuing such strategies realize location economies which can be defined as
the economies that arise from performing a value creation activity in the optimal
location of that activity, wherever in the world that might be. Locating a value
creation activity in the optimal location can have one of two effects. It can lower value
creation costs and help the firm to achieve a low-cost position and/or enable a firm to
differentiate its products from those of competitors.
Experience Effects
The experience curve refers to systematic reductions in production costs that have
been observed to occur over the life of a product. Some studies have observed that
production costs decline by some quantity each time the cumulative output doubles.
This was observed in the aircraft industry where each time the cumulative output of
airframes doubled, the unit costs declined by 80 percent of their previous level.
Learning Effects
Learning effects are savings in cost that come from learning by doing. For instance,
labor learns more efficiently by repeating how to carry out a task, such as assembling
airframes. The productivity of labor is enhanced over time as the laborers learn to
perform the tasks more efficiently. Similarly, in production facilities, management
learns to manage new operations efficiently over time. Thus the increasing efficiency
and management and labor productivity result in a decline in production costs, which
in turn enhances the profitability of the firm.
Learning effects become more significant when technologically complex tasks are
repeated, because there is more to be learned about the task. Thus learning effects are
noteworthy in an assembly process involving 1,000 complex steps than in just 100
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simple steps. However, the learning effects are important only during the start-up
period and disappear after two to three years. Any decline in the experience curve
after such a point is attributed to economies of scale.
Economies of Scale
Economies of scale refer to the reductions in unit costs achieved by producing a large
volume of a product. Attaining economies of scale helps in lowering unit costs of a
firm and increases its profitability. There are a number of sources for economies of
scale. First, the ability to spread fixed costs over a large volume. Fixed costs are costs
incurred in a setting up a production facility, developing a new product, etc. Second, a
firm may not be able to attain efficient scale of production unless it serves the global
markets.
Finally, as global sales increase the firms size, its bargaining power increases. This
may allow it to barrage down its cost of inputs, helping it boost its profitability.
Leveraging on Subsidiary Skills
Valuable skills are developed by a firm in its home market and are then transferred to
foreign operations. For instance, Wal-Mart developed its retailing skills in the US and
then transferred them to its foreign operations. However, for mature multinationals
that already have a network of subsidiary operations in foreign markets, valuable
skills can be developed in foreign subsidiaries as well.
Leveraging on the skills developed within subsidiaries and applied to the firms other
operations under the firms global network may create value. For instance,
McDonalds finds in its foreign franchisees a source of valuable ideas. Due to low
growth in France, McDonalds franchisees experimented with the menu as well as the
layout and theme of restaurants. Following the change, the increase in same stores
sales grew from 1 percent to 3.4 percent in 2002. Impressed by the idea, executives at
McDonalds adopted similar changes at other McDonalds restaurants where same
stores sales growth was sluggish, including in the US.
This phenomenon creates new challenges for managers of multinational enterprises.
First, they should have the humility to recognize that valuable skills that lead to
competencies can arise anywhere within the global network of the firm and not just at
the corporate center. Second, they should establish an incentive system that
encourages local employees to acquire new skills. Third, managers should have a
process to identify when valuable skills have been created in a subsidiary. Finally,
managers have to act as facilitators for transferring the valuable skills within the firm.
Pressures for Cost and Local Responsiveness

Firms competing in a global marketplace face two types of competitive pressures that
have an effect on their ability to realize location economies and experience effects, for
leveraging on products and transferring competencies and skills within the firm. They
face pressures for cost reduction and pressures for local responsiveness. These
pressures place competitive demands on a firm. For responding to cost pressures, a
firm has to minimize its unit costs. For responding to pressures of local
responsiveness, a firm has to differentiate its marketing strategy and product offering
from one country to another in a bid to accommodate diverse sets of demands that
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arise due to national differences in consumer tastes and preferences, distribution

channels, business practices, competitive conditions, and government policies. As
differentiation across countries may involve significant duplication and a lack of
standardization of products, it may increase costs.
Cost Reduction Pressures
International business often faces cost pressures in competitive global markets. For
responding to cost pressures, a firm has to lower its value creation costs. For instance,
a manufacturer may mass-produce a product at an optimal location in the world and
may outsource certain functions to low-cost suppliers in a bid to reduce costs.
Cost reduction pressures can be intense in industries where commodity-type products
are produced, where differentiation on non-price factors is difficult, and price is the
major competitive weapon. This is the case with products that serve universal needs.
Universal needs exist when tastes and preferences of consumers in different nations
are similar if not identical. Examples are conventional commodity products such as
petroleum, sugar, steel, etc. It is also the case with several industrial and consumer
products such as personal computers, liquid crystal display screens, handheld
calculators, and semiconductor chips.
Cost reduction pressures are also intense in industries where major competitors are
based in low-cost locations, where consumers are powerful and face low switching
costs, and where there is persistent excess capacity. The liberalization of the world
trade and investment environment by facilitating greater international competition has
resulted in an increase in cost pressures.
Local responsiveness pressures
Local responsiveness pressures arise from national differences in consumer tastes and
preferences, infrastructure, business practices, distribution channels, and from the
demand of the host-government. To respond to these pressures, a firm has to
differentiate its products and marketing strategy across countries to accommodate
these factors, all of which tend to raise the cost structure of the firm.
Differences in consumer tastes and preferences
Consumer tastes and preferences differ significantly across countries due to deeply
rooted historic or cultural reasons. In such cases, a multinationals marketing message
should be customized to appeal to the local consumers. This creates pressures for a
firm to delegate production and marketing functions and responsibilities to the
overseas subsidiaries of a firm. For instance, consumers in North America have a
strong demand for pickup trucks whereas the European consumers consider pickup
trucks as utility vehicles because of which these are purchased mostly by firms as
opposed to individuals.
Some commentators argue that consumer demands for localization are on the decline
worldwide. This has been highlighted by the fact that modern communication and
transport technologies have created conditions for convergence of consumer tastes and
preferences from different nations. This has resulted in the emergence of several
global markets with standardized consumer products. For instance, companies and
products such as Coca-Colas soft drinks, McDonalds burgers, Nokias cell phones,
and Sonys PlayStations have gained worldwide acceptance.
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However, significant differences in consumer tastes and preferences still exist across
nations and cultures. International business managers do not yet have the luxury to
ignore such differences.
Differences in infrastructure and traditional practices
The local responsiveness pressures that arise from differences in infrastructure and
traditional practices create a need for product customization. This requires a firm to
delegate its manufacturing and production functions to its foreign subsidiaries. For
example, in North America, electrical systems are based on 110 volts whereas in
European countries, the standard is 240 volts. Thus, domestic electrical appliances are
required to be customized for this difference in infrastructure. The traditional practices
also differ among nations. For instance, people in Britain drive left-hand cars thus
creating a demand for left-hand cars whereas in France, people drive right-hand drive
cars and hence want right-hand drive cars.
Differences in distribution channels
The marketing strategies of a firm have to be responsive to differences in distribution
channels among countries, which may demand delegation of the marketing functions
to national subsidiaries. For instance, in the pharmaceutical industry, the Japanese and
the British systems are radically different from the US system. Japanese and British
doctors do not respond to a high-pressure sales force. Thus, pharmaceutical companies
have to adopt different marketing practices in Japan and Britain compared with what
they follow in the US.
Host-government demands
Political and economic demands imposed by governments of the host country may
require local responsiveness. For example, pharmaceutical companies are subject to
registration procedures, local clinical testing, and pricing restrictions, all of which
make it essential that the manufacturing and marketing of a drug should meet local
requirements. As governments and government agencies control a significant
proportion of the healthcare budget in most of the countries, they are in a powerful
position to demand a high level of local responsiveness.
In general, threats of protectionism, local content rules, and economic nationalism
dictate that international businesses manufacture locally. For example, Canada-based
manufacturer of railcars, jet boats, and aircraft, Bombardier, has 12 railcar factories in
Europe. Critics argue that the resulting duplication of manufacturing facilities leads to
high costs and helps explain why Bombardier makes lower profit margins on its
railcar operations than on its other line of businesses. In reply, Bombardier managers
argue that in Europe, informal rules with regard to local content favor people using
local workers. For selling railcars in Germany, they claim manufacturing should be
done in Germany. For addressing its cost structure in Europe, Bombardier has
centralized its engineering and purchasing functions but has no plans to centralize
manufacturing.
Choosing a Strategy
When competing internationally, firms typically select from one of the four strategies
global standardization strategy, localization strategy, transnational strategy, and
international strategy. The appropriateness of each strategy varies given the extent of
cost reduction and local responsiveness pressures.
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Firms pursuing a global standardization strategy focus on increasing profitability and
profit growth by making use of the reductions in cost arising from location economies,
learning effects, and economies of scale -- that is, the strategic goal of a firm is to
pursue a low-cost strategy on a global scale. The marketing, R&D, and production
activities of a firm that pursues a global standardization strategy are concentrated in
some favorable locations. Such firms do not make any attempt to customize their
product offering and marketing strategy to local conditions as customization involves
shorter production runs and the duplication of functions, which may increase costs.
Instead, firms prefer to market a standardized product worldwide to reap the
maximum benefits from learning effects and economies of scale. They may also make
use of their cost advantage for supporting aggressive pricing in world markets.
The global standardization strategy makes a lot of sense when the demand for local
responsiveness is minimal and there are strong pressures for cost reductions. These
conditions are prevalent in many industrial goods industries, whose products serve
universal needs. For instance, in the semiconductor industry, global standards have
emerged, creating a huge demand for standardized global products. Accordingly,
companies such as Texas Instruments, Intel, and Motorola pursue a global
standardization strategy. However, these conditions are not found in consumer goods
markets, where the demand for local responsiveness is high.
A localization strategy focuses on increasing the profitability of a firm by customizing
its goods or services so that they offer a good match to tastes and preferences in
different national markets. Localization can be appropriate when cost pressures are
not too intense and when there are substantial differences across nations with regard to
consumer tastes and preferences. By customizing a product to suit local demands, a
firm increases the product value in the local market. However, as customization
involves duplication of functions and smaller production runs, it limits the ability of a
firm to capture the cost reductions that are associated with mass-producing of a
standardized product for global consumption. MTV is a good example of a company
that has adopted the localization strategy. If it had not localized its programs, it would
have lost its market share to local competitors; its advertising revenues would have
fallen, and its profitability would have declined.
When a firm simultaneously faces strong cost pressures and pressures for local
responsiveness, it is advisable for it to pursue a transnational strategy.
According to researchers Christopher Bartlett and Sumantra Ghoshal, in todays
global environment, competitive pressures are so intense that to survive, firms need to
do anything to respond to pressures for cost reductions and local responsiveness.
Firms should realize experience effects and location economies for leveraging on
products internationally, for transferring core competencies and skills within the
company, and for paying attention to local responsiveness pressures. Bartlett and
Ghoshal note that in a modern multinational enterprise, core competencies and skills
do not reside just in the home country but can also be developed in any of the firms
operations worldwide. Thus, they maintain that product offerings and skills should not
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just flow from home country to foreign subsidiary but also from foreign subsidiary to
home country and foreign subsidiary to foreign subsidiary. In other words,
transnational enterprises should focus on leveraging on the skills of the subsidiary.
In essence, firms pursuing a transnational strategy make attempts to simultaneously
achieve low costs from location economies, learning effects, and economies of scale;
differentiate their product offerings across geographic markets to account for local
differences; and foster a multidirectional flow of skills between different subsidiaries
of the firm. The transnational strategy is not easy to pursue as it places conflicting
demands on the company. Differentiating the product in different geographic markets
to suit local demands may increase costs, which is in contrast to the firms goal of
reducing costs.
Some multinationals find themselves in a fortunate position where they confront low
cost pressures and low pressures for local responsiveness. Such firms pursue an
international strategy where products are produced in the domestic market and are
then sold in international markets with minimal localization. The distinguishing
feature of such firms is that they sell products that serve universal needs but do not
face significant competitors and thus, unlike firms pursuing a global standardization
strategy, are not confronted with pressures to reduce their cost structures. Xerox found
itself in such position in the 1960s after it invented and commercialized a photocopier.
The technology was protected by patents so Xerox had no competition and had a
monopoly. The product served universal needs and was highly valued in many
developed nations. Thus, Xerox sold the same basic product worldwide, charging a
relative high price. Since Xerox did not face any direct competitor, it did not have to
deal with strong pressures to minimize its cost structure.
Firms pursuing an international strategy have followed a similar developmental
pattern as they have expanded into foreign markets. They tend to centralize product
development functions such as R&D at home. However, they may also make attempts
to establish manufacturing and marketing functions in each major geographic region
or country where they conduct their business. The resulting duplication can increase
costs, but this is not a major issue if a firm does not face strong pressures to reduce
costs. Though the firms may undertake some local customization of marketing
strategy and product offering, this may be limited in scope. Eventually, in most of the
firms that pursue an international strategy, the head office retains tight control over
product and marketing strategy.
Summary
The strategy of a firm can be defined as the actions that managers take to attain
the goals of the firm.
The value created by a firm is measured by the difference between its cost of
production and the value perceived by the consumers in its products.
The operations or value creation activities can be categorized as primary activities
and support activities. For a firm to implement its strategies efficiently, it should
manage these strategies effectively.
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after-sales service of a product. The primary activities are divided into four
functions -- research and development, production, marketing and sales, and
customer service.
The support activities of the value chain provide inputs for the primary activities
to take place.
Global expansion helps firms increase their profitability and profit growth rate.
Firms operating internationally can expand the market for their local products by
selling them in international markets, by realizing location economies, by
realizing greater cost economies, and by leveraging on valuable skills developed
in foreign operations.
Firms competing in a global marketplace face two types of competitive pressures
pressures for cost reduction and pressures for local responsiveness. These
pressures have an effect on their ability to realize location economies and
experience effects, for leveraging products and transferring competencies and
skills within the firm.
When competing internationally, firms typically select from one of the four
strategies global standardization strategy, localization strategy, transnational
strategy, and international strategy.
Example: Innovation as a Core Competency at Whirlpool

All through the 1990s, Whirlpool Corporation (Whirlpool) had focused on having
quality and cost reduction as its core competency. David R. Whitwam (Whitwam),
chairman and CEO of Whirlpool, believed that only innovative products could
command premium prices and build customer loyalty. He emphasized the need to
develop a culture that would spur Whirlpools growth through consumer-focused
innovation. This would be a part of the companys competitive strategy. In fact,
Whitwam wanted to make innovation a core competency at Whirlpool. Moreover,
he did not want creativity to be limited to a few people in the organization; he
wanted all the employees to be creative.
The practical aspect of such an initiative was also overwhelming. Whirlpool had to
first figure out what it meant by innovation, how to measure success or failure, and
how to inculcate creativity in its people.
Initially, Whirlpool had trouble deciding on its definition of innovation. The top
management decided that for any idea to be considered innovative, it had to meet
three criteria innovative
it had to create a competitive advantage, it had to be
unique and differentiating, and it had to create shareholder value. However, after
working for about three years on those metrics, the management realized that these
criteria alone would not be sufficient. Measuring the results was equally difficult.
Linking the results of an innovation to revenues was another problem. The
management at Whirlpool also had to consider what should be the measure of
success or failure: the number of employees trained in innovation or the revenue
generated from innovation? What should the goal for revenue generated from
innovation in a year be: should it be US$500 million, or should it be US$1 billion?
Contd
91
Contd
There was also the aspect of training the employees in creativity, giving them
access to expertise and small amounts of seed funding, the freedom to work on
their ideas, and a way to share information. In short, Whirlpool needed to set up a
formal framework to bring about a culture change and supporting infrastructure
like IT to support this change initiative. Another challenging aspect was that
everything had to be built up from scratch.
While the core groups were being trained, Nancy T Snyder (Snyder), vice president
of leadership and strategic competency development at Whirlpool, focused on
getting the rest of the companys global workforce involved in the initiative
through the Internet and innovation fairs. Strategos, a US-based management
consultancy firm, helped Whirlpool to put the necessary infrastructure in place and
to use Information Technology (IT) to facilitate the objective. Whirlpool reengineered management processes that slowed down innovation and used IT to
improve and accelerate the innovation chain from idea to final product. Instead of
going in for a few big projects, it encouraged many low-cost stratlets (also
known as small strategies).
Snyder put a leadership team in place. The team included a global director of KM,
three regional vice presidents of innovation, and regional innovation boards (IBoards) to set goals, allocate resources, and review ideas for funding. Executive Iboards in each region strove to keep the companys innovation pipeline full. They
were responsible for building innovation capability, identifying the next generation
of innovation consultants (I-consultants), coordinating innovation-related
programs, and keeping innovation at the top of Whirlpools corporate agenda. Iconsultants were full-time staff that helped divisions adopt and implement
innovation techniques. They also facilitated individuals, groups, or business units
to come up with new ideas and put these ideas into action.
Later, each major business unit also established an I-Board. Twenty-five people
from each region were trained to serve as in-house I-consultants and I-mentors. Imentors were people specially trained to facilitate innovation projects and to help
people with their ideas. I-consultants hired their own team of I-mentors.
A knowledge management system called the Innovation E-Space was started which
provided a course in innovation. It started with the fuzzy front end of innovation
where random insights were systematically generated and shared to spark ideas. If
an employee had a concept, he/she could go to the knowledge management system
and post the idea on a bulletin board. The home page linked employees to all the
tools and resources they needed, from insight libraries and innovation templates to
I-mentors. According to Snyder, this provided an informal social system enabled
by technology that worked across the hierarchy level.
All the projects that were in the pipeline were listed on the I-Pipe on the website.
The I-Pipe gave a dashboard view of the innovation pipeline adapted from
Strategos. It tracked ideas from concept to scale-up and provided project details as
well as the big picture, enabling management to focus on areas that needed
Contd
92
Contd
attention. According to Gary Hamel (a visiting professor of Strategic and

International Management at the London Business School, chairman of Strategos,
and director of the Woodside Institute), the I-Pipe helped innovators to create
strategy and top managers to edit it so as to fit the companys requirements. He
also acknowledged that using IT to support innovation sessions was challenging.
The Innovation E-Space was cost-effective and did not require a big investment.
On the front end, Whirlpool used a Lotus Notes-based intranet and added new
capabilities using collaboration tools like QuickPlace and Sametime from Lotus.
For the I-Pipe, the company built a platform on its SAP infrastructure using SAPs
xApps for project resource management. Organizing tactical training was
complemented by a significant amount of e-learning technology. Some courses
were put online using LearningSpace of IBM Mindspan Solutions. Using such selfpaced courses freed up Whirlpool resources for assignment tp other products and
significantly reduced costs.
Whirlpool also hosted innovation fairs to felicitate inventors and encourage the
flow of ideas. At these fairs, proud employees demonstrated their new designs and
discussed their proposals.
Instead of waiting for employees to come out with ideas, the I-mentors helped
employees reflect on customer needs, industry trends, and their own experience to
come up with insights on formal innovation sessions.
The insight gained from the cross-fertilization of ideas between people from
various disciplines such as marketing and engineering also helped. For the
employees, the thrill of achievement was its own reward, and innovators received
no bonuses or perks for their ideas. According to Tammy Patrick, global director of
knowledge management, the innovators got charged up by the opportunity for
exposure and the fact that someone was listening to their idea.
Though initially Whirlpool got very few ideas out of the process, the rank-and-file
employees were happy that their participation was being sought on important
matters. However, the immediate superiors of the people who were engaged in this
process and senior managers were not happy as they thought that this initiative was
a distraction from their regular work. Moreover, in the absence of concrete goals
and this initiative not being tied to their performance in any way, the middle level
management had little incentive to support the initiative. The hardest part for
Whirlpool was to change the way leaders saw their roles as this required a huge
shift in thinking. According to Snyder, only leaders could change an environment
and allow an innovator the freedom to pursue different things.
Example: Localization Strategies of MTV in India

MTV Networks International (MTVI) adopted the policy of Think Globally, Act
Locally, in the mid-1990s and began to launch separate channels in its different
regions. Although many programs were adapted from American originals, the
channels were presented in a localized format. MTVI tried to establish MTV as a
global brand with a local outlook.
Contd
93
Contd
MTVI built its base outside the US by not only launching the MTV channel but
also by acquiring local music channels. It followed the practice of tying up with a
local company for the initial launch and acquiring the channel from the company
after some time.
MTVI entered India in the early 1990s in a tie-up with STAR TV but exited the
country in 1994 after differences erupted between the partners in the tie-up. By the
time it re-entered India in 1995, STAR TV had launched Channel [V], a 24-hour
music channel, which was available in many parts of South-Asia. Channel [V]
became very popular, especially in India, because it aired programs in Hindi.
On its re-entry, MTV Asia tied up with Indias national television service
Doordarshan (DD). Initially, MTV Asia was aired for two hours every day on DD
Metro, one of the channels of DD, before becoming a 24-hour channel. MTV India
was later launched as a separate channel in 1996.
Taking its cue from Channel [V], MTV India began broadcasting Hindi film songs.
Officials at MTV Asia were confident that the channel would become successful in
India.
By the late 1990s, MTV India had launched a variety of programs with Indiaspecific content. Most of the programs were film based and were targeted at the
youth. The VJs, many of whom were picked through VJ hunts conducted across the
country, became very popular. Some Indianized programs like MTV Bakra (a
reality prank show), Fully Faltoo (a spoof show on Hindi films and songs), and
MTV Roadies (based on the US reality show Road Rules) also gained popularity.
MTV India also co-sponsored many music events and began merchandising
products like clothes and perfumes under the MTV banner in 2001.
Though the programming format of MTV India was more or less similar to that of
MTV in America, the content was localized to suit the preferences of Indian
viewers. By 2004, MTV India had become the leading Indian music channel in
terms of advertising revenues, with a 35% market share. MTV Asia also launched
VH1 and Nickelodeon in a localized format in India.
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Concept Note - 4
International Monetary System

1. Introduction
International business is carried out in an uncertain environment in which the
exchange rates are very volatile. Volatile exchange rates increase the risk for
international firms. An understanding of the international monetary system helps in
managing foreign exchange risk.
Balance of payments record the economic transactions between one country and the
rest of the world.
This unit discusses the history of the international monetary system. It then explains
different exchange rate systems. It talks about the methods that help in determining
foreign exchange rates. The unit finally takes a look at the concepts relating to balance
of payments and its accounts.
2. History of the International Monetary System

The international monetary system refers primarily to the set of policies, institutions,
practices, regulations, and mechanisms that determine foreign exchange rates. The
system comprises currencies from individual countries in addition to composite
currency units such as the European Currency Unit (ECU) and Special Drawing
Rights (SDR). Foreign exchange refers to the money of a foreign country, such as
foreign currency bank balances, banknotes, checks, and drafts. A foreign exchange
rate is the price of one currency expressed in terms of another currency (or gold). A
system can be classified as a fixed or managed exchange rate system if the government
of a country regulates the rate at which the local currency can be exchanged for other
currencies. If a countrys currency is pegged or tied to the currency of another
country, it is called a pegged exchange rate system. The rate at which the currency is
fixed is often referred to as its par value. If a government does not interfere in the
currency valuation, it is classified as a floating or flexible exchange rate system. The
real exchange rate is the exchange rate after deducting an inflation factor. The
nominal exchange rate is the exchange rate before deducting an inflation factor.
The changes in exchange rates may move in one of the two directions. Associated
with the fixed exchange rate system, devaluation of a currency refers to a drop in the
foreign exchange value of a currency that is pegged to another currency or gold.
Associated with the floating exchange rate system, depreciation refers to a drop in
the foreign exchange value of a floating currency. Appreciation refers to a gain in
the foreign exchange value of a floating currency.
The choice of foreign currencies used by international firms influences their cash flows
and income levels. For instance, firms in countries with soft currencies use hard foreign
currencies in their export businesses. A soft or weak currency is one that is anticipated
to devaluate or depreciate relative to major trading currencies. A currency is considered
hard or strong if it is expected to revalue or appreciate relative to major currencies.
A brief review of the history of the international monetary system will help in
understanding the current monetary system and appraise the strengths and weaknesses
of different foreign exchange systems.
2.1 The Gold Standard Period (1876-1914)

Gold has been used as an exchange medium and a store of value since the days of the
pharaohs (about 3000 B.C). In the 1870s, the gold standard was accepted as an
international monetary system. Under this system, each country pegged its currency to
gold.
The governments using the gold standard agreed to buy or sell gold on demand at their
own fixed parity rate. Thus, the value of each currency in terms of gold and the fixed
parities between currencies remained stable. The system required the countries to
maintain an adequate reserve of gold to back their currencys value. The gold standard
worked adequately until World War I that interrupted trade flows and free movement
of gold. Thus, the major trading nations suspended the gold standard.
2.2 The Inter-War Years and World War II (1914-1944)

During World War I and the early 1920s, currencies were allowed to fluctuate over
wide ranges in terms of another currency and gold. This led to the creation of
arbitrage opportunities for international speculators. Such fluctuations led to
hampering of world trade in the 1920s, resulting in the Great Depression in the 1930s.
In 1934, the US returned to a modified gold standard, when the dollar was devalued to
$35 per ounce of gold from $20.67 per ounce of gold in price. Though the US
returned to the gold standard, gold was not traded with individual citizens but only
with foreign central banks. From 1934 to the end of World War II, the exchange rates
were determined by each currency value in terms of gold. However, during World
War II and its aftermath, many of the major trading currencies lost their convertibility
into other currencies. The dollar remained the only major trading currency that
continued to be convertible.
2.3 The Bretton Woods System (1944-1973)

This period was characterized by a fixed exchange system. Under the provisions of
the Bretton Woods Agreement that was signed in 1944, the governments of all the
member countries took a pledge to maintain a fixed or pegged exchange rate for their
currencies vis--vis gold or the dollar. Fixing the gold price of a currency was
equivalent to its exchange rate in relation to the dollar, because one ounce of gold was
equal to $35. The countries participating in the agreement agreed to make an effort to
maintain their currency values within a 1 percent band by buying or selling gold or
foreign exchange as needed. Devaluation could not be used as a competitive trade
policy but in case the currency became too weak to defend, it could be devaluated up
to 10 percent without formal approval from the International Monetary Fund (IMF).
During this period, the US dollar was the key to the web of exchange rate values and
was the main reserve currency held by central banks. Unfortunately, the US grew
deficits on its balance of payments. To finance these deficits and meet the growing
demand for dollars from businesses and investors, a heavy capital outflow of dollars
was required. Eventually, a heavy overhang of dollars held abroad resulted in a lack of
confidence in the ability of the US to meet its commitment to convert dollars to gold.
On August 15, 1971, the US gave a response to the huge trade deficit by making the
dollar inconvertible to gold. A program for wage and price controls was introduced
and a 10 percent surcharge was placed on imports. Many major currencies were
allowed to float against the dollar. Then the dollar began a decade of decline.
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Under the Smithsonian Agreement, which was reached in Washington DC in

December 1971 among the worlds trading nations, the US agreed to devalue the
dollar to $38 per ounce of gold. In return, the other countries present decided to
revalue their currencies upward by specified amounts relative to the dollar. Actual
revaluation ranged from 7.4 percent in Canada to 16.9 percent in Japan. Furthermore,
the allowed floating band was expanded to 1 to 2.5 percent.
The high inflation in the US resulted in the dollar devaluation remaining insufficient
to restore stability to the system. By 1973, even at devalued rates, the dollar was under
heavy selling pressure. By February 1973, a fixed-rate system was no longer feasible
given the speculative currency flows. In March 1973, major foreign exchange markets
were closed for several weeks and after they reopened, most currencies were
permitted to float to levels that were determined by market forces.
2.4 The Post-Bretton Woods System: 1973-Present

This period is characterized by a floating exchange rate system. Since March 1973,
the exchange rates had become very volatile and less predictable than they had been
during the fixed exchange rate period. The system became more volatile as it
approached the oil crisis in 1973. By October 1973, the Organization of Petroleum
Exporting Countries (OPEC) made efforts to raise oil prices and these proved
successful. By 1974, the oil prices had quadrupled. Several nations, especially the US,
made efforts to offset the high energy bills by boosting spending. This resulted in high
inflation and vast deficits in the balance of payments, which eventually caused the
dollar crisis of 1977-1978.
During 1981-1985, the US dollar rebounded strongly due to President Reagans
economic policy. However, the dollar resumed its downhill slide attributed chiefly to
a slowdown in the US and changes in US government policy. After the dollar had
declined considerably, the US, Japan, West Germany, France, Britain, Italy, and
Canada also known as the Group of Seven (or G-7) met in February 1987 and
agreed to slow down the fall of the dollar. This agreement, also known as the Louvre
Accord, required the G-7 nations to support the falling dollar by pegging exchange
rates within an undisclosed and narrow range. In early 1988, the dollar rallied, thereby
ending its dramatic volatility. In 1990, the US dollar fell again and stayed flat during
1991-1992. In 1993, it fell against the Japanese yen and DM.
The third major crisis of the 1990s was the turmoil rocking the Asian foreign
exchange markets since June 1997. The predecessors to this were the crisis in the
European Monetary System (EMS) of 1992-1993 and the Mexican peso crisis of
1994-1995. The Asian crisis was sparked by the collapse of the Thai currency, the
baht. In one month, the baht lost 20 percent of its value against the dollar. The
currencies of Indonesia, Malaysia, and the Philippines also weakened. In August
1997, the Indonesian authorities were forced to allow the rupiah, their national
currency, to move freely against other currencies. In December 1997, the IMF put up
a US$ 58.4 billion international bailout for Korea. The Koreans decided to float the
won. In August 1998, the Russian authorities devalued the ruble due to the rapidly
deteriorating foreign currency reserves. The US Federal Reserve responded to the US
credit crunch by lowering the interest rates three times in quick succession. This
included a unilateral move by Alan Greenspan, Fed Chairman. In September 1998,
other industrialized countries such as Japan, Canada, and most of the European
nations also eased monitory policies. In October 1998, the G-7 nations endorsed a
plan for allowing the IMF to lend to countries before they got into financial troubles.
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3. Exchange Rate System

3.1 Fixed-rate System
Under a fixed-rate system, governments can buy or sell their currencies in the foreign
exchange market whenever there is a deviation in the stated par values. A few centrally
planned economies such as North Korea and Cuba employ a purely fixed-rate system. In
these economies, it is usually mandatory for the foreign exchange earnings of a local
firm to be surrendered to the central bank. The firm receives a return for this, a
corresponding amount in local currency. The foreign exchange income is allocated by
the central bank to state-owned users based on governmental priorities.
The fixed-rate system helps economies in stabilizing their economic environment, control
foreign exchange reserves, and emphasize priority projects that are in need of foreign
exchange. The fixed-rate system also has certain drawbacks such as distortion of foreign
exchange demand and supply, resource misallocation, and drag on company performance.
3.2 Crawling peg System

The peg system is situated between the fixed-rate and float-rate systems. The crawling
peg is an automatic system for revising the exchange rate, establishing a par value
around which the rate can vary up to a given percentage point. The par value is
regularly revised according to the formula which is determined by the authorities.
After the par value is set, the central bank intervenes whenever the market value
approaches a limit point. For instance, if the par value of the Mexican peso is 3,000
pesos for one dollar, it can vary 2 percent around this rate, between 3,060 pesos and
2,940 pesos. If the dollar approaches the rate of 3,060 pesos, the central bank
intervenes by selling dollars and buying pesos. If the dollar approaches the rate of
2,940 pesos, the central bank intervenes by selling pesos and buying dollars.
A government can peg its currency either to a single currency or a basket of foreign
currencies. Other countries peg their currency to a composite basket of currencies,
where the basket comprises a portfolio of currencies of their major trading partners.
This basket has a base value which is more stable than any single currency. Under this
regime, a country can peg its currency to the standard basket such as SDRs (e.g.
Myanmar, Libya), or its own basket, which is designed to fit the unique trading and
investing needs of the country (e.g. Czech Republic, Jordan, Cyprus, Bangladesh,
Israel, Iceland, Kuwait, Nepal, Thailand, and Morocco). In the latter approach, the
basket contains currencies of major trading partners.
The peg system is a universal remedy. When pegged rates get overvalued, countries
have to forcibly deplete their foreign exchange reserves to defend the currency peg.
When reserves get depleted, countries attempt to manipulate interest rates but are
often forced to devalue, repegging at a low rate or giving up the peg in total. With a
floating rate system, countries can maintain their reserves and hence can maintain a
defense against financial panic. Foreign creditors understand that the central bank has
reserves sufficient for paying short-term debts, thus eliminating the possibility of selffulfilling creditor panic.
3.3 Target-zone Arrangement

A target-zone arrangement is virtually a joint float system cooperatively arranged by
a group of nations sharing common interests and goals. Under this system, countries
make adjustments to their national economic policies so as to maintain their exchange
98
rates within a specific margin around fixed central exchange rates that are agreed
upon. The target-zone arrangement exists for major European currencies that
participate in the EMS. The European Union members have a cooperative agreement
for maintaining their currencies within a set range against other group members. The
EMS is a peg of each countrys currency to all the others, as well as joint float of all
member currencies together against non-EMS currencies. The target-zone
arrangement helps in minimizing the instability in exchange rates and enhances
economic stability in the group.
However, the target-zone arrangement is not without its problems. Due to the
divergence of national policies, the trade structure and the level of economic
development, it gets difficult for every member to maintain the central exchange rate
for a long time period. Moreover, if the currency speculators attack one of the zone
currencies, defense becomes very costly.
3.4 Managed Float System

Also known as dirty float, the managed float is designed to eliminate excess volatility.
Governments use this to preserve an orderly pattern of changes in exchange rates.
Each central bank sets the exchange rate of a nation against a predetermined goal, but
allows the exchange rate to vary. In other words, the change in exchange rates does
not take place automatically, but is based on the view of the government of an
appropriate rate in the context of the countrys position in balance of payments,
foreign exchange reserves, and rates that are quoted outside the official market. The
authorities, rather than resisting the underlying forces, sometimes intervene by selling
or buying domestic currency for smoothing the transition from one rate to another. At
other times, the authorities intervene for moderating or counteracting self-correcting
cyclical or seasonal market forces. The rationale for the managed float system is to
reduce uncertainty for improving the economic and financial environments. For
instance, the intervention of the government may reduce the uncertainty of the
exporters caused by disruptive exchange rates. Some of the countries that maintain a
managed float system are Brazil, China, Israel, Egypt, Hungary, Korea, Poland,
Turkey, and Russia.
3.5 Independent Float System

The independent float system is also known as clean float. Under this system, an
exchange rate is allowed to freely adjust to the demand and supply of this currency for
another. As a consequence of this, the economy does not have to undergo the painful
adjustment process set in motion by an increase or decrease in the supply of money.
This category includes the currencies of both developed (e.g. the USA) and
developing nations (e.g. Peru). The central banks of these countries allow market
forces to determine the exchange rates. The central banks may intervene from time to
time to alleviate speculative pressures on their currency. They also intervene
occasionally as one of the anonymous participants in the free market.
3.6 Floating system Advantages and Disadvantages

The flexible exchange rate system offers a less painful mechanism to adjust trade
imbalances than fixed exchange rates and prevents a country from large persistent
deficits. Flexible exchange rates only lower the foreign exchange value of a currency
unlike the fixed-rate system, which requires recession to reduce real income or prices
when trade deficits arise.
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Flexible exchange rates do not require central banks to hold foreign exchange reserves
as there is no need for intervention in the foreign exchange market. They also avoid
the need for strict import and export regulations such as import restrictions, foreign
exchange control, and tariffs.
Finally, floating exchange rates can help in ensuring the independence of trade
policies.
However, the role of flexible rates is limited in balancing trade after a certain time
period. A currency devaluation or depreciation will help the balance of trade if it
reduces the relative prices of goods and services produced locally. However, after a
short time period, the domestic prices of tradable goods will rise following
devaluation or depreciation. This results in an increase in the cost of living, which in
turn puts upward pressure on wages. In addition, flexible rates could increase the
governments difficulty in controlling inflation and also create less motivation for the
government to combat it. Finally, free floats may lead to more uncertainty, which may
in turn hamper the stability and growth of economies vulnerable to international
financial and export markets.
4. Determining Foreign Exchange Rates

During the gold standard regime (1876-1914), the base level of the exchange rate
could be determined by the stated value of the gold per unit of the currency. However,
under other foreign exchange rate regimes, there is no direct way for valuing a
currency against other currencies in terms of flows as well as stocks. Moreover, the
current international monetary system is a blend of free floating, managed floating,
pegged or target zone, and fixed exchange rates. There is no single general theory that
forecasts foreign exchange rates under all conditions. But it is widely agreed that the
purchasing power parity (PPP) principle helps in explaining both the stocks and the
flows of exchange rates. Other principles that help in analyzing foreign exchange
movements include interest rate parity and international Fisher parity. The PPP
approach lays emphasis on the role of prices of goods and services in determining
exchange rates whereas the role of capital movements is focused by interest rate
parity.
4.1 Purchasing Power Parity

The PPP principle states that in the long run, the exchange rate between two
currencies should reflect the differences in purchasing power. That is, the exchange
rate should equalize the price of identical goods and services in two countries. The
PPP principle has two perspectives -- absolute PPP and relative PPP. Absolute PPP
suggests that the exchange rate can be determined by the relative prices of identical
baskets of goods and services. For instance, if the identical basket of goods cost 100
in Japan and $ 1 in the US, the PPP-based exchange rate would be 100/$ 1.
Due to the difference in consumption behaviors and demand structures, different
baskets of goods are used in different countries. This deficiency can be avoided by
relative PPP which focuses on the relationship between price changes of the two
countries and change in exchange rates during the same period. According to relative
PPP, if the exchange rate starts in equilibrium between the two countries, any change
in the differential inflation rate between them tends to be offset in the long term by an
opposite equal change in the exchange rate. The exchange rate depreciates if the
domestic inflation level rises faster than the foreign inflation level. The exchange rate
appreciates if the foreign inflation level rises faster than the domestic inflation level.
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In this situation, if there is no change in the exchange rate, the export of goods and
services in a country will become less competitive than comparable products produced
elsewhere. Imports will also become more price-competitive than domestic products
that are highly priced.
The PPP principle offers an economic foundation that determines and adjusts
exchange rates. However, in the real business world, PPP conditions may not always
hold. Thus the exchange rates are always not determined by PPP.
4.2 Interest Rate Parity (IRP)

The PPP principle focuses only on goods and services and excludes the importance of
capital flows while determining exchange rates. This limitation is addressed by the
interest rate parity (IRP) principle which explains how interest rates are linked
between different countries through capital flows. The IRP principle suggests that the
difference in national interest rates for securities of similar risk and maturity should be
equal to, but opposite in sign of, the forward rate discount or premium for the foreign
currency. A forward rate is the rate at which a bank is willing to exchange one
currency for another at some specified future date. If the exchange takes place
immediately, it is termed spot rate. A forward rate discount measures the percentage
by which the forward rate is more or less than the spot on a specific date. The IRP
implies that the forward premium of exchange rate will match the interest rate
differential between two countries. This relation holds because of efficient arbitrage in
risk-free assets. It applies to international lending as well as international investments.
The rationale underlying IRP is that for financing projects, borrowers compare the
costs in the domestic market with that of the foreign market. For investment projects,
investors compare the return from the domestic market with the return from the
foreign market. When interest parity is established, equilibrium will be achieved.
Like PPP, IRP also faces deviations due to tax factors and transaction costs in
financial markets. The deviations from interest parity between countries are also
caused by political risks because of the need of compensation for the greater risk of
investing in a foreign country.
In general, IRP is applicable to securities that have maturities of one year or less since
forward contracts are not available for a period of more than a year.
Similar to the principle of IRP but involving securities with a maturity of over a year,
the international Fisher effect addresses the relationship between the change in
percentage in the spot exchange rate over time and the differential between interest
rates that are comparable in different national capital markets. The international Fisher
effect states that the spot exchange rate should change in an equal amount but in
opposite direction to the differences in interest rates between two countries.
4.3 Implications for MNEs: Foreign Exchange Forecasting

Participants in international financial markets can never be sure what the exchange
rate will be after a month as future exchange rates are uncertain. Hence, a forecast
should be made. Some forecasters believe that for major floating currencies, forward
exchange rates are unbiased predictors of future spot exchange rates and forward
exchange rates are efficient. On the other hand, this hypothesis has been rejected by
empirical studies. Though reference to forward rate is necessary, international
managers should take into account many economic and non-economic factors to
predict foreign exchange rates.
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Economic factors influencing long-term exchange rates include balance of payment,

foreign exchange reserves, relative interest rates, relative inflation rates, and the long-term
properties of PPP. The long-term exchange rates of a country are also influenced by the
strength of a local countrys economy, which is often reflected in its Gross Domestic
Product, national income, export growth, and investment growth. As governments differ in
the ways in which they exert influence on foreign exchange rates even under the floating
system, managers should be aware about government declarations and agreements
regarding exchange rate goals. Non-economic factors include political or social events,
market speculations against the currency, bilateral relations between the two countries, the
confidence of market participants, and natural disasters.
In emerging markets where the foreign exchange control is set by the government, there
usually exists a foreign exchange black market where the buyers and sellers transact
foreign currencies using the market rate, which is different from the official rate.
International managers also take into consideration the countrys foreign exchange rate
system in predicting exchange rates. For predicting a long-term fixed rate, managers
should also see if the government has the capability to control domestic inflation to
generate hard currency reserves and to run trade surpluses. For predicting a long-term
floating rate, managers should focus on inflationary fundamentals and PPP as well as
economic health indicators such as stability and growth.
Time-series analysis is a technique widely applied for predicting foreign exchange
rates, particularly short-term trends.
5. Balance of Payments
The exchange rate system is a tool essential for international transactions that involves
multiple currencies. The national goal of international transactions is to accomplish
gains from investment and trade activities, which are recorded in the balance of
payments account. The balance of payments is an accounting statement that
summarizes all the economic transactions between residents (individuals, companies,
and other organizations) of the home country and other countries. It reports the
international performance of a country in trading with other nations and the volume of
capital that flows in and out of the country. The balance of payments uses the doubleentry bookkeeping system, which means that every credit or debit in the account is
reflected as a credit or debit somewhere else. In the balance of payments sheet,
inflows of currency are recorded as credit (plus sign) and outflows of currency are
recorded as debit (minus sign).
A standard balance of payments includes current account, capital account, and official
reserves account. Statistical discrepancy is also included in the balance of payments
account for maintaining the balance of total credit and total debit. Statistical discrepancy
reflects omissions and net errors in collecting data on international transactions.
5.1 Current Account

The current account records flows of goods, services, and unilateral transfers. It includes
service transactions (also called invisible items) and export and import of merchandise
(trade balance). The service account includes several service income and fees (e.g. royalty,
interests, and dividends). Service income includes transportation charges (i.e. shipping and
air travel), financial charges (i.e. banking and insurance), and tourism income. The
investment income account separates investment income from service income and records
income payments on foreign-owned assets within the country and income receipts on the
country-owned assets abroad. Unilateral transfers include remittances, pensions, and other
transfers for which specific services are not furnished.
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5.2 Capital Account

The capital account records private and public investment or lending activities and is
divided into portfolio (short and long-term) and foreign direct investment. Direct
investments include wholly-owned subsidiaries, joint ventures, and foreign branches.
Portfolio investments include mutual funds, foreign bonds, and notes. The portfolio
account includes both short-term (e.g. cash, bills, deposits, etc.) as well as long-term
(e.g. securities, mortgages, bank loans, etc.) investments or lending. Government
lending and borrowing are also part of the capital account.
5.3 Official Reserves Account

The official reserves account records net holdings of the official reserves held by a
national government. Reserves include gold, reserve positions in the IMF, SDRs, and
convertible foreign currencies. For most countries, foreign currency is the largest
component of total international liquidity. Governments usually keep foreign
exchange reserves in the form of short-term and long-term government securities,
foreign treasury bills, euros, etc.
6. Summary
The international monetary system refers primarily to the set of policies,
institutions, practices, regulations, and mechanisms that determine foreign
exchange rates.
In the 1870s, the gold standard was accepted as an international monetary system.
Under this system, each country pegged its currency to gold.
During World War I and the early 1920s, currencies were allowed to fluctuate
over wide ranges in terms of another currency and gold. This led to the creation
of arbitrage opportunities for international speculators.
Under the provisions of the Bretton Wood Agreement that was signed in 1944,
the governments of all the member countries took a pledge to maintain a fixed or
pegged exchange rate for their currencies vis--vis gold or the dollar.
The Post-Bretton Woods system is characterized by a floating exchange rate system.
Under a fixed-rate system, governments can buy or sell their currencies in the
foreign exchange market whenever there is a deviation in the stated par values.
The crawling peg is an automatic system for revising the exchange rate, establishing
a par value around which the rate can vary up to a given percentage point.
Target-zone arrangement is virtually a joint float system cooperatively arranged
by a group of nations sharing common interests and goals.
Also known as dirty float, the managed float is designed for eliminating excess
volatility. It is employed by governments to preserve an orderly pattern of
changes in exchange rates.
The independent float system is also known as clean float. Under this system, an
exchange rate is allowed to freely adjust to the demand and supply of this
currency for another.
The purchasing power parity (PPP) principle states that in the long run, the
exchange rate between two currencies should reflect differences in purchasing
power, that is, the exchange rate should equalize the price of identical goods and
services in two countries.
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The Interest Rate Parity principle suggests that the difference in national interest
rates for securities of similar risk and maturity should be equal to, but opposite in
sign of, the forward rate discount or premium for the foreign currency.
The balance of payments is an accounting statement that summarizes all the
economic transactions between residents (individuals, companies, and other
organizations) of the home country and other countries.
A standard balance of payments includes current account, capital account, and
official reserves account.
Example: Indias Forex Reserves

Indias forex reserves consist mainly of US government treasury bills, i.e. assets
denominated in US dollars; treasury bills of other developed countries
denominated in Euros, and in Yen; and gold and Special Drawing Rights with the
IMF. In 2004, Indias forex reserves were worth US$ 122 billion.
Till 1991, India followed a fixed exchange rate system. Under this system, there
was a need for a high level of reserves. In 1991, the oil price shock left India in a
precarious position. Imports had to be sharply cut as India was left with barely two
weeks worth of foreign exchange reserves. Following the crisis, India adopted a
flexible exchange rate system. The RBI built up forex reserves so that it could
intervene in the forex market when necessary. By April 2002, India had over US
US$ 60 billion of forex reserves. Since one of the objectives of the RBI is to reduce
exchange rate fluctuations of the rupee, it acquired large amounts of dollars (over
US $30 billion) in 2002, so that it could act as a cushion in the forex market and
reduce fluctuations in the value of the rupee. With inflows of Foreign Direct
Investment and Foreign Institutional Investor, there has been a substantial increase
in the forex reserves.
Some analysts argue that it was possible to use forex for infrastructure
development. They opined that given India's infrastructure investment requirement
of around US$ 150 billion, there was no harm in using a small portion of the huge
idle forex reserves for such investment. For instance, Hong Kong invested one fifth
of its reserves in equity.
Some analysts felt that the RBI could create a separate portfolio for investments
from foreign exchange reserves which could be managed by either the RBI or by
an external fund manager.
Others argue that by comparing the returns from highly liquid financial assets with
returns from physical investments, RBI was ignoring the differences in liquidity
and the risk characters between them.
Example: Revaluation of Yuan

The possible revaluation of the Chinese currency, the Yuan, against the US dollar
in 2005 helped speculators make a quick buck in the foreign exchange market.
The Yuan had been pegged at 8.28 against the US dollar since the Asian financial
crisis in the late 1990s. US manufacturers were of the opinion that the Yuans peg
to the US dollar was undervalued, which gave China an unfair trade advantage. US
Contd
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Contd
was not the lone suffer; the undervalued Yuan also became a cause for concern for
countries of the European Union, Germany in particular. On April 16, 2005, US
Treasury Secretary, John Snow, at a meeting of G7 countries said, Theyve made
enormous strides in fixing the financial infrastructure.... It's time for the Chinese to
move to flexible currency. This view was not only supported by the G7 countries,
but also by most of the countries across the globe. The G7 countries gave a call for
flexible currencies in the world, thus indicating to China that it had to alter its
current fixed exchange rate system. In fact, there was growing international
pressure on China to revalue the Yuan in order to correct the global trade
imbalances among various countries.
Considering the pressure from different quarters, China also agreed to reconsider
its decision of continuing with the fixed exchange rate system. But it also made it
clear that before it moved to a flexible currency rate system, it would like to have a
healthy financial system and economic stability in place. It eased controls on
capital outflows, allowing its domestic firms to invest abroad. Some analysts were
of the opinion that China needed some time to reform and strengthen its banking
system. Experts opined that China would have to move to a flexible exchange rate
sooner or later.
Though China had agreed to move to a managed float exchange rate system, it was
still not certain what kind of impact revaluation of the Yuan would have on its
economy. Bowing to international pressure, China had in fact agreed to some
extent to the revaluation of the Yuan. Probably, a closer look at the history of world
currency markets would help China take the appropriate steps to alter the present
exchange rate system. As far as history goes, the currency market, which had been
relatively stable until World War I, became more speculative after it. Till World
War II, the pound was the currency against which all currencies of the world were
pegged. The German government launched a massive counterfeit campaign of the
pound during World War II, and this made people lose confidence in the currency.
The pound shrank during the War, and the US dollar emerged as the most preferred
currency in the world.
Since the Chinese currency Yuan, also called renminbi had been pegged to the US
dollar for more than a decade, the entire world insisted that it should be appraised.
The World Bank also advised China to revalue the renminbi to ensure the stability
of economies in the Asian region. But analysts were of the view that China had to
step carefully in reforming its exchange rate because if things went wrong, it would
inevitably affect financial market stability in all countries with which China had
trade relations. If China decided to revalue its currency, it had the option of
revaluing the Yuan upward or of pegging it to a basket of currencies rather than
against only the dollar. While speculation regarding its exchange rate reform went
on, China continued to consider the various options and had yet to make the final
move.
Compiled from various sources
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Appendix - 5
International Economic Integration and Institutions

Introduction
International economic relations are governed by a variety of institutions and treaties
which have boosted economic integration and erased barriers to free trade, service,
and investment among nations. International economic integration is propelled by
three levels of cooperation global, regional, or commodity. Global-level cooperation
occurs through international economic agreements or organizations (e.g. WTO).
Regional-level cooperation takes place through common markets or unions (e.g.
NAFTA), and commodity-level cooperation takes place through multilateral
commodity cartels or agreements (e.g. OPEC).
With the increasingly integrated environments, multinational enterprises have also
realigned their international strategies as they are a critical force in steering
international economic integration.
This unit discusses the different forms of economic integration. It then goes on to
explain the three fundamental institutions affecting cooperation among nations at the
global level the World Trade Organization, the International Monetary Fund, and
the World Bank. It discusses different regional agreements and international
commodity agreements. It finally turns to the strategic responses of multinational
enterprises to regional economic integration.
International Economic Integration

Economic integration concerns removal of trade barriers or impediments between at
least two participating nations and establishing and coordinating between them.
Economic integration helps steer the world toward globalization. The following forms
of economic integration are implemented often:
A free trade area involves country combinations, where the member nations remove
trade barriers among themselves while retaining their freedom related to policy
making vis--vis non-member countries. Examples of a free trade area are the Latin
American Free Trade Agreement and the North American Free Trade Agreement.
A customs union is identical to a free trade area except that member nations must
pursue and conduct common external commercial relations like common tariff
policies on imports from non-member nations. Examples of this form are the
Caribbean Community and Common Market (CARICOM) and the Central American
Common Market (CACM).
A common market is a particular customs union that permits free trade of products
and services with free mobility of production factors across member nations borders.
An example of this form is the Southern Common Market Treaty (MERCOSUR).
An economic union is a particular common market that unifies fiscal and monetary
policies. The participants bring in a central authority for exercising control over these
matters so that member nations become an enlarged entity.
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A political union requires participating nations to become one nation in a political and
economic sense. This union involves establishing a common parliament and other
political institutions.
The forms just described reflect economic integration between or among nations in a
region. Global economic integration also takes place through multilateral cooperation
in which nations that participate are bound by rules, responsibilities, or principles
which are stipulated in commonly agreed agreements. Multilateral agreements
promote worldwide economic exchanges. They may be designed for governing
general trade, investment, service, capital flows, financial market stability, or specific
areas of trade.
Economic integration generates economic gains for participating nations. Production
efficiency can be enhanced by increased specialization according to the law of
comparative advantage. The increased market size increases economies of scale which
in turn elevate the level of production. Further, the collective bargaining power of the
member nations increases against non-member nations. This power leads to better
terms of trade, that is, higher price on products exported to non-participating countries
and lower prices on imports from non-participating countries. However, these gains
are not guaranteed nor will each member country benefit equally from integration.
Free mobility of production factors may create pressures on inflation rates,
employment levels, income distribution, or trade balance for nations that are in
different economic stages or have a varying dependence on the goods and services of
other nations.
Cooperation among Nations at the Global-level

The three fundamental institutions affecting cooperation among nations at the global
level are the World Trade Organization, the International Monetary Fund, and the
World Bank. While the WTO serves as the institutional foundation of the international
trade system, the IMF and the World Bank serve as institutional foundations of the
international monetary and financial systems.
The World Trade Organization (WTO)
Background and structure
The World Trade Organization came into being on January 1, 1995, as a multilateral
trade organization that aimed at international liberalization of trade. It came as a
successor to the General Agreement on Tariffs and Trade (GATT). GATT was set up
after the first round of tariff negotiations at the Geneva conference held in 1947 on the
proposed International Trade Organization (ITO). GATT was evolved after periodic
rounds of multilateral negotiations on tariff cuts and non-tariff reductions..
Prior to the Kennedy Round, early negotiations primarily dealt with reducing tariffs.
By the end of the Tokyo Round in 1979, the need to confront increasing usage of nontariff barriers, especially by developed countries, led to the adoption of a number of
codes that dealt with specific practices. The scope of GATT was broadened in the
Uruguay Round where it reintroduced the idea of a comprehensive international trade
organization for coordinating international economic activities.
107
The Uruguay Round agreement took effect in 1995 and specified several liberalization
measures that had an effect on the threats and opportunities of international
companies. First, members agreed to slash export subsidies by 36 percent and
domestic agricultural price supports by 20 percent. These subsidy reductions benefited
major exporters in Canada, Australia, Thailand, New Zealand, and the US. Second,
the Uruguay Round set up several principles concerning trade in services. Third, the
Uruguay Round agreement strengthened the protection of intellectual property rights
which includes trademarks, patents, copyrights, brand names, and expertise.
As a successor to GATT, the main objective of the WTO is to establish trade policy
rules that raise living standards and help expand international trade. The WTO pursues
these objectives by administering trade agreements, settling trade disputes, acting as a
forum for trade negotiations, cooperating with international organizations, and
assisting developing countries on trade policy issues through training programs and
technical assistance.
The WTO had 153 members as of July 2008. The Ministerial Conference is the toplevel decision-making body of the WTO, which meets at least once in two years. The
General Council is the highest-level decision-making body of the WTO where
member nations are represented as heads or ambassadors of delegations. The General
Council also meets as the Dispute Settlement Body and the Trade Policy Review
Body. The Goods Council, Trade-Related Aspects of Intellectual Property Council,
and Services Council report to the General Council. In addition, several specialized
working groups or committees deal with individual agreements and other crucial areas
such as the development, membership applications, environment, trade and
investment, regional trade agreements, trade and competition policy, and transparency
in government procurement. Electronic commerce is also studied by many councils
and committees.
Functions
The dominant function of the WTO is reduction of import duties. Other functions
include elimination of discrimination. The main principles designed for eliminating
discrimination are the most-favored-nation treatment and the national treatment. The
most-favored-nation (MFN) treatment means that any advantage, favor, or privilege
granted to one country must be extended to all other member countries. For instance,
if Canada reduces its import tariffs on German cars to 20 percent, it should cut its
tariffs on imported cars from all other member nations to 20 percent. The national
treatment means that once they have cleared customs, foreign goods in a member
country should be treated the same as domestic goods.
There are some exceptions to the MFN principle. First, the WTO permits members to
establish regional or bilateral custom unions or free trade areas. Second, the WTO
permits members to lower tariffs for developing countries without lowering them for
developed countries. The third exception is the escape clauses allowed by the WTO.
Escape clauses are special allowances permitted by the WTO to safeguard infant
industries or nourish economic growth for newly admitted developing countries. The
purpose of the escape clauses is to help the developing country members to safeguard
their economies.
Another WTO function is to combat forms of protection and trade barriers. The WTO
eliminates quantitative restrictions to maintain agricultural products or to balance
foreign exchange reserves by a member government. Quantitative restrictions on
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industrial products can be levied by imposing an anti-dumping duty. Dumping is sale

of imported goods either at prices below what a company charges in its home market
or at prices below cost. Other forms of protection include customs valuation,
subsidies, import deposit without interest, excise duties, and countervailing duty. The
non-tariff barriers were effectively combated in the Uruguay Round. The Trade Policy
Review of the WTO monitors the trade policies of its members regularly.
Another significant function of the WTO is to provide a forum for dealing with
various emerging issues that concern the world trade system such as the environment,
regional agreements, economic development, intellectual property, government
procurement, unfair trade practices, and special sectors such as agriculture, financial
services, telecommunications, and maritime services. From such forum discussions,
many new rules have been derived. For instance, the Trade-Related Intellectual
Property Agreement (TRIP) brings new discipline for protecting copyrights, patents,
trade secrets, and similar components of intellectual property.
To add to its functions, the WTO acts as a united dispute settlement system for
members through its Dispute Settlement Body (DSB) which consists of
representatives from every WTO member. The DSB has the sole authority for
establishing dispute settlement panels for cases, for adopting panel reports, for
monitoring implementation of its rulings and for authorizing suspension of rights if its
rulings are not acted upon by the members in a timely fashion.
The WTO and GATT are viewed as clubs of rich nations by some developing
countries. It is alleged by the developing nations that, while being beneficial for world
trade in total, benefits of these organizations largely pertain to the bargaining powers
of a select member nations or some particular group of member nations. Developing
countries often believe that they are victims of the unfair trade practices and policies
adopted by rich nations. Developing countries have asked affluent nations to honor
commitments to remove unfair treatments and open more markets.
The International Monetary Fund (IMF)
The IMF and the World Bank are together referred to as the Bretton Woods
Institutions, as they were established at Bretton Woods, New Hampshire, in July
1944. The overall objectives of the IMF include expansion of international trade,
reduction of the disequilibrium in balance of payments of member countries, and
promotion of international monetary cooperation. For accomplishing these objectives,
IMF seeks to maintain orderly exchange arrangements, promote exchange stability,
avoid competitive exchange depreciation, and provide confidence to member states.
IMF was established for rendering temporary assistance to member countries trying to
defend their currencies against random, seasonal, or cyclical fluctuations. It also
assists countries having structural trade problems if they take ample steps for
correcting their problems.
The IMF is headed by the Board of Governors consisting of representatives from all
member countries. The IMF requires all members to collaborate with the Fund in
promoting a stable system of exchange rates for facilitating the exchange of goods,
capital, and services, and for providing conditions essential for economic and financial
stability. Members should avoid manipulating exchange rates in order to prevent
effective balance of payments adjustments or as an effort to gain unfair competitive
advantage.
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The world community has been increasingly using the IMF as a vital forum for
multilateral surveillance and coordination of monetary and fiscal policies.
IMF has begun to develop greater flexibility for responding purposefully and quickly
to constantly change economic conditions.
The IMF created the Special Drawing Rights (SDR) for carrying out tasks of
monitoring the international monetary system and supplementing foreign exchange
reserves. SDR serves as a unit account for the IMF and other regional and
international organizations, and is also the base against which countries peg the
exchange rate of their currencies. SDRs are not circulated internationally. Individual
countries hold SDRs in the IMF in the form of deposits. Members settle transactions
among themselves by transferring SDRs.
The World Bank Group
The World Bank refers to the International Bank for Reconstruction and Development
(IBRD). It has three affiliates the International Development Association, the
International Finance Corporation (IFC), and the Multilateral Investment Guarantee
Agency (MIGA). Together with its affiliates, the World Bank is known as the World
Bank Group. The common objective of these institutions is to help raise living
standards in developing countries by channeling financial resources to them from
developed countries.
The World Bank was set up in 1945 and is owned by 160 countries. The subscription
of its member countries provides the capital for the World Bank. Its lending
operations are financed chiefly through its borrowings in the world capital markets. A
significant contribution to the World Banks capital resources also comes from its
flow of repayments on its loans and its retained earnings. The loans offered by the
World Bank are repayable over 15 to 20 years with a grace period of five years. Loans
are geared toward developing countries that are in advanced stages of social and
economic growth. The interest rates on these loans are calculated based on the cost of
borrowing, which makes the interest rate lower than market interest rates.
The World Banks charter lists the basic rules governing its operations. It should lend
only for productive purposes and should stimulate economic growth in the developing
countries which are recipients of the loan. It must pay due regard to prospects of
repayment. Each loan is made to a government or should be guaranteed by the
concerned government. The use of loans cannot be restricted to purchases in any
member country particularly.
The IDA was established in 1960. It concentrates on developing the least developed
nations. The terms of IDA credits, which are usually made to governments, are a grace
period of ten years, 35- or 40-year maturities, and no interest. The IFC was set up in
1956 with the stated aim of assisting the economic development of developing
countries by promoting growth in the private sector of the economies and serving to
mobilize domestic and foreign capital for this purpose. The MIGA was established in
1988. It specializes in encouraging equity investment and other direct investment flows
to the developing countries by mitigating the non-commercial investment barriers.
Since the late 1990s, the cooperation between the WTO, IMF, and the World Bank
has increased significantly. This includes information sharing, participation in
meetings, contacts at the staff level, and the creation of a High Level Working Group
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on Coherence that manages the process and prepares an annual joint statement on
Coherence. In 1998, the WTO Secretariat collaborated with the IMF and the World
Bank staff for assisting developing countries to stimulate their foreign trade and their
participation in the multilateral trading system.
Other International Economic Organizations
The Organization for Economic Cooperation and Development (OECD)
In December 1960, the Organization for Economic Cooperation and Development
(OECD) was established. It includes the US, Canada, Japan, Australia, New Zealand,
and Mexico. Its stated mission is to aid in achieving the highest possible growth in the
economies of member countries as well as non-member states. Its emphasis is on
employment expansion, financial stability, economic development, improvement of
living standards, and extension of world trade on a non-discriminatory and
multilateral basis. The highest authority in the OECD is the council. The OECD does
not have specific provisions on liberalization of goods, capital, and invisible
transactions. After the formation of the European Union, the aim of the OECD is to
coordinate the economic policies of all developed countries.
The United Nations Conference on Trade and Development (UNCTAD)
UNCTAD is a forum that examines economic problems that plague developing
countries. It also formulates, negotiates, and implements measures for improving the
development process of developing countries. This forum is essential for achieving
the demand for a new international economic order that involves more trade and
capital concessions on the part of developed countries. Developing countries hope to
solve three problems through UNCTAD:
The share of developed countries in world trade is decreasing and the terms of
trade with developed countries are deteriorating.
Developed countries markets are not adequately open for manufacturing
products of developing countries.
The aid given to developing countries is inadequate and they have huge foreign
debts.
Cooperation among Nations at the Regional Level

After World War II, multilateral trade liberalization has been paralleled by an
integration process through regional agreements. From 1947 to 1994, 109 agreements
have been reported to the GATT.
Post-war Regional Integration
Post-war regional integration is characterized by three features. First, it has been
primarily centered in Western Europe. The creation of the European Economic
Community (EEC) in 1958 after the signing of the treaty in 1957 and the European
Free Trade Association in 1960 initiated a process that aimed to enlarge the scope of
regional integration among European countries with other countries. A significant
feature of the trade policies of non-European countries is integration through
preferential trade agreements.
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Second, many developing countries, particularly in Asia and Latin America, have
renewed their interest in regional integration since the beginning of the Uruguay
round. Regional integration can broaden the openness and internationalization of
developing economies while avoiding overdependence on world markets. Moreover,
continued economic reforms suggest that the overall policy environment have become
conducive to the objectives of regional integration.
Third, the level of economic integration varies among different agreements. Most of
the regional integration agreements involve free trade areas, and the number of
customs union agreements is small. It is useful to distinguish between reciprocal
arrangements and non-reciprocal arrangements among free trade agreements. In a
reciprocal agreement, each member agrees to reduce or eliminate trade barriers. In a
non-reciprocal agreement, some developed countries may reduce barriers to trade.
North America: The North American Free Trade Agreement (NAFTA)
On December 17, 1992, the leaders of Canada, Mexico, and the US signed the North
American Free Trade Agreement (NAFTA), creating a tri-national market area.
NAFTA is the first free trade agreement between industrial countries and a developing
nation (Mexico). The agreement enhances the ability of North American producers to
compete globally.
NAFTA came into effect on January 1, 1994, uniting the US with its largest (Canada)
and third largest (Mexico) trading partners. On the basis of the earlier US-Canada
Free Trade Agreement, NAFTA dismantled trade barriers for industrial goods and
included agreements on agriculture, investments, services, and intellectual property
rights.
NAFTA also includes side agreements on import surges, labor adjustments, and
environmental protection. The side agreement on import surges creates an early
warning mechanism for identifying sectors where sudden, explosive trade growth may
significantly harm the domestic industry. The side agreement on labor adjustments
came due to concerns of American workers that US jobs would be exported to Mexico
due to the cheap labor, weak child labor laws, etc. prevailing in the country. The side
agreement on environmental protection ensures the rights of the US to safeguard the
environment.
With the integration of the Mexican, Canadian, and the US markets, many companies
have changed their plans and business strategies for serving the North American
market efficiently.
Europe: The European Union
The post-war efforts for the formation of the European Union have been a long
process, beginning with the formation of the EEC in 1957. On January 1, 1995, the
European Community (EC) was formed. The EC comprised the Netherlands,
Belgium, France, Luxembourg, Ireland, the UK, Denmark, Italy, Germany, Portugal,
Greece, Spain, Finland, Sweden, and Austria. These member states constitute the
economic level of the European economic integration. The outer tier of trade and
economic liberalization around the EC is composed of countries in eastern and central
Europe as well as the Mediterranean countries with which the EC had included
reciprocal trade agreements.
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The Treaty of the European Union, signed in February 1992, was enforced in
November 1993. The most basic step in strengthening political and economic ties
among member states of the EC occurred with this treaty. The treaty promotes
economic and trade expansion in a common market besides embracing the formation
of a monetary union, common citizenship, establishment of a common foreign and
security policy, and the development of cooperation on social affairs and justice. The
treatys significance was marked by the adoption of the European Union (EU). The
Maastricht Treaty includes several high-impacting provisions such as:
It creates a common European currency called the European currency unit (ECU).
The ECU is a popular unit for international payment, security investment, bond
issuance, commercial loans, bank deposits, and travelers checks.
Every citizen in an EU member state is eligible to obtain a European passport,
which allows them to move freely from one country to another within the EU.
It includes provisions on cooperation in fields of domestic affairs and justice.
It empowers the EU to play an active role in trans-European transport and
environmental protection.
It increases the European Parliaments power to enact legislation.
It removes restrictions on capital movements between member states.
It sets a European Central Bank that is responsible for monetary policy.
Asia Pacific
In November 1994, the Asia-Pacific Economic Cooperation Forum (APEC) was
founded. Its member states comprise New Zealand, Mexico, Canada, Australia, the
US, Chile, China, Japan, Hong Kong, South Korea, Papua New Guinea, Chinese
Taipei (Taiwan), Indonesia, Singapore, Malaysia, the Philippines, Thailand, and
Brunei. APEC is cross-regional, spanning Asia, North and South America, and the
Pacific.
On August 8, 1967, the Association of South East Asian Nations (ASEAN) was
established by Malaysia, the Philippines, Indonesia, Thailand, Singapore, and Brunei.
ASEAN aims to promote peace, stability, and economic growth in the region. In order
to become a free trade zone, ASEAN countries have cut tariffs on several products
such as chemicals, ceramics, cement, pharmaceuticals, etc. The member countries of
ASEAN are diverse in terms of geographical, economic, political, and cultural
backgrounds.
Asia is distinctive in many ways. First, many countries have accelerated their trade
liberalization in the region at the sub-national level by authorizing special investment
areas and export processing zones within each country.
Second, many neighbors which are geographically proximate in Asia have reached
less formal trade agreements. For instance, members of the South Asian Association
for Regional Cooperation (SAARC) Bhutan, Pakistan, Sri Lanka, Maldives, and
India concluded a trade agreement in April 1993
Finally, numerous sub-regional economic zones have emerged. These zones are also
called transnational export processing zones, natural economic territories, or growth
triangles.
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Latin America
In 1960, the Latin American Free Trade Association (LAFTA) was formed in Latin
America by Argentina, Brazil, Bolivia, Colombia, Chile, Ecuador, Mexico, Peru,
Paraguay, Uruguay, and Venezuela. In the same year, the Central American Common
Market (CACM) was formed by Costa Rica, El Salvador, Guatemala, the Honduras,
and Nicaragua. Both the agreements failed to achieve their objectives due to the
different economic policies and economic conditions of the countries involved.
In 1973, the Caribbean Community and Common Market (CARICOM) was started by
the Caribbean region. The objectives of this treaty is to achieve economies of scale in
the regional production of transportation, services, health, education, and to pool
financial resources for investment in a regional development bank. This treaty also
targets coordination of development planning and economic policies.
In 1980, LAFTA was superseded by the Montevideo Treaty, which set up the Latin
America Integration Association (LAIA) with the stated goal of increasing bilateral
trade among member countries.
In 1991, the Southern Common Market Treaty (MERCO-SUR) was formed by
Argentina, Brazil, Paraguay, and Uruguay, which formed a common market for free
circulation of labor, capital, goods, and services. The member countries also aimed to
coordinate macroeconomic policy and harmonize legislation for strengthening the
integration process. Since January 1, 1995, members of the MERCOSUR have used
common external tariff rates and common tariff structures.
Other members of the LAFTA including Colombia, Peru, Bolivia, Ecuador, and
Venezuela formed the Andean Free Trade Area in 1992 with a common external
tariff. On January 1, 1993, the Central American Common Market (CACM)
established a customs union and reactivated its objectives.
Africa and the Middle East
In 1975, the Economic Community of West African States (ECOWAS) was
established with members comprising Burkina Faso, Benin, Mali, Niger, Mauritania,
Cote dlvoire, Senegal, Liberia, Guinea, Cape Verde, Sierra Leone, Ghana, Gambia,
Nigeria, Togo, and Guinea-Bissau. In 1981, ECOWAS eliminated duties on
unprocessed agricultural products and handicrafts. In 1990, it implemented free trade
for all unprocessed products. Other activities include steps to avoid the use of hard
currencies in intra-member trade through a regional payments-clearing system,
progressive liberalization of industrial products, and cooperation on industrial and
agricultural investment projects.
In 1966, in former French Africa, the Central African Economic and Customs Union
(UDEAC) was established comprising Gabon, Chad, Congo, the Equatorial Guinea,
the Central African Republic, and Cameroon. The EDEAC offers a framework for
free capital movement throughout the area, harmonization of fiscal incentives, and
coordination of industrial development. In 1990, a common external tariff was
introduced by four member countries Cameroon, Gabon, the Central African
Republic, and Congo.
In 1967, the East African Economic Community (EAEC) was formed in former
British East Africa by Tanzania, Uganda, and Kenya. In 1979, the EAEC was
dissolved and the three members joined with other states (Angola, Burundi, Comoros,
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Djibouti, Ethiopia, Lesotho, Malawi, Mauritius, Mozambique, Namibia, Rwanda,

Somalia, Sudan, Swaziland, Zambia, and Zimbabwe) for establishing the Preferential
Trade Area for eastern and south African states in 1981. Its goal includes establishing
a common market and promoting trade and economic cooperation among its
members.
In 1981, Kuwait, Oman, Bahrain, Qatar, Saudi Arabia, and the UAE established the
Gulf Cooperation Council (GCC) in the Middle East. A free trade area that covered
agricultural and industrial products was set up. In 1989, the Arab Maghreb Union was
set up by Algeria, Morocco, Mauritania, and Tunisia, for laying the foundation for a
Maghreb Economic Area.
Cooperation among Nations at the Commodity-level

The emergence of several international commodity agreements is a natural
development in the international economic relations. Countries may also cooperate to
control the pricing, sale, and production of goods that are traded internationally. A
commodity cartel is a group of producing countries that wish to protect themselves
from the wild fluctuations that often occur in the prices of certain commodities traded
internationally (e.g. coffee, rubber, cocoa, or crude oil). Cartel members may seek
stable and higher prices for their goods. A commodity cartel can increase the prices of
their goods in international markets by limiting overall output and assigning
production quotas to individual countries. The two important commodity cartels that
influence the world economy are the OPEC and the Multifiber Arrangement.
Organization of Petroleum Exporting Countries (OPEC)
The Organization of Petroleum Exporting Countries (OPEC) is the most notable
organization involving a critical commodity. It is not a commercial entity, but an
intergovernmental organization. It has 13 members Iraq, Iran, Kuwait, Saudi Arabia,
Algeria, Venezuela, Ecuador, Indonesia, Libya, Gabon, Nigeria, Qatar, and the United
Arab Emirates. OPEC is the strongest collective force that impacts oil prices in the
international oil market. It controls the price in world markets by assigning its
members production quotas that limit the overall amount of crude oil that is supplied
internationally.
OPEC became a catalyst for action by developing countries that wanted to ensure that
they received remunerative export earnings from their topical products and raw
materials. For instance, The Intergovernmental Council of Copper Exporting
Countries and The International Bauxite Association were formed in the 1970s by
major developing countries that produced these commodities.
The Multifiber Arrangement (MFA)
The Multifiber Arrangement (MFA), originally signed in 1972, is an agreement
between exporting and importing countries for controlling the export of apparel and
textiles from developing countries to developed countries. The MFA takes advantage
of a GATT rule exemption that allows individual importing countries to establish
quota and other restrictions on apparel and textile exports on a country-by-country
basis. Nearly two-thirds of the apparel and textile products traded internationally are
covered by the MFA.
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The MFA has been renewed several times due to the lack of a better solution between
developing and developed countries over the trade involving apparel and textile trade.
For instance, the US and China negotiate yearly over the quota of Chinese exported
garments and textiles. The process is lengthy due to conflicts over issues on which
both the parties do not compromise.
Other multilateral commodity arrangements include The International Sugar
Agreement, The International Tin Agreement, The International Cocoa Agreement,
The Wheat Trade Convention, the International Coffee Agreement, and the
International National Rubber Agreement.
Strategic Responses of Multinational Enterprises

International economic integration has a profound effect on the operations of
multinational enterprises. The activities of an MNE are triggered by economic
integration, which then increases foreign direct investment in the integrated region. In
response to regional economic integration, some strategies can be identified. The
defensive export substituting investment is a strategy by which MNEs protect their
existing market share gained through exports by switching to direct production inside
the region. For instance, Dow Chemicals and Du Pont increased investments in their
export-oriented operations in Canada in reaction to NAFTA.
Another strategy adopted by MNEs is the offensive export substituting strategy in
which MNEs prefer to ensure market penetration by making direct investments in the
region before the region is officially integrated. This strategy helps an MNE gain an
early position in the market.
The third strategy is the rationalized foreign direct investment strategy in which
MNEs increase their investment and heighten resource commitment to the integrated
region to gain greater economic efficiency through market expansion and scale
economies.
Finally, the reorganization investment is a strategy by which MNEs realign their
value-added activities and organizational structures in order to reflect a regional
market. Firms realign investment capital among trading bloc members once the
protective barriers are removed. Under this strategy, MNEs increase their cross-border
investment activities within the region.
In response to economic integration, MNEs, including those from developing
economies such as Brazil, South Korea, Singapore, and Taiwan, have been actively
employing cross-border strategic alliances. These alliances allow then to enter new
markets more rapidly than mergers or acquisitions.
Summary
Economic integration concerns removal of trade barriers or impediments between
at least two participating nations and establishing and coordinating between them.
A free trade area involves country combinations, where the member nations
remove trade barriers among themselves while retaining their freedom related to
policy making vis--vis non-member countries.
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A customs union is identical to a free trade area except that member nations must
pursue and conduct common external commercial relations like common tariff
policies on imports from non-member nations.
A common market is a particular customs union that permits free trade of
products and services only but with free mobility of production factors across
national member borders.
An economic union is a particular common market that unifies fiscal and
monetary policies.
A political union involves establishing a common parliament and other political
institutions.
The World Trade Organization came into being on January 1, 1995, as a
multilateral trade organization that aimed at international liberalization of trade.
The overall objectives of the International Monetary Fund include expansion of
international trade, reduction of disequilibrium in balance of payments of member
countries, and promotion of international monetary cooperation.
In December 1960, the Organization for Economic Cooperation and Development
(OECD) was established. Its stated mission is to aid in achieving the highest
possible growth in the economies of member countries as well as non-member
states.
UNCTAD is a forum that examines economic problems that plague developing
countries.
NAFTA is the first free trade agreement between industrial countries and a
developing nation (Mexico). The agreement enhances the ability of North
American producers to compete globally.
The Treaty of the European Union, signed in February 1992, promotes economic
and trade expansion in a common market besides embracing the formation of a
monetary union, common citizenship, establishment of a common foreign and
security policy, and the development of cooperation on social affairs and justice.
In November 1994, the Asia-Pacific Economic Cooperation Forum (APEC) was
founded.
The Association of South East Asian Nations aims to promote peace, stability,
and economic growth in the region.
In 1960, the Latin American Free Trade Association (LAFTA) was formed in
Latin America by Argentina, Brazil, Bolivia, Colombia, Chile, Ecuador, Mexico,
Peru, Paraguay, Uruguay, and Venezuela.
The Economic Community of West African States (ECOWAS) eliminated duties
on unprocessed agricultural products and handicrafts.
In 1981, Kuwait, Oman, Bahrain, Qatar, Saudi Arabia, and the UAE established
the Gulf Cooperation Council (GCC) in the Middle East. A free trade area that
covered agricultural and industrial products was set up.
The Organization of Petroleum Exporting Countries (OPEC) is the strongest
collective force that impacts oil prices in the international oil market.
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The Multifiber Arrangement (MFA), originally signed in 1972, is an agreement

between exporting and importing countries for controlling exports of apparel and
textiles from developing countries to developed countries.
1.
In response to regional economic integration, some strategies can be identified.

a.
defensive export substituting investment
b.
offensive export substituting strategy
c.
rationalized foreign direct investment strategy
d.
reorganization investment.
Example: Chinas Entry into WTO

In the last two decades, China experienced rapid growth in foreign trade and
investment. Its entry into the WTO further strengthened this growth and the
country was fast transforming itself into a market-based economy. China was one
of the worlds leading exporters, and also the biggest single destination for foreign
investment among developing countries. It was likely to play a major role in the
coming multinational trade negotiations. China was fast lifting its trade barriers.
Other members of the WTO were trying to get a share of sectors which were
previously restricted in China, including telecommunications, banking and
insurance. China also reduced tariffs on a range of goods entering the country, from
agricultural products to engineering goods. Some sectors of the Chinese economy,
such as textiles, footwear, and electronics, were likely to benefit from free trade.
The Chinese economy was considered flexible enough to meet the fast-changing
needs of the global consumer goods market.
According to analysts, India would have to accelerate the pace of its economic
reforms and liberalization to meet the competitive challenge posed by China's entry
into the WTO. Chinas entry into the WTO would have both a positive and a
negative impact on India. On the positive side, there would be more transparency in
Chinas rules and regulations on trade, because under the WTO it was mandatory
for trading nations to provide information regarding rules and regulations on trade
and investment to the WTOs General Council. If any trade-related problem arose
between China and a trading partner, a dialogue could be initiated under the
WTOs dispute settlement mechanism. Greater transparency would lead to easier
market access for Indian companies, which were then hesitant to export to China.
On the negative side, the high transparency of the Chinese system would also give
other countries a competitive edge (such as those in Southeast Asia) in accessing
the Chinese market. For similar reasons, the flow of foreign direct investment to
China was likely to increase. This would prove costly for India. With the entry of
China into the WTO, a rule-based trading system would come into operation,
paving the way for even larger amounts of global capital to flow into the country.
Being a member of the WTO, China would have MFN (most favored nation)
status, giving it access to all WTO member countries. Under the WTO rules, China
would be guaranteed non-discriminatory access to the markets of all major
industrial countries, which were members of the WTO. Quid pro quo, foreign
companies would be given the right to trade and invest in China, with the
confidence that any concessions granted by the Chinese government could not be
reversed.
Contd
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Contd
With MFN status, China would move to an even more advantageous position.
According to analysts, the challenge before India was to undertake macroeconomic reforms to step up overall growth. Reforms should include reducing the
fiscal deficit and high borrowings. To compete with China for FDI, India needed to
improve its infrastructure.
Example: China and the Multifiber Agreement

China, the worlds largest exporter of apparel, was expected to be the major
beneficiary of the phasing out of the Multifiber Agreement on 1st January 2005.
Many foreign multinational clothing companies, especially US-based companies
like Wal-Mart, Gap, and Liz Claiborne, which had been importing textiles and
apparels from at least 30 countries would now source from countries with large
production capacities such as China, and to some extent from India.
The availability of cheap labor and the low cost of production in China would work
in its favor, and it also planned to modernize its textile industry to boost its exports.
Chinese apparel exports were worth US$ 41 billion in 2002 -- approximately one
fifth of the worlds total exports. Chinas share in the US textile market, the largest
textiles market in the world, was around 53 per cent in June 2003, and was
expected to go up to 75 per cent by 2004. However, there were many things that
could work against China, preventing it from becoming a major player in the US
textile market.
First, The National Council of Textile Organizations (NCTO) of the US was
expected to lobby with the Bush government to apply the provisions in the treaty
signed by China when it joined WTO. The treaty was in operation till 2008. The
treaty had provisions to safeguard the textile industry of importing countries from
Chinese exports. Apart from this, the importing country or the United States could
act unilaterally to limit imports to the extent necessary, if imports from China
caused disruptions in their domestic market. Further, China had agreed to a
product-specific safeguard, which applied to all products relating to textiles and
apparel, industries, and agriculture, and allowed the United States to address the
rapidly increasing Chinese imports till 2013. Though a public hearing was required
before the restraints were invoked, China has no right to retaliate against these
restraints.
Many US textile manufacturers had filed a number of petitions with the US
Department of Commerce requesting protection from cheap Chinese imports. US
textile manufacturers were of the view that cheap Chinese imports would definitely
flood the US market, thus disrupting the local market. Further, the US textile
industry feared that these cheap imports would put around 713,000 US jobs at risk.
However, the US Association of Importers of Textiles and Apparel, supporter of
the free trade regime, filed a lawsuit in a federal court to prevent the US
government from imposing restrictions on imports from China and other countries.
Contd
119
Contd
Fifty developing countries including Turkey, Bangladesh, Indonesia, Morocco, Sri

Lanka, and Tunisia met in Istanbul, Turkey, and signed the Istanbul Declaration,
requesting the WTO to reconsider the decision to phase out the MFA regime, and
asking for an extension of the present system by a few more years. They also
requested the WTO to develop a new mechanism or to use certain regulations
through WTO to prevent huge market disruptions due to the dominance of a few
countries. The countries that signed the Istanbul Declaration were apprehensive
about the prospects for their textile industries since most of them were dependent
on the quota system of the MFA.
Though the countries neighboring the US (Mexico and Caribbean Islands) had
trade agreements such as the North American Free Trade Agreement (NAFTA) and
the Caribbean Basin Trade Partnership Act (CBTPA), they were protected only to a
very small extent from the Chinese onslaught. Euro Cotton, which represented
trade groups from eleven countries in the EU, had been bringing pressure on the
European Union to request the WTO to extend the quota regime, but to no avail, as
the EU voted in favor of free trade.
According to analysts, if the US-China tangle continued and the WTO did not
extend the present MFA regime, India, and to a lesser extent, Pakistan, could well
manage to become important players in the global textile market, as they also had
abundant cheap labor and the required production facilities.
On the other hand, China had imposed export tariffs on six categories of 148 items,
after January 1, 2005, to assuage the fears in importing countries as regards
Chinese domination. Chinas decision to impose export tariffs was one of eight
measures it announced to help the global textile market and other countries adjust
more smoothly to unrestricted trade.
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Concept Note - 5
Foreign Exchange Markets

1. Introduction
The international monetary system and international financial markets are inherently
linked such that the former impacts the operations of a firm or company decisions
through the latter. International financial markets are composed of international
foreign exchange markets and international capital markets. The Asian financial crisis
in 1997-98 illustrates how a financial crisis is reflected simultaneously in the
international foreign exchange markets and international capital markets.
This unit discusses different concepts in international foreign exchange rate markets.
It then goes on to explain the different international capital markets. It finally
discusses three perspectives that highlight the causes for the Asian financial crisis.
2. International Foreign Exchange Markets

2.1 Background of the International Foreign Exchange Market
A foreign exchange market is where foreign currencies can be bought and sold. It is
the institutional and physical structure through which currency exchange takes place,
exchange rates are determined, and foreign exchange transactions are completed. A
foreign exchange transaction is an agreement between a buyer and seller for the
delivery of certain amount of one currency at a specified rate in exchange for some
other currency. A 1999 survey of foreign exchange markets conducted by the Bank
of International Settlements revealed that the international foreign exchange market
had a daily turnover of US$ 1.5 trillion. The US dollar was the most actively traded
currency. The second and third most traded currencies were the deutsche mark and the
Japanese yen, respectively.
The global foreign exchange business is concentrated in four centers London, New
York, Tokyo, and Singapore. Other important foreign exchange markets are located in
Paris, Amsterdam, Zurich, Frankfurt, Toronto, Hong Kong, Milan, Bahrain, and
Brussels. The foreign exchange market is dominated by dealers and is becoming
increasingly concentrated and automated.
2.2 Participants and Functions

The foreign exchange market includes individuals, banks, corporations, and brokers
who buy or sell currencies. The foreign exchange brokers intermediate to conduct
currency trading in each country, match currency bids and offers of banks, and also
trade directly among themselves internationally. Banks throughout the world are
linked by telephone, telex, the Internet, and satellite communications network called
the Society for World-wide International Financial Telecommunications (SWIFT)
based in Brussels, Belgium.
Though the market is global, the exchange market in each country has its own identity
and regulatory and institutional framework. An efficient communication system can
substitute for participants having to convene at some specific location (bourse).
Indeed, the US-UK type of market is based on communication networks, whereas the
European approach is traditional with the participants meeting physically at the
bourse. Daily meetings take place in some markets such as Paris and Frankfurt, where
representatives of central banks and commercial banks meet and determine a fixed
rate. In those countries, the posted fixed rate acts as a guide for pricing small and
medium-sized transactions between banks and their customers. Major industrial
countries such as Italy, Belgium, France, Japan, and the Benelux and Scandinavian
countries have a daily fixing. The US, the UK, Canada, and Switzerland do not have a
daily fixing.
Foreign exchange trades are done in a 24-hour market. As the market in the Far East
closes, trading in the Middle East financial centers begins. After a couple of hours,
trading in Europe begins. As the London market closes, the New York market opens.
After a few hours, the market in San Francisco opens and trades with the Far East and
the East Coast of the US. The foreign exchange market is dominated by banks with
about 90 percent of foreign-exchange trading comprising interbank trading. Nonbank
participants in foreign-exchange trading include multinational corporations,
commodities dealers, and nonbank financial institutions.
The three major functions performed by the foreign exchange market are described
here:
1.
It is part of the international payment system and offers a mechanism for

exchange or transfer of the national currency of a country into the currency of
another country, thus facilitating international business.
2.
It assists in supplying credits for the short-term through swap arrangements and
the Eurocurrency market.
3.
It offers foreign exchange instruments to hedge against risk.
Foreign exchange trading sharply expanded under the floating exchange rate system
and the number of banks participating in the market significantly increased as they
entered the market for servicing their corporate clients. Increased hedging by
companies of their balance sheets and cash flows was accompanied by the entry of
new corporate participants into the market.
2.3 Foreign Exchange Rate Quotations

A foreign exchange rate quotation is the expression of willingness to buy or sell at a
set rate. In foreign exchange businesses, several pairs of quotations are used.
Direct and Indirect
A direct quote is a home currency price of a foreign currency unit. (e.g. C$1.489/US
$1 in Canada). An indirect quote is a foreign currency price of a home currency
unit. (e.g. US $ 0.67182/C$ 1 in Canada). Under a direct quote, an increase of the
exchange rate (e.g. from C$ 1.489 to C$ 1.589) means appreciation of the foreign
currency (US$) and depreciation of the home currency (C$). In contrast, an increase in
exchange rate (e.g. from US$ 0.67182 to US$ 0.68182 per Canadian dollar) under
indirect quote means depreciation of the foreign currency (US$) and appreciation of
the home currency (C$). Direct quote is used in most of the countries.
Bid and Offer
A bid is the exchange rate in one currency at which a dealer will buy another
currency. An offer is the exchange rate at which a dealer will sell the other
currency. The difference between the bid and offer prices is called the bid-ask spread
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and is the dealers compensation or the transaction cost. For instance, a Canadian bank
quotation for the US dollar (US/C$) may be 0.6748 (offer) and 0.6718 (bid). The
transaction cost charged by the Canadian Bank may be 0.0030.
Spot and Forward
Spot rate and forward rate are used for foreign exchange transactions between dealers
in the interbank market. A spot rate is the exchange rate for a transaction that
requires almost immediate delivery of foreign exchange. A forward rate is the
exchange rate for a transaction that requires delivery of foreign exchange at specified
future date.
Cross Rates
The cross rate is the exchange rate between two infrequently traded currencies,
calculated through a widely traded third currency.
2.4 Transaction Forms

Spot Transactions
Spot transactions include spot transactions between banks and bank notes transactions
for individuals. Spot transactions are usually settled on the second working day on
which the transaction concludes. Bank notes transactions include currency changes for
individuals that are exchanged for each other instantaneously over the counter. The
largest financial market in the world is interbank foreign exchange. On the settlement
date, most dollar transactions in the world are settled through the computerized
Clearing House Interbank Payments Systems (CHIPS) in New York, which provides
for calculating new balances owed by any one bank to another and for payment on the
same day in Federal Reserve of New York funds.
When an individual or a company needs foreign exchange to be paid to a foreign
company, it can either use international wire transfers or customer drafts. Under a
wire transfer, the payment instructions are sent through SWIFT or other electronic
means. Under the customer drafts, the bank sells the individual or company a foreign
exchange draft that is payable to the stated holder.
Forward Transactions
A forward transaction occurs between a bank and a customer calling for delivery at a
fixed future rate, of a specified amount of foreign exchange at the fixed forward
exchange rate. The exchange rate is set at the time of the agreement, but until
maturity, payment and delivery are not required. International companies may either
buy a foreign currency forward from a bank or sell a foreign currency forward to a
bank. The position where the initial transaction represents an asset or future ownership
claim to foreign currency is termed as long position. The position where the cash
market position represents future obligation or liability to deliver foreign currency is
termed as short position.
Swap Transactions
A swap is an agreement to buy and sell foreign exchange at prespecified exchange
rates where the buying and selling are separated in time. A swap transaction involves
simultaneous sale and purchase of a given amount for two different dates of
settlement. The same counter-party carries out both sale and purchase. Swap
transactions are of two types spot forward swap and forward-forward swap.
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In a spot-forward swap, an investor sells forward the foreign currency maturity value
of the bill, and simultaneously buys the spot foreign exchange to pay for the bill.
Because a known amount of the home currency of the investor will be received
according to the forward swap component, no uncertainty will exist from exchange
rates. Similarly, those borrowing in foreign currency can buy forward the foreign
currency essential for repaying a foreign currency loan at the same time as they
convert the foreign funds that are borrowed on the spot market.
A forward-forward swap involves two forward transactions. For instance, a dealer
sells Euro 1,000,000 forward for dollars for delivery in three months at US$
0.94/Euro, and simultaneously buys Euro 1,000,000 forward for delivery in six
months at US$ 0.94/Euro.
The two preceding swaps are popular with banks as it is difficult to avoid them when
making a market for future currencies and dates.
2.5 Foreign Exchange Arbitrage

In the foreign exchange market, the information related to price is easily available
through computer networks, which makes it easier for price comparison in other
markets. As such, exchange rates between two particular currencies tend to be equal
worldwide though temporary discrepancies do exist. These discrepancies offer profit
opportunities for buying a currency in one market while simultaneously selling it in
another. This activity is called arbitrage. It continues until the exchange rates in
different locales are so close that it is not worth the costs incurred in additional buying
and selling.
2.6 Black Market and Parallel Market

Due to legal prohibitions or government restrictions on foreign exchange transactions,
illegal markets in foreign exchange exist in many developing countries in response to
private or business demand for foreign exchange. These illegal markets are known as
black markets. The illegal markets exist openly in some countries (e.g. Venezuela and
Brazil) where there is very little government interference. However, in some other
countries, foreign exchange laws are enforced strictly and lawbreakers when caught
receive harsh sentences (e.g. China before 1985).
Often, governments set an official exchange rate that widely deviates from the one
established by the free market. If the government wishes to purchase foreign exchange
at the official rate but private citizens wish to pay the market-determined rate, there
would be a steady supply of foreign exchange to the black market. Thus it can be
inferred that government policy creates a black market. The demand arises due to
legal restrictions on buying foreign exchange, and the supply exists because official
exchanges that are mandated by governments offer less than the free market rate.
Ironically, governments defend the need for restrictions on foreign exchange based on
conserving scarce foreign exchange that flows to the government as traders may
instead wish to sell it to the black market.
The black market when legalized by the government is referred to as parallel market.
It operates as an alternative to the official exchange rate. In countries facing economic
hardship, the parallel markets allow continuation of normal economic activities
through a steady supply of foreign exchange.
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3. International Capital Markets

3.1 International Monetary Markets
International money markets are markets where foreign monies are invested or
financed. MNEs make use of international money markets for financing global
operations at a lower cost than is possible in domestic markets. The MNEs borrow
currencies having lower interest rates and are expected to depreciate against their own
currency. However, they incur the risk of the borrowed currencies appreciating, which
would increase their cost of financing. On the other hand, investors may substantially
achieve higher returns in foreign markets than in their domestic markets when they
invest in currencies that appreciate against that of their home country. If the currencies
depreciate, however, the effective yield on foreign investments would be lower than
the domestic yield, and may be even negative. Investors make attempts to capitalize
on potentially high effective yields on foreign market securities, while reducing the
exchange rate risk by diversifying investments across currencies.
Often transactions in the international money markets take place through the
Eurocurrency market. The Eurocurrency market comprises commercial banks that
offer large loans in foreign currencies and accept large deposits. The banks offering
Eurocurrency services are either local banks or subsidiaries of foreign banks in a host
country. The growth of the Eurocurrency market is attributed to growing international
trade and capital flows as well as cross-border differences in interest rates. In this
market, Eurodollar deposits are transacted intensively.
Eurodollars are US dollar deposits in non-US banks. Eurodollar deposits are not
subject to reserve requirements and hence banks can lend out 100 percent of deposits.
Loan transactions and deposits on Eurodollars are usually US$ 1 million or more per
transaction.
Two popular Eurodollar deposits are the Eurodollar fixed-rate certificate of deposits
(CDs) and the Eurodollar floating-rate certificate of deposits. The fixed-rate
Eurodollar CDs are adversely affected by the rising market interest rates but they
receive guaranteed interest. This problem is neutralized by the floating-rate Eurodollar
CDs that offer the rate that can be adjusted periodically to the London Interbank Offer
Rate (LIBOR) the rate charged on interbank loans.
3.2 International Bond Markets

International bond markets are the markets where corporate bonds or government
bonds are issued, bought, or sold in foreign countries. The growth of these markets is
attributed to some unique features that are offered by international bonds which are
not offered by domestic bonds. The development of the international bond market is
attributed to tax law differentials across countries. In 1984, the elimination of
withholding tax on US-placed bonds caused a large increase in the foreign demand for
US-placed bonds.
Bonds placed in international bond markets are typically underwritten by an
association of investment banking firms. Many underwriters in the Eurobond (refers
to any bond that is denominated in a currency other than that of the country in which it
is issued; e.g. an Eurobond denominated in Japanese yen but issued in the U.S. market
is called Euroyen bond) market, are US bank subsidiaries that have focused their
growth on non-US countries since they were banned historically by the Glass-Steagall
Act from underwriting corporate bonds in the US.
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3.3 International Stock Markets

International stock or equity markets are markets where company stocks are listed and
traded on foreign stock exchanges. Firms in need of finance make use of foreign stock
exchanges as additional sources of funds. Foreign stock markets are used by investors
for enhancing the performance of their portfolio. This source of financing allows
MNEs to attract more funds without flooding their home stock market and thus
circumventing the decline in share price. Many MNEs also issue stock in foreign
markets for circumventing regulations as regulatory provisions differ among markets.
Firms believe that by issuing stock in foreign markets, they can achieve worldwide
recognition among consumers. Further, listing stock on a foreign stock exchange
enhances the liquidity of the stock and also increases the perceived financial standing
of the firm when the exchange approves the listing application. It also protects firms
against hostile takeovers as it disperses ownership and makes it difficult for other
firms to gain a controlling interest.
The Euroequity market is a market where US dollar-denominated stocks are issued on
non-US exchanges. This market has grown and developed since the 1980s. The stocks
issued in the Euroequity market are designed specifically for distribution among
foreign markets. They are underwritten by an association of investment banks and are
purchased chiefly by institutional investors in several countries.
The firms ability to place new shares in foreign markets depends partially on the
perceived liquidity of the stock in that market. To enhance liquidity and make newly
issued stocks attractive, a secondary market has to be established in foreign markets.
3.4 International Loan Markets

International loan markets comprise large commercial banks and lending institutions
that offer loans to foreign companies. Loan markets are not restricted only to foreign
currency transactions, unlike international money markets that have dealings only
with foreign money. As regulations across the US, Europe, and Japan have
standardized, the markets for loans and other services have become globalized. Thus
some financial institutions make attempts to achieve greater economies of scale on the
services offered by them. Even financial institutions that do not plan to undertake
global expansion, experience increased foreign competition in their home markets.
International lending is perceived as a means of diversification by banks from all
countries. International lending also allows banks to develop relationships with
foreign firms, which creates a demand for other services offered by the bank. In
addition, a major portion of international lending is to support international
acquisitions. Investment banks and commercial banks serve as advisers as well as
financial intermediaries by providing loans or by placing stocks and bonds. A
common form of participation has been to offer direct loans to finance acquisitions,
especially for leveraged buyouts (LBOs) by management or other investor groups.
Since LBOs are most often financed through debt, they result in a large demand for
loanable funds. Most of the LBOs are supported by debt from an international
syndicate of banks. In this way, each bank limits its exposure to a particular borrower.
As the firms engaged in LBOs are from diversified industries, a problem in any
industry does not lead to a lending crisis. In addition, the debt of each individual firm
is relatively small so that many borrowers do not have access to sufficient bargaining
power for rescheduling their debt payments. For this reason, international bank
financing of LBOs is considered to be less risky than offering loans to the
governments of developing countries.
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Lending to developing countries requires credit checking. International commercial

banks and other lending institutions carry out credit checking based on an analysis by
credit rating agencies such as Moodys and Standard and Poors. The focus of analysis
is on political risks and overall pressures on the balance of payments and
macroeconomic conditions.
4. Asian Financial Crisis

The Asian financial crisis depicts how a crisis takes place in international financial
markets and how the crisis relates to international financial markets, financial
institutions, and governments. The Asian financial crisis first afflicted Thailand in
June 1997. It then quickly spread to the Philippines, Indonesia, Malaysia, South
Korea, and other Southeast and East Asian countries. Initially, the crisis took the form
of a financial meltdown, with stock markets, currencies, and property prices dropping
across the region. Economic aftershocks ensued. The crisis was soon to have its effect
on markets and economies across the world from Europe to Latin America. The
nations of East and Southeast Asia, familiar with high single or double digit growth
rates, shifted to sluggish and negative growth. These poor economic conditions
prevailed in most of these nations until early 1999.
4.1 The Financial Perspective

From the financial perspective, the Asian financial crisis resulted primarily due to the
weakness of the financial sector and market failure. Two factors stand out for
contributing to the financial sector weakness and market failure. First is the
maintenance of the pegged exchange rates that were viewed as implicit guarantees of
exchange that constrained monetary remedies. The second is excessive private sector
short-term and dollar-denominated borrowing.
Additionally, contagion fueled the crisis through the wake-up effect and the
dynamics of competitive devaluation. The former explains the tendency of most of
the foreign investors to treat all Asian countries as one and pull out investments from
a country regardless of its market and economic fundamentals. The latter pertains to
the pressure faced by Asian countries for devaluing their currency to match
devaluation by neighboring countries.
4.2 The Political/Institutional Perspective

According to political/institutional-based explanations, the causes of the Asian crisis
extend beyond weaknesses in the financial sector and market failure. The political and
institutional perspectives point to irresponsible domestic governance, corruption in the
public and private sectors, crony capitalism, weak national and political institutions, a
misguided and poorly enforced regulatory environment, and other political and
institutional-related factors as the principal forces behind the crisis.
The crisis highlighted key weaknesses in the institutions and the political/economic
systems of several Asian countries. The prevalent practice of crony capitalism, the
incestuous relationship between the business, the government, and banking in
countries such as Malaysia, Thailand, and Indonesia led to an overextension of credit
to undeserving companies with close ties to the military and political leadership. Due
to conflicting business interests, politicians and government bureaucrats were
ineffective in responding to the crisis.
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The IMF noted three political and institutional-related considerations as forces

contributing to the Asian financial crisis:
In financial systems, lax enforcement of providential rules and inadequate
supervision, weak management, poor control of risks, and government direct
lending practices resulted in a sharp deterioration of the loan portfolios of banks.
Lack of transparency and problems of data availability hindered market
participants from maintaining a realistic view of economic fundamentals, and also
added to uncertainty.
Political uncertainties and governance problems aggravated the crisis of
confidence, the downward pressure on currencies and stock markets, and the
reluctance of foreign creditors to roll over short-term loans.
4.3 The Managerial Perspective

The third group of explanations advocates that micro-management was at the heart of
the crisis. The booming economy of the 1990s encouraged many industrial companies
in East and Southeast Asia to pursue risk over-diversification. These companies relied
on short-term debt financing to fund their expansion. In 1996, the chaebols or the
five largest conglomerates of South Korea (i.e. Samsung, Hyundai, Lucky Goldstar,
Daewoo, and Sunkyong) controlled over 250 subsidiaries in over dozen business lines.
The combined liability of the five conglomerates amounted to 70 percent of South
Koreas GDP in 1996.
Over-diversification and extended leveraging led to the creation of a vicious cycle for
many companies. Firms pursued risky ventures to service their expensive, short-term debt
and earn large returns on their investment. When these risky projects failed, the firms
borrowed more to keep their operations afloat. These companies maintained this practice
until the banks were willing to extend their credit. When the financial crisis hit, the banks
refused to extend their credit and this forced many firms into bankruptcy.
The problems for these firms were compounded by contracting export markets, falling
commodity prices, and other external pressures. Instead of addressing these external
pressures by cutting costs, improving productivity, and focusing on the bottom line, the
majority of the firms opted for growth and diversification into unrelated businesses. This
strategy proved costly when the financial crisis hit and dried up the funds. In contrast,
firms that focused on their core competencies by cutting costs, enhancing productivity,
and focusing on profitability were able to weather the storm.
Financial institutions and banks extended their credit to undeserving companies. When
those companies could not repay, banks rolled over their loans and extended their credit.
The financial perspective views the process as a market failure while the
political/institutional perspective blames overextended credit. The managerial perspective
attributes such credit overextension to lack of sophistication in management and absence
of administrative apparatus for conducting proper analysis and oversight.
5. Summary
A foreign exchange transaction is an agreement between a buyer and seller for the
delivery of a certain amount of one currency at a specified rate in exchange for
some other currency.
The foreign exchange market includes individuals, banks, corporations, and
brokers who buy or sell currencies.
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International money markets are markets where foreign monies are invested or
financed.
International bond markets are markets where corporate bonds or government
bonds are issued, bought, or sold in foreign countries.
International stock or equity markets are markets where company stocks are listed
and traded on foreign stock exchanges.
International loan markets comprise large commercial banks and lending
institutions that offer loans to foreign companies.
The Asian financial crisis depicts how a crisis takes place in international
financial markets and how the crisis relates to international financial markets,
financial institutions, and the governments.
Example: The Indian Rupee-US Dollar Exchange Rate:

The Economic Impact of a Strengthening Currency
In April 2007, on the back of a rising rupee, the Indian economy became a trillion
dollar-economy, moving the country into an elite group of nations. By August 31,
2007, the Indian currency was trading at 40.96 against the dollar, as compared to
46.55 on August 31, 2006, an appreciation of around 12 percent.
The rise in the value of the rupee was a result of the general weakening of the
dollar in international markets, plus Indias growing attractiveness to foreign
investors. In 2006-07, India attracted huge capital inflows in terms of foreign direct
investment (FDI), and foreign institutional investment (FII). External commercial
borrowings (ECB) and non-resident Indian (NRI) deposits and remittances also
contributed to the dollar inflow.
Although India had been witnessing strong dollar inflows for some time, the rupee
had not appreciated as steeply as it had between September 2006 and July 2007
mainly because on earlier occasions, strong dollar inflows into India usually saw the
Reserve Bank of India (RBI), Indias central bank, intervene in the foreign exchange
market and purchase excess dollars so as to minimize volatility in the value of the
rupee. This time around, the RBI chose not to intervene, in order to keep domestic
inflation, which had been hovering around 6 percent in early 2007, in check.
While the RBI and the finance ministry were able to tame the inflation rate
(inflation fell to 3.52% in August, 2007), the rupees appreciation affected Indian
exporters as Indian goods became more expensive for foreign buyers. Information
technology (IT) and textiles industries were particularly hard-hit, as they were the
most dependent on the US. Leather, sugar, and plantation crops were some of the
other sectors that were starting to lose competitiveness. The Indian Micro, Small
and Medium Enterprises (MSMEs) were also affected. It was feared that falling
export competitiveness would cause substantial job losses.
On the other hand, the rupees appreciation against the dollar was a welcome
development for Indian importers, who were happy to pay less for their imports in
terms of rupees. Sectors which were neither net exporters nor net importers were
unaffected.
Contd
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Contd
Analysts were divided in their opinion on the long-term effects of the rupees
appreciation against the dollar on the Indian economy. Some believed that as
exports as a percent of GDP are low in India, the rupees appreciation against the
dollar, though sure to impact exports, would not significantly affect the economy as
a whole. They were also confident that Indian exports would gradually regain
competitiveness. However, others were not so optimistic and were in favor of the
RBI intervening in the foreign exchange market.
In July-August 2007, the government of India announced measures to counter the
negative impact of the rupees appreciation on Indias exports. The RBI also started
buying dollars from the market to absorb the oversupply of dollars, indicating that
the rupee-dollar rate had crossed the comfort zone of the central bank.
Example: Exchange Rate Crisis in Argentina

In 1991, Argentina introduced free-market reforms. A currency board was established
to control the exchange rate and money supply. The peso was fixed to the dollar, and
money supply was tied to hard currency reserves. The country lifted price controls and
regulations on the movement of capital and embarked on a privatization program.
Public sector companies in mining, oil, telecommunications, transport, and utilities were
privatized. These moves brought inflation under control and pushed down interest
rates; the fiscal deficit was reduced, and interest payments on foreign debt became
manageable. From 1990 to 1995, the countrys GDP grew by 5.9 percent a year and
labor productivity by 4.5 percent. The International Monetary Fund (IMF) hailed
Argentina as the role model for reform in emerging markets.
Then things started to go wrong. In the second half of the nineties, the growth of
labor productivity slowed to 0.4 percent. Tax revenues slumped while public
spending continued to boom, debt obligations became increasingly hard to meet,
and the currency peg came under pressure. The prices of commodities stopped
rising, while the cost of capital started increasing. The dollar (and hence
Argentinas peso) appreciated against other currencies, and Argentinas major
trading partner, Brazil, devalued its currency. The currency board was too rigid to
respond quickly to the shocks. Though finance ministry officials insisted that the
economy would maintain 6% growth in 2001, the economy was in a debt trap.
Many industries in Argentina were unable to compete abroad, particularly after the
devaluation of the Brazilian currency. As Argentina could not devalue its currency,
the economy went into recession accompanied by deflation, falling wages, and
rising unemployment. The economic crisis in Argentina could be attributed not
only to its rigid exchange rate regime, but also to its loose fiscal policy. The share
of public spending in GDP increased from 27% in 1995 to 30% in 2000. The
countrys tax system was inefficient and tax evasion was high.
On December 23, 2001, the president of Argentina declared that the country was in
a debt trap of over $ 155 billion. The unemployment rate had reached 20%. In
2002, Argentina stopped pegging the peso to the dollar, and the peso was devalued
and made a floating currency. As most savings, loans, and contracts were in dollars,
the devaluation added to the financial chaos. In early 2002, unemployment had
risen to 25% in some cities, and official figures stated that 44% of the population
was below the poverty line, with an income of less than 120 peso per month.
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Concept Note - 6
Global Marketing and Supply Chain

1. Introduction
International markets are more complex but offer vast opportunities for firms with a
product or a service that has potential demand abroad. Newness, appropriate
marketing strategies, and cultural attractiveness are what make a product welcome in
international markets.
Globalization forces include the emergence of global brands, potential savings in
costs, technological advances, and lower trade barriers. Localization forces include
country level factors that affect product introduction and adaptation.
In recent years, supply chains have undergone substantial globalization with firms
consolidating sourcing and distribution operations.
This unit discusses how the market potential of a foreign country can be determined. It
then goes on to explain the concepts of globalization and localization in international
markets. The unit finally discusses how supply chains are globalized.
2. The International Marketing Challenge

The essence of international marketing, especially in context of industries which have
worldwide presence, is that competition can come from anywhere around the globe.
Success in international markets depends on many skills such as accurate assessment
of market potential; selection of the right product mix, and appropriate adjustments in
pricing, packaging, advertising, and distribution. Cultural values and social customs,
rules and regulations, economic conditions, and political realities constitute the
context within which international marketing takes place.
2.1 Assessing Market Potential

To assess market potential, firms seek to identify aggregate demand for a product or a
service and estimate the costs associated with product introduction and distribution. In
deciding market priority, profitability, accessibility, and market size play a major role.
The size of the population reveals a little about the short-term market potential.
Population growth offers a coarse estimate of future market potential. For instance,
Japan and many European Union countries face low and negative population growth
forecasts whereas most of the Asian countries show a rapid population growth. The
best indicator of market potential is economic development and its correlate,
disposable income. The consumers ability to afford certain products and services is
found by nominal income figures. Purchasing power parity (PPP) is an index used to
adjust nominal figures to the purchasing power of local consumers.
Market potential is also influenced by consumption patterns. For example, the French
drink six times more wine than the British do. Consumption patterns are dynamic and
current patterns need to be interpreted with caution. Often, consumption is driven by
factors different from those in domestic markets. For instance, BCG research indicates
that in some economies such as Colombia or the Philippines, Coca-Cola is a substitute
for drinking water at places where the available water is non drinkable.
To assess market potential within the context of corporate strategy, firms carry out
marketing research. The research aims at finding solutions to questions such as (a)
what are the objectives to be pursued by firms in foreign markets?; (b) what foreign
market segments have to be pursued?; (c) Which are the best product, distribution,
pricing, and promotion strategies; and (d) what must the product-market-companymix be to take advantage of the available foreign marketing opportunities?
3. Globalization and Localization in International Markets

Striking a balance between globalization and localization is a key challenge. While the
lack of globalization can prove detrimental to a companys performance,
indiscriminate standardization of marketing practices without any attention to
localization factors can turn out to be as harmful.
In the marketing sense, globalization is the standardization of products (or services),
brands, marketing, advertising, and the supply chain across countries and regions. In
contrast, localization is the adjustment of one or more of the above elements to be
idiosyncratic characteristics of a given national market.
The major challenge that Multi-national Enterprises (MNEs) face is with regard to
fine-tuning the globalization-localization balance.
3.1 Globalization Forces

The function of marketing can be coordinated increasingly on a global basis.
3.2 Global Brands

Behind the trend of globalization, there is an assumption that many consumer and
industrial products can be standardized. For instance, Kellogg has designated Special
K, Corn Flakes, Frosted Flakes, Nutri-Grain bars, and Fruit Loops as global brands.
Global products are products that are recognized worldwide and are unaltered in terms
of appearance and brand when sold abroad. To be designated global, products should
be sold throughout the world under the same brand name with over US$ 1 billion in
sales and over 5 percent of those sales coming from outside the home market.
The primary motivation toward product and service globalization is to gain scale
economies. Selling the same product using the same distribution channel and
promotional message reduces costs. Globalization allows firms to leverage on the
experience they gain in one market in another market, using communication
technologies, for facilitating integration and coordination. Moreover, the appeal of a
global product can be a crucial selling point for some customers.
3.3 Marketing Repercussions of a Global Approach

Some of the key ramifications of globalizing the marketing function are described
here:
Rapid roll-out of new products across major markets, preventing competitors
from introducing similar products in new markets.
Prioritizing and targeting a product across markets, limiting local product
offerings.
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Uniform branding and advertising globally creates a consistent message,

reassures customers with global reach, and reduces cost and duplication. This
enhances the chances of entering the crowded shelves of retailers that display
only best-selling and major brands.
Manufacturing relatively standardized products to scale economies.
Transferring marketing best practices across borders.
A by-product of the increased globalization of the function of marketing is erosion in
the authority of country managers. Country managers have less control over pricing,
marketing budget, and other key marketing decisions. Though they usually maintain
control over local brands and have some say in new product development, their
influence over the marketing of global brands in their country of jurisdiction is on the
decline. National brand managers are rare, and they frequently report directly to a
global marketing group as opposed to the country manager.
While marketing globalization is evident worldwide, there are significant differences
in how MNEs approach it from different countries.
3.4 Localization Forces

Localization forces represent pressures toward adjustment in product marketing or
distribution to make the product more appealing or for meeting requirements
particular to a foreign market.
Following a spate of alleged product contamination in foreign markets, Coca-Cola
executives noted that the firms motto think globally and act locally had to be
changed to think locally and act locally. Despite globalization, local conditions and
content remain vital.
Cross-national variations have a major impact on marketing. The income level
differences create different consumer requirements. Diverse regulatory regimes put
different constraints on product design, packaging, and promotion. Even in the European
Union, where trademarks and logotype are relatively standardized, pricing, promotion,
and media-mix are far from uniform. Public opinion and social attitudes also make a
difference. For instance, Kelloggs Nutri-Grain was successful in the US but did not do
as well in the UK, where health consciousness was not strained at that time.
Another major influence is culture. Cultures with high uncertainty avoidance and
power distance emphasize appearance for reaffirming ones status and for reducing
uncertainty regarding others positions. Culture also has an influence on sales
practices. In high-power distance cultures, a sales pitch is made in a formal manner
whereas it is likely to be personalized in individualistic countries.
Cultural and social customs also shape the context in which the product is utilized. For
instance, McDonalds restaurants in mainland China, Hong Kong, and Taiwan serve
as bases for social activity in late mornings for seniors and in afternoons for school
children.
3.5 Product Adaptation

Facing a foreign market with different characteristics, a firm may not offer a product
or a service it offers in other markets, or it may adapt it to suit that country or the
regional market. Firms use benefit/cost and user/needs models to make decisions.
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Benefit/cost models evaluate the advantages and disadvantages of a product or a

distribution mode in a given market. User/need models test the needs of prospective
customers, including the circumstances in which the product or service may be used.
The analysis yields a decision for customizing or standardizing the product and/or
promotion and distribution.
For the MNE, it is necessary to achieve a fine balance in global marketing. While
making adjustments to local tastes and customs, it is equally important for the MNE to
leverage on its global reputation and name recognition.
The challenge of adaptation exceeds all aspects of marketing. For example,
OfficeMax and Office Depot launched their outlets in Japan as replicas of their USbased large, warehouse type discount stores. They discovered that the global
efficiencies derived were insufficient to compensate for local rents and unwillingness
to buy in an impersonal, warehouse-type store. Accordingly, the firms changed their
strategies.
3.6 Country-of-origin Effect

The country-of-origin effect is the influence of the country of manufacturing image
on the buying decision. The effect comprises dimensions such as innovativeness,
namely using new technology and engineering advances; design, namely style,
appearance, color, and variety; prestige, brand name reputation, status, and
workmanship, including reliability, durability, craftsmanship, and manufacturing
quality. The country-of-origin has an influence on the perception of the buyers.
However, the impact has more to do with perception than reality. For instance, British
firms are not associated with many strong products and innovations they have created
actually.
Overtime, the country-of-origin effect changes. In the 1960s, Japanese products had a
reputation of being of substandard quality. It was decades before the country was able
to build up a reputation for quality manufacturing. As products from developed
nations tend to receive higher evaluation, a country moving into the ranks of
developed economies may also enhance its products reputation. Firms from emerging
economies also engage in activities that enhance the reputation of their products.
3.7 Leveraging Positive Country Image

Country image differs across product categories. German automakers take advantage
of the countrys reputation for advanced engineering, reliability, and quality. Some
countries may be noted for a single product as for instance, Russian caviar or Iranian
carpets.
A positive country image minimizes customization that is not inherent in product use.
To highlight the national origin of the product, the original appearance and packaging
will be preserved to the extent permitted by law.
3.8 Leveraging Nationalist Sentiments

Country-of-origin might serve as a patriotic appeal for buying domestic products.
Many countries carry out campaigns that urge customers to buy local products in
order to support the local industry and employment.
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At times, supporting domestic products may extend to disparagement of foreign

products. For instance, Japanese farmers placed advertisements in local newspapers
accusing orange growers in the US of spreading Agent Orange on their fruit. (Agent
Orange is a chemical used by the US armed forces in Vietnam for retarding vegetation
growth).
Some foreign firms make attempts to disarm nationalist sentiment by emphasizing the
local content in their product. Local content is the portion of a product (or service)
that includes locally made and procured inputs. For instance, Airbus in its
advertisements mentions its US suppliers.
Others may downplay the foreign origin of the product, using packaging and brand
names reflecting local heritage. In Russia, for instance, the the beloved taste of real
Russian butter appears on the package of butter from New Zealand.
Often MNEs point out that local firms do not essentially suffer from their entry. For
instance, an Israeli burger chain, Burger Ranch, continued to prosper following the
entry of Burger King and McDonalds, which greatly increased the overall domestic
market.
3.9 Branding
Branding is the process of creating and supporting positive perceptions associated
with a product or service. Branding is complex in global markets, especially given
varying demand and environmental characteristics. Proctor & Gamble entered China
in 1988 with one product. For the financial year ended June 2010, the company had
net sales of US$ 78.9 billion.
3.10 Channel Decisions

Channel decisions involve the length (the number of intermediaries or levels
employed in the process of distribution) and width (the number of firms in each level)
of the channel used to link manufacturers to consumers. In business-to-business sales,
channel decisions are more important than brand name, pricing, and advertising.
Localization is pronounced, especially among affiliates in the UK, perhaps due to the
assumption of cultural similarity.
3.11 Intermediation
Most of the international sales are not made by firms directly but through export
intermediaries. Export intermediaries are firms mediating between firms, especially
Small and Medium Sized International Enterprises (SMIEs) and their export markets,
by offering logistics, documentation, and related services. For smaller firms,
intermediaries play a key role, though some MNEs prefer outsourcing of this function.
3.12 Direct Marketing

Direct marketing involves direct sales to customers through individual agents who
make a commission on their sales, in addition to the sales by agents recruited by them.
The pioneers of the direct marketing system are Avon and Mary Kay. It was adopted
eventually by manufacturers of other products.
The image of direct selling is quite low, especially in Asia. In Japan, Avon found that
its system of making sales to random groups was ineffective as people were reluctant
to invite strangers into their home. However, direct marketing prospered after it
started relying on groups of friends or acquaintances.
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3.13 Niche marketing

Niche marketing is directed in a narrow manner toward a pre-defined market segment.
In international markets, niche marketing may be directed toward not only a product
category but also a geographical or an ethnic segment. An example is that of
Convencao, a small soft-drink company in Brazil, which cut into the market share of
beverage industry giants Coca-Cola and Pepsi by offering lower-priced products in its
home market. However, a niche may also serve as a base for expansion. Timberland,
originally known for its weather-proofed boots, exported casual wear to over 50
countries, including Italy.
3.14 Pricing
Pricing is the process and decision of setting a price for a product or a service. In
international markets, pricing is more complex due to varying cost structures (e.g.
tariffs, transportation costs) and market positioning.
Price differentials facilitate market segmentation that allows firms to position their
products differently in different markets. Where there is little competition and
consumer resistance to price increases is low, firms increase the price of their
products. Or firms may price a brand higher so they can position it as premium.
Price consistency is not easy to achieve. For example, some subsidiaries offer a higher
service level than others. Host government decisions also have an influence over
price. The Turkish government, for example, imposes an 80 percent import tax on all
vehicle imports thus protecting domestic manufacturers as well as the international
firms manufacturing in Turkey.
3.15 Predatory pricing

Predatory pricing is the selling of goods at prices that are below the real cost in order
to drive competition out of the market. For instance, it was alleged that Matsushita
priced its Panasonic TV sets below cost in the US, subsidizing sales with its high
margins in the Japanese market and driving US manufacturers out of business.
3.16 Promotion
Globalization can yield substantial savings in promotion. General Motors Europe uses
a unified promotional approach to drive brand identity. However, the company
recognizes the need for adaptation in some markets.
3.17 Advertising
Advertising needs to be adjusted to local tastes, regulations, and norms to make it
effective in international markets. When Lego exported the advertising it was using
successfully in the US to Japan, it flopped. Lego discovered that moving advertising
across borders is difficult linguistically, socially, and culturally.
The standardization of advertising can be considerable. Standardization provides a
consistent and coherent message and greatly reduces production cost by spreading it
across multiple markets. For instance, Coca-Cola, Benetton, and Ford have launched
global advertising campaigns.
As the firms globalize their marketing, they increasingly seek advertising agencies
with global reach which will provide a one-stop shop. For instance, Kellogg assigned
the advertising responsibilities for its global brands to J Walter Thompson and Leo
Burnett which operates globally.
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3.18 Marketing Alliances

International strategic alliances are a major venue for market entry. Such alliances and
mergers and acquisitions allow a firm to quickly establish itself in a foreign market.
An example is Interbrew based in Leuven, Belgium, which grew from a small familyowned brewery to the second largest brewer in the world and the owner of hundreds
of brands through acquisitions. Marketing alliances can also be formed between large
firms. For example, IBM and Dai Nippon Printing cooperate in database marketing.
All marketing alliances do not prosper. For instance, Timex established an alliance with
Titan in India. Timex offered low-end watches, whereas Titan offered high-end luxury
watches. Titan shops serviced Timex watches while Timex had access to Titans dealers
and showrooms. In return, Titan had access to low-cost mass production market through
Timex. With the changing of market conditions, the firms decided to enter other
segments and in 1997, they eventually decided to break up the alliance.
4. The Global Supply Chain

The global supply chain covers both logistics and operations. It includes activities
such as sourcing, procurement, order processing, manufacturing, warehousing,
inventory control, servicing and warranty, custom cleaning, wholesaling, and
distribution. In a firms global strategy, supply chain management plays a key
component, influencing key decisions such as plant and service location.
The costs of logistics have declined in recent years. The decline reflects increasing
efficiencies such as the incorporation of Just-in-time and the resulting decrease in
inventory levels.
Issues such as international shipping costs, currency translation, language, customs
documentation, and cross-border financial settlement are beginning to be addressed.
4.1 The Globalization of Supply Chains

Firms are increasingly consolidating production and distribution in some strategic
locations to ensure the effective delivery of a product or a service. The shift from
domestic to global supply chains is due to rapidly escalating capital costs and
enhanced technologies as well as regional integration. The evolution of flexible
manufacturing systems has enabled mass customization for meeting consumers
demands at reasonable costs. Consolidation of the transport industry facilitates
seamless transportation. Developments in management information systems permit
accurate tracking of material flow and variable customer demands.
Where integration has progressed as in the EU, standardized regulations have replaced
local rules, enhancing consolidation. With nations being increasingly served by
logistic centers in other countries, geographic designs have become less of an option
for MNEs. Other repercussions of globalization of the supply chain are increased
transportation from and to transportation centers, extended supply and distribution
chains, and more small-volume transactions.
The challenge for SMIEs
SMIEs do not have the necessary economies to justify a specialized facility.
Mutualization is one solution where the logistic facilities are shared by two or more
partners. Some SMIEs form alliances with local firms as the local partner may already
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have the logistic component, or a long-term logistic provider, which makes the foreign
firm consolidate its supply chain locally. Another solution for SMIEs is sourcing
logistic services from third parties. In such alliances, the shipper leads strategy
formulation while the provider leads day-to-day operations. There exists a sole key
provider with whom the manufacturers establish a close working relationship.
Global Sourcing
Global sourcing is the procurement of production or service inputs or components in
international markets. Global sourcing provides an opportunity to the MNE to
leverage on its scale and competitive advantage in spotting opportunities for
procurement worldwide for use in its various locations and divisions. For instance,
Wal-Mart, procures globally in huge quantities which helps it in arriving at lower
prices for its customers.
MNEs are also increasingly using outsourcing or buying the inputs outside their
network. Some firms may even outsource the logistic function itself.
Logistic Providers
While a one-stop international provision of logistics continues to be the ultimate goal,
national services may be replaced by regional providers. For instance, Texas
Instruments Semiconductors Group contracts with a key logistic provider for
managing forwarding and distribution in each region of the world.
4.2 Customizing the Supply Chain

As the globalization of the supply chain proceeds, several factors require continuous
attention being paid to localization and customization. Localization is supported by
three factors variation among national environments, product customization that
triggers logistic adjustments, and existence of national borders that impede the free
flow of goods and services thus limiting global solutions. Advantages such as the
incorporation of suppliers input at the phase of product design heighten dependencies
and logistic challenges accompanying the need to control and coordinate them.
National Variation
World regions vary in size, terrain, and other characteristics that have an impact on
the supply chain. For instance, the land area of NAFTA is over six times that of the
EU. Quality of supplies, skill level, availability of process equipment and
technologies, and the level of transportation and communications differ substantially
among regions. Asia, large parts of the Middle East, Africa, and Latin America suffer
from poor infrastructure. Though Asian infrastructure is relatively weak, Singapore
has superb infrastructure in terms of both shipping and air.
Conditions often vary even among developed nations. For instance, in the US, it takes
three weeks for breakfast cereals to reach the retailers shelves from the time of
manufacturing but it takes eleven weeks in France. This explains why domestic supply
chains continue to dominate the transfer of goods. In addition, increased foreign direct
investment in local production base creates even more reliance on domestic supply
chains. A great number of intermediaries and fragmented supply chains add to the
problem.
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Product and Logistic Customization

Product customization challenges the characteristics of supply chain management as it
impacts modularity, packaging, transportation, shipping, tracking, and distribution. A
postponement strategy designed for delaying customization to the latest value-adding
phase is not always feasible without a compromise being made on product variety. For
instance, Meritor which used to provide several automotive parts in North America,
now manufactures only suspension systems, roofs, and doors but provides them to car
manufacturers across the globe.
4.3 Packaging
Standardization in packaging eases logistics and also promotes brand recognition.
Coca-Cola uses a similar color and logo to enhance its brands. Standardization in
packaging results in savings in design and promotion costs. Packaging size must also
be adapted to the market concerned. Where space is scarce, bulk packaging is less
attractive, for instance, Japanese households.
Some adaptations are essential for logistic reasons. For instance, sturdier packaging is
required to shield the product from outside elements in a harsh environment. Other
adaptations are needed to meet legal requirements. The 1991 German Packaging
Ordinance requires manufacturers to use recyclable and environmentally friendly
packaging material whenever feasible. Various laws govern safety requirements.
In most countries, labels have to be printed in the local language, adding to the time
and cost of distribution. The US requires all food products to carry labels indicating
their nutritional value. Many countries also require clear labeling of the products
country source. In the US, US content should be disclosed on textiles, cars, wool, and
fur products.
Some packaging adaptations are essential for cultural or religious reasons. For
instance, Hogla-Kimberly, a joint venture between an Israeli manufacturer and
Kimberly Clark, sells diaper to the orthodox segment in Israel in a specially designed,
easy-to-prop open packaging that meets the religious requirements for doing no work
on the Sabbath.
3.19 Transportation Modes

Customer demands can be met in a timely and cost-effective manner by effective
modes of transportation. One of the driving forces behind intermodal transportation
is globalization. Intermodal transportation is a term that denotes the combination of
ocean vessels (including short sea shipping), river transport, rail, road links, and air
transport within a seamless supply chain. However, intermodal transportation
represents many challenges. Comparing the prices of alternative modes of
transportation is difficult because price is based on several product (e.g. value,
weight, space) and non-product (e.g. custom administrative procedures, port of the
shipment) factors. Intermodal transport also requires standardization and modularity
to permit frequent transfer of goods from one mode to another. Other obstacles to
intermodal and seamless logistics lie at the political and legal level. For instance,
regulations in Thailand require warehousing and transport to be handled by separate
companies.
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Maritime Transportation
Over 90 percent of the international trade is served by maritime transportation. Most
of the US-Mexico trade was handled by 9 ports, of the 29 border crossing points
between the US and Mexico.
Impediments to further globalization of maritime transport include the issuance of
flags of convenience, that is, registering ships in countries with less stringent
regulations such as Panama and Liberia. Such registries pose less stringent safety
standards and confer labor and tax benefits but they do not raise opposition in some of
the countries in which the MNEs operate.
Port Facilities
Port facilities represent a vital ingredient in the convenience and cost of maritime
transport. According to a report by Conference Board, the most competitive ports
offer low cost, speed processing, and superb intermodal links. Ports are of four types
(1) the maritime hub dedicated to transshipment from an ocean vessel to a feeder or
another vessel; (2) the gateway port an interchange between the maritime hub and
maritime and/or land transport; (3) the logistic-industrial port interchange between
modes of transport combined with logistic support; and (4) the trade port logistic
activities together with other value-added international trade services.
Singapore and Hong Kong are the two largest container ports in the world, and
together, they have 44 percent of the container lifts in the world. Non-hub ports can
compete by adopting niche strategies. One port strategy is to specialize in a particular
product line in order to achieve economies of scale.
Ports as key links in the global supply chain face the challenge of accommodating
local distribution. For instance, in needs to integrate domestic and international
shipping in situations where the final destination is closer to a port.
The Inland Port
In central Ohio, Port Columbus is an inland port. It utilizes 86 million square feet of
warehousing and distribution facilities on the grounds of a former air force base. The
port has arteries to highways, airports, and rail and coastal port access through
agreements with the ports of Los Angeles, New York/New Jersey, and Virginia.
Countries with vast underdeveloped hinterlands show immense interest in the inland
port concept in a bid to improve access to less developed regions.
Trucking
Trucking plays an important role in international trade in geographically contiguous
areas such as Texas/Mexico and Hong Kong/Shenzhen in southern China as in
Europe, where distances are relatively short. Trucks are also vital in the domestic
distribution of products delivered internationally by rail, air, or ship. The utilization of
containers has made such intermodal transportation substantially easier.
While Europe, the US, and other developed countries have standardized safety and
other regulations related to motor vehicles, substantial impediments to the
globalization and standardization of truck transportation have remained. For example,
there are different conventions in different countries regarding the use of rentals,
manufacturers fleet, and so forth.
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Traffic congestion is costly to trucking in terms of high energy costs, delayed

shipments, deteriorating service quality, and lower productivity of vehicles and
workforce. Developing countries such as Iran and China have less congestion
problems but a higher proportion of unpaved roads than the US and other developed
countries and this poses serious constraints on the domestic transportation of goods.
Rail
Rail transportation is considered to be an attractive mode of transportation
domestically and internationally due to its competitive time to cost ratio as well as
road and sky congestion. For instance, nearly half of the grain exports from the US are
transported to Mexico by rail. Where rails are not contiguous, railways can still play a
crucial role as part of intermodal transportation.
Air transport
Air transportation was initially confined to high value or perishable items. It is now
increasingly being used when logistics infrastructure is in place and speed of
transportation is vital. A major impediment to globalization of air transport is the
stringent safety standards imposed by developed nations, especially the EU and the
US, vis--vis the lax regimes common in most of the developing countries. If the
safety standards are not complied with, the US does not permit the landing of foreign
aircraft.
4.4 Crossing national Borders

A seamless supply chain spanning national borders is difficult to establish. Customs
inspection, processing, and other barriers associated with crossing borders create
unpredictable and costly delays.
The NAFTA agreement offers substantial non-tariff movement of goods across the
US, Canada, and Mexico, on the condition that goods originate from one of these
three countries. For this to take place, substantial documentation is essential to
establish country-of-origin source. Moreover, shortage of border-crossing points, rails,
docks, and bridges undermine traffic expansion.
In the aftermath of the September 11, 2001, terrorist attacks in the US, border delays
worsened considerably in many parts of the world, including major borders such as
that between the US and Canada. Though the delays since then have shortened, they
show that global logistics is vulnerable to the problem of overlapping international
boundaries and the expected contingencies that characterize the global supply chain
and other facets of international business.
5. Summary
Success in international markets depends on many skills such as accurate
assessment of market potential; selection of the right product mix, and making
appropriate adjustments in pricing, packaging, advertising, and distribution.
For assessing market potential, firms seek to identify aggregate demand for a
product or a service and estimate the costs associated with product introduction
and distribution.
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Globalization is the standardization of products (or services), brands, marketing,

advertising, and the supply chain across countries and regions. In contrast,
localization is the adjustment of one or more of the above elements to the
idiosyncratic characteristics of a given national market.
Country-of-origin effect comprises dimensions such as innovativeness, namely
using new technology and engineering advances; design, namely style,
appearance, color, and variety; prestige, brand name reputation, status, and
workmanship, including reliability, durability, craftsmanship, and manufacturing
quality.
Channel decisions involve the length (the number of intermediaries or levels
employed in the process of distribution) and width (the number of firms in each
level) of the channel used to link manufacturers to consumers.
Pricing is the process and decision to set a price for a product or a service.
Advertising needs to be adjusted to local tastes, regulations, and norms to make it
effective in international markets.
International strategic alliances are a major venue for market entry. Such alliances and
mergers and acquisitions allow a firm to quickly establish itself in a foreign market.
The global supply chain covers both logistics and operations. It includes activities
such as sourcing, procurement, order processing, manufacturing, warehousing,
inventory control, servicing and warranty, custom cleaning, wholesaling, and
distribution.
Global sourcing provides an opportunity to the MNE for leveraging on its scale
and competitive advantage in spotting opportunities for procurement worldwide
for use in its various locations and divisions.
As the globalization of the supply chain proceeds, several factors require
continuous attention being paid to localization and customization. Localization is
supported by three factors variation among national environments, product
customization that triggers logistic adjustments, and existence of national borders
that impede the free flow of goods and services, thus limiting global solutions.
Standardization in packaging makes for logistics ease and also promotes brand
recognition.
Customer demands can be met in a timely and cost-effective manner by effective
modes of transportation.
A seamless supply chain spanning national borders is difficult to establish.
Customs inspection, processing, and other barriers associated with crossing
borders create unpredictable and costly delays.
Example: Bacardi Localizes Advertising in India

Bacardi Martini India Ltd. (BMIL), a joint venture between Gemini Distilleries and
Bermuda-based Bacardi Ltd. (in which Gemini Distilleries had a 74% holding and
Bacardi Ltd. the remaining 24%), entered India in 1998 with the launch of its white
rum Carta Blanca. The brand had a dream start with sales growing steadily in the
initial years. From 20,000 cases in the first year, sales reached almost 100,000
cases by the third year. But after this, sales stagnated. Later, the company launched
Contd
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Contd
the premium dark rum Reserva. Since the new spirit was light gold colored, it was
a completely new category in dark rum and failed to evoke the desired response.
Seeing a potential in the Flavored Alcoholic Beverage (FAB) or Ready-To-Drink
(RTD) segment, BMIL launched the Bacardi Breezer, the largest selling brand in
the RTD segment worldwide.
BMIL launched its Breezer brand targeting young professionals in the 25-30 age
group. The brand was first available in three flavors orange, lime, and cranberry.
It was priced between Rs 35 and Rs 40 for a 330 ml bottle. To differentiate the
product from the competition and create excitement in it, BMIL launched variants
of Breezer every year. BMIL used its global ad campaign in India to create brand
awareness and build a brand image. It showcased fun, color, and passion in these
global campaigns. The company stuck to the global format since it was unable to
identify its target customers clearly. In 2002, the company conducted a study,
which revealed that its global ad campaigns could only influence those people who
were willing to test new products. The regulations on advertising of alcoholic
products in various media (electronic, print and outdoor) by the Government of
India added to the woes of the company.
To overcome these problems, BMIL released a new localized advertising campaign
to replace its global TV ad campaign. That was the first time that BMIL was using
a localized ad campaign for its products across any market in the world. The fun,
excitement, and vigor in its advertisements were present but the locales changed
from sandy beaches and fun in the afternoons, to an evening get-together after a
laborious days work. The objective was to make the ads more suitable to the
Indian consumer. This change suited the Indian consumers as the ads focused on
fun after work unlike the global ads. The tag line Live Life in Color aptly
reflected BMILs philosophy.
To overcome the regulations on advertising alcoholic products, BMIL made use of
below-the-line promotions and event sponsorships to promote Bacardi Breezer. It
also made use of surrogate advertising. Bacardi Blast was initially launched as a
promotional program through a tie-up with a private music channel. As part of the
promotions, BMIL promoted musical concerts in the metros. The campaign grew
manifold to become a musical extravaganza attracting thousands of consumers,
thereby increasing brand awareness for Bacardi Breezer. Bacardi Blast parties
became the symbol of youthful energy and began to be considered as one of the
hottest post-work parties. BMIL also released Bacardi CDs containing the latest hit
numbers as part of its brand communications. In addition to the Bacardi Blast
parties, the company also mooted Bacardi Night Shift. Though BMIL aimed at
targeting new customers like women and young people by distributing the brand
through retail chains, it was not successful in this venture as the various state
governments had laws against distribution of liquor through departmental stores.
Through consistent promotions, the brand was able to garner a major share in the
RTD segment, though it was still negligible when compared to the total spirits
market in India.
BMIL also brought about changes in the packaging of its earlier brands, Carta
Blanca and Reserva. The new packaging design was intended to highlight the
brands heritage established in 1862 in Cuba, and the product quality the
worlds smoothest rum.
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Example: Global Logistics at Wal-Mart

By October 2010, the worlds largest retailing agent, Wal-Mart had 750 discount
stores, 2,843 supercenters, and 607 SAMs club stores in the US and several others
located worldwide. Much of the growth at Wal-Mart was fueled by its acquisitions,
for instance, that of ASDA in the UK and German chains Spar and Wertkauf. The
company had also purchased a stake in Seiyu, a Japanese retailer.
The biggest competitive advantage for Wal-Mart was its efficient and large-scale
supply chain management. The different store size and product composition
required adjustments in the store layout and display, as well as in warehousing,
transportation, and distribution. Wal-Mart had replaced ASDAs information
system with its own to benefit from worldwide sourcing, distribution scale, and
buying power.
In Argentina, Wal-Mart expanded aisle size initially set to the US standards to
accommodate higher than expected customer traffic. When it entered the difficult
and recession-plagued Japanese market, Wal-Mart relied on the modest learning
curve gained through working with its Japanese partners. It also leveraged on the
capabilities that it had developed through earlier entries. For instance, Wal-Mart
used the lessons it had learned in its Chinese operations about handling fresh
produce in Asia, a critical category that the company had not emphasized in its
domestic operations.
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Concept Note - 7
Global Human Resource Management

1. Introduction
International human resource management (IHRM) is the procurement, allocation,
utilization, and motivation of human resources in the international arena. IHRM is
crucial to the strategy and success of global operations. In international business,
multinational enterprises (MNEs) from different home countries employ different
strategies for staffing their subsidiaries. Expatriates play a vital role in the operations
of MNEs. International joint ventures and wholly-owned subsidiaries face as many
staffing problems as any foreign venture.
This unit defines strategic international human resource management (SIHRM). It then
goes on to explain how staffing takes place in MNEs. It discusses the concept of
expatriates; their selection and failure; how they are trained and compensated; and
recommendations on how expatriates should be compensated in different cultures. The
unit finally talks about the human resource problems faced by MNEs in foreign affiliates.
2. Strategic IHRM
SIHRM is defined as human resources, management issues, functions and policies,
and practices that result from the strategic activities of MNEs and that impact the
international concerns and goals of these enterprises. SIHRM is more complex than
strategic human resource management in a domestic context because it concerns
multiple employee groups and environments and because it needs to be aligned with
the multi-faceted considerations of the MNE. The SIHRM model has three
orientations:
The adaptive system that imitates local human resource management (HRM)
practices.
The exportive system that replicates the HRM system in the home country and
other affiliates.
The integrative system that emphasizes global integration while allowing for
some variations.
An optimal SIHRM has the capacity to balance the different forces in the environment
of the firm, particularly the tension between local responsiveness and global
integration. The overall SIHRM strategy chosen by the parent in conjunction with the
specific conditions of the affiliate (e.g. the cultural distance from the parent)
determines the degree of similarity in SIHRM between the headquarters and the
affiliate. This, in association with the criticality of the group, determines the similarity
of HRM practices for each employee group.
3. Staffing the Multinational Enterprise

3.1 The Globalization of Board of Directors
In 1998-99, a survey was conducted by the Conference Board (Conference Board is a
global, independent business membership and research association working in the
public interest) to assess how globalization affected the composition of the board of
directors. The survey revealed that between 1995 and 1998, the percentage of firms
with non-national directors had increased from 39 percent to 60 percent. Companies

with three or more non-national directors showed an increase from 11 to 23 percent.
For the year 1998, 10 percent of the directors of surveyed firms were non-national.
The survey also revealed that entering new markets and exposure to new demands
from investors and customers were the chief internal drivers for seeking non-national
board members. The initiative comes from new managers who wish to expand their
international operations where the expertise and credibility of non-national directors
makes a difference.
Selecting Global Board Members
Firms seeking to internalize their boards commence by selecting someone who is similar
culturally to existing members but has an international perspective. In the next phase,
firms look for individuals with in-depth business and cultural experience in a given part
of the world. Even then, most of the appointments are made from among those who
have experience of living or working in the country in which the company is based.
Searches for non-national directors result on an average in 9 to 10 rejections for one
accepted. The extra commitment, language and culture, and different time zones are
barriers to the appointment of non-national directors, as is the process of board
evaluation. The Conference Board recommends accommodation of non-nationals by
rotating locations, reducing the number of annual meetings, setting up orientation
programs, and widening the definition of non-national director to include nonnationals living and working abroad who maintain close ties with their home country.
Another obstacle for non-national directors is representation. US institutional investors
are concerned with having non-national directors in domestic business as well as
national directors in non-US firms. As these institutions have a fiduciary duty to protect
the interests of the shareholders, they need to consider limited shareholders
representation in the decision to elect directors. Representation is more difficult when
vital shareholders sit on the board, especially with board members of companies with
significant cross-share-holdings, board members of major suppliers, or labor or pension
fund representatives. While US shareholders are relatively dispersed, shareholders with
major control blocks are common in Asia, Latin America, and Europe.
3.2 Staffing the Ranks in an MNE

Factors affecting MNE staffing include strategy, organizational structure, and
subsidiary-specific factors such as duration of operations, technology, production and
marketing technologies, and host-country characteristics such as level of economic and
technology development, political stability, regulation, and culture. MNEs can draw
employees from the country where they are headquartered (parent company nationals or
PCNs), where the foreign operations are located (host-country nationals or HCNs), or
from a third country (third country nationals or TCNs). Alternative staffing philosophies
abroad are ethnocentric, polycentric, regiocentric, and geocentric.
In ethnocentric staffing, PCNs are chosen for key positions regardless of the location.
This approach is used by Japanese companies and Korean firms. For instance, at
Samsung, an all-Korean management existed until 1999.
In polycentric staffing, HCNs are hired at the subsidiaries in key positions but not at
the corporate headquarters.
In regiocentric staffing, recruiting is done on a regional basis. In geocentric staffing,
the best managers are recruited worldwide regardless of their nationality. The value of
this approach is apparent in introducing new perspectives and modes of operation.
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Most MNE employees abroad are foreign employees or HCNs, for several reasons.
They are easier to employ administratively and legally. They are also knowledgeable
about the local environment. In case of developing and emerging markets, HCNs are
often cheaper to employ than home country nationals, even without adjusting for
expatriate terms.
The availability of qualified candidates is a decisive factor in the selection of HCNs.
Foreign MNEs in Japan finds it difficult to hire qualified Japanese employees. In
some countries, hiring requires a government-controlled labor bureau that may assign
employees to work for the MNE.
The cultural challenges go beyond staffing. A formal career planning system where
individuals are evaluated in terms of abilities, skills, and traits that will be tested,
scored, and computerized may appear to be impersonal in collective cultures.
Individualistic societies use cognitive testing because they emphasize performance,
individual rights, and individual interests, whereas collective cultures emphasize
organizational compatibility and loyalty that cannot be evaluated via cognitive tests.
Finally, the MNE is expected to monitor employment conditions at home as well as at
its subsidiaries. For instance, Wal-Mart was caught in a controversy when it was
reported that it was buying from vendors who used child labor in Bangladesh.
3.3 Country Specific Issues

As in other functional realms, the need for adjustment in corporate practices and
policies is anchored in the variation of employment conditions and labor markets. In
transition economies, older employees who are accustomed to a central planning
system face difficulties adjusting to the higher productivity expected in an MNE.
Despite the overall high employment in such economies, skilled workers are usually
in short supply due to lack of educational infrastructure. For instance, in China, the
biggest problem faced by MNEs is very high employee turnover, which undermines
investment in recruitment and training. To overcome this problem, MNEs in China
customize solutions. Ford Motor Company, for example, offered retention incentives
to its Chinese workers.
4. The Expatriate Workforce

4.1 Expatriates: Types and Distribution
There are different types of expatriates. The traditional expatriate, older and
experienced, is selected for his/her managerial and technical skills for one to five
years. International cadres are individuals moving from one foreign assignment to
another. They seldom return to their home country and sometimes become permanent
expatriates who stay in foreign assignments for extended periods of time or even
permanently. Young, inexperienced expatriates are sent on local hire terms for six
months to five years. Temporaries go on short assignments for up to a year. Another
type is the expatriate trainee, who is placed overseas for the purpose of training as part
of initiation into an MNE. The virtual expatriate takes on foreign assignments without
relocating physically. The virtual expatriate uses telecommunications and
videoconferencing to stay in touch.
4.2 Expatriates: Pros and Cons

MNEs use expatriates to get the business off the ground, put in the infrastructure,
and, more importantly, have a plan to change the mix of expatriates versus nationals.
Expatriates contribute essential knowledge and experience; serve as a mechanism for
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control, and as a way to transmit corporate culture and goals. Expatriation creates a
global perspective and is necessary for knowledge and technology transfer.
Some firms do not use expatriates because they block promotion of the local
workforce. The local workforce may also feel deprived by the fact that their wage
levels are lower than that of the expatriates. An expatriate can also rob a company of
the insights, skills, and initiative of local nationals. Another reason for not using
expatriates is their high rates of failure.
4.3 Expatriate Failure

Expatriate failure occurs when the assignee returns prematurely to the home country
or when his/her performance does not meet expectations. Japan and China show the
highest failure rates for US expatriates.
The cost of expatriate failure is substantial, ranging from US$ 55,000 to US$ 150,000
in direct costs. However, the real cost of expatriate failure is considerably higher. It
includes cost of selection, training, preparation, and moving, in addition to the
consequences of poor performance in lower revenues, damage to the firms reputation,
and lost business opportunities. All these may undermine the companys future
ventures in the host country.
There are numerous reasons for expatriate failure. They may include a spouses
unhappiness, inability to cope with the responsibilities and stress posed by overseas
work, inability to adjust to an unfamiliar physical and cultural environment,
personality or emotional immaturity, and lack of technical competence. Lack of
motivation to work overseas when a firm attaches low value to an overseas
assignment is also a problem.
4.4 Expatriates Selection

MNEs look for several attributes in an expatriate including cultural empathy, language
skills, adaptability and flexibility, education, maturity, motivation, and leadership.
Adler specifies these competencies: local responsiveness, a global perspective,
transition and adaptation, synergetic learning, cross-cultural interaction, collaboration,
and foreign experiences. The ability to exercise discretion in choosing when to engage
in global integration and when to be locally responsive is another crucial factor.
Successful expatriates need three sets of skills (1) personal skills, that facilitate
emotional and mental well-being as for instance, reinforcement, stress orientation,
substitution, technical competence, physical mobility, dealing with isolation,
alienation, realistic expectations prior to departure; (2) people skills such as
willingness to communicate, relational abilities, non-verbal communication, respect
for others, and empathy for others; and (3) perception skills, namely the cognitive
process that helps executives understand the foreigners behaviors. Being culturally
adventurous and extroversion are crucial for expatriate success in culturally distant
cultures.
Expatriate Selection Instruments
Several instruments assist in expatriate selection. The Prospector evaluates the
potential of aspiring international executives on 14 dimensions: cultural sensitivity,
integrity, business knowledge, motivational ability, courage, insight, commitment,
seeking feedback, using feedback, risk taking, culturally adventurous, seeking
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learning opportunities, flexibility, and open to criticism. Another instrument is the

Overseas Assignment Inventory (OAI) developed by Tucker International. This
instrument uses success predictors on a foreign assignment: open-mindedness, trust in
people, expectations, respect for others beliefs, locus of control, tolerance, patience,
flexibility, social adaptability, initiative, risk taking, sense of humor, and spouse
communication.
Another popular selection tool is role-based simulation. They are either generic or
specific.
4.5 Preparing for Foreign Assignment

Expatriates entering a foreign country should adjust to the new environment,
including a new culture, and job responsibilities. The first phase of adjustment is
anticipatory and takes place before departure. This is followed by in-country
adjustment. Adjustment varies by organizational culture, organization socialization,
individual factors (self-efficacy, perception skills, and relation), job-related factors
(role discretion, role novelty, role clarity, role conflict, and non-work factors such as
culture novelty and family-spouse adjustment. Adjustment is also influenced by
language fluency and previous assignments.
Five determinants of cross-cultural adjustment include: previous overseas experience;
pre-departure cross-cultural training; multiple candidates, multiple-criteria selection;
individual skills, and perceptual skills; and non-work factors such as cultural distance
and spouse and family adjustment.
Expatriate Training
Training for an overseas assignment has two components information giving and
experiential learning. Information-giving consists of practical information on living
conditions in the destination country, area studies, which include facts about the
countrys macro-environment, and cultural awareness information. Experiential
learning combines cognitive and behavioral techniques. The goal is to acquire
intercultural effectiveness skills including relationship building, stress management,
cross-cultural communication, and negotiation techniques.
Effective cross-cultural training requires an integrated approach which includes both
general orientation and specific cultural development. Yoshida and Brislin list five
guidelines for cultural training: (1) identify become aware of the skills needed to
function in the target culture; (2) understand know why, where, when, to whom, and
how the behavior is appropriate; (3) use cultural informants for understanding
specifics observe and consult people from the target culture to ensure that the
behaviors are used in the proper context and are delivered appropriately, (4) practice
practice helps in gaining proficiency in a new skill; and (5) deal with emotions
trainees should anticipate new behaviors they use as well as strong emotional
reactions to cultural differences.
Harrison proposed a two-stage cultural orientation. The first stage focuses on trainees
attention and prepares them for cross-cultural encounters. This stage involves selfassessment of factors and cultural awareness. In the second stage, specific cultural
orientation is designed to develop the ability of the trainees to interact effectively
within the specific culture they have been assigned. This stage includes two phases:
knowledge acquisition and skill training.
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Choosing a Training Method

Tung proposed a contingency framework to determine the nature and level of training
rigor based on the cultural distance between the expatriates native and new culture
and the degree of interaction required in the overseas position. If the cultural distance
is low and the expected interaction between the HCNs and expatriates is low, training
should focus on task-related issues as opposed to cultural issues, and the level of rigor
required is low. If the cultural distance and expected interaction is high, training
should focus on cross-cultural skill development as well as on the new task and on the
new culture, and the level of rigor should be moderate to high.
Another training model is based on the social learning theory, where rigor is defined
as the degree of cognitive involvement by the trainee. The model distinguishes
between participative modeling, which involves observing and participating in the
modeled behavior, and process-symbolic modeling, which involves observation of
modeled behavior.
If the level of interaction and cultural distance is low, training should be less than a
week. If the individual is going overseas for 2 to 12 months, the training should be for
four weeks. If the individual is going into a novel culture and the expected degree of
interaction is high, the level of training rigor should be high and training should be
given for two months. Some field experiences and sensitivity training would be
appropriate.
Compensation
MNE compensation programs focus on attracting and retaining qualified employees,
facilitating transfer between the headquarters and the affiliates, creating consistency
and equity in compensation, and maintaining competitiveness. Compensation systems
are derived from the MNEs international strategies as well as its organizational
and/or product life cycle. They also reflect the laws, regulations, and cultural
traditions of the host country.
An effective compensation system begins with an accurate performance appraisal. In
case of expatriates, difficulties include the choice of the evaluator, differences in
performance perceptions between the home and host countries, inadequate recording
of performance objectives, parent-country ethnocentrism, communication difficulties
with headquarters, and indifference to the foreign experience of the expatriate. Other
problems include difficulties in balancing local responsiveness and global integration,
environmental variations across subsidiaries, and non-comparability of data from
different regions/subsidiaries. Decisions are made related to raters location, their
expatriate experience, and regarding the use of standard, hybrid, or customized
evaluation forms.
Cost and Elements of Expatriate Compensation
The cost of hiring an expatriate is 3 to 5 times higher than the domestic salary of a
local hire.
Expatriate compensation comprises the following elements:
Salary: Base pay plus incentives determined through competency-based plans or job
evaluation. Incentives in the form of cash or deferred payment may be based on homecountry plans or host-country plans or both.
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Housing: Most MNEs offer housing allowances to expatriates to allow them to

maintain living standards at their home country level.
Services allowance and premiums: These are paid to compensate for differences in
expenditures between home and host countries. Allowances are offered for higher cost
of living in the host country, home leave, education, and relocation. The purchasing
power of the employees in the home and the host country can be equalized using the
balance sheet approach. It also offsets qualitative differences between locations.
Tax equalization: Expatriates face income tax liability in the home and the host
country. Tax equalization adjusts the expatriates pay to reflect taxes in the home
country.
Approaches to Expatriate Compensation
There are three approaches to expatriate compensation home-based, host-based, and
hybrid.
A home-country compensation system links the base salary of an expatriate to the
home country salary structure. For instance, the salary of a US executive transferred to
Japan would be based on the US as opposed to the Japanese level.
In a host country-based compensation system, the expatriate base salary is linked to
the host country pay structure. However, supplemental compensation provisions are
linked to the home-country salary structure.
A hybrid compensation system blends features from the home as well as host-based
approaches. The purpose of this compensation system is to create an international
expatriate workforce that while not coming from one location is paid as if it were. The
simplest form of hybrid system assumes that all expatriates, regardless of the country f
origin, belong to one nationality. Other forms include applying identical cost-of-living
allowances to all nationalities, uniform housing, uniform premium, and other local
allowances.
Other compensation approaches include lump-sum/cafeteria and negotiation
approaches. In the lump-sum/cafeteria approach, the salary is set according to the
home-country system. Firms allow a total allowance package instead of breaking
compensation up into component parts and expatriates make their own choices. The
negotiation approach means that the employer and the employee find a mutually
acceptable package. This approach is common in smaller firms with very few
expatriates.
4.6 Culture and Compensation

The performance of a business improves when HRM practices are consistent with the
national culture. In masculine cultures, work units with merit-based reward practices
performed better while in feminine cultures, work units with fewer merit-based
reward practices performed better. The propensity to use both skill-based and
seniority-based compensation systems was positively correlated with uncertainty
avoidance. Compensation practices based on individual performance were correlated
with individualism. High masculinity is associated with less use of flexible benefits,
career break schemes, child care programs, and maternity-leave programs. High
collectivism is negatively related to equity-based and individual reward and meritbased promotion system.
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The following recommendations are made vis--vis compensation in different

cultures:
In high-power distance cultures, MNEs need to pursue hierarchical compensation
for local managers. Pay and benefits should be tied to the position of the local
managers.
In high individualism cultures, extrinsic and performance-based rewards are
important. In low individualism cultures, group-based pay and compensation
packages that reflect seniority and family needs are more acceptable.
In cultures with high masculinity, MNEs need to pursue a compensation strategy
for local managers that recognize and reward dominance, aggressiveness, and
competitiveness. In cultures with low masculinity, compensation should focus on
quality of work life, equity, and social benefits.
In high uncertainty avoidance cultures, consistent and structured pay plans are
preferable. In low uncertainty avoidance cultures, pay should be linked to
performance.
In masculine cultures with moderate to high uncertainty avoidance, policies
designed to protect job security are preferred.
In feminine cultures with moderate to high uncertainty avoidance, polices
designed to protect income security are preferred.
Employees in low-power distance and low individualistic cultures prefer a
flexible benefits program.
Training and performance evaluation also varies across cultures. Management by
objectives (MBO), where superiors and subordinates develop goals that can be
measured, fails miserably in high-power distance culture.
4.7 Repatriation
Repatriation represents an adjustment that is equal to if not more than the foreign
assignment. Most returning employees are dissatisfied with the process of repatriation.
Most US firms do not provide a written guarantee about where the employee will be
reassigned prior to departure, and most returnees are not aware of what their next
assignment will be prior to repatriation. Most of the firms do not offer spouse career
counseling or other forms of family repatriation assistance. Thus it is evident from the
fact that one quarter of repatriated employees leave their firm within a year of
repatriation, and that many decline to accept subsequent foreign assignments.
5. HRM in Foreign Affiliates

The issues and problems related to human resources (HR) vary depending on the type
of foreign affiliate involved. Though wholly-owned subsidiaries (WOSs) employ
three employee groups including host-country nationals (HCNs), third country
nationals (TCNs), and expatriates, international joint ventures (IJVs) employ multiple
groups such as (1) foreign parent(s) expatriates (i.e. nationals of the country where the
headquarters of the foreign partner(s) are located, assigned by that parent to the
affiliate; (2) host parent(s) transferees (i.e. HCNs employed by the host parents and
transferred to the affiliated either through the host-parents headquarters or one of its
subsidiaries); (3) HCNs (i.e. nationals of the host country employed by the affiliate;
(4) Third-country expatriates of the host parents (i.e. TCNs assigned by the host
parents to work in the affiliate); (5) Third-country expatriates of the foreign parents
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((i.e. TCNs assigned by the foreign parents to work in the affiliate); (6) Third-country
expatriates of the affiliate (i.e. TCNs recruited by the affiliate); (7) foreign
headquarters executive (i.e. policymakers at foreign parents headquarters who are
board members of the affiliate or play a key role in the functioning of the affiliate at
headquarters); and (8) Host headquarters executives (i.e. policymakers ate the host
parents headquarters, who are board members of the affiliate or play a key role in the
functioning of the affiliate at headquarters).
5.1 HR Problems in Foreign Affiliates

The following HR problems can be expected in WOSs and IJVs:
Staffing friction: As a control measure, parent companies prefer to appoint their own
transferees or expatriates for major positions in the affiliate. If the staffing policy is
not specified contractually, friction could arise. Sometimes, friction develops
regarding the level of staffing. In WOSs as well as IJVs, HCNs are deprived of
opportunities of serving the senior-most positions.
Blocked promotion: In WOs and IJVs, the lack of promotion opportunities frustrates
the local employees if senior positions are reserved for outsiders. The local
employees may be reluctant to join, stay, or contribute their best to the affiliate, when
such outsiders are abundant.
Exile syndrome and reentry difficulties: Feeling exiled in a foreign assignment due to
fear of interruption in the career track in the home country occurs in both WOSs and
IJVs. The exile syndrome can proved to be damaging for the foreign affiliate as
employees may bypass their superiors in the affiliate, report only achievements
leaving behind failures, and take a short-term perspective.
Split loyalty: This problem is unique to IJVs. Employees recruited by the host or the
foreign parent may remain loyal to that parent rather that shifting their loyalty to the
IJV. This results in suspicion and low level of cooperation that prevents the IJV from
attaining its goals.
Compensation gaps: The compensation gap problems (i.e. HCNs receiving much
lower pay than expatriates) occur in both WOSs and IJVs. For example, many USbased executives of foreign MNEs earn more than their seniors in Asia or Europe.
IJVs face an additional problem of relative deprivation where employees are
compensated based on affiliation with a particular parent or IJV rather than on
universal criteria, such as skills, experience, etc. Every employee has a compensation
policy where differences are significant. Moreover, each employee group has a
different perception about the desired compensation package. The result is a feeling of
deprivation resulting in reduced morale and motivation.
Blocked communication: Effective communication between a parent and an affiliate
and among parents can be hampered by cultural differences and varying
organizational norms and procedures. Such communication blockages can impede
decision making. This problem is serious in IJVs with a 50:50 equity distribution.
Limited delegation: Many parent companies maintain control of their affiliate by
limiting the decision making power and scope of authority delegated by them. This is
true when parents have conflicting goals, when they feel that the staff of the affiliate is
loyal to the other parent, and when they depend on the affiliate for scarce and vital
resources. Under these conditions, the management of the affiliate finds it difficult to
operate effectively, especially in a fast-changing environment.
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Information screening: Most of the firms hesitate to pass on information and

technology to an affiliate, especially in an IJV whose partner could be a current or
future competitor. The venture may thus operate ineffectively.
Unfamiliarity: In most cases, expatriates joining a foreign affiliate are unfamiliar with
the environment in which the venture operates. In case of IJVs, employees are
unfamiliar with the unique organization structure and with its conflict-prone nature.
Research suggests that the HR problems can be alleviated by organization
development training for working in an IJV, interpersonal and negotiation skills vital
in IJV systems, identifying and rewarding leadership, career planning, opening up of
communication channels among parents and the venture organization.
6. Summary
Strategic international human resource management (SIHRM) is defined as
human resources, management issues, functions and policies and practices that
result from the strategic activities of MNEs and that impact the international
concerns and goals of these enterprises.
Firms seeking to internalize their boards commence by selecting someone who is
similar culturally to existing members but has an international perspective. In the
next phase, firms look for individuals with in-depth business and cultural
experience in a given part of the world.
There are different types of expatriates such as the traditional expatriate;
international cadres; young, inexperienced expatriates; temporaries; expatriate
trainee; and virtual expatriate.
MNEs use expatriates to get the business off the ground, put in the infrastructure,
and, more importantly, have a plan to change the mix of expatriates versus
nationals.
Expatriate failure occurs when the assignee returns prematurely to the home
country or when his/her performance does not meet expectations.
MNEs look for several attributes in an expatriate including cultural empathy,
language skills, adaptability and flexibility, education, maturity, motivation, and
leadership.
Five determinants of cross-cultural adjustment include: previous overseas
experience; pre-departure cross-cultural training; multiple candidate, multiplecriteria selection; individual skills and perceptual skills; and non-work factors
such as cultural distance and spouse and family adjustment.
MNE compensation programs focus on attracting and retaining qualified
employees, facilitating transfer between the headquarters and the affiliates,
creating consistency and equity in compensation, and maintaining
competitiveness.
There are three approaches to expatriate compensation home-based, host-based,
and hybrid.
HR problems that can be expected in WOSs and IJVs include staffing friction,
blocked promotion, exile syndrome and reentry difficulties, split loyalty,
compensation gaps, blocked communication, limited delegation, information
screening, and unfamiliarity.
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Example: Globalizing the Board of Directors at BP Amoco

British Petroleum (BP) embarked on a series of mergers and acquisitions and
expansions that helped it transform itself into a global company. In 1998, BP
merged with US-based Amoco and the merged entity was called BP Amoco,
headquartered in London, England.
After the merger, the board at BP Amoco comprised 14 non-executive directors
and 7 executive directors. Of the first group, one was a Canadian, another was
Irish, and the remaining six were Americans. The remaining non-executive
directors were British. Of the 7 executive members, one was from New Zealand,
another from the US, and five were British. All these executive members had
significant overseas experience.
According to BP Amoco, the breadth of experience and understanding brought by nonnational directors and directors with significant expatriate experience was invaluable.
They offered several insights on different facets of operations ranging from corporate
governance to compensation systems. The company also used these invaluable insights
gained from its international experience for developing human resource policies that
maintain both equity and consistency among its employees worldwide.
Example: Expatriate Management at Astra Zeneca

Over the years, AstraZeneca Plc (AstraZeneca) has developed a strong reputation
for its expatriate management practices. Expatriate management at AstraZeneca
goes beyond tackling issues such as compensation, housing, and issues related to
the spouses career abroad, etc. It also takes care to ensure that employees on
international assignments are able to adapt well to the new environment and
achieve a work/life balance. With the global economic situation continuing to be
grim in 2009, AstraZeneca also began emphasizing more thoughtful planning and
selection process of candidates for international assignments.
AstraZeneca is the worlds fifth largest pharmaceutical company by global sales. It
is headquartered in London, UK, and Sdertlje, Sweden. For the year 2008,
AstraZenecas revenues were US$31.6 billion and it employed around 66,000
employees. As of 2009, AstraZeneca had around 350 employees working on
international assignments in 140 countries worldwide. These were employees who
were on short-term, long-term, or commuter assignments. AstraZenecas policy
stipulates that for any international assignment, there had to be a business rationale.
The company sees to it that the costs involved are acceptable, and that the career
management of the employee during the assignment is consistent with personal
development goals as well as the business need. The contractual arrangements for
the assignment are also centrally managed.
Once an assignment offer is made to a potential expat, AstraZeneca pairs them up
with an international assignment manager (IA manager), who briefs them on
company policy and opportunities for cultural and language training. Before
leaving for their international assignment, employees are provided training in a
workshop that focuses on relevant issues (such as leaving and returning to the home
Contd
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Contd
country and the destination location). The expats are given information about the
culture of the destination country particularly differences with the home country,
and social considerations and dos and donts. If necessary, the employee and
his/her spouse are given training in the local language. Tessi Romell (Romell),
research and development projects and HR effectiveness leader at AstraZeneca,
said that the company also helps connect new expats with those who had already
served in that location.
Sometimes, follow-up workshops are held in the host country. Once on assignment,
expats stay in touch with their IA manager in addition to the manager they reported
back to in the home country. AstraZeneca sees to it that expats are given the
necessary flexibility for them to achieve a work/life balance.
With AstraZeneca taking various initiatives on this front, there have been few
complaints about work/life balance among the companys expat population. Romell
attributes this to the mechanisms the company has put in place to prepare the
employees for life in a different country. Experts too feel that the practices
followed by AstraZeneca, such as preparing the employees for international
assignments, providing them with support and assigning an IA manager are
effective. They laud AstraZenecas practices, which are in contrast to those of
many companies that rush employees to foreign assignments without adequate
support. Chris Buckley, manager of international operations for St. Louis-based
Impact Group Inc., points out that the expats know that the organization is
spending a lot of money on them and might be wary about coming up with any
complaints regarding their new assignment with their boss. In such a scenario,
contact with the IA manager is useful as it can encourage them to open up.
With the economic situation around the globe continuing to be grim in 2009,
experts felt that organizations would be forced to take a relook at the costs
associated with international staffing. Some felt that organizations would send
fewer people on international assignments, or allot them to shorter terms abroad.
They even predicted that the high compensation and benefits generally associated
with foreign assignments could also see cuts. While AstraZeneca also took
measures to cut costs (specifically tax costs), by sending employees on short-term
assignments, Daly (Ashley Daly, senior manager of international assignments at
AstraZeneca noted that this was not always possible. When the expat had a family
and was being posted for a longer term, Daly pointed out that some of the elements
of AstraZenecas expat packages, such as comprehensive destination support and
educational counseling for expatriate children, played a critical role in ensuring the
employees productivity. These supports ensured that the expatriate family was
able to settle down in the host country. Not providing them could result in
employees not being able to focus on their new job, putting the companys
investment in risk. So, the company was not looking at this issue in terms of
expenditure alone. The company also did not have any plans to decrease the
number of its staff deployed internationally.
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Concept Note - 8
Global Research and Development

1. Introduction
Many Multinational Enterprises (MNEs) are increasingly dedicating their human,
financial, and technological resources to global research and development (R&D).
Many western MNEs are extending their R&D activities in developed as well as
developing countries, especially emerging markets. Also MNEs from industrialized
nations such as South Korea, Hong Kong, Taiwan, and Singapore have started
relocating many of their R&D activities abroad.
This unit discusses the concept of globalizing R&D and the benefits and challenges of
global R&D. It then goes on explain the design and structure of global R&D activities.
It discusses how multinational enterprises (MNEs) manage their R&D operations. The
unit finally goes into how technology transfer takes place across borders.
2. Globalizing R&D
Globalizing R&D is a process of locating and operating R&D laboratories in different
countries, under a coordinated and integrated system by the companys headquarters, in
order to leverage the technical resources of each facility to further the companys overall
technological capabilities and competitive advantage. Globalizing R&D differs from
internalizing R&D. The former requires global integration of geographically dispersed
R&D units while internalizing R&D is an early stage of globalizing R&D, which
evolves as the international expansion of a firm grows larger and more complex in scope
and scale. The R&D function serves as the major avenue to build and sustain a
companys global competitive advantage. MNEs with a well-defined strategy on
globalizing R&D tend to achieve superior sales and profit performance.
R&D intensity has increased at a steady pace in many industries such as
pharmaceuticals, electronics, chemicals, and medical equipment. While American
MNEs lead in innovation in many high-technology industries such as computers,
software, automobiles, healthcare, and advanced materials, MNEs from Europe,
Japan, Canada, and newly industrialized countries such as Israel, Taiwan, and Korea
also demonstrate a high level of R&D and incentive productivity. Of late, the number
of patents developed by MNEs worldwide has surged. The main thrust for global
firms has been to increase the patent output per unit of R&D spending.
Managing global R&D receives greater attention from international business managers
for three reasons: First, technology is recognized as a primary source of competitive
advantage. International R&D augments and expands the overall R&D process of the
firm. Second, the nature of the technological innovation process has changed.
Technological innovations are a result of the integration of technologies from different
disciplines. Countries differ in their competitive advantage and globalizing R&D
enables firms to tap these sources of strength. Third, time is a critical competitive factor
in many industries. R&D activities are decentralized for accelerating the process of
innovation and adaptation. Finally, the growth of network and information exchange
systems facilitates long-distance communication, which lowers the costs of coordination
that are associated with globalization of R&D activities.
Globalizing R&D is a strategic response to changes in international markets. Foreign

customers demand customized products and higher levels of technical service along
with a shortened product life cycle in many industries. Targeting and developing
regional markets such as the Latin American Free Trade Association (LAFTA) and
the European Union may offer rewards for modifying products in order to meet
specific market requirements. To gain access to cutting-edge technologies developed
by foreign companies or improve the adaptations of their own innovations, MNEs
send their own scientists and engineers to onsite laboratories. The globalization
process moves up the R&D value chain from technology support to product
development and further to technology development. This indicates the important role
assumed by foreign facilities in knowledge creation.
2.1 Benefits and Challenges of Global R&D

The following benefits may ensue from globalizing R&D:
First, globalizing R&D may offer a vehicle for extracting benefits from the technical
resources, local expertise, and scientific talent of the target country. MNEs may also
receive benefits such as low interest financing and tax breaks offered by host
governments to MNEs when they establish R&D centers overseas.
Second, globalizing R&D may enhance the competitive advantage of a firm. Setting
up R&D facilities in host countries signals the long-term commitment of a firm to its
local customers.
Finally, globalizing R&D may enable an MNE to enjoy the benefits that arise from
international division of labor in R&D among multiple foreign countries or regions.
MNEs that are well-coordinated can allocate specific responsibilities to different but
integrated R&D subsidiaries based on their knowledge, expertise, and external
resources. This multilateral cooperation enables the firm to obtain a more diverse flow
of new ideas, processes, and products, providing greater input into the innovation
process of the firm. This also creates a synergy earned from comparative advantage in
R&D resources from all the participating nations.
Globalizing R&D is a complex process that involves several challenges and
difficulties. It creates the following challenges:
First, maintaining a minimum efficient scale in foreign R&D operations is not always
easy. It may be difficult to staff the foreign laboratories with enough qualified people
for achieving the minimum efficient scale. In addition, splitting up the most qualified
people of an MNE over several international R&D sites may dilute the critical mass at
the centralized R&D facility based in the home country. Further, government controls
and political risks in the host country may increase the uncertainty of R&D
operations. It may create a rift between the motivations of an MNE and those of the
local government. In developing countries where import restrictions exist, it may not
be easy to import the essential research materials. Hiring of local people can also be
subject to government controls.
Second, the leakage of proprietary knowledge poses a serious threat when R&D is
globalized. This arises because of the presence of a foreign joint venture partner, lax
patent laws in the country, or due to foreign nationals being hired by indigenous firms
after they acquire the MNEs expertise. Maintaining the confidentiality of technical
knowledge and information is difficult and costly.
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Finally, globalizing R&D inevitably increases coordination and control costs. MNEs
may face coordination issues such as allocating research tasks among dispersed R&D
centers, developing products that are responsive to market needs in different countries,
and exchanging information among different R&D centers. The decentralized and
distant MNE R&D facilities increase the coordination and control costs. Lack of
coordination and control can lead to costly duplication of effort since different
facilities may not be completely aware of what other facilities are doing. In addition,
the cultural and business differences between home and host countries may intensify
the difficulties in running R&D activities abroad.
Despite these challenges, there is increased globalization of R&D activities as MNEs
have become more internalized. To derive the advantages of global R&D requires
design and structuring in the building phase and well-established systems of
coordination, management, communication, and control in the operational phase.
Managing global R&D activities is complex and difficult while formulating strategies
and policies that concern R&D dispersion and control. The global R&D system of a
firm should be structured to fulfill organizational needs while taking advantage of
external opportunities. Internally, the R&D function has to face the ongoing task of
coordinating and controlling across the firms international network of R&D
laboratories. Externally, corporate R&D creates and manages technical cooperation
with research consortia, universities, and even competitors to stay abreast of leading
edge developments. A firm also has to essentially manage critical areas such as
coordination and communication, technology transfer, human resource management,
and collaboration with local firms. Without such management, the economic return of
R&D dispersion cannot be ensured.
3. Design and Structure of Global R&D

3.1 Type of Foreign R&D Units
The first step in globalizing R&D is to define the type of planned R&D program. With
regard to the role of foreign R&D units, R&D subsidiaries can be categorized into
corporate technology units, specialized or regional technology units, global
technology units, technology transfer units, and indigenous technology units.
A corporate technology unit is designed to generate basic, long-term technology of an
exploratory nature for use by the parent company. A specialized technology unit is set
up to develop specialized products, processes, or technologies predefined by
headquarters for serving either the regional or the global market. A global technology
unit is established to develop new products and processes for major world markets. A
technology transfer unit facilitates the transfer of the corporate parents technology to
a subsidiary and to provide local technical services. Finally, an indigenous technology
unit is formed overseas to develop new products specifically for the local market.
Technology transfer units and indigenous technology units are locally adapting
laboratories. The function of these units is to help the production and marketing
facilities in a host country make use of the existing technology of the MNE. They may
also assist the technology transfer process by advising on necessary adaptation of the
manufacturing technology. They may act as a technical service center where they
examine why a product may not satisfy a local market and how it can be adapted to
meet local needs better. For instance, Exxon used this technique in the development of
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products in the European market. When indigenous technology units are designed to
serve a foreign market, they become locally integrated laboratories and involve some
of the basic developmental activities. The particular host-market may be considerably
diverse, fast-growing, large, and may need a nationwide R&D office for coordinating
and integrating host-country R&D activities.
Corporate technology units and global technology units are both globally
interdependent laboratories. These two laboratories provide inputs into a centrally
defined and coordinated R&D program with no essential connection with the
production operations of the host country. The function of these units is to focus on
research and development as opposed to improvement and adaptation. They do not
link to local manufacturing but to corporate and divisional R&D. Examples of
successful corporate technology are Eastman Kodaks R&D unit in Australia and CPC
Internationals R&D affiliates in Japan and Italy. IBM is known for establishing
several global technology units worldwide for developing a product or process that
will have universal applicability in all major local and foreign markets.
Specialized technology units are globally integrated yet individually differentiated
laboratories. These specialized units focus on specific technological areas defined by
headquarters. For instance, DaimlerChrysler has its corporate research center in
Germany. Its R&D center in Bangalore, India, emphasizes the development of
telematics, multimedia, and manufacturing solutions. In Shanghai, the automakers
joint R&D center was established to focus on microelectronics and electronic
packaging. These R&D activities are coordinated with microelectronics research in
Germany, and scientists are exchanged between China and Germany regularly.
Regional units focus on respective geographical areas as opposed to specialized units
that focus on specific technological areas.
As international expansion increases, the R&D unit may change over time, the R&D
subsidiary may grow, or the MNEs strategy may change. The global R&D function
may evolve in stages, along with the extent of internationalization of the MNE. In the
initial stage, a firm may dedicate few technical resources abroad and maintain a highly
ethnocentric management group and domestically oriented management structures. As
its commitment to the foreign market grows, it builds up technical capabilities for
responding to local market conditions, either by modifying the partners products or
by generating products for sale in the local market. When the headquarters realizes
that the foreign laboratories have achieved a level of technical competence ahead of
the rest of the firm, it may switch the orientation of its foreign laboratories from the
host-country markets to the world market. The headquarters may assign new product
development projects to the foreign laboratories to take advantage of their specialized
technical skills.
3.2 Selecting R&D Location

Selecting an R&D location is a crucial and complex decision because external
parameters such as resource availability, market conditions, and government policies
differ across countries and even at locations within a country. Once a laboratory is
built, switching costs from one location to another are enormous.
First, location selection depends on the strategic role of an R&D subsidiary that is set
by the parent company. If the subsidiary is designed to serve the home market,
managers should take into consideration the availability of scientific knowledge and
talent from foreign universities. For a subsidiary that targets the world market,
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location factors include availability of adequate infrastructure and universities and

accessibility to foreign scientific communities. When the subsidiary serves just as a
center for technology transfer, it should be located in countries where the company
already has made substantial investments in manufacturing and/or marketing. In
general, R&D follows manufacturing and marketing in the globalization process. In
cases where the laboratories are established for performing basic research or
developing new products for the global market, they should be located in places in
which there is a concentration of technology resources and advanced innovation. This
concentration is a vital reason why MNEs tend to cluster their technology
development centers around numerous hot spots.
Second, host government policies may have an influence on location decision. The
policies include: work permit regulations for expatriate scientists, engineers, and
managers; government requirements for increasing local technological content of the
activities of the firm; tax subsidies for supporting the R&D activities of the foreign
firm; and efficient patent laws.
Third, the local infrastructure and technological level of a foreign country are vital
points to be considered before selecting an R&D location. Technological capability
must exist in the country to permit R&D to take place. Some MNEs tap technologies
that are more advanced. For instance, Germany is a world leader in areas of chemistry,
physics, metallurgy, and medicine while Britain has spent heavily on pharmaceuticals
and chemicals. The presence of research universities or local firms with advanced
technologies becomes crucial in these circumstances.
Finally, socio-cultural factors may affect location selection. MNEs prefer locating
R&D facilities in nations with a similar culture and language, considering the
difficulties associated with operating business in a different social and cultural
environment. The decision makers at the headquarters should consider the
attractiveness of the lifestyle of the foreign country to the staff assigned overseas. If
the location is undesirable, it may be difficult to find qualified people willing to work
abroad. As R&D largely depends on the creativity and efficiency of human resources,
the living and working conditions abroad may determine the incentives and
commitments of the expatriates.
3.3 Structuring Global R&D Activities

To ensure the success of their global R&D, MNEs should design an appropriate
organizational structure governing the R&D activities. The two factors crucial for
structuring global R&D operations are (1) the level of authority an MNE plans to offer
to its foreign R&D activities and (2) the scope of the geographical market to be
covered. Based on these two axes (level of autonomy and market breadth), five
models can be identified. They are ethnocentric centralized, polycentric decentralized,
specialized lab, global central lab, and the globally integrated network. These models
serve an organizational framework in which different R&D units may be designed
with different roles and types.
In the ethnocentric centralized R&D structure, all key R&D activities are concentrated
in one home country. This structure has a corporate technology unit at home and may
also include a few technology transfer units for distributing centralized R&D results to
local operations. In this model, the core technologies in the home country are viewed
as national treasure, designing products that are manufactured subsequently at other
locations and are distributed worldwide.
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The disadvantage of this structure is the lack of sensitivity to signals from overseas
markets and insufficient consideration of local market demands. MNEs select this
structure only if they manufacture global, standardized products and do not take into
consideration differentiating between foreign markets.
The polycentric decentralized R&D structure is characterized by a decentralized alliance
of R&D sites with no corporate R&D center for supervision. This structure contains
several indigenous technology units in major foreign markets. Foreign R&D laboratories
are highly autonomous with little incentive for sharing information with central R&D or
other R&D units. Foreign R&D laboratories emphasizes on product development
process in response to local consumer demands and localization requests. In this
structure, efforts to preserve autonomy and national identity may hinder cross-border
coordination, and thus lead to inefficiency on a corporate level and for duplication of
R&D activities. The firm may also lose its focus on a particular technology.
In the specialized laboratory structure, foreign R&D units are assigned global
directives. The aim is to enhance the global efficiency of the product development
process, concentrating on a single location the resources related to development
operations in a particular product category. This structure has specialized technology
units in respective product areas. When a leading market exists in terms of size and
presence of customers, the MNE assigns the global responsibility to develop and
manufacture the product to the laboratories and plants in that country. This approach
helps in achieving economies of scale in R&D and for placing the product
development operations close to the key customers of the company. The global
development laboratories are selected based on their proximity to the manufacturing
plants because there are costs involved in transferring R&D to a manufacturing plant
that is away from the R&D center.
The global center lab structure is used for leveraging on the companys centralized
technical resources for creating new global products. Though it is also centralized, R&D
under this structure covers a broader market domain than R&D in the ethnocentric
centralized model. In this structure, there can be more than one global technology unit
for generating worldwide innovation. In this model, companies concentrate their
technical resources in the country of origin. To make this structure work, it is crucial to
create an effective market information network that provides an information flow from
the decentralized marketing or production units to the parent company. This helps the
central development laboratories to generate products suitable for the global market
and/or to adapt different product versions to individual markets.
The globally integrated network structure may be filled with a number of foreign
R&D units with different types and roles, such as the corporate technology unit, the
indigenous technology unit, the global technology unit, and the specialized technology
unit. In this model, home R&D is not the center of control for all R&D activities but
rather one among many interdependent R&D units that are interconnected by means
of varied and flexible coordination mechanisms. A central coordinating body
exercises the needed supervision for preventing duplication and integrating the diverse
contributions. Development processes which can be exploited across several markets
involve resources from different facilities whose work is coordinated according to a
common plan. Each unit in the network specializes in a particular component, product,
or technology area, and a set of core capabilities. At times, this unit takes a lead role
as a competence center and is then responsible for the entire value generation process.
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4. Management and Operations of Global R&D

The rapid dispersion of R&D laboratories in foreign markets has forced MNEs to take
a global view in managing their research operations through areas such as human
resource management, autonomy specification, global planning, and communications
improvement.
4.1 Human Resource Management

R&D human resources need to be managed in such a way that they fulfill the unique
needs of global R&D. First, selection of key personnel must be linked to the role or
type of foreign R&D unit. For instance, if the laboratory belongs to an indigenous
technology, then local talent that is well qualified should be considered for both
management and R&D positions. If the lab belongs to a specialized or global
technology unit or is to accept technology from the parent company, then qualified
expatriates should be preferred. Second, personnel policies for foreign lab should be
standardized to the extent allowed by local customs and laws. Promotions, titles, and
rewards and recognition programs should be the same to the extent possible. Because
there needs to be frequent contact between home and overseas laboratory personnel,
this uniformity of management positions and titles can help make foreign laboratories
feel that they are equal partners with parent laboratories. Reward and recognition
programs instilled at the headquarters should be extended to include the global R&D
personnel. Third, maintaining some regular visits and contacts between foreign R&D
units and home land center is useful.
4.2 Autonomy Setting

Autonomy refers to the decision-making power of an R&D unit concerning R&D
activities. The autonomy of a foreign R&D unit depends largely on the role it plays in
the MNE network. For instance, managerial autonomy in a laboratory that serves as a
specialized center for global competence must be delegated a greater power. Generally,
autonomy should be higher if the technical resources in the laboratory are scarce, have
to be located together in a center of excellence, or have to be put to use where they could
create more leverage for the company. When a foreign R&D unit serves as a unit for
technology transfer for the MNE network, its autonomy will be low and the authority for
decision making will be centralized at the headquarters. In this situation, the unit plays
the role of an effective adopter of new products and processes that are created by the
parent company. If the unit is an indigenous specialized technology laboratory or global
technology center, it requires a low level of formalization (i.e. specifying the essential
behaviors in the form of rules procedures or programs) and a high level of autonomy.
The subsidiaries need increased degrees of freedom and more resources distributed by
the parent companies. Some R&D subsidiaries of companies such as ITT, Philips, and
Unilever enjoy considerable strategic and operational autonomy, though headquarters
exercises administrative control through financial reporting and budgeting systems.
These autonomous subsidiaries have been found to be more productive than other R&D
units in these companies.
The autonomy of a foreign R&D unit is subordinating the strategic needs of an MNE
for global integration. There are positive associations between creating, adopting, and
diffusing innovations by a subsidiary and the degree to which the subsidiary is
integrated with the parent company and shares its overall goals, strategy, and values.
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Such integration results from a high degree of organizational socialization and is

achieved through extensive transfer and travel of managers between the headquarters
and the subsidiary and through joint work-in teams, committees, and task forces.
Resource allocation is a significant vehicle in balancing global integration and local
autonomy to manage dispersed R&D units abroad. In general, resources allocated to
specialized technology units or global technology units may be those involved in
strategic and exploratory research, core competency, global market coverage, or
significant areas of investment. Resources that are likely to be duplicated in regional
R&D centers are the ones that focus chiefly on product development as opposed o
technology development. In addition to technological factors, geopolitical and
financial factors play a major role in determining the proper allocation of resources.
Finally, in resource allocation, it is important to consider the interface between
physical resources and human resources in a new information technology
environment. Networks connecting the facilities of a company worldwide enable
researchers to work on one project from many locations.
4.3 Global Planning

The corporate R&D office has the crucial task of coordinating the dispersed global
network of R&D laboratories. Global planning is a primary means of information
exchange among decentralized R&D laboratories and projects. In the process of planning,
corporate headquarters outlines a strategic goal of globalizing R&D and communicating it
to foreign R&D units. For instance, Matsushita set up a three-pillar blueprint:
Construction of a tri-pole R&D network between laboratories in Europe and
North America and domestic research laboratories for establishing advanced
technological bases and creating products for the global market.
Improved R&D efficiency through expansion of collaborative relationships with
international research institutions.
Increased speed of globalization of R&D through superior management and
effective communication across borders.
R&D planning activities also contribute to learning throughout the MNE if they
request participation from scientists and technicians on a routine basis. Planning can
be transformed into an education process by the central R&D office. Planning
activities also help in global integration. Though budgeting is considered to be
difficult due to development cycles spanning five years or more, global planning is
easier due to the ability to disseminate information and establish priorities.
Planning helps in the alignment of a companys technological and business strategies.
Once the technology strategy is set, it can be carried into specific project areas. A key
aspect of alignment of R&D on the business objectives is cross-functional planning
and execution. With participation of manufacturing, marketing, and sales, R&D
groups can optimize the process of project assessment, selection, and project portfolio
balancing. Progress on R&D projects can be assessed on a regular basis and can be
reported to multi-functional teams.
4.4 Communication Improvement

Geographic distances pose a major communication challenge across a network of
international R&D laboratories. Cross-border communication breakdowns lower
productivity. Moreover, the role of informal communication networks is important as
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much of the work can be accomplished in teams. An effective communication system

is essential not only within the R&D function but also between R&D and other
functional activities such as manufacturing, marketing, and sales. For improving
communication within a global R&D network, international managers need to be
aware of the following issues:
Rules and Procedures
For overseas laboratories, careful documentation and reporting of research progress
can help the R&D personnel be aware of research activity across the company.
Research progress reports supplement the communication flows related to the
planning cycle which can also serve the purpose of education.
Electronic Communication
Videoconferencing images, electronic mail facsimiles of visual and written material,
and computer conferencing offer greater communication possibilities than a simple
telephone call. They provide an essential infrastructure for communication across
borders. However, they cannot replace the informal face-to-face communication that
builds trust.
Boundary Spanners
The R&D staff at the headquarters often performs the role of boundary spanners
between the R&D laboratories that are dispersed. They travel to site location to share
development somewhere else in the global R&D network and for discussing progress
at the particular site. They may also divulge sensitive information across the network
about developments with joint venture partners, customers, or suppliers.
Informal Network
Communicating through an informal network is an efficient means of teamwork.
Informal networks can be stimulated through a central R&D group, which may be
created both inside and outside the company, locally or internationally. An external
local network comprising local suppliers, customers, and research institutions offers
an opportunity for learning from foreign environments. The central office R&D group
can put in place an external international network of academics who work on
company projects. Private conferences help in bringing these academics together for
presenting their research and for exchanging information. The central office can
supervise locating and funding outside academic researchers. The internal network of
an MNE can be activated with international project teams. The project team members
stay in their respective laboratories and collaborate on projects using personnel
transfers and electronic means.
Cultural Adaptation
Global R&D projects need to overcome cultural differences. Though many
researchers speak in English there is no assurance that the members of a multicultural
R&D team understand each other. Research suggests that significant cross-cultural
differences exist among R&D professionals on the dimension of power individualism,
risk avoidance, and masculinity/femininity. An effective means to minimize cultural
differences is to socialize R&D professionals through a wide range of activities.
International training seminars help in building a shared corporate culture as well as a
network of colleagues who can communicate on an informal basis.
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5. Technology Transfer Across Borders

A common alternative for setting up a foreign-based R&D center or laboratory is to
enter into collaborative agreements or technology transfers with foreign partners. This
approach is attractive to firms or projects in need of large investments which may
involve high uncertainties.
International technology transfer is a process by which one firms technology or
knowledge is passed on to another firm in a different country for economic benefits.
Technology transfer helps a firm acquire the needed knowledge or technology from a
foreign provider. The methods most often used for technology transfer include
international licensing turnkey operations, non-equity or equity joint ventures, and
countertrade. In general, firms that acquire technology through international transfer
seek increasing competitiveness by reducing development costs, increasing
competitiveness, enhancing their technological position in the market, or reducing
prices while not compromising on quality. If firms want to transfer the technology
they own to foreign firms, they need to consider factors such as protection of
proprietary technology, impact on the existing market power of the firm, competition,
and earning royalties from remote markets.
Technology transfer is a complex and ongoing activity as demonstrated by the fact
that the license relationships have been in operation for over 50 years. Moreover,
variations are prevalent across market lines, company, or industry. Even within an
MNE network, the management and policies of technology transfer vary according to
the subsidiaries, type of technologies, and stages of the technology life cycle. As such,
it would be inappropriate for a firm to try controlling it through uniform rules.
A major problem with technology transfer across borders is that much of the
technological capability cannot be transferred easily from one partner to another. This
is because the successful operationalization of many technologies depends on the
experiences acquired and the expertise of critical personnel including engineers,
equipment operators, key scientists, and suppliers. The ways in which interdependent
technologies are tuned to work effectively in a complex system are tacit or implicit in
nature, relying on overall experiences, understanding, and skills that have they
internalized or learned over time. Due to this, it is necessary to check the absorptive
capability of a transferee. The absorptive capability concerns the ability of a firm to
integrate, assimilate, acquire, and exploit the skills and knowledge that are transferred
from others. This capability depends on the firms level of related skill or technology
that have already been developed, the ability to combine the skills owned by the firm,
as well as those acquired from others, and the effectiveness of organizational learning
systems.
Effective technology transfer, especially through a joint venture, requires coordinating
mechanisms, labeled as bridges, which link two parties. Bridges are of three
categories procedural bridges, human bridges, and organizational bridges.
Procedural bridges involve activities such as joint planning and joint staffing
particularly during technology transfer. Here, the emphasis is on collaboration through
joint planning, problem solving, and implementation. Human bridges rely on
establishing direct interaction between individuals belonging to different
organizational areas typically through the transfer and rotation of personnel. The
personal contacts allow enthusiasm and responsibility to be transferred from one
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person to another and it establishes a common work-related and social context that
facilitates more learning and cooperation. Organizational bridges use dedicated
transfer teams for establishing more formal ties between organizational areas. These
groups are formed for building a more formal structure and common context for
effective experience transfer.
6. Summary
Globalizing R&D involves several benefits. First, globalizing R&D may offer a
vehicle for extracting benefits from the technical resources local expertise, and
scientific talent of the target country. Second, globalizing R&D may enhance the
competitive advantage of a firm. Finally, globalizing R&D may enable an MNE
to enjoy the benefits that arise from international division of labor in R&D among
multiple foreign countries or regions.
Globalizing R&D is a complex process that involves several challenges and
difficulties. First, maintaining minimum efficient scale in foreign R&D
operations is not always easy. Second, the leakage of proprietary knowledge
poses a serious threat when R&D is globalized. Finally, globalizing R&D
inevitably increases coordination and control costs.
With regard to the role of foreign R&D units, R&D subsidiaries can be
categorized into corporate technology units specialized or regional technology
units, global technology units, technology transfer units, and indigenous
technology units.
Selecting an R&D location is a crucial and complex decision because external
parameters such as resource availability, market conditions, and government
policies differ across countries and even at locations within a country.
The two crucial factors essential for structuring global R&D operations are (1) the
level of authority an MNE plans to offer to its foreign R&D activities and (2) the
scope of the geographical market to be covered.
The five models in structuring global R&D are ethnocentric centralized,
polycentric decentralized, specialized lab, global central lab, and the globally
integrated network.
The rapid dispersion of R&D laboratories in foreign markets have forced MNEs
to take a global view in managing their research operations through areas such as
human resource management, autonomy specification, global planning, and
communications improvement.
A common alternative for setting up a foreign-based R&D center or laboratory is
to enter into collaborative agreements or technology transfers with foreign
partners. This approach is attractive to firms or projects in need of large
investments which may involve high uncertainties.
Example: Managing Global Research and Development at Nestl

Nestl SA (Nestl) is a research and development leader in the worlds food
industry. The company makes substantial investments every year in R&D, which is
carried out at the Nestl Research Center (NESTEC) at Lausanne, Switzerland, and
in 28 R&D centers worldwide.
Contd
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Contd
The R&D activities are incorporated at NESTEC, which offers technical assistance
to all operating units of Nestl throughout the world. The company has several
researchers who work in many disciplines such as bioscience, food science, plant
science, food safety, food technology, and nutrition.
R&D management sets some research priorities that help in determining Nestls
long-term competencies (category I projects), while Nestls strategic business
units (SBUs) are responsible for prioritizing and monitoring R&D work linked to
new process and product developments (category II projects). The SBUs have close
working relationships with the R&D network as well as operating businesses, and
adopt a multifunctional approach for setting priorities. The R&D coordinators at
the SBUs are responsible for assigning the related research project to the most
competent R&D group within the network and also monitor the progress.
The R&D centers are instructed by NESTEC to take on additional responsibility as
product area managers for improving coordination across various R&D centers
working in the same product area. The product area manager leads the R&D groups
and also helps them in meeting their assigned tasks and deadlines.
Example: Ford Locates its R&D Center in Germany

In 2008, Ford Motor Company (Ford), US-based automaker, selected Aachen in
Germany as its new European R&D center, partly because of the centers proximity
to one of the most industrialized regions in Europe. Aachen is centrally located in
Europe, allowing for close cooperation with over 40 research universities in 16
different countries. Aachen is also home to one of the most prestigious technical
universities in Europe, RWTH Aachen University. This enabled Ford to easily
recruit qualified scientists and engineers. Technical cooperation with institutes and
local universities has helped Ford acquire new technologies and support strategic
technology monitoring.
Another significant advantage to Ford in choosing Aachen is that it can easily
design and develop product variants or monitor European Community politics from
Aachen to other locations. Thus by locating its R&D center in Germany, Ford has
been able to work on sophisticated technologies for meeting growing demand for
safety improvements, emission control, and personal mobility.
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Concept Note - 9
Accounting in the International Business

1. Introduction
Accounting information is the means by which firms communicate their financial
position to the providers of capital, investors, creditors, and government. It enables the
capital providers to evaluate the value of their investments or the security of their
loans and to make decisions about future resource allocations.
International businesses confront many accounting problems that domestic businesses
do not face. The lack of consistency in accounting standards of different countries is a
major problem. Thus international standards have been formed to standardize
accounting practices. Multinational enterprises (MNEs) make use of consolidated
financial statements and methods of foreign currency translation to correctly report
their financials. A control system is also a crucial aspect of accounting in international
business.
This unit discusses country differences in accounting standards. It then takes a look at
national and international standards. It discusses the significance of consolidated
financial statements and the methods used for currency translation. The unit finally
examines the different aspects of accounting in control systems.
2. Accounting Standards: Country Differences

As is the case with the business which it records, accounting is shaped by the
environment in which it operates. Countries have different accounting systems just as
they have different economic systems, political systems, and cultures. The accounting
system has evolved in each country in response to the demand for accounting
information.
An example of differences in accounting conventions concerns employee disclosures.
In many European countries, government regulations require firms to publish detailed
information about their employment and training policies. Such a requirement does
not exist in the US. Another difference is with regard to treatment of goodwill. The
goodwill of a firm is any advantage such as brand name or a trademark that enables
the firm to earn higher profits than its competitors. When one company acquires
another company, the goodwill value is calculated as the amount paid for a firm above
its book value, which is often substantial. Under accounting rules that are prevalent in
many countries, acquiring firms have been allowed to deduct the goodwill value from
the amount of equity or net worth reported on their balance sheet.
Despite several attempts to harmonize standards by developing internationally
acceptable conventions, differences between national accounting systems still remain.
Though many factors can influence the development of an accounting system in a
country, there are five main variables:
The relationship between business and capital providers;
Political and economic ties with countries;
The inflation level;
The level of economic development of a country;

The prevailing culture in a country.
2.1 Relationship between Business and Capital Providers

The three main sources of external capital for business enterprises are individual
investors, banks, and government. In most advanced countries, all three sources are
crucial. For instance, in the US, business firms can raise capital by selling shares and
bonds to individual investors through the bond market and stock market. They can
borrow capital from banks and in some cases from the government. The importance of
each capital source varies from country to country. In some countries, such as the US,
individual investors are the major capital source; in others, banks play a greater role;
in still others, the government is the major capital provider. The accounting system of
a country tends to reflect the relative importance of these three constituencies as
capital providers.
Consider the case of Britain and the US. Both have well-developed stock and bond
markets in which firms can raise capital by selling stocks and bonds to individual
investors. Most individual investors purchase a very small proportion of the total
outstanding stocks or bonds of a firm. The investors leave the task to professional
managers. But due to their lack of contact with the management of the firms in which
they invest, individual investors may not have the information needed to evaluate how
well the companies are performing. Individual investors generally lack the ability to
get information on management demand because of their small stake in the firms. The
financial accounting system in both Britain and the US evolved to cope with this
problem. In both countries, the financial accounting system is oriented toward offering
individual investors the information they require to make decisions about selling or
purchasing corporate stocks or bonds.
In countries such as Japan, Switzerland, and Germany, a few large banks satisfy most
of the capital needs of business enterprises. In these countries, the role of the banks
has been so important that a banks officers often have seats on the boards of firms to
which it lends capital. In such circumstances, the information needs of the providers
of capital are satisfied in a straightforward manner through direct visits, personal
contacts, and information provided at board meetings. Consequently, though firms do
prepare financial reports, as government regulations in these countries mandate some
public disclosure of the financial position of the firm, the reports historically tend to
contain less information than those of the US or British firms. Because banks are
major capital providers, financial accounting practices are oriented toward protecting
a banks investment. Hence, assets are valued conservatively and liabilities are
overvalued to offer a cushion for the bank in the event of default.
In still other countries, the national government has been a crucial capital provider,
and this has influenced accounting practices. This is the case in Sweden and France,
where the national government has often stepped in to make loans available or
invest in firms whose activities are deemed to be in the national interest. In these
countries, financial accounting practices are oriented toward the needs of
government planners.
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2.2 Political and Economic Ties with Countries

Similarities in the accounting systems of countries are sometimes due to the close
political and economic ties between the countries. For instance, the accounting system
in the US has influenced the accounting practices in Mexico and Canada, and since
the passage of NAFTA, the accounting systems in these countries have converged on
a common set of norms. Another significant force in accounting worldwide has been
the British system. A majority of former colonies of the British Empire have
accounting practices modeled after Britains. Similarly, the European Union (EU) has
also made attempts to harmonize accounting practices in its member countries. The
accounting systems of EU members have converged on the norms of the International
Accounting Standards Board.
2.3 Inflation Accounting

In many countries, including the US, Japan, and Germany, accounting is based on the
historic cost principle. This principle assumes the currency unit used to report
financial results is not losing its value due to inflation. Firms record sales, purchases,
and the like at the original price of the transaction and make no adjustments in the
amounts later. The historic cost principle affects accounting most significantly in the
area of asset valuation. If the inflation is high, the historic cost principle
underestimates the assets of a firm so the depreciation charges based on these
underestimates can be inadequate for replacing worn out or obsolete assets.
The appropriateness of this principle varies inversely with the inflation level in a
country. During the 1970s and 1980s, the high level of price inflation in many
industrialized countries created a need for new accounting methods that could adjust
inflation. Many industrialized countries adopted new practices. In 1980, an approach
called current cost accounting was adopted in Britain. Current cost accounting adjusts
all items in a financial statement assets, liabilities, revenues, and costs -- in order to
factor out the effects of inflation. The method makes use of a general price index for
converting historic figures into current values. However, the standard was not made
compulsory and once the inflation rate fell in the 1980s in Britain, most of the firms
stopped providing the data.
2.4 Level of Development

Developed nations have large, complex organizations, whose accounting problems are
more complicated than those of small organizations. They also have sophisticated
capital markets in which business organizations raise funds from investors and banks.
The capital providers require comprehensive reports of the financial activities of the
organization in which they invest. The workforces of developed nations tend to be
highly skilled and educated and can perform complex accounting functions. These
reasons make accounting in developed countries more sophisticated than accounting
in less developed countries, where the accounting standards may be moderately
primitive. In most developed nations, the accounting system used is inherited from
colonial powers. For instance, many African nations have accounting practices based
on either the French or British models. These models may not be applicable to small
businesses in a poorly developed economy. Another problem in the poorer countries is
the lack of trained accountants.
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2.5 Culture
The culture of a country has a major impact upon the nature of its accounting system.
Researchers have found that the degree to which a culture is characterized by
uncertainty avoidance has an impact on the accounting system. Uncertainty avoidance
refers to the extent to which cultures socialize their members to accept ambiguous
situations and tolerate uncertainty. Members belonging to a high uncertainty
avoidance culture give importance to career patterns, job security, retirement benefits,
etc. They also have a strong need for rules and regulations; the manager is expected to
give clear instructions and the initiatives of the subordinates are controlled tightly.
Lower uncertainty avoidance cultures are characterized by an increased readiness to
take risks and less emotional resistance to change. Research indicates that countries
with low uncertainty avoidance cultures tend to have strong independent auditing
professions that audit the accounts of the firms to ensure that they comply with
generally accepted accounting regulations.
3. National and International Standards

Accounting standards are rules for preparing financial statements. They define what
useful accounting information is. Auditing standards specify the rules for performing
an audit the technical process through which an independent person (the auditor)
gathers evidence to determine if the financial accounts conform to required accounting
standards and also if they are reliable.
3.1 Lack of Comparability

An adverse result of national differences in accounting and auditing standards has
been a general lack of comparability of financial reports from one country to another.
For example, Dutch standards favored the use of current value for replacement assets;
Japanese law prescribed historic cost and generally prohibited revaluation; in Britain,
capitalization of financial leases was a required practice, but this was not practiced in
France; in the US, R&D costs must be written off in the year they were incurred but in
Spain it could deferred as an asset and might not be amortized as long as benefits
covering them were expected to arise in the future.
Such differences would not have mattered much if there was little need for a firm
headquartered in one country to report its financial results to citizens of another
country. However, a striking development has been the growth of the capital markets.
A growth of both transnational financing and transnational investment has also been
noticed.
Transnational financing takes place when a firm based in one country enters the
capital market of another country for raising capital from the sale of stocks or
bonds. A German firm raising capital by selling stock through the London Stock
Exchange is an example of transnational finance. Large firms have been
increasingly making use of transnational financing by gaining listings, and
ultimately issuing stock, on foreign stock exchanges, particularly the London and
the New York stock exchanges.
Transnational investment takes place when an investor based in one country enters
another nations capital market for making investments in the stocks or bonds of a
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firm based in that country. An investor based in Britain buying stock of General
Motors through the New York stock exchange is an example of transnational
investment.
The rapid expansion of transnational financing and transnational investment is
accompanied by a corresponding growth in transnational financial reporting. For
instance, a Danish firm raising capital in London should issue Danish financial
reports, in addition to the financial reports that serve the needs of its British investors.
However, a lack of comparability between accounting standards in different nations
can cause confusion. For instance, the German firm that issues two sets of financial
reports, one prepared under German standards and the other under US standards, may
find that the two reports show a significant difference in its financial position, and its
investors may have difficulty in identifying the true worth of the firm.
In addition to the problems related to lack of comparability faced by the investors, the
firm has to explain to its investors why its financial position looks so different in the
two accountings. Also, an international business may find it difficult to evaluate the
financial positions of key foreign suppliers, customers, and competitors.
3.2 International Standards

Many companies raise money from capital providers across national borders. The
providers demand consistency in the way in which financial reports are reported to
that they can make informed decisions. Also, adoption of common accounting
standards facilitate the development of global capital markets, since more investors
will be willing to make investments across borders, and the end result will be to lower
the cost of capital and stimulate economic growth. Thus, accounting standards were
standardized across national borders in the best interests of the participants in the
world economy.
Formed in March 2001, the International Accounting Standards Board (IASB) has
emerged as a proponent of standardization. The IASB replaced the International
Accounting Standards Committee (IASC), which was established in 1973. The IASB
is responsible for formulating new international financial reporting standards. By
2005, the IASC and the IASB had issued 41 international accounting standards. For a
new standard to be issued, 75 percent of the members of the IASB must agree. It can
be difficult to get three-quarters agreement as members come from different cultures
and legal systems. The IASB offers two acceptable alternatives to get around this
problem.
Another hindrance to the development of international accounting standards is that
compliance is voluntary; the IASB has no power to enforce the standards. Despite
this, the support for IASB and recognition of its standards has been growing.
The impact of IASB standards has been least noticeable in the US as most of the
IASB standards are consistent with opinions already articulated by the US Financial
Accounting Standards Board (FASB). The FASB writes the generally accepted
accounting principles (GAAP) by which the financial statements of US firms should
be prepared. By contrast, the IASB standards have had a significant impact on many
other countries as they have eliminated a commonly used alternative.
EU also has substantial influence on the harmonization of accounting standards. The
EU mandates its accounting principles in its member countries.
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4. Multinational Consolidation and Currency Translation

A consolidated financial statement combines the different financial statements of two
or more firms to yield a single set of financial statements as if the individual
companies were a single entity. Most of the multinational firms comprise a parent
company with several foreign subsidiaries located in various countries. Such firms
issue consolidated financial statements, which merge the accounts of the parent
company as well as its subsidiaries as opposed to issuing individual financial
statements for the parent company and each subsidiary.
4.1 Consolidated Financial Statements

Many firms find it beneficial to organize themselves as a set of separate legal entities.
For example, a firm may incorporate the various business components separately so as
to limit its total legal liability or to take advantage of corporate tax regulations.
Multinationals are often required by the countries in which they carry out their
business to set up a separate company. Thus a multinational comprises a parent
company and several subsidiaries located in different countries, most of which are
wholly-owned by the parent company. Though the subsidiaries may be separate legal
entities, they are not separate economic entities. Economically, all the companies in a
corporate group are interdependent. For instance, if the Brazilian subsidiary of a US
parent company experiences considerable losses that drain off the corporate funds, the
cash available for investment in that subsidiary, the parent company in the US, and
other subsidiary companies will be limited. Hence, the purpose of consolidated
financial statements is to provide accounting information about a group of companies
that recognize their economic interdependence.
Transactions that take place among members of the corporate family are not included
in consolidated financial statements; only assets, liabilities, revenues, and expenses
with external third parties are shown. However, by law, separate legal entities need to
maintain their own accounting records and prepare their own financial statements.
Thus, transactions with other members of a corporate group should be identified in
separate statements so they can be excluded during the preparation of consolidated
statements. The process involves adding up individual assets, liabilities, revenues, and
expenses reported on the separate financial statements and then eliminating the ones
in the intragroup.
Preparing consolidated statements has become a norm for multinational firms.
Investors realize that in the absence of a consolidated financial statement, a
multinational can conceal losses in an unconsolidated subsidiary, thereby hiding the
economic status of the entire corporate group.
4.2 Currency translation

Normally, foreign subsidiaries keep their accounting records and prepare their
financial statements in the currency of the country in which they are located. When an
MNE prepares its consolidated records, it should convert all these financial statements
into the home countrys currency. However, exchange rates vary due to changes in
economic conditions. Two main methods that determine what exchange rate should be
used by firms when translating financial statement currencies are the current rate
method and the temporal method.
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The Current Rate Method

In the current rate method, the exchange rate as on the balance sheet date is used for
translating the foreign subsidiarys financial statements into the MNEs home
currency. Though this seems logical, it is incompatible with the historic cost principle,
which is a generally accepted principle in accounting followed in many countries. For
instance, a US firm invests US$ 100,000 in a subsidiary in Malaysia. Assume the
exchange rate at that time is 1 US$ = 5 Malaysian ringgit. The subsidiary converts the
US$ 100,000 into ringgit to make it 500,000 ringgit and buys land with this money.
Subsequently, if the dollar rate depreciates against the ringgit, so that by the year end
1US$ = 4 ringgit and if this exchange rate is used for converting the value of the land
in dollars for preparing consolidated accounts, the land will be valued at US$ 125,000.
The land value appears to have increased by US$ 25,000, though in reality the
increase will be a function of the change in exchange rate. Therefore, the consolidated
accounts present a misleading picture.
The Temporal Method
The temporal method avoids the problem encountered in the current rate method. The
temporal method translates the value of the assets in a foreign currency into the
currency of the home country using the exchange rate that exists when the assets are
purchased. Though the temporal method ensures that the dollar value of the land does
not fluctuate due to changes in exchange rates, it has its own problems. As the various
assets of the subsidiary will in all probability be acquired at different points of time
and because exchange rates rarely remain stable for a long time, different exchange
rates would need to be used for translating the foreign assets into the MNEs home
currency.
4.3 Current US Practice

US-based multinationals should follow the requirements of Statement 52, Foreign
Currency Translation issued in 1981 by the Financial Accounting Standards Board.
Under Statement 52, a foreign subsidiary is classified either as an autonomous, selfsustaining subsidiary or as being integral to the activities of the parent firm.
According to Statement 52, the local currency of the foreign subsidiary, which is selfsustaining, should be its functional currency. For such subsidiaries, the balance sheet
is translated into the home currency using the exchange rate at the end of the financial
year of the firm, whereas the income statement is translated using the average
exchange rate for the firms financial year. On the other hand, for an integral
subsidiary, the functional currency would be in US dollars. The financial statements
of integral subsidiaries are translated at various historic rates using the temporal
method, and the swinging debit or credit increases or decreases consolidated earnings
for the period.
5. Accounting Aspects of Control Systems

The role of corporate headquarters is to control subunits within the organization in
order to ensure that they achieve the best possible performance. Typically, the control
process is annual and involves three steps:
The head office in conjunction with the subunit management determines the
subunits goals for the coming year.
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The head office monitors the performance of the subunit against the agreed goals.
In case any subunit fails to achieve its goals, the head office intervenes to learn
the reason for the shortfall and also takes corrective action when appropriate.
In this process, the accounting function plays a critical role. Most of the subunit goals
are expressed in financial terms and are embodied in the budget of the subunit for the
coming year. The main instrument for financial control is the budget. The budget is
usually prepared by the subunit but has to be approved by the management at the
headquarters.
During the budget approval process, the managements at the headquarters as well as
the subunit debate the goals that need to be incorporated into the budget. A function of
the headquarters management is to ensure that the budget of the subunit contains
challenging but realistic goals. After the budget has been approved, accounting
information systems collect the data throughout the year in order to evaluate the
subunits performance against the goals set in the budget.
In international business, most of the subunits of the firm are foreign subsidiaries.
Thus the performance goals for the coming year are set by negotiation between the
corporate management and the managers of foreign subsidiaries. The most important
criterion for evaluating a foreign subsidiarys performance is comparing the actual
profits with the budgeted profits. This is closely followed by a comparison of actual
sales to budgeted sales and its return on investment. The same criteria can be used for
evaluating the performance of the subsidiary managers.
5.1 Exchange Rate Changes and Control Systems

Most international businesses require all budgets and performance data within the firm
to be expressed in the corporate currency, which is normally the home currency. For
instance, the Malaysian subsidiary of a multinational firm in the US would submit its
budget in US dollars as opposed to the Malaysian ringgit and performance data would
be reported to the headquarters in US dollars. This facilitates comparisons between
subsidiaries in different countries and makes things easier for the management at the
headquarters. However, it also allows changes in exchange rates to introduce
substantial distortions. For instance, the profit goals of the Malaysian subsidiary may
not be attained not due to any problems in its own performance but due to a decline in
the value of the ringgit against the dollar. The opposite can also occur, making the
performance of the foreign subsidiary look better than it actually is.
The Lessard-Lorange Model
A research study by Donald Lessard and Peter Lorange suggest that several methods
are available to international businesses for dealing with this problem. Lessard and
Lorange point out three exchange rates for translating foreign currencies into the
corporate currency in setting budgets and in performance tracking:
The initial rate, which is the spot exchange rate when the budget is adopted.
The projected rate, which is the spot exchange rate forecast for the end of the
budget period (i.e. forward rate).
The ending rate, which is the spot exchange rate when the budget is compared
with performance.
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Lessard and Lorange recommend that firms use the projected spot exchange rate for
translating both the budget and the performance figures into the corporate currency.
The projected rate will be the forward exchange rate as determined by the foreign
exchange market or some company-generated forecast of future spot rates, referred to
as the internal forward rate. The internal forward rate might vary from the forward
rate quoted by the foreign exchange market if the firm wishes to bias its business
against or in favor of the particular foreign currency.
5.2 Transfer Pricing and Control Systems

The global strategy and the transnational strategy give rise to a globally dispersed web
of productive activities. Firms that pursue these strategies disperse each value creation
activity to its optimal location in the world. Thus a product can be designed in one
country, some of its components can be manufactured in a second country, other
components can be manufactured in a third country and assembled in a fourth country,
and then sold across the globe.
The intra-firm transaction volumes will be very high in such companies. The firms
ship component parts and finished goods between subsidiaries in different countries
on a continuous basis. The price at which such goods and services are transferred is
referred to as the transfer price.
The choice of transfer price may have a critical effect on the performance of two
subsidiaries that exchange goods or services. When budgets are set and performance
of the subsidiary is reviewed, corporate headquarters need to keep in mind the
distorting effect of transfer prices.
International businesses manipulate their transfer prices often to minimize import
duties, minimize their worldwide tax liability, and avoid government restrictions on
capital flows.
5.3 Separating Subsidiary and Manager Performance

In many international businesses, the same quantitative criteria are used for evaluating
the performance of both the foreign subsidiary and its managers. However, many
accountants argue that while it is legitimate to compare subsidiaries against each other
based on return on investment (ROI) or other indicators of profitability, it may not be
suitable to use these to compare and evaluate the managers belonging to different
subsidiaries. Foreign subsidiaries operate in an environment that has different
political, social, and economic conditions that have an influence on the costs of doing
business in a country and the profitability of the subsidiary. Thus, it is suggested that
evaluation of a subsidiary should be separated from the evaluation of its managers.
The evaluation of the managers should take into consideration how benign or hostile
the countrys environment is for that business. Also, managers should be evaluated in
terms of local currency after making allowances for items over which they do not
have any control (e.g. tax rates, interest rates, transfer prices, inflation rates, and
exchange rates).
6. Summary
Accounting is shaped by the environment in which it operates. Countries have
different accounting systems just as they have different economic systems,
political systems, and cultures.
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An adverse result of national differences in accounting and auditing standards has

been a general lack of comparability of financial reports from one country to
another.
Adoption of common accounting standards facilitates the development of global
capital markets, since more investors will be willing to make investments across
borders, and the end result will be to lower the cost of capital and stimulate
economic growth. Thus, accounting standards were standardized across national
borders in the best interests of the participants in the world economy.
A consolidated financial statement combines the different financial statements of
two or more firms to yield a single set of financial statements as if the individual
companies were a single entity.
Two main methods that determine what exchange rate should be used by firms
when translating financial statement currencies are the current rate method and
the temporal method.
The role of corporate headquarters is to control subunits within the organization
in order to ensure that they achieve the best possible performance.
Example: Consequences of Different Accounting Standards at

AstraZeneca and at British Airways
In 1999, two major drug firms, Astra and Zeneca merged to form AstraZeneca. The
merged entity was based in the UK and had a profit of US$ 3,318 million under
British accounting rules and US$ 865 million under US accounting rules. The
difference between the two sets of accounts was US$ 1,756, which was related to
amortization and other acquisition-related costs. Under US rules, AstraZeneca was
treated as an acquisition, which required goodwill recognition with consequent
amortization. Under British rules, amortization had to be avoided as the
combination was treated as a merger and there was no question of goodwill.
In 2000, British Airways reported a 21 million loss under British accounting
rules, but under US accounting rules, it had lost 412 million. The difference was
attributed to adjustments for a small number of items such as depreciation and
amortization, deferred taxation, and pensions. The largest adjustment was due to a
reduction in revenue reported in the US accounts of 136 million. This reduction
in revenue was related to frequent flier miles, which under US rules, had to be
deferred until the miles had been redeemed. On the other hand, this was not the
case under British rules.
Example: Lack of Controls leads to Accounting Fraud

at Royal Ahold
In May 2006, a Dutch court charged three former executives of the Netherlandsbased Royal Ahold NV (Ahold), one of the leading retailers in the world, with
fraud. These executives were found guilty in an accounting fraud that brought the
company to the brink of bankruptcy. The former CEO of Ahold, Cees van der
Hoeven (Hoeven) and Michiel Meurs (Meurs), former CFO of Ahold, were issued
Contd
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Contd
nine-month suspended prison sentences and a fine of 220,000 each. The European
executive board member of Ahold, Jan Andreae (Andreae) received a four-month
suspended sentence and a fine of 120,000.
Of the total accounting fraud that led to the reduction in Aholds pre tax earnings to
the tune of US$ 966 million, Aholds wholly-owned subsidiary US Foodservice
(USF) accounted for about US$ 856 million. USF was the second largest
foodservice distributor in the US. In February 2003, after Ahold announced that the
earnings of USF for the financial year 2000 and 2001 had been overstated, its shares
fell by more than 65 percent to a 15-year low of 3.43 on February 24, 2003. The
market capitalization of Ahold plunged to 3.3 billion in February 2003 from 30
billion in the end of 2001. The media was quick to term Ahold Europes Enron,
while analysts downgraded the companys stock.
Immediately after the accounting irregularities in USF were reported by Deloitte, on
February 12, 2003, the company authorized an investigation by law firm White &
Case LLP and by forensic accounting advisors from Protiviti Inc. In March 2003,
Morvillo, Abramovitz, Grand, Iason and Silberberg PC (Morvillo) and
PricewaterhouseCoopers (PWC) conducted additional investigations of the accounts
of USF. SEC also conducted a probe on the accounting irregularities at Ahold.
PWC concluded that Ahold did not have a good internal control system in place. As
Ahold expanded globally, it had not given adequate priority to setting up strict
financial and accounting controls. The company had several divisional operations
without proper control or monitoring mechanisms in place. The company did not
document the policies and procedures for review and supervision. There were
several IT systems (more than 27 IT platforms) in the company, many of which
were not documented. Adequate communication between the division and corporate
staff was lacking and the quality of accounting staff was not uniform. PWC
reported that the system followed in booking a promotional allowance at USF was
highly opaque. The senior management at USF was blamed for failing to put in
proper internal controls and systems to track promotional allowance. USF had a
weak internal control mechanism.
USF was blamed for not revealing the existence of written contracts with suppliers
and for informing Deloitte that no written contracts existed, though such contracts
did exist. In its forensic audit, PWC found around 151 written agreements between
USF and its suppliers. The audit report also highlighted corrupt practices that some
of the employees of USF had indulged in. The companys determination of the
promotional allowance rate, which could not be verified, was cited as the main
reason for the false increases in reported earnings.
In the interim report of Morvillo submitted on April 25, 2003, it was alleged that
Miller (Jim Miller, President & CEO, USF) and Resnick (Michael Resnick, CFO,
USF), did not have adequate control over the operations of USF and that they had
paid no attention at all to the way promotional allowances were accounted. They
were blamed for not implementing proper control mechanisms and accounting
systems in the company.
Contd
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Contd
According to the report of investigation conducted by the Enterprise Chamber of

the Amsterdam Court of Appeal, the CEO and CFO of USF were primarily
responsible for the weak internal control systems. The report stated that Miller did
not possess adequate knowledge of promotional allowances and their accounting.
Miller was not even aware of the year-end confirmations obtained from the
suppliers and the way they were obtained.
Though the necessity of promotional allowance tracking system was envisaged, not
much was done on that front.
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Concept Note - 10
Financial Management in International Business

1. Introduction
Financial management in international business includes three sets of decisions
investment decisions -- decisions on what activities are to be financed; financing
decisions -- decisions on how to finance those activities; and money management
decisions -- decisions on how to efficiently manage the financial resources of a firm.
Good financial management enables a firm to both reduce costs of value creation and
add value at every possible opportunity of value creation.
This unit discusses the different investment decisions firms take in international
business. It then goes on to explain the various factors firms consider for financing in
an international business. It explains the money management decisions firms take in
international business. It also examines how money management decisions help firms
in achieving their tax objectives. The unit discusses the techniques used by
international businesses for moving across borders. It ends with a look at the
techniques used for global money management.
2. Investment Decisions
When a firm is considering investing in activities in any country, it should take into
account many political, economic, cultural, and strategic variables before arriving at a
decision. A significant role of the financial managers in international business is to
make attempts to quantify the various benefits, costs, and risks that may flow from an
investment in a given location. This can be done by making use of capital budgeting
techniques.
2.1 Capital Budgeting

As mentioned, the benefits, costs, and risks of an investment can be quantified using
capital budgeting techniques. This helps managers to compare different alternatives of
investment within and across countries in order to make informed choices about
where the firm should invest its scarce financial resources. The theoretical framework
used in capital budgeting for a foreign project is the same as that used in a domestic
project. That is, the firm has to estimate the cash flows with the project over time. In
most cases, the cash flows will be negative first because the firm invests heavily in
production facilities. However, after some time, they will become positive as revenues
grow and investment costs decline. After estimating the cash flows, they have to be
discounted using an appropriate discount rate to know the net present value. The
commonly used discount rate is either the cost of capital of the firm or some other
required rate of return. If the net present value of the discounted cash flows is greater
than zero, the firm should go ahead with the project.
Capital budgeting is a complex process. There are several factors complicating the
process for international businesses. Some of them are:
A distinction has to be made between cash flows to the parent company and cash
flows to the project.
Economic and political risks, including risks associated with foreign exchange,
can significantly change the foreign investment value.
The connection between the source of financing and cash flows to the parent
company needs to be recognized.
2.2 Parent and Project Cash Flows

A theoretical argument exists for analyzing any foreign project from the parent
companys perspective because cash flows to the project are essentially not the same
as cash flows to the parent company. The project may not have the ability to remit all
the cash flows to the parent company for several reasons. For instance, the repatriation
of cash flows may be blocked by the government of the host country; the cash flows
may be taxed at an unfavorable rate, or the host government may require a certain
percentage of the cash flows from the project to be reinvested in the host country.
Though these restrictions do not affect the projects net present value, they do affect
the net present value of the project to the parent company as they limit the cash flows
that can be remitted to it from the project.
When a parent firm evaluates a foreign investment opportunity, it should be interested
in the cash flows it will receive as opposed to the cash flows generated by the project
because those are the basis for dividends to stockholders, repayment of worldwide
corporate debt, investment somewhere else in the world, etc. Stockholders do not
perceive blocked earnings as contributing to the value of the firm, and creditors do not
count those earnings when calculating the ability of the parent to service its debt.
The issue of blocked earnings is not very serious. The greater acceptance of free
market economics has reduced the number of countries in which governments may
prohibit the foreign multinationals affiliates from remitting cash flows to their parent
companies.
2.3 Adjusting for Political and Economic Risk

When analyzing a foreign investment opportunity, firms should consider the political
and economic risks stemming from the foreign location.
Political Risk
Political risk is defined as the likelihood that political forces will cause drastic
changes in a countrys business environment that hurt the profit and other goals of a
business enterprise. Political risk is greater in countries that experience social unrest
or disorder and in countries where the fundamental nature of the society makes the
probability of social unrest high. When political risk is high, there is a high probability
that change will take place in the political environment of a country that will endanger
the foreign firms there.
Political and social unrest may sometimes result in economic collapse, which can
render the assets of a firm worthless. In less extreme cases, political changes may
result in increased tax rates, the imposition of price controls, the imposition of
exchange controls that limit or block the ability of a subsidiary to remit earnings to its
parent company, and the interference of government in existing contracts.
Many firms pay considerable attention to political risk analysis and to quantifying
political risk. The problem with forecasting political risk is that the firms try to predict
a future and in most cases the guesses are wrong.
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Economic Risk
Economic risk can be defined as the likelihood that economic mismanagement will
cause drastic changes in a countrys business environment that hurt the profit and other
goals of a business enterprise. The biggest problem arising from economic
mismanagement is inflation. Price inflation leads to a drop in the value of the currency
of a country on the foreign exchange market. This can be a major problem for foreign
firms with assets in that country because the value of the cash flows the firm receives
from those assets will fall as the currency of the country depreciates on the foreign
exchange market. This decreases the attractiveness of foreign investment in that country.
There have been many attempts to quantify the economic risk of a country and longterm movements in their exchange rates. There have been several empirical studies
done of the relationship between the inflation rates of countries and the exchange rates
of their currencies. The studies showed a long-run relationship between the countrys
relative rates of inflation and exchange rate changes. However, the relationship is not
reliable in the short run and totally unreliable in the long run. So, as with political
risks, the attempts to quantify economic risk were tempered with healthy skepticism.
2.4 Risk and Capital Budgeting

When analyzing a foreign investment opportunity, the additional risk stemming from
its location can be handled in at least two ways. The first method is to treat all kinds of
risks as one problem by increasing the discount rate that is applicable to foreign
projects in countries where political and economic risk are perceived to be high. The
higher the discount rate, the higher the projected net cash flows should be for any
investment to have a positive net present value.
The second method is adjusting discount rates to reflect the riskiness of a location. For
instance, several studies of large US multinationals have found that many of them add a
premium percentage for risk to the discount rate they use in the evaluation of potential
foreign investment projects. For any investment decisions, the political and economic
risk being evaluated is not of immediate possibilities, but rather at some distance in the
future. Thus, it can be argued that rather than using a high discount rate to evaluate such
risky projects, it is better to revise future cash flows from the project downward to
reflect the possibility of adverse political or economic changes sometime in the future.
3. Financing Decisions
An international business should take into consideration some factors when
considering its options for financing. The first factor is how the foreign investment
will be financed. If the firm requires external financing, it should decide whether to
borrow from the host countrys sources or tap the global capital market for funds. The
second factor is how to configure the financial structure of the foreign affiliate.
3.1 Financing Decisions and the Global Capital Market

A capital market brings together those who want to make investments and those who
want to borrow money. Corporations with surplus cash, non-bank financial
institutions, and individuals make investments in the capital market. Individuals,
companies, and governments borrow money from the capital market. The global
capital market benefits borrowers by increasing the supply of funds available for
borrowing, which lowers the cost of capital for the firm.
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Capital market loans offered to corporations are either equity loans or debt loans. An
equity loan is made when a corporation sells its stock to investors. The money the
corporation receives in return for its stock can be used for purchasing plants and
equipment, paying wages, funding R&D projects, etc. A share of stock gives the
holder a claim to the profit stream of the firm. Corporations honor the claim by paying
dividends to the stockholders. The dividend amount is not fixed in advance; rather, it
is determined by the management based on the profits made by the corporation.
Investors purchase stock for the dividends that they will yield and in anticipation of
gains in the stock price, which in theory reflects future dividend yields. Thus,
investors purchase equity in firms that do not currently issue dividends to stockholders
because they anticipate that the firm will do so at some point. Stock prices increase
when a corporation is projected to have higher earnings in the future, which increases
the probability that it will increase dividend payments in future.
A debt loan requires the corporation to repay a predetermined portion of the loan
amount at regular intervals regardless of how much profit the corporation is making.
Management has no discretion as to the amount it will pay its investors. Debt loans
include cash loans from banks and funds raised from the sale of corporate bonds to
investors. When a corporate bond is purchased by an investor, he/she purchases the
right to receive a specified fixed income stream from a corporation for a specific
number of years, i.e., until the bond matures.
3.2 Lowering Capital Costs

In a domestic capital market, the pool investors are limited to the country residents.
This places an upper limit on the funds supply available to borrowers i.e. the liquidity
of the market is limited. A global capital market, which has a larger pool of investors,
offers a larger supply of funds for borrowers to draw on.
Perhaps the most crucial drawback of the limited liquidity of a domestic capital
market is that the cost of capital tends to be higher than it is in an international market.
The cost of capital is the price of borrowing money, which is the rate of return that
borrowers must pay investors. This is the rate of interest on debt loans and the
dividend yield and expected capital gains on equity loans. The limited pool of
investors in a domestic market implies that borrowers should pay more in order to
persuade investors to lend them their money. The larger pool of investors in an
international market implies that borrowers will be able to pay less.
The greater pool of resources in the global capital market leads to greater liquidity.
Thus the global capital market lowers the cost of capital for borrowers.
3.3 Growth of the Global Capital Market

The global capital market is growing rapidly, increasing the opportunities for firms to
lower their capital costs by accessing the market.
The international capital market boomed in the 1980s due to advances in information
technology and governments deregulations through the world, especially the western
markets and the Far East. The financial services industry is information-intensive,
drawing on large volumes of information about markets, risks, interest rates, exchange
rates, credit worthiness, etc. This information is used by the financial services industry
to make decisions on what to invest where, how much the borrowers should be
charged, how much interest should be paid to the depositors, and the value and
riskiness of several financial assets including stocks, corporate bonds, currencies, and
government securities.
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The financial services industry is the most tightly regulated of all industries.
Governments worldwide have kept financial services firms of other countries from
entering the capital markets. In some cases, they have also restricted the overseas
expansion of their domestic financial services firms. In many countries, the domestic
financial services industry is segmented by law. For instance, in the US, commercial
banks were prohibited from performing the functions of investment banks and vice
versa. Historically, many countries have limited foreign investors ability to purchase
significant equity positions in domestic companies.
Many of these restrictions have been done away with since the early 1980s with a
series of changes that allowed foreign banks to enter the US capital market and
domestic banks to expand to expand their operations overseas.
3.4 Source of Financing

When a firm seeks external financing for a project, it will want to borrow funds from
the lowest-cost capital source available. Firms are increasingly moving toward the
global capital market to finance their investments. The cost of capital in the global
capital market is lower by virtue of its size and liquidity, than in domestic capital
markets, especially those that are small and relatively illiquid. For instance, a US firm
making an investment in Denmark may finance the investment by borrowing through
the London-based Eurobond market as opposed to the Danish capital market.
Despite the trends toward deregulation of financial services, in some cases, the
restrictions of the host countrys government may rule out this option. The
governments of some countries prefer foreign multinationals to finance projects in
their country by local sales of equity or local debt financing. In countries where there
is limited liquidity, this increases the cost of capital used for financing a project. Thus,
in capital budgeting decisions, the discount rate needs to be adjusted to reflect this.
However, some governments court foreign investment by providing foreign firms with
low-interest loans, thus lowering the capital cost. Accordingly, in capital budgeting
decisions, the discount rate should be revised downward in such cases.
In addition to the impact of host government policies on financing decisions and the
cost of capital, the firm may consider local debt financing for investments in countries
where the local currency is expected to depreciate on the foreign exchange market.
When a countrys currency depreciates, the amount of local currency needed to meet
interest payments and retire principal on local debt obligations is not affected.
However, if the foreign debt obligations have to be served, the amount of local
currency needed for doing this will increase as the currency depreciates, and this
effectively raises the cost of capital. Thus, though the initial capital costs may be
greater with local borrowing, it might be better to borrow locally in case the local
currency is expected to depreciate on the foreign exchange market.
3.5 Financial Structure

Different countries have a different financial structure for firms. Financial structure
refers to the mix of debt and equity used to finance a business. For instance,
Japanese firms rely more on debt financing than most US firms.
A possible explanation for why the financial structures of firms vary across countries
is that different tax regimes determine the relative attractiveness of equity and debt in
a country. However, empirical research shows that country differences in financial
structure are not related systematically to country differences in tax structure. Another
possibility is that the country differences may reflect cultural norms.
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International businesses should decide whether they should conform to local capital
structure norms. A significant advantage of conforming to debt norms of the hostcountry is that management can more easily evaluate its return on equity relative to local
competitors in the same industry. Conforming to host-country debt norms can also
enhance the image of foreign affiliates that operate with too little debt and thus appear
sensitive to local monetary policy. The best recommendation is that an international
business needs to adopt a financial structure for each foreign affiliate that minimizes its
cost of capital irrespective of whether that structure is consistent with local practice.
4. Global Money Management: The Efficiency Objective

Money management decisions make attempts to manage the global working capital in
the most efficient manner, especially the firms cash resources.. This involves
minimizing cash balances and reducing transaction costs.
4.1 Minimizing Cash Balances

A firm should hold certain cash balances for any given period. This is essential for
serving any accounts and notes payable during that period and as a contingency
against unexpected cash demands. The firm invests its cash reserves in money market
accounts in order to earn an interest on them. However, it should be able to withdraw
money easily and freely from those accounts. Such accounts offer low rates of
interest. In contrast, a firm can earn a higher interest rate if it invests its cash resources
in longer-term financial instruments. However, the problem with longer-term financial
instruments is that the firm cannot withdraw its money before the instruments mature
without bearing a financial penalty.
4.2 Reducing Transaction Costs

Transaction costs are the cost of exchange. Every time a firm changes cash from
one currency to another, it bears a transaction cost the commission fee it pays
foreign exchange dealers to perform the transaction. Most banks also charge a transfer
fee for moving cash from one location to another. This is another transaction cost.
5. Global Money Management: The Tax Objective

Different countries have different tax regimes. Many nations follow the worldwide
principle that they have the right to tax income earned outside their boundaries by
entities based in their country. When the income of a foreign subsidiary is taxed by
the host countrys government and by the parent companys home country, double
taxation occurs. Double taxation can be mitigated to some extent by tax credits, tax
treaties, and the deferral principle.
A tax credit allows an entity to reduce the taxes paid to the home government by the
amount of taxes paid to the foreign government. A tax treaty is an agreement
between two countries specifying what items of income will be taxed by the
authorities of the country where the income is earned. A deferral principle specifies
that parent companies are not taxed on foreign source income until they actually
receive a dividend.
For an international business with activities spread across many countries, the various
tax regimes and tax treaties have crucial implications for how the firm should
structure its internal payments system among the parent company and the foreign
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subsidiaries. Firms can use transfer prices and fronting loans to minimize their global
tax liability. In addition, the form in which income is remitted from a foreign
subsidiary to the parent company can be structured in order to minimize the global tax
liability of the firm.
Some firms use tax havens such as Bermuda and the Bahamas to minimize their tax
liability. A tax haven is a country with exceptionally low or even no income tax.
International businesses avoid or defer income taxes by setting up a wholly-owned
non-operating subsidiary in the tax haven. The tax haven subsidiary owns the common
stock of the operating foreign subsidiaries, which allows for transferring funds from
foreign subsidiaries to the parent company by funneling them through the tax haven
subsidiary. The tax levied on foreign source income by the home government of the
firm can be deferred under the deferral principle until the tax haven subsidiary pays
the dividend to the parent. This dividend payment can be indefinitely postponed if the
foreign subsidiaries continue to grow and require new internal financing from the tax
haven affiliate.
6. Moving Money Across Borders

Pursuing the objectives of utilizing the cash resources of a firm efficiently and
minimizing the global tax liability requires the firm to be able to transfer funds from
one location to another across the globe. International businesses use many techniques
to transfer liquid funds across borders. These include dividend remittances, royalty
payments and fees, transfer prices, and fronting loans. Some firms rely on more than
one of these techniques to transfer funds across borders a practice known as
unbundling. Unbundling helps international businesses to recover funds from their
foreign subsidiaries without piquing the sensitivities of the host-country with large
dividend drains.
A firms ability to select a particular policy is limited when a foreign subsidiary is
partly-owned either by a local joint venture or by local stakeholders.
6.1 Dividend Remittances

The most common method for transferring funds from foreign subsidiaries to the
parent company is by payment of dividends. The dividend policy differs in each
subsidiary depending on factors such as tax regulations, age of the subsidiary, extent
of local equity participation, and foreign exchange risk.
6.2 Royalty Payments and Fees

Royalties represent the remuneration paid to the owners of patents, trade names, or
technology for the right to manufacture/sell products under those patents or trade
names or use that technology. Parent companies charge their foreign subsidiaries
royalties for patents, trade names, or technology as they transfer them. Royalties may
be levied as a fixed monetary amount per unit of the product sold by the subsidiary or
a percentage of the gross revenues of the subsidiary.
A fee is compensation for expertise or professional services supplied by the parent
company or another subsidiary to a foreign subsidiary. Fees are differentiated into
technical fees for guidance in technical matters and management fees for advice
and general expertise. They are levied as fixed charges for the services provided.
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Royalties and fees have some tax advantages over dividends, particularly when the
corporate tax rate is higher in the host country than in the home country. Royalties and
fees are tax-deductible locally, so arranging for payments in royalties and fees reduces
the tax liability of the foreign subsidiary. If a foreign subsidiary provides the parent
company dividend payments as compensation, local income taxes need to be paid
before the dividend distribution, and withholding taxes should be paid on the dividend
itself. Though the parent company can offer a tax credit for the local withholding and
income taxes it has paid, a portion of the benefit would be lost is the combined tax
rate of the subsidiary is higher than that of the parent.
6.3 Transfer Prices

In any international business, a large number of goods and services are transferred
between the parent company and foreign subsidiaries and between subsidiaries. This
usually happens in firms pursuing global and transnational strategies because these
firms are likely to have dispersed their value creation activities to various locations
around the globe. The price at which goods and services are transferred between
entities within the firm is referred to as the transfer price.
Transfer prices can be used for positioning funds within an international business. For
instance, funds can be moved out of a country by setting high transfer prices for goods
and services that are supplied to a subsidiary in that country and by setting low
transfer prices for the goods and services sourced from that subsidiary. This
movement of funds takes place between the subsidiaries of the firm or between the
parent company and a subsidiary.
Benefits of Manipulating Transfer Prices
The benefits derived from manipulating transfer prices include the following:
1.
The firm can reduce its tax liabilities by making use of transfer prices for shifting
earnings from a high-tax country to a low-tax country.
2.
Firms use transfer prices for moving funds out of a country where significant
devaluation in currency is expected, thereby reducing its exposure to foreign
exchange risk.
3.
Firms use transfer prices for moving funds from a subsidiary to the parent
company when financial transfers in the form of dividends are blocked or
restricted by the polices of the host government.
4.
Firms can use transfer prices for reducing the import duties it has to pay when an
ad valorem tariff is in force tariff that is assessed as a percentage of value. In
such cases, low transfer prices on goods and services being imported into the
country are required. Since this lowers the value of the goods or services, it
lowers the tariff.
Problems of Transfer Pricing

Significant problems are associated with transfer pricing policies. When transfer
prices are used for reducing the tax liabilities or import duties of a firm, governments
feel that they are being cheated of their legitimate income. When transfer prices are
manipulated for circumventing government restrictions on capital flows, governments
perceive this as breaking the spirit of the law, if not the law itself. Many governments
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impose limits on the ability of international businesses to manipulate transfer prices.

The US has strict regulations governing transfer prices. According to Section 482 of
the Internal Revenue Code, the Internal Revenue Service (IRS) can reallocate gross
income, credits, deductions, or allowances between related corporations for
preventing tax evasion or for reflecting proper income allocation. According to IRS
guidelines, the correct transfer price is arms-length price the price that would
prevail between unrelated firms in a market setting.
Another problem associated with transfer pricing is that it is inconsistent with a policy
of treating each subsidiary in a firm as a profit center. When transfer prices are
manipulated and deviate significantly from the arms-length price, the performance of
the subsidiary depends a lot on transfer prices. A subsidiary told to charge a higher
transfer price on goods supplied to another subsidiary appear to do better than it
actually does while the subsidiary purchasing the goods appears to be doing worse.
Unless this is recognized during performance evaluation, serious distortions in
management incentives can occur.
Despite these problems, research indicates that all international businesses do not use
arms-length pricing; some use a cost-based system for transfer pricing among their
subunits.
6.4 Fronting Loans

A fronting loan is a loan between a parent and its subsidiary channeled through a
financial intermediary, usually a large multinational bank. In a direct intra-firm loan,
the parent company lends cash to the foreign subsidiary directly, and the subsidiary later
repays the loan. In a fronting loan, the parent company deposits funds in an international
bank, and the bank lends the same amount deposited to the foreign subsidiary. From the
banks viewpoint, the loan is free from risks as it has 100 percent collateral in the form
of a deposit of the parent company. The bank fronts for the parent, hence the name.
The bank profits by paying the parent company a lower interest rate on its deposit than it
charges the foreign subsidiary on the funds borrowed.
Fronting loans are used by firms for two reasons. First, these loans can circumvent
restrictions of the host-country on funds remittance from a foreign subsidiary to the
parent company. A host government may impose restrictions on a foreign subsidiary
regarding loan repayment to its parent for preventing the foreign exchange reserves of
a country, but it is less likely to restrict the ability of a subsidiary to repay a loan to a
large international bank. International businesses sometimes make use of fronting
loans when they want to lend funds to a subsidiary based in a country with a high
probability of political turmoil that may lead to capital flow restrictions. A fronting
loan also provides tax advantages.
7. Techniques for Global Money Management

Firms make use of two money management techniques for managing their global cash
resources efficiently centralized depositories and multilateral netting.
7.1 Centralized Depositories

Businesses need to hold some cash balances to service accounts that should be paid
and to insure against unanticipated negative variation from their projected cash flows.
The critical issue for an international business is whether each foreign subsidiary
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should hold its cash balances or whether cash balances should be held at a centralized
depository. Firms generally prefer to hold cash balances at a centralized depository for
three reasons. First, by centrally pooling the cash reserves, the firm can deposit larger
amounts. Usually cash balances are deposited in liquid accounts such as overnight
money market accounts. As interest rates on such deposits increase with the size of the
deposit, the firm should be able to earn a higher interest rate than it would if each
subsidiary managed its own cash balances.
Second, if the centralized depository is located in a major financial center such as
London, Tokyo, or New York, it should have access to information about good shortterm investment opportunities that are lacking in a typical foreign subsidiary. The
financial experts at the centralized depository must have the ability to develop
investment skills and know-how that are lacking in managers in a typical foreign
subsidiary. Hence, the firm would make better investment decisions if it pools its cash
reserves at a centralized depository.
Third, pooling cash reserves helps a firm in reducing the total size of the cash pool it
should hold in highly liquid accounts, which enables the firm to invest cash reserves
in large amounts in longer-term, less liquid financial instruments that earn a high rate
of interest.
The ability of a firm to set up a centralized depository that can serve short-term cash
needs may be limited by restrictions imposed by governments on flow of capital
across borders. The advantages of this system are also limited by transaction costs of
moving money into and out of different currencies. Despite this, many firms hold
precautionary cash reserves at the centralized depository, having each subsidiary hold
its own day-to-day-needs cash balance. The trends likely to increase the use of
centralized depositories are globalization of the world capital market and the general
removal of barriers for free cash flow across borders.
7.2 Multilateral Netting

Multilateral netting allows a multinational firm to reduce its cost of transaction that
arises when many transactions take place between its subsidiaries. These transaction
costs are the commissions paid to foreign exchange dealers for foreign exchange
transactions and the fees charged by banks for transferring cash between locations.
The volume of such transactions is high in firms that have a globally dispersed web of
independent value creation activities. Multilateral netting reduces the costs of
transaction by reducing the number of transactions.
Multilateral netting is an extension of bilateral netting. Under bilateral netting, if a
French subsidiary owes US$ 6 million to a Mexican subsidiary, for instance, and the
Mexican subsidiary owes US$ 4 million to the French subsidiary, a bilateral
settlement will be made with a single payment of US$ 2 million from the French
subsidiary to the Mexican subsidiary cancelling the remaining debt.
Under multilateral netting, the transactions take place between multiple subsidiaries
within an international business. Consider a firm establishing multilateral netting
among four Asian subsidiaries based in China, Taiwan, South Korea, and Japan.
These subsidiaries trade with each other and at the end of the month a large
transaction volume needs to be settled. If US$ 43,000 is required to flow among the
subsidiaries, the amount can be reduced by multilateral netting. The firm can
determine the payments to be made among its subsidiaries for settling these
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obligations. Multilateral netting reduces the transactions to just three; the Korean
subsidiary pays US3 million to the subsidiary in Taiwan; and the Chinese subsidiary
pays US$ 1 million to the Japanese subsidiary and US$ 1 million to the Taiwanese
subsidiary. The total funds are reduced to just US$ 5 million from US$ 43 million,
and the transaction costs are reduced to US$ 50,000, a savings of US$ 380,000 is
achieved through multilateral netting.
8. Summary
A decision to make investments in activities in any country should consider many
political, economic, cultural, and strategic variables.
An international business should take into consideration some factors when
considering its options for financing. The first factor is how the foreign
investment will be financed. The second factor is how to configure the financial
structure of the foreign affiliate.
Money management decisions make attempts to manage the global working
capital in the most efficient manner, especially the firms cash resources.. This
involves minimizing cash balances and reducing transaction costs.
Different countries have different tax regimes. Many nations follow the
worldwide principle that they have the right to tax income earned outside their
boundaries by entities based in their country.
International businesses use many techniques to transfer liquid funds across
borders. These include dividend remittances, royalty payments and fees, transfer
prices, and fronting loans.
Firms make use of two money management techniques for managing their global
cash resources efficiently centralized depositories and multilateral netting.
Example: Expropriation of Assets at Black Sea Energy Ltd.

In 1996, Canada-based Black Sea Energy Ltd. (Black Sea) formed a 50:50 joint
venture (JV) with Russias largest integrated oil company, Tyumen Oil Company
(Tyumen). The JV, called Tura Petroleum Company (Tura) was set up with the
stated aim of exploring the Tura oil field in Siberia. As Tyumen was 90 percent
owned by the Russian government, Black Sea had to negotiate directly with the
Russian government representatives when the JV was established.
Under the agreement, both the companies had to contribute over US$ 40 million
Black Sea in the form of cash, technology, and expertise and Tyumen in the form
of infrastructure and licenses for exploration and production of oil in the region.
The venture was successful from the operational perspective. After Black Sea made
cash injections, the Tura field went from 4,000 barrels a day to nearly 12,000.
However, Black Sea could not capture any of the economic profits coming from
this investment.
In 1997, the Moscow-based Alfa Group purchased a controlling stake from the
government of Russia in Tyumen. The new owners of Tyumen concluded that the
Tura JV was unfair to them and so wanted to cancel the agreement. The argument
was that the asset value contributed by Tyumen was in excess of US$ 40 million while
Contd
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Contd
while the value of technology and expertise contributed by Black Sea was
significantly less than US$ 40 million. The new owners also found that the licenses
were owned by Tyumen and therefore Black Sea had no right to the resulting oil
production. The issue was taken to court by Tyumen who subsequently won.
Consequently, Black Sea had to back out from the deal. According to Black Sea, by
legal maneuvering, Tyumen had expropriated Black Seas investment in the Tura
JV. The Tyumen management, however, maintained that the company had behaved
in a legal manner.
Example: Deutsche Telkom tapping the Global Capital Market

Deutsche Telekom (Deutsche), one of the largest telephone companies in the world,
was wholly-owned by the German government until 1996. In the mid-1990s, the
German government privatized the utility. Privatization was driven by two factors
(1) realization that state-owned enterprises tend to be inefficient and (2) the
impending deregulation of the European Union telecom industry in 1998, which
promised to expose Deutsche to foreign competition.
Deutsche realized that in order to become more competitive, it needed substantial
investments in new telecommunication infrastructure, including wireless and fiber
optic. As financing these investments from state sources was almost impossible in
the 1990s when the German government was limiting its budget for meeting the
membership criteria in the European monetary union, Deutsche planned to sell its
shares to the public in a bid to finance its investment in capital equipment.
In 1996, Deutsche was valued at US$ 60 billion. Analysts opined that if the
company maintained this valuation, it would dwarf other companies listed on the
German stock market. However, some analysts doubted if there was anything close
to US$ 60 billion available in Germany for investment in Deutsche. A major
problem was that there was no tradition of retail stock investing in Germany.
Another problem was that a wave of privatization had already started in Germany
and the rest of Europe. Hence, Deutsche had to compete with many other stateowned enterprises to attract investors attention.
The managers at the company opined that Deutsche had to privatize the company in
stages and sell a substantial portion of the company to foreign investors. The
company also planned an initial public offering (IPO). Besides, the managers listed
the companys shares in Frankfurt, Tokyo, London, and New York. In 1996, the
company successfully executed its IPO, raising US$ 13.3 billion in the process.
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Concept Note - 11
Global Internet and E-Commerce

1. Introduction
Firms in international markets use the Internet and e-commerce as a supplementary
tool in their global sales and service. The different transactions in e-commerce such as
Business-to-Business, Business-to-Consumer, and Consumer-to-Consumer have
spurred the growth of global e-commerce.
E-readiness offers guidance in terms of the future growth of e-commerce in any region
or country. Cross-border e-commerce opens new opportunities for small and medium
international enterprises (SMIEs). As in other international business realms,
international e-commerce requires a balance between globalization and localization.
This unit defines the Internet and e-Commerce. It then goes on to explain the factors
of e-readiness. It discusses the impact of e-commerce on international business. The
unit finally discusses the challenges faced by global e-commerce.
2. Internet and E-Commerce

The Internet is the worldwide network of computer networks known as the World
Wide Web (WWW). WWW comprises all the resources and users on the Internet
that use Hypertext Transfer Protocol (HTTP). HTTP uses a set of rules to exchange
files such as text, video, sound, graphic images, and other multimedia files on the
WWW.
Electronic commerce (E-commerce) is the conduct of transactions to buy, sell,
distribute, or deliver goods and services over the Internet. E-commerce transactions
can be business-to-business (B2B), Business-to-Customer (B2C), or Customer-toCustomer (C2C). B2B involves inter-firm transactions, including government
procurement. B2C transactions are between firms and individuals buying goods or
services over the Internet. Ordering a book online is an instance of a B2C transaction.
C2C transactions involve individual transactions via online auctions. All the three
transactions occur domestically as well as globally.
Global e-commerce is the conduct of electronic commerce, whether B2B, B2C, or
C2C across national boundaries. A customer in the US buying pharmaceuticals from
a Canadian site is an example of Global e-commerce.
E-commerce has been the fastest growing segment of the Internet economy. Leading
industry observers suggest that B2B transactions will be a major driver for the growth
of e-commerce.
3. E-Readiness
McConnell International has developed a classification of e-readiness factors that
includes connectivity, e-leadership, information security, human capital, and ebusiness climate.
3.1 Connectivity
Connectivity is the existence and affordability of a transportation and communication
network. The US is less competitive when it comes to telephone systems. In China,
Israel, Japan, and Germany, all phones are connected to digital exchanges as against
about 90 percent in the US.
The cost of Internet access is prohibitive in countries such as most of those in Latin
America. In the UK, the low cost of a dial-up connection has much to do with the
remarkable increase in Internet usage.
Another facet of connectivity is distribution. The wide variety of overnight and
ground delivery services in the US are either unavailable or very expensive in many
parts of the world. In developing countries such as China, conventional ground
distribution is also problematic outside a few urban areas. Products are delivered by
bicycles or by pedicarts. The cash is collected upon the product being delivered.
3.2 Information Security

Information security refers to the existence of security and other protections
pertaining to information dissemination. The single most important obstacle to online
shopping is concerns related to security. Confidentiality is a product of the
availability of secure servers as well as transcription technologies. All governments
do not help in fixing security concerns. To ensure support from the government,
Chinese regulations forbid using foreign-designed encryption software. The Chinese
government assigns domain registration names in the Chinese language exclusively to
domestic firms though this acts as a barrier to foreign entrants and also as a security
measure.
3.3 Privacy Protection

Most potential customers are reluctant to provide information and buy online out of
fear that their information may be given to other vendors, or may be inappropriately
used. These concerns can be alleviated with the help of privacy laws. However, these
laws may limit the information flow and the effective consumer targeting that is likely
to enhance the volume of online transactions.
European laws give more protection to Internet users than US laws. European laws are
based on safe harbor principles that require a firm to seek explicit agreement before
transferring potential data to another firm. Also the data subject gets reasonable access
to personal data for reviewing and correcting it. Data collection is permitted when the
subject has given his/her consent, the data is needed to complete a contract such as
billing, it is needed by law or for protecting the subjects vital interests, or it is needed
for the purpose of enforcement of laws.
In 2000, the US data privacy protection was termed inadequate by the European
Parliament. Under a tentative agreement negotiated by the US Department of
Commerce, US firms can (1) subject themselves to the data protection authority in one
the nations in the European Union (EU); (2) show that they are subject to similar US
privacy laws; (3) sign up with a self-regulatory organization which offers adequate
privacy protection; or (4) agree to refer privacy disputes to the European panel of
regulators.
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3.4 E-Business Climate

An e-business climate comprises the regulatory and institutional frameworks
facilitating or hindering e-commerce. The usage of credit cards is critical in ecommerce. Credit card usage is low in developing nations such as China and also in
many developed nations. In some countries such as Japan, the fee charged for credit
card processing is extremely high, while in some other nations, it has the lowest cost
of transaction of any payment system.
3.5 National E-Readiness

E-commerce readiness is an index comprised of the three aforementioned criteria of
connectivity, information security, and e-business climate, plus e-leadership (the
extent of which e-commerce is a national priority) and human capital (the availability
of human resources to support e-commerce. Wide variations exist between nations.
For instance, Taiwan and South Korea are among the most prepared economies,
though Asian economies are generally hampered by problems related to data security.
Buoyed by the availability of widespread and inexpensive Internet access, South
Korea also enjoys strong support from the government in realms such as the
acceptance of electronic signatures.
4. The Impact of E-Commerce on International Business

The Forrester report suggests, The Internet removes barriers to communication with
customers and employees created by geography, time zones, and location, creating a
frictionless business environment. For this to happen, barriers need to be removed
on both sides of the border. For instance, an EU ruling that says that customers can
sue non-EU retailers in their national courts can put a constraint on the e-commerce
evolution there.
4.1 Prospects for Large MNEs

For the larger multinational enterprises (MNE), the Internet and e-commerce create an
opportunity that allows for quicker global products dissemination. However, they also
facilitate rapid imitation on the part of competitors. Theoretically, the Internet creates
pressure toward price parity that poses a problem for the MNE with different
distributors that price products differently in diverse markets. However, there is some
evidence that the Internet may encourage collusion. For instance, in Germany, Philips
and Sony faced some legal problems when trying to stop the online sales of Primus
Online by offering less expensive products.
The motivation to locate activities internationally may change under the Internet and
e-commerce. Zaheer and Manrakhan noted potential vital impacts such as a reduction
in transaction costs and improvement of coordination and monitoring by the MNE,
and the ability to export human skills.
4.2 Prospects for SMIEs

The reduction in barriers should open the doors for small and medium international
enterprises (SMIEs), especially those from developed countries that have been kept
out of international trade and investment. For such firms, the transaction costs should
be lowered and their international competitiveness too should be improved. Many
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SMIEs have taken advantage of the new opportunities. Latinexus is a Latin American
electronic marketplace that aims to offer an even playing field for SMIEs by providing
them with the same cost benefits and broad audiences available to blue chip firms.
Some SMIEs piggyback on intermediaries such as L L Bean and Amazon in order to
reach international customers.
However, where physical goods are concerned, barriers in the form of logistic
challenges in dealing with dispersed and multiple customers remain significant for the
smaller firm. Size and volume matter even more in an e-commerce operation. The
handling of a large and diverse number of customers might lie beyond the ability of
many SMIEs that lack managerial and strategic capabilities.
4.3 Prospects for Intermediaries

Initially, it was believed that the Internet would make intermediaries superfluous,
however the impact diverged. The number of intermediaries has been reduced for
digitalized products as well as services such as retail, brokerage, and auctions.
However; intermediaries have remained rooted in other areas. A new breed of valueadding intermediaries have emerged which are no longer involved in the physical
distribution of goods, but are very much present in the coalition, collection,
interpretation, and dissemination of vast amounts of information.
4.4 Other Impacts

The impact of e-commerce extends to other realms as well. For instance, it has made it
difficult to determine the origin of a product or a service, with concomitant
implications for tariffs, taxation, and customers. This is because the manufacturer, the
server, and the physical distributor may be located in different countries. E-commerce
should speed up the mobility of people as a production factor. Jobs in customer
service and back-office may shift to lower-cost countries, particularly where language
is not an obstacle (e.g. from the US to Ireland, India, and Canada).
5. Challenges for Global E-Commerce

Entering global e-commerce is not easy. Dominant Internet portals such as AOL
reveal that penetrating the UK, Germany, and other European markets is difficult. As
in other realms of international business, finding the right balance between
globalization and localization has proven to be complex.
5.1 Standardization Forces

Consumers from other nations mostly use US sites. Canadians reportedly do most of
their online shopping on US sites. Latin Americans prefer using US e-commerce sites
to the ones developed in their own countries because of convenience, lower prices,
and, above all, trust.
At times, standardization appears to be appealing. The position of English as a lingua
franca has been strengthened considerably on the Internet, supported by the
dominance of English as a second language and by the dominance of US-hosted
websites. However, there are predictions that other languages, mainly Chinese, will
soon take over as the most popular language on the Internet.
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5.2 Localization Challenges

The risks of overlooking customization can be substantial. Many US firms have
underestimated the customization they would require in e-trading with foreign
markets, whether tangible (currencies, tariffs, tax) or intangible (buying habits,
culture).
Web Site Localization
Many companies trading on the Internet had to suffer when they did not adopt
localization strategies while doing business in a foreign market. For instance, online
auction site e-Bay had to withdraw from the lucrative Japanese e-commerce market as
it took missteps such as emphasizing collectibles as opposed to new goods, believing
that the Japanese market would mirror the development of its US site. It did not.
Cultural faux pas are numerous. A British consulting firm, for instance, used
snapshots of colorful candy to symbolize miscellaneous. While this was widely
recognized in England, it was not in the US, where a small yellow folder icon is
commonly used. Language blunders are also common. In the US, for example,
Getgift.com makes sense but its Swedish translation is go get poison for goats.
A key response to localization pressures has been to set up local websites. MNEs have
to set up their local premises in foreign countries in order to have a local presence. For
example, Reebok and UPS offer their services around the globe. A research study
suggests that MNEs localizing their websites had higher media visibility, wider global
reach, higher revenues, and more alliances.
The need for customization goes beyond language. It should also include local
content, design, and cultural awareness. Some vendors such as the Swedish furniture
maker Ikea have localized their websites. Ikeas German site is traditional, its Italian
site is stylish, and the Saudi Arabian site shows a reassuring family shopping scene. A
number of start-up firms help SMIEs in customizing their Internet ware. For instance,
Thinkamerican.com assists small apparel brands in the US to sell in Japan. The
company does language translation, in addition to translating sites into Japanese while
keeping a watch for cultural errors.
Logistics
Logistics is a key area where many firms have failed to make the adjustments
necessary in terms of global e-commerce or in terms of customizing the system for
dealing with the requirements of a particular country.
5.3 Taxation Issues

The Supreme Court in the US ruled that states do not require an out-of-state firm to
collect sales tax on goods coming into the state unless the (?) firm has a nexus or
physical presence within the state. Some states suggested that local Internet service
providers should be considered as electronic retailers and be subject to local taxation.
In the international arena, the implications of e-commerce taxation are more ominous.
While cross-border catalog sales have existed for many years, they have not generated
ay substantial interest among governments. All this has changed with the advent of ecommerce. In the EU, value-added taxes range from 15 to 25 percent, which means
(?) a major portion of government revenues are at risk. A website is not considered as
a fixed business place that could trigger taxation. It could be subject to taxation if it is
in conjunction with a server location and other operations in the country. E-commerce
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makes it easy for MNEs to shift their domicile to low-tax locations and to offshore tax
havens as it makes it difficult for other countries to claim the physical presence of the
firm in their territory. In such an environment, problems such as transfer pricing
become acute.
Other taxation issues also arise because of the Internet. For instance, the distinction
between income and royalty taxation is difficult to determine when a customer
downloads software from a vendor. Individual income tax might be avoided in
countries which have a territorial tax base, whereas countries with a global taxation
base, such as the US, might find it difficult to enforce their tax legislation.
The e-commerce tax represents a significant challenge for the MNE as well as the
SMIE. The MNEs can employ various tax strategies to meet this challenge. Additional
strategic opportunities such as placing servers in areas of low-tax jurisdiction are
provided by global e-commerce. It also creates some additional risks. For instance,
most of the tax treaties do not refer to e-commerce activities, and they may be open to
challenge.
6. Summary
The Internet is the worldwide network of computer networks known as the
World Wide Web (WWW). Electronic commerce (E-commerce) is the conduct
of transactions to buy, sell, distribute, or deliver goods and services over the
Internet.
McConnell International has developed a classification of e-readiness factors that
includes connectivity, e-leadership, information security, human capital, and ebusiness climate.
For the larger multinational enterprise (MNE), the Internet and e-commerce
create an opportunity that allows for quicker global products dissemination but
they also facilitate rapid imitation on the part of competitors.
The reduction in barriers should open the doors for small and medium
international enterprises (SMIEs), especially those from developed countries that
have been kept off from international trade and investment.
MNEs should set up their local premises in foreign countries in order to have a
local presence.
Example: Alibaba Dominating the E-Commerce Market in China

Alibaba.com Corporation (Alibaba), Chinas leading e-commerce company, has
several Internet businesses focused on various e-commerce business models such
as Business-to-Business (B2B), Consumer-to-Consumer (C2C), and Business-toConsumer (B2C).
Alibabas business portfolio includes Alibaba China, a website in the Chinese
language serving domestic B2B trade in China, Alibaba International
(www.alibaba.com), an English website which connects a number of Chinese
SMEs with a number of businesses worldwide, and Taobao (www.taobao.com
Chinas most popular C2C trading site.
Contd
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Contd
B2B Market
In 1999, Alibaba was launched when the Chinese Internet industry was in its
infancy. In order to gain a strong foothold in the B2B market, Ma announced that it
would not charge any transaction fees initially. Considering the growth potential of
the budding e-commerce market, other players like Global Sources and MeetChina
were launched in 1999. These players were expected to intensify competition in the
emerging B2B market. Global Sources had an advantage over Alibaba because of
its search technology and detailed information about the products listed on its site.
There was also the threat of many new players entering this space. Despite several
attempts made by Alibabas competitors to carve out a place for themselves in the
rapidly growing B2B market, they failed to make a mark, largely because of
Alibabas dominance in that market. On the other hand, Alibaba continued to enjoy
phenomenal growth.
C2C and B2C Market
Alibabas increasing popularity and the burgeoning Chinese e-commerce market
attracted several foreign competitors to China. In 2002, US-based eBay Inc. (eBay)
entered China by acquiring a 33 percent equity stake in the Shanghai-based ecommerce website EachNet.com (EachNet). eBay launched its Chinese site based
on its business model in the US. By 2002, it had emerged as one of the leading
online auction sites in China with 3.5 million registered users. By 2003, eBay had
cornered a 79 percent market share in the Chinese online auction market.
eBays success in China and the good prospects offered by the budding ecommerce market spurred Ma on to team up with Masayoshi Son (Son), founder
and CEO of SoftBank Corporation, to start a rival website to compete with eBay.
Ma raised funds of up to US$ 56 million from Softbank. Mas decision to team up
with Son was due to Sons experience in defeating eBay in Japan by collaborating
with Yahoo! Japan. Subsequently, eBay had to move out of Japan in 2002. Ma, in
association with his experienced employees, drafted a plan to launch a consumer
auction website in his apartment in Hangzhou. Finally, they came up with the idea
of launching Taobao, which means digging for treasure.
In May 2003, Ma launched Taobao as a wholly-owned subsidiary of Alibaba. Taobao
aimed to create an online trading platform for both B2C and C2C models. Taobao
differentiated itself from rival eBay by allowing free listings on its website. eBay
charged for listings on its website so as to ensure quality. According to Ma, a loyal
customer base had to be built before Taobao could start charging for its services.
Analysts were uncertain about Taobaos success since the C2C market was still in its
infancy in China. On the other hand, Ma was confident and cited the fact that EachNet
had only five million users among the 82 million-odd Internet users in China.
To gain a strong foothold in the Chinese e-commerce market and combat
competition from Taobao, eBay bought the remaining equity stake in EachNet for
US$ 150 million in July 2003. The website was called eBay EachNet. Yibo Shao,
one of the founders of EachNet who remained with eBay, believed that there could
only be one big consumer auction site in China and predicted that eBay would win
Contd
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Contd
the race against Taobao. Soon after, Ma announced his plans to invest another US$
12 million in Taobao. He said it would be unwise to wait until the market matured
and hinted at using the money on building infrastructure, recruitment, and an online
credit system for the customers.
Analysts said growth in the Chinese e-commerce market was hampered by the
absence of the trust factor between buyers and sellers while trading online. Buyers
refused to send money to sellers before they had received the goods while sellers
were unwilling to ship the goods until they had received payment. To counter this
problem, Alibaba launched an online payment platform called AliPay based on
the lines of eBays payment system, Paypal, in 2004. AliPay was an escrow-based
payment solution which allowed customers to safely and quickly send and receive
money online. Once a deal had been finalized, the buyer paid the money through
AliPay. The money was held in an AliPay account and was sent to the seller only
after the buyer intimated AliPay about the receipt of the product. Alibaba partnered
with a number of Chinese banks such as China Merchants Bank, Agricultural Bank
of China, etc. to provide AliPay services.
Alibaba devised an aggressive promotional strategy for Taobao which would
enable it to compete with eBay EachNet. Taobao advertised itself online by placing
ads on websites and through billboards in major city centers. All these promotional
strategies were ignored by eBay EachNet. By the fourth quarter of 2004, Taobaos
market share had jumped to 41 percent while eBay EachNets had declined to 53
percent. While eBay EachNet had about 10 million users, Taobao quickly gained
four million users in 2004. Further, Taobaos easy-to-use features on the website
attracted a number of users and resulted in users shifting to Taobao. Taobao
provided additional features like e-mail and chat facilities to users on its site. It also
allowed the buyers to call the sellers before buying a product while eBay EachNet
concealed the sellers identity until the end of the auction and allowed
communication only through offline messages that could be left on the site.
Another reason cited for users shifting to Taobao was the difficulty they faced
while using the new eBay website that was created after it fully acquired EachNet.
The number of product listings decreased from 780,000 to 250,000 after the
website was changed. Further, the lack of a secure online payment system like
AliPay hindered eBay EachNets growth.
In 2005, eBay EachNets market share slipped further to 29.1 percent compared to
Taobaos 67.3 percent. Taobao was ahead of eBay EachNet on various counts.
In October 2005, Ma announced a new strategy to phase out eBay EachNet from
China the services at Taobao would be offered free of charge for three
consecutive years.
In May 2006, Ma announced his plans to launch B2C services on Taobao. By then,
Taobao had already begun to outshine eBay EachNet by gaining more than 20
million users. According to Ma, the B2C services were launched with the aim of
removing the middleman concept by directly connecting large sellers with
consumers. For this, Taobao had already tied up with companies such as Motorola,
the Haier Group, Nokia Corporation, Adidas Group, etc., and was aggressively
planning to expand its product offerings. Analysts opined that a large number of
Alibabas 10 million members would join Taobao.
Contd
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Contd
Sensing the need for the support of a local company to control its declining market
share, eBay EachNet entered into a joint venture (JV) with TOM Online Inc. (TOM
Online) to form TOM eBay in December 2006. Subsequently, the company also
stopped charging its sellers listing fees and decided that free was a business model.
Despite all these efforts, TOM eBay continued to lose market share.
Industry observers opined that Alibaba and Taobao have been much more
successful in China than their competitors because they were able to cater
specifically to the China market.
Example: Facebooks Data Privacy Controversies

Facebook was launched in 2004 by Mark Zuckerberg (Zuckerberg) as a social
networking website for students of Harvard University. In the initial years of
operation, it allowed members only from educational institutions. In 2006, anyone
with a registered email address could post a profile on the website. Within three
years, Facebook went on to become the largest social networking website in terms
of number of users.
Since 2006, Facebooks different features and applications raised a controversy
relating to privacy. On September 5, 2006, two new features were introduced
News Feed and Mini Feed. News Feed appeared on the members home page and
showed new photos posted by friends, any recent changes in his/her friends
Facebook pages, and information about new friends joining groups, etc. After the
introduction of the News Feed, members did not require to individually check all
friends Facebook profiles to know the new happenings in their life. Mini Feed
appeared on the members profile page and showed recent information about the
member. The News Feed and Mini Feed were criticized by some members who
said that these features were attacks on their privacy. Some members created
groups to protest against the new features. However, Facebook maintained that
people could view a members profile only when the member allowed other people
to see it.
Faced with increasing protests from members against News Feed and Mini feed,
Zuckerberg issued an open letter of apology to the members of Facebook and
announced the addition of new privacy settings to control information in News
Feed and Mini Feed.
In September 2007, a public facing search function, which allowed any person
who had not even registered with Facebook to search for a member of Facebook,
was added to the website. The new feature also allowed any person to search for
Facebook members using search engines like Google. However, if anyone wanted
to add a friend or to send messages, the person would have to register with
Facebook. Facebook gave its members one months time to change their privacy
settings, so as to control what information they would want to share with people
who were not registered members of Facebook.
Contd
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Contd
In November 2007, a new advertising system, Beacon, was introduced on

Facebook. With the introduction of Beacon, members activities on 40 partner
websites could be viewed by their friends on Facebook. Beacon too fuelled
controversy, as Facebook users termed it an invasion of their privacy. An activist
group, MoveOn.org, started a paid ad campaign, protest group on Facebook and
an online petition, against Facebooks Beacon advertising.
Faced with severe protests against Beacon, Facebook Inc. introduced an option on
November 29, 2007, by which Facebook members could decline to take part in the
new advertising system. Before publishing any information about a members
activity on Facebooks page, the partner website would send some information to
Facebook so that Facebook could send a notification to the member. If the member
selected the No, Thanks icon in response to that notification, the information
would not be published in Facebook. However, if the member clicked on Close or
ignored the notification, then the information would be sent to Facebook. But
before publishing the information, Facebook would send another message to the
member reminding him that the information had been sent to Facebook. If the
member clicked Remove then the information would not appear on the Facebook
page. If the member again ignored the message, then the information would remain
with Facebook, but the information would not be published on the Facebook page.
Whenever the member got a notification of new information published, the
previous ignored notification would also appear along with the new notification.
On February 4, 2009, Facebook revised the websites privacy policy, mentioned as
Terms of Use. In the earlier Terms of Use policy of the website, it was clearly
mentioned that Facebook could not use members information after they had
removed their content from the website or discontinued their accounts. However, in
the revised policy, this statement was not made. The new privacy policy invoked
protests from several members of the Facebook. According to them, the new policy
allowed Facebook to control users information even after they had discontinued
their accounts with the social networking site.
On February 17, 2009, Facebook posted a Terms of Use update on all its
members home pages. The Terms of Use mentioned that Facebook Inc. would
not revise its privacy policy.
On February 26, 2009, Facebook Inc. announced a proposed Statement of Rights
and Responsibilities, which was termed Terms and Service, for governing
Facebook. The company also announced that the Statement would be applicable
for privacy and data ownership issues and not for its product. In the Statement,
Facebook clearly mentioned that it did not claim ownership of users content.
On March 4, 2009, Facebooks redesigned home page was launched. In the new
home page, users could filter their inbox for unread messages. They could filter
news feeds based on friend groups and families. The news feed could also be
filtered by applications like photos, videos etc. Users could also designate
unwanted messages as spam.
Analysts pointed out that one of the main challenges before Facebook would be
complying with new regulations on privacy set up by different countries.
Contd
202
Contd
On July 1, 2009, Facebook announced that it would test a new way of adjusting the
privacy settings of its users. With the new settings, members of Facebook could
select with whom they wanted to share all the information they had posted on their
Facebook profile. Members could select any person even if they were not members
of Facebook. Members could also change the privacy settings for specific content
they posted on their Facebook profile, so that the content could be seen only by
some selected people.
The company also made it clear that all the new privacy settings would appear on
the same page so as to avoid confusion. It insisted that there would not be any
overlapping in the options and the options would be standardized so that they
would remain the same each time a user went through the page. Industry experts
opined that with the proposed change in privacy settings, Facebook had addressed
the privacy concerns of many users.
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Appendix - 6
Implementation and Control in International Business

Introduction
As firms evolve from purely domestic to multinational, their control systems have to
change to reflect new strategies. The type and degree of control exercised from
headquarters maximizes the effort in an organization.
This unit discusses how firms implement and control their international operations in
international business.
Implementation of International Operations

Though organization structures provide frameworks for decision making, they neither
indicate where the authority of decision making and control rests within an
organization nor reveal the level of coordination between units.
The Locus of Decision Making

If the subsidiaries have a high degree of autonomy, the system is called decentralized.
In such systems, the controls are simple and loose, and each subsidiary operates as a
profit center. On the other hand, if the subsidiaries have tight controls and strategic
decision making is concentrated at headquarters, the system is called centralized.
Typically, firms are neither completely centralized nor decentralized. For instance,
some functions of the firm such as finance require centralized decision making while
others such as promoting a product require decentralized decision making. Research
and development (R&D) in organizations is usually centralized. Sometimes due to
pressure from the government, some firms add the R&D function on a regional or
local basis. However, in many instances, the variations are product and market based.
For instance, Corning Incorporateds TV tube marketing strategy requires local
decision making for service and delivery and global decision making for pricing.
The key advantage of allowing maximum flexibility at the country-market level is that
since the subsidiary management is aware of its market, it can rapidly react to the
changes. Problems associated with acceptance and motivation are avoidable when
decision makers are also responsible for implementation of strategy. However, many
multinationals facing global competitive threats and opportunities adopt global
strategy formulation, which needs a high degree of centralization. As a result, what
emerges can be called coordinated decentralization, which means that the
headquarters provide the overall corporate strategy while the subsidiaries are free to
implement it within the range agreed on during consultations between the
headquarters and the subsidiaries.
Firms moving in this mode may face significant challenges. Some of the difficulties
could be lack of widespread commitment to dismantling traditional national
structures, driven by poor understanding of the global forces at work. Barriers to
power from perceived threats to the personal roles of national managers may
challenge the proposals without any valid reasons. Finally, some organizational
initiatives such as corporate chat rooms or multicultural teams may be jeopardized by
the fact that people may lack the necessary skills (e.g. language) or an infrastructure
(e.g. intranet) may not exist in a suitable format.
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Factors Affecting Decision Making

The locus of decision making in a multinational enterprise (MNE) can be determined
by several factors such as its degree of involvement in international operations, the
product marketed by the firm, the size and importance of the firms market, and the
human resource capability of the firm.
Low degrees of involvement give high degrees of autonomy to the subsidiaries as long
as they meet their profit targets.
The country of origin of a firm and the political history of the area can influence
decision making.
The variety and type of products marketed affect organizational decisions. Typically,
companies marketing consumer products have product organizations with a high
degree of decentralization, allowing for maximum local flexibility. However,
companies marketing technologically sophisticated products such as General Electric
which markets turbines have centralized organizations with product responsibilities
worldwide.
Firms going global need to transfer world headquarters of vital business units abroad.
For instance, Philips moved the headquarters of several of its global business units to
the US.
In any organization, the human factor is critical. Managers at the headquarters and at
the country organizations should bridge the physical and cultural distances separating
them. If country organizations have managers who are competent and do not require
to consult headquarters to deal with their challenges, they may be granted a high
degree of autonomy. In case of global organizations, local management needs to
understand overall corporate goals in that decisions that meet the long-term objectives
might not be favorable for the individual local market.
The Networked Global Organization

Firms that adopt the networked global organization incorporate three dimensions into
their organizations: (1) developing and communicating a clear corporate vision; (2)
the effective management of human resource tools for broadening individual
perspectives and developing identification with corporate goals; and (3) integrating
individual thinking and activities into the broad corporate agenda. The first dimension
relates to an obvious and consistent long-term corporate mission that guides
individuals working anywhere in an organization. Johnson & Johnsons corporate
credo is an example of this. The second dimension relates both to the development of
global managers who have the ability to identify opportunities in spite of
environmental challenges as well as creating a global perspective among country
managers. The third dimension relates to the development of a cooperative mindset
among country organizations for ensuring effective implementation of global
strategies. Managers might believe that global strategies intrude on their operations if
they lack an understanding of the corporate vision, if they have not made their
contribution to the global corporate agenda, or if they have not been assigned direct
responsibility for its implementation. Territorial, defensive attitudes can lead to the
emergence of the not-invented-here syndrome, that is, country organizations
objecting or rejecting a sound strategy.
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The network avoids problems such as duplication of effort, inefficiency, and

resistance to ideas developed somewhere else. Headquarters considers each unit as a
source of ideas, capabilities, skills, and knowledge that can be used for the benefit of
the entire organization. This means that subsidiaries should be upgraded from
adaptors and implementers to contributors and partners in the development and
execution of worldwide strategies. R&D units should be converted into centers of
excellence and leading subsidiary groups should be given the leadership role in order
to develop new strategies for the entire organization.
Promoting Internal Cooperation

The global business entity can achieve success only if it moves intellectual capital
within the organization. One of the tools is teaching. For instance, at General Electric,
the top leadership spends considerable time at training centers interacting with
employees at all levels of the organization. In each training class, the participants are
given a real, current company problem to solve and the reports make or break the
careers of employees. Participants in teaching situations are encouraged to maintain
the international networks developed by them during the session.
Another method to promote internal cooperation for global strategy implementation is
to use international teams or councils. In case of a new process or a product, an
international team of managers may be assembled for developing strategy. Some firms
also make use of councils to share best practices e.g. an idea that may have saved time
or money, or a process that is more efficient than existing processes. Most of the
professionals at leading global companies will be members of multiple councils.
While technology has made such teamwork possible, human relations are still
paramount. Team members can be bound to a particular task only through trust and
face-to-face meetings.
The term network also implies two-way communications between headquarters and
subsidiaries and between subsidiaries themselves. While communication can be in the
form of newsletters or regular or periodic meetings, new technologies are able to link
far-flung entities and are eliminating the barriers related to time and distance. Intranets
integrate the information assets of a company into a single accessible system using
Internet-based technologies such as e-mail, World Wide Web, and news groups. Some
companies also establish virtual teams. For instance, Levi Strauss & Co. can join an
electronic discussion group with colleagues around the globe. The benefits of the
intranet are: (1) increased productivity as there is no time lag between an idea and the
information needed to evaluate and implement that idea; (2) enhanced knowledge
capital; (3) facilitation of teamwork; and (4) incorporation of best practices that enable
managers and personnel in different functional areas to make decisions anywhere in
the world.
The Role of Country Organizations

The role that a particular country organization can play depends on that markets
overall strategic importance as well as organizational competence. From these criteria,
four roles emerge strategic leader, contributor, implementer, and black hole.
The role of a strategic leader could be played by a highly competent national
subsidiary that is located in a strategically crucial market. Such a country organization
serves as a partner of headquarters for developing and implementing a strategy.
206
A contributor is a country organization that has a distinct competence, such as product

development. Country organizations have increasingly become a source of new
products. For instance, IBMs breakthrough in superconductivity research was
generated in its Zurich lab. Country organizations may be designed as worldwide
centers of excellence for a particular product category. For products or technologies
having multiple applications, leadership may be divided among different country
operations.
Implementers offer the critical mass for a global effort. These country organizations
exist in smaller, less-developed countries where there is less corporate commitment to
market development.
The black hole situation is one in which the international firm has a low competence
country organization or no organization in a highly strategic market. One of the ways
of remedying a black hole situation is by entering into strategic alliances. For instance,
AT&T, which had restricted itself to its domestic market for a very long time needed
to go global rapidly. Some of the alliances it formed were with Olivetti in office
automation and computers and with Philips in telecommunication.
Depending on the role of the country organization, its relationship with the
headquarters varies from exercising loose controls to tighter controls in order to
ensure that strategies are implemented effectively. In any case, it is imperative for
country organizations to have enough operating independence to cater to their local
needs and to motivate country managers. The country organization initiative helps
global companies to tap opportunities in markets worldwide. For instance, the unmet
demand of customers in a given market may not only result in the launch of a local
product but may lead to the global roll-out of the product. Strategy formulators ensure
that appropriate implementation is achieved at the country level.
Controlling International Operations

Controls are the means used by organizations to verify and correct actions that differ
from the established plans. Control serves as an integrating mechanism within an
organization. Controls are designed to increase predictability, reduce uncertainty, and
ensure that behaviors that originate in different parts of the organization are
compatible and in support of common organizational goals despite physical and
temporal distances.
Types of Control
In the design of control systems, a major decision concerns the object of control. The
two major objects identified are output and behavior. Output controls include sales
data, production data, balance sheet, product-line growth, and performance reviews of
personnel. Output measures are accumulated at regular intervals and are forwarded
from the foreign subsidiary to the headquarters, where they are assessed and reviewed
based on comparisons to the budget or plan. Behavioral controls require influence to
be exerted over behavior before or after it leads to action. Behavioral controls can be
achieved either through the preparation of manuals on areas such as sales techniques
which can be made available to subsidiary personnel or through efforts to fit the new
employees into the corporate culture.
For instituting these measures, instruments of control need to be decided on.
Generally, the alternatives are bureaucratic/formalized control or cultural control.
Bureaucratic controls comprise an explicit and limited set of regulations and rules
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outlining the desired performance levels. On the other hand, cultural controls are less
formal and result from shared beliefs and expectations among organizational
members.
Bureaucratic/Formalized Control
The elements of a bureaucratic/formalized control system are (1) an international
budget and planning system; (2) the functional reporting system; and (3) policy
manuals used for directing functional performance.
Budgets refer to shorter term guidelines regarding investment, cash, and personnel
policies. Plans refer to formalized plans with more than a one-year horizon. The
budget and planning process is the major control instrument in headquarterssubsidiary relationships. Through the system and execution vary, the aim is to achieve
a good fit with the objectives and characteristics of the firm and its environment.
The period of the budget is typically one year as it is tied to the multinationals
accounting system. The budget system is used for several purposes: (1) allocating
funds among subsidiaries; (2) planning and coordinating global production capacity
and supplies; (3) evaluating performance of the subsidiary; and (4) communication
and information exchange among product organizations, subsidiaries, and corporate
headquarters. Long-range plans vary from two years to ten years, and are more
judgmental and qualitative in nature. Shorter periods such as two years are usually the
norm, considering the added uncertainty associated with diverse foreign
environments.
Another control instrument used by headquarters is functional reports. They vary in
number, frequency, and complexity. The structure and elements of the report are
highly standardized in order to allow for consolidation at the level of headquarters.
Since the frequency of reports required from subsidiaries is likely to increase as a
result of globalization, it is necessary that subsidiaries adhere to the basic principle for
conducting efficiently through the time consuming exercise. Two approaches facilitate
this process: participation and feedback. These approaches also enhance
communication between headquarters and the subsidiaries.
Cultural Control
Many multinationals emphasize corporate values and culture, and evaluations are
done on how the individual or an entity fits in with the norms. Cultural controls
require an extensive socialization process in which informal, personal interaction is
central. Substantial resources are spent on training the individual to share the
corporate culture.
The key instruments of cultural controls are careful selection and training of corporate
personnel and the institution of self-control.
MNEs exercise cultural controls in selecting home-country nationals and to some
extent, third-country nationals. Expatriates are used in subsidiaries for control
purposes as well as to effect change processes. Firms control the management efforts
through compensation and promotion policies, as well as through policies concerning
replacement.
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Exercising Controls
In most organizations, different functional areas are subject to different guidelines as
they face different constraints. For instance, the marketing function incorporates more
behavioral dimensions than finance or manufacturing. Thus, many MNEs employ
control systems that are responsive to the needs of the function. It is hypothesized that
manufacturing subsidiaries are controlled more than the sales subsidiaries as
production readily lends itself to centralized direction, and engineers and technicians
adhere more firmly to standards and regulations than salespeople.
In the international environment, new dimensions such as inflation, differing rates of
taxation, and exchange rate fluctuations may distort the performance evaluation of any
individual or organizational unit. For an MNE, measuring whether a business unit in a
particular country is earning a superior return of investment relative to risk may be
irrelevant to the contribution an investment may make worldwide or to the firms
long-term results. In the short term, the return may be negative. Therefore, the control
mechanisms may inappropriately indicate reward or punishment. To design a control
system that is acceptable worldwide, great care should be taken to use only relevant
data. Therefore, major concerns include the data collection process and the analysis
and utilization of the data. Evaluators need management information systems that
provide for comparability and equity in administering controls.
In designing a control system, management needs to consider the costs of establishing
and maintaining the system versus the benefits that would be gained. Control systems
require investments in management structure and systems design. If controls are
misguided or consume too much time, they can slow down or undermine the process
of strategy implementation and thus the overall capacity of the firm. The result could
be lost opportunities or increased threats.
The impact of the environment should also be taken into account. First, the control
systems should measure only those dimensions over which the organization has actual
control. Second, control systems should be in harmony with local regulations and
customs. Thus MNEs are faced with many challenges in exercising appropriate and
adequate controls in their organizations.
Summary
If the subsidiaries have a high degree of autonomy, the system is called
decentralization. In such systems, controls are simple and loose, and each
subsidiary operates as a profit center. On the other hand, if subsidiaries have tight
controls and strategic decision making is concentrated at headquarters, the system
is called centralization.
The locus of decision making in a multinational enterprise (MNE) can be
determined by several factors such as its degree of involvement in international
operations, the product marketed by the firm, the size and importance of the
firms market, and the human resource capability of the firm.
Firms adopting the networked global organization have incorporated three
dimensions into their organizations: (1) developing and communicating a clear
corporate vision; (2) the effective management of human resource tools for
broadening individual perspectives and developing identification with corporate
goals; and (3) integrating individual thinking and activities into the broad
corporate agenda.
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The global business entity can achieve success only if it moves intellectual capital
within the organization.
The role that a particular country organization can play depends on that markets
overall strategic importance as well as organizational competence. From these
criteria, four roles emerge strategic leader, contributor, implementer, and black
hole.
Controls are the means used by organizations to verify and correct actions that
differ from the established plans.
Bureaucratic controls comprise an explicit and limited set of regulations and rules
outlining the desired performance levels. On the other hand, cultural controls are
less formal and result from shared beliefs and expectations among organizational
members.
Example: Wal-Marts Implementation Problems in Brazil

US-based Wal-Mart, the worlds largest retailer had its operations throughout the
world. Most of its global operations were successful. In some markets, the retailer
could not succeed. One such market was South America where the retailer failed to
make its mark. Analysts attributed several reasons for the failure. A major reason
was that the retailer did not adapt to the local tastes in the Sao Paulo market in
Brazil. In addition, the market conditions and aggressive competition from local as
well as foreign retailers such as France-based Carrefour SA and Brazil-based
Grupo Pao de Acucar SA added to its troubles. Moreover, the retailers insistence
on doing things the Wal-Mart way alienated local suppliers and employees.
Some vendors felt that Wal-Marts problems in Brazil were due to its inability to
meet customer demands. Since the retailer did not own a distribution system it
could not control the delivery of the products to its stores in time.
Some analysts felt that Wal-Marts problems in Brazil also stemmed in part from
its own mistakes. The retailer sold some food products which were hardly
consumed by the consumers. The retailer installed a computerized book-keeping
system that failed to take into account Brazils complicated tax system. In addition,
Wal-Mart failed to adapt to Brazils rapidly changing credit culture under which
the retailer had to identify postdated checks. The retailers strategy of charging a
membership fee for its Sams Club stores did not go down well with the Brazilians
who were not used to paying membership fees. The customers were also not in the
habit of making bulk purchases unlike its customers in the US. Analysts felt that
Wal-Marts failure to understand the local tastes and lifestyles of customers had led
to its implementation problems in Brazil.
Example: Governance and Control at AXA

France-based AXA Group (AXA) specializes in insurance and investment
management solutions. Its operations were spread across Western Europe, North
America, and the Asia Pacific. Since the mid-1980s, AXA had begun spreading out
its operations across the world mainly through acquisitions. But it remained a
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highly focused company with insurance and investment products as its core
business area. AXAs strategy was to be a leader in financial protection. In light of
the rapid globalization, Henri de Castries, (Castries), Chairman, Management
Board and CEO of AXA, realized that there had to be more coordination between
the subsidiaries and headquarters if the company was to be run efficiently. In order
to achieve synergies, AXA centralized some of the functions, while decentralizing
some. It made efforts to leverage on the strengths of each of its global subsidiaries.
In 1997, AXA established a dual corporate governance structure with a
management board and supervisory board managing its activities. The management
board looked after the companys day-to-day activities, while the supervisory board
was responsible for the efficient operation of the company. To achieve the
objective of becoming a global company, there were several management issues
that AXA had to sort out first. These included cultural and communication issues,
legal compliance, capital allocation, and integrating people and processes. AXA
operated in many countries across the world and had to take into account several
kinds of statutory, regulatory, and legal systems and accounting and tax systems as
these differed from country to country.
AXA decided to reduce the complexity of its global operations by maintaining a
balance between centralization and decentralization. It centralized its operations to
the extent it felt was necessary. Claude Brunet (Brunet), Member of the AXA
Management Board, described this as everything decentralized but strategy. AXA
had strong governance practices at both the central and local levels. Since 1997, it
had been governed by a supervisory and a management board. This system
demarcated the power of the management from that of the supervisors.
At the headquarters, the functions that remained strongly centralized included
AXAs corporate strategy, brand management, some key processes like approval
for new products, and standard Key Performance Indicators (KPIs).
The capital allocation was centralized in order to minimize cost of capital and
ensure financial strength. The risk management function also remained centralized.
AXA had a centralized risk management department, which developed and
deployed several risk measurement and monitoring methods. Each operating unit
also had risk management teams to support the central risk management team.
AXA also centralized functions like procurement and technology services.
AXA ensured that the principles of good corporate governance were implemented
across the group. All the subsidiaries were governed by a board, which included nonexecutive directors. An audit committee with independent members also oversaw the
functioning of the subsidiaries. All the subsidiaries were made aware of the groups
strategy, operational objectives, reporting lines, and accountability for organizational
objectives. Formal guidelines for business and operations were in place along with a
written code of ethics, anti-fraud, and anti-laundering policies.
All the subsidiaries of AXA prepared three-year forecasts. AXA aimed at
exercising control over the forecasts developed by the subsidiaries by subjecting
the forecasts to critical review. After the review, any adjustments that were
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Contd
required were made. A consolidated forecast was prepared that was used as the
groups budget. Based on these, the objectives and annual targets of each of the
operating units were arrived at.
The subsidiaries of AXA presented details of their strategic position, performance
review, quantitative targets like revenue, expenses, profitability, etc., about each of
their business segments. Also forming part of the presentation was sensitivity
analysis considering macro-economic conditions and specific plans for HR, IT, and
other aspects. Through this procedure, group management could exert control over
the strategies, plans, and resources of the principal subsidiaries and set targets that
were in tandem with the ambitions of the group.
All employees at the subsidiaries were informed about the corporate strategy, the
target of the group, and their own individual unit. The managers were asked to
inform employees about the details of what was expected of them and the resources
that they had at their disposal to carry out the task. The managers were required to
encourage teamwork and empower employees.
The subsidiaries had their own local strategies. This was necessary because local
laws, practices, and distribution models guided insurance companies. They also had
their own product strategies, market development, distribution, and risk
management practices.
In the Asia Pacific markets like Malaysia, Singapore, Hong Kong, Thailand, and
Indonesia, functions like sales and marketing, underwriting, and regulatory issues
were managed locally. AXAs subsidiaries had their own strategic plans, which
were in accordance with the strategic plans of the group.
All the subsidiaries were free to have their own distribution practices. They could
distribute through traditional methods like distribution partners or through
Bancassurance. AXA Japan had different distribution methods for corporate
customers and for new markets. The distributors were placed under four categories
AXA Advisors, who sold medical and term insurance, AXA Partners, who sold
group policies, AXA Corporates and Agents, who sold term products, and AXA
New Markets, which looked after the savings products.
AXA reaped several benefits by striking a balance between centralization and
decentralization of its operations. The company had firm control over some of the
most important activities and was able to steer the subsidiaries toward the growth
path. At the same time, the subsidiaries were free to carry out their day-to-day
operations. Due to geographical diversification, the groups volatility of earnings
went down. AXA was able to replicate the best practices in one country in other
countries and thus obtain a competitive advantage over local players.
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Concept Note - 12
Ethics in International Business

1. Introduction
Ethics refers to accepted principles of right or wrong that govern the conduct of a
person, the members of a profession, or the actions of an organization. Business
ethics are the accepted principles of right or wrong governing the conduct of
business-people. An ethical strategy is a strategy, or course of action, that does not
violate these accepted principle. Ethical issues should be incorporated into the
decision-making processes in international business.
This unit discusses the different ethical issues in the context of international business.
It then goes on to explain the ethical dilemmas that managers are confronted with. It
talks about the roots of unethical behavior before going on to deal with the different
philosophical approaches to business ethics. The unit finally discusses the ways to
carry out ethical decision making.
2. Ethical Issues in International Business

Most ethical issues arise due to the differences in economic development, legal
systems, politics, and culture among nations. Consequently, it may so happen that
what may be considered a normal practice in one nation could be considered unethical
in another. As managers in a multinational enterprise (MNE) work across national
borders and cultures, they need to be sensitive to these differences and have the ability
to choose the ethical actions in circumstances where differences across nations create
the potential for ethical problems. The most common ethical issues in an international
business setting are discussed here:
2.1 Employment Practices

Ethical issues may be associated with employment practices in other nations. If a firm
finds that the working conditions in the host nation are inferior to those in its home
nation, it has to decide what standards it should apply in international business those
of the host nation, home nation, or something in between. While it is suggested that
work and pay conditions should be the same across nations, international managers
have to decide to what level divergence can be allowed. For instance, 12-hour
workdays, low pay, and failure to protect workers against toxic chemicals may be a
common practice in developing nations. Does that mean, however, that the MNE
should also tolerate such conditions in the foreign subsidiaries or overlook them by
using local subcontractors?
2.2 Human Rights

Basic human rights are not respected in many nations. Rights taken for granted by
many nations such as freedom of speech, freedom of movement, freedom of
association, freedom of assembly, freedom from political repression, etc. are not
universally accepted. One example is South Africa during the days of apartheid and
white rule, which ended in 1994. The apartheid system denied basic political rights to
the majority non-white population of South Africa. It mandated segregation between
whites and non-whites, prohibited blacks from occupying positions where they could
manage whites, and reserved certain occupations only for whites.
2.3 Environmental Pollution

Ethical issues arise when environmental regulations are inferior to those of the home
nation. Developed nations have many regulations that govern the emission of
pollutants, the use of toxic materials in the workplace, dumping of toxic chemicals,
etc. These regulations are often lacking in developing nations. This results in the
operations of multinationals in these countries contributing to higher levels of
pollution than would be allowed in their home countries.
Critics ask whether a multinational should be free to pollute in a developing nation.
What is the moral thing to do in such circumstances? Is there a danger that an MNE
will move its production to the host nation as costly pollution controls are not required
and hence the company is free to damage the environment, while lowering its
production costs and gaining a competitive advantage even as it endangers the lives of
local people? Should they be allowed to pollute in order to gain a competitive
advantage or should it be ensured that the foreign subsidiaries adhere to the common
standards regarding pollution control, they ask?
These questions take on added importance as some parts of the environment are a
public good that no one owns but anyone can damage. No one owns the ocean and the
atmosphere but polluting both harms all. The oceans and the atmosphere can be
viewed as a global common from which everyone benefits but for which no one is
specifically responsible. In such cases, a phenomenon known as the tragedy of the
commons becomes applicable. This occurs when a resource is commonly held by all,
but is not owned by anyone and is overused by individuals, resulting in degradation.
The phenomenon was named by Garrett Hardin.
In the modern world, corporations can contribute to the global tragedy of the
commons by moving their production to locations where there are no strict pollution
control standards and where they can freely dump pollutants in oceans or rivers,
thereby harming these valuable global commons.
2.4 Corruption
Corruption has been a problem which is prevalent in almost every society. There have
been and always will be corrupt government officials. By making payments to such
officials, international businesses have gained economic advantages. For instance, in
the 1970s, Carl Kotchian, Lockheed president, made a payment of US$ 12.5 million to
Japanese agents and government officials in order to secure a larger order for
Lockheeds TriStar Jet from Nippon Air. When this was discovered, the US officials
charged Lockheed with tax violations and falsification of records.
The Lockheed case gave an impetus for the passage of the Foreign Corrupt Practices
Act (FCPA) in the US in 1977. The act outlawed the paying of bribes to foreign
government officials for gaining business. Some US businesses argued that the act
would put US firms at a competitive disadvantage. Subsequently, the act was
amended to allow for facilitating payments. Facilitating payments, also known as
grease payments or speed money, are not payments for securing contracts nor do they
help in gaining preferential treatment; rather, they are payments to ensure receiving
the standard treatment that a business should receive from a foreign government but
may not due the obstruction by a foreign official.
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In 1997, the trade and finance ministers from the member states of the Organization
for Economic Cooperation and Development (OECD) followed the US lead and
adopted the Convention on Combating Bribery of Foreign Public Officials in
International Business Transactions. In 1999, the convention came into force and
obliged member states to make the bribery of foreign public officials a criminal
offense. The convention excluded the facilitating payments made to government
officials.
While the facilitating payments are excluded from both the FCPA and the OECD
convention on bribery, the ethical implications of making such payments are unclear.
In many countries, payoffs in the form of speed money to government officials are a
part of life. Such investments bring substantial benefits to the local populace in terms
of jobs and income. Some economists argue that corruption in the form of smuggling,
black-marketeering, and side payments to government officials to speed up approval
for business investments may enhance welfare. Such arguments persuaded the US
Congress to exempt facilitating payments from the FCPA. In contrast, other
economists have argued that corruption reduces the return on business investments
and leads to slow economic growth.
2.5 Moral Obligations

Multinationals have power that comes from their control over resources and their
ability to move production from one location to another. That power may be
constrained by laws and regulations and by the market discipline and the competitive
process. Nevertheless it is substantial. Moral philosophers argue that with power
comes the social responsibility for multinationals to give something back to the
society that enabled them to grow and prosper. Social responsibility refers to the idea
that businesspeople should consider the social consequences of economic actions
when making business decisions and that there should be a presumption in favor of
decisions that have both good economic and social consequences. Advocates of this
approach argue that businesses, particularly large successful ones, should realize that
they have to fulfill their noblesse oblige and give something back to the society that
has made them successful. Noblesse oblige is a French term that refers to honorable
and benevolent behavior considered the responsibility of people of high (noble) birth.
Some multinationals, however, abuse their power for private gain.
Some multinationals have acknowledged that they have a moral obligation to use their
power to enhance social welfare in the communities where they carry out their
business. For instance, BP, one of the worlds largest oil companies has made social
investments a part of its company policy in countries where it does business. In
Algeria, BP has invested in a major project to develop gas fields near the desert town
of Salah. The company noticed that there was lack of clean water in Salah and
subsequently built two desalination plants to offer drinking water to the local
community and distributed containers to residents.
3. Ethical Dilemmas
The ethical obligations of an MNE toward employment conditions, human rights,
corruption, environmental pollution, and the use of power are not always clear cut.
There may be no agreement about accepted ethical principles. From an international
business perspective, some argue that what is ethical depends on ones cultural
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perspective. Consider the practice of gift-giving between parties to a business
negotiation. While this may be considered right and proper behavior in many cultures
in Asia, some westerners view this as a form of bribery, and therefore find it
unethical.
Managers need to confront real ethical dilemmas though real-world decisions are
complex and difficult to frame. Doing the right thing or even knowing what the right
thing may be is often not very easy.
4. The Roots of Unethical Behavior

Why do managers behave in an unethical manner? There is no simple answer to this
question but a few generalizations can be made. First, business ethics is not
dissociated from personal ethics, which are the generally accepted principles of right
and wrong that govern the conduct of individuals. An individual with a strong sense of
personal ethics is less likely to behave in an unethical manner in a business setting.
Thus it can be inferred that to establish a strong sense of business ethics, society
should emphasize strong personal ethics.
Home-country managers working overseas in MNEs might experience lot of pressure
to violate their personal ethics. They are away from their social context and
supporting culture, and they are geographically and psychologically distant from the
parent company. They may be placed in a culture that does not follow the same ethical
norms that are crucial in the managers home country. Moreover, they may be
surrounded by local employees who have less rigorous ethical standards. The parent
company may pressure expatriate managers to meet unrealistic goals by acting in an
unethical manner. Local managers might encourage the expatriate to adopt such
behavior.
Second, many studies of unethical behavior in a business setting conclude that
businesspeople sometimes do not realize that they are behaving unethically, chiefly
because they fail to ask, is this decision or action ethical? The fault lies in the
processes that do not incorporate ethical considerations into business decision making.
Third, the climate in some business settings does not encourage people to think
through the ethical consequences of business decisions. The unethical behavior in
businesses can be attributed to the organizational culture that deemphasizes business
ethics. Organizational culture refers to the values and norms that are shared among
employees of an organization. Together, norms and values shape the culture of a
business organization, and that culture has a key influence on the ethics of business
decision making.
5. Philosophical Approaches to Ethics

The different approaches to business ethics are discussed here:
5.1 Straw Men

Business ethics scholars have raised the straw men approaches to business ethics
chiefly to demonstrate that they offer inappropriate guidelines for ethical decision
making in an MNE. Four such approaches discussed in business ethics are described
here:
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The Friedman Doctrine

In 1970, Milton Friedman wrote an article that since then has become a classic straw
man that business ethics scholars outline. Friedmans basic position is that the only
social responsibility of business is to increase profits as long as the company stays
within the rules of law. He explicitly rejects the idea that businesses must undertake
social expenditures beyond those mandated by law and required for efficient business
functioning. His belief is that businesses should maximize their profits in order to give
maximum returns to their stockholders.
Though Friedman is talking about social responsibility as opposed to business ethics
per se, most business ethics scholars equate social responsibility with unethical
behavior and thus believe that Friedman argues against business ethics. However, the
assumption that Friedman argues against business ethics is quite untrue. In other
words, Friedman states that businesses should not engage themselves in fraud and
deception and should behave in an ethical manner.
Nevertheless, Friedmans arguments do break down under examination. This is true in
the context of international business where the rules of the game are not well
established or vary from country to country. For instance, child labor may not be
against the law in a developing nation but it is immoral to use child labor as the
practice conflicts with widely held views of what is the right and proper thing to do.
Cultural Relativism
Cultural relativism is another straw man raised by business ethics scholars. Cultural
relativism is the belief that ethics are nothing more than the reflection of a culture
all ethics are culturally determined and that accordingly, a firm should adopt the
ethics of the culture in which it is operating. Cultural relativism rejects the idea that
universal morality notions transcend different cultures. However it has been noted that
universal morality notions are found across cultures.
Some ethicists argue that there is residual value in this approach. As societal values
and norms vary across cultures, customs also differ, so it might follow that certain
business practices are ethical in one country but may not be so in another. The
facilitating payments allowed in FCPA can be seen as an acknowledgement that in
some countries, the payment to government officials is essential to get business done,
that they are at least ethically acceptable if not ethically desirable.
Righteous Moralist
A righteous moralist claims that the home country ethical standards of the MNE are
appropriate for firms to follow in foreign countries. Typically, this approach is
associated with managers from developed nations. The righteous moralist argues that
the right thing to do is to follow the prevailing cultural norms of the MNEs home
country in all foreign countries where it operates.
The major criticism against this approach is that its proponents go too far in insisting
upon home country norms. While some universal moral principles coming from the
home country should not be violated, it does not always follow that the appropriate
thing to do is adopt home-country standards.
Nave Immoralist
A nave immoralist states that if an MNE manager sees that firms from other nations
are not following ethical norms in the host nation, that manager should not either. This
approach can be illustrated using the drug lord problem. For instance, in one variant of
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this problem, an American manager in Columbia routinely pays the local drug lord in
order to guarantee that his plant will not be bombed and that none of his employees
are abducted. The manager argues that such payments are ethically defensible, not
because everyone else is doing so but because not doing so may cause greater harm.
The objection to this approach is two-fold. First, to say that the action is justified
ethically if everyone is doing it is insufficient. The firm has a clear choice. It need not
abide by the local practices and it can decide not to make any investments in a country
where it finds the practices repulsive. Second, the MNE should recognize that it does
have the ability to change the practices prevalent in a country. It can make use of its
power for a positive moral purpose.
Another solution to the drug lord problem is to refuse to invest in a country where the
rule of law is so weak that drug lords demand protection money. The drug lord
problem constitutes one of those ethical dilemmas where there is no obvious right
solution, and managers need a moral compass to help them find an acceptable solution
to the dilemma.
5.2 Utilitarian and Kantian Ethics

The Utilitarian and Kantian approaches were developed in the 18 th and 19th centuries.
The utilitarian approach to business ethics dates back to philosophers such as David
Hume, Jeremy Bentham, and John Stuart Mill. Utilitarian approaches to ethics hold
that the moral worth of actions or practices is determined by their consequences. An
action is considered to be desirable if is leads to the best possible balance of good
consequences over bad consequences. Utilitarianism is committed to maximizing
good and minimizing harm. As a business ethics philosophy, it focuses attention on
the need to carefully weigh all the social benefits and costs of a business action and
pursue only those actions where the benefits outweigh the costs. From the utilitarian
perspective, the best decisions are those that produce the greatest good for the most
number of people.
Many businesses have adopted tools such as risk assessment and cost-benefit analysis
that are firmly rooted in a utilitarian philosophy.
The approach has some drawbacks. One problem is measuring the costs, benefits, and
risks of an action before deciding to pursue it. Second, the philosophy omits the
consideration of justice. The action that does good for many people may result in the
unjustified treatment of a minority. Such an action is unethical because it is unjust.
Kantian ethics are based on the philosophy of Immanuel Kant. Kantian ethics hold
that people should be treated as ends and never purely as means to the ends of
others. People are not instruments; they have dignity and need to be respected.
Employing people in sweat shops, making them work for long hours for low pay and
poor working conditions is a violation of ethics, according to Kantian philosophy, as it
treats people like cogs in a machine and not as moral beings who have dignity.
Though contemporary moral philosophers tend to view Kants ethical philosophy as
incomplete for instance, his system does not have any place for moral emotions or
sentiments such as caring or sympathy the notion that people should be respected
and treated in a dignified manner still resonates in the modern world.
5.3 Rights Theories

Rights theories developed in the 20th century recognize that human beings have basic
rights and privileges that transcend national cultures and boundaries. Rights set up a
minimum level of morally acceptable behavior. Moral theorists argue that basic
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human rights form the basis for the moral compass that should be navigated by
managers when they make decisions that have an ethical component. More precisely,
the managers should not pursue actions that violate the basic human rights.
The notion that basic rights that transcend national cultures and boundaries were the
underlying motivation for the United Nations Declaration of Human Rights, which
have been ratified by all countries worldwide and lay down basic principles to be
adhered to irrespective of the culture in which one is doing business.
Within the framework of the rights theory, certain people or institutions are obliged to
offer benefits or services that secure the rights of others. Such obligations fall upon
more than one class of moral agent. (A moral agent is any person or institution that is
capable of moral action such as government or corporation.).
5.4 Justice Theories

Justice theories focus on attaining a just distribution of economic goods and services.
Just distribution is one that is considered to be fair and equitable. A justice theory
attributed to philosopher John Rawls argues that all economic goods and services
should be equally distributed except when an unequal distribution will work to
everyones advantage.
According to Rawls, valid justice principles are the ones which are agreed upon by all
people if they can impartially and freely consider the situation. Impartiality is
guaranteed by a conceptual device called the veil of ignorance. Under the veil of
ignorance, everyone is presumed to be ignorant of all of his/her particular
characteristics, for instance, race, nationality, sex, intelligence, family backgrounds,
and special talents. Rawls then asks under the veil of ignorance what system would
people design? Under these conditions, people unanimously agree upon two
fundamental principles of justice.
The first principle is that every person should be allowed the maximum amount of
basic liberty compatible with a similar liberty for others. This refers to political
liberty, liberty of conscience and freedom of thought, freedom of speech and
assembly, the freedom and right to hold personal property, and freedom from arbitrary
arrest and seizure.
The second principle is that once equal basic liberty is assured, inequality in basic
social goods such as income and wealth distribution, and opportunities should be
allowed only if such inequalities benefit everyone. Rawls formulates what he calls the
difference principle, which states that inequalities are justified if they benefit the
position of the person with least advantage.
In the context of international business ethics, Rawls theory generates an interesting
perspective. Managers can ask themselves whether the policies that they have adopted
in foreign operations can be considered just under the veil of ignorance. For instance,
is it just to pay foreign workers less than what workers are paid in the firms home
country? Rawls theory would suggest that it is just as long as the inequality benefits
the least-advantaged members of the global society. Alternatively, it is difficult
imagining that mangers operating under a veil of ignorance will design a system
where foreign employees would be paid subsistence wages for working long hours in
sweatshop conditions and where they are exposed to toxic and hazardous materials.
Such working conditions are unjust in Rawls framework and hence, it is unethical to
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adopt them. While operating under a veil of ignorance, most people would probably
design a system that imparts some level of protection from environmental degradation
to vital global commons, such as the tropical forests, oceans, and atmosphere. Thus,
Rawls veil of ignorance is a conceptual tool contributing to the moral compass that
can be used by managers for navigating through complex ethical dilemmas.
6. Ethical Decision Making

International business and managers can focus on several things to ensure that ethical
issues are considered in business decisions. These are discussed here:
6.1 Hiring and Promotion

Businesses should strive to hire people who have a strong sense of personal ethics and
who will not engage in illegal or unethical behavior. Similarly, a business is expected
not to hire and promote people whose behavior does not match with the generally
accepted ethical standards. Many people hide their lack of personal ethics from public
view as they realize that unethical people are not trusted.
Promoting people who have displayed poor ethics should not occur in a firm where
the organizational culture values the need for ethical behavior and where leaders act
accordingly.
6.2 Organization Culture and Leadership

Businesses need to build an organizational culture that values ethical behavior. Such a
culture helps in fostering ethical behavior. Three things are crucial for building such a
culture. First, businesses should articulate values that emphasize ethical behavior.
Many companies draft a code of ethics, which is a formal statement of the ethical
priorities to which the business adheres. Second, leaders should give life and meaning
to the values articulated in a code of ethics. This can be done by emphasizing their
significance and acting upon them. Some companies like Nike have hired independent
auditors to ensure that the subcontractors in the company are living up to the
companys code of conduct.
Finally, building an organizational culture that places high value on ethical behavior
requires benefits and incentive systems, including promotions that benefit people
engaging in ethical behavior.
6.3 Decision-making Processes

Businesses should think through the ethical implications of decisions in a systematic
way. In order to provide an idea of ethical consequences of a decision, a a moral
compass on the rights theories and as well as the Rawls theory of justice is required.
Beyond these theories, some ethics experts have proposed a straightforward practical
guide or ethical algorithm for determining whether a decision is ethical. These
experts need to answer questions such as:
Does my decision fall within the accepted standards or values that can be applied
in an organizational environment?
Am I willing to see the decision communicated to all stakeholders affected by it?
Will the people with whom I share a significant personal relationship such as
family, friends, or even managers in other businesses, approve of the decision?
220
Others have recommended a five-step process in order to think through the ethical
problems. In Step 1, businesspeople should identify a decision which would affect a
stakeholder and in what ways it would affect the stakeholder. Stakeholders in a firm
are individuals or groups having a claim, interest, or stake in the company. Internal
stakeholders are individuals or groups working for or owning the business. They
include employees, stockholders, and board of directors. External stakeholders are
other individuals or groups having a claim on the firm. The group comprises
customers, lenders, suppliers, unions, local communities, governments, and the
general public.
Each stakeholder group supplies important resources to the organization and, in
exchange, expects its interest to be satisfied.
Stakeholder analysis involves the analysis of a certain amount of moral imagination.
This means standing in the stakeholders shoes and asking how a proposed decision
may impact that stakeholder.
Step 2 involves judging the ethics of the proposed strategic decision using the
information gained in Step 1. Managers should determine whether a proposed
decision would violate the fundamental rights of any stakeholder. For instance, the
customers should have the right to know about the potentially dangerous features of a
product. Mangers should also ask themselves whether they would allow the proposed
strategic decision if they were designing a system under Rawls veil of ignorance. For
instance, if the decision is whether to outsource work to a subcontractor who offers
low pay and poor working conditions, managers might ask themselves whether such
an action could be allowed under a veil of ignorance, where they themselves might
ultimately be the ones working for the subcontractor.
At this stage, the judgment should be guided by various moral principles that should
not be violated. The principles might be the ones articulated in the code of ethics or
other documents of the company. In addition, certain moral principles that are adopted
by members of the society such as prohibiting stealing should not be violated. The
judgment at this stage will also be guided by the decision rule that is selected for
assessing the proposed strategic decision. Though maximizing profits is the decision
rule stressed by businesses, it should be noted that no moral principles are violated.
Step 3 requires managers to establish moral intent. This means that businesses should
place moral concerns ahead of other concerns in cases where either the key moral
principles or the fundamental rights of stakeholders have been violated. At this stage,
input from top management will be valuable.
Step 4 requires the firm to engage in ethical behavior.
Step 5 requires the business to audit its own decisions, reviewing them to ensure they
were consistent with the ethical principles stated in the companys code of ethics. This
final step is critical and is often overlooked. Without auditing past decisions,
businesspeople will not know if their decision process is working and if changes need
to be made to ensure greater compliance with the code of ethics.
6.4 Ethics officers

Businesses have ethics officers to ensure that their business behaves in an ethical
manner. These individuals are entrusted with the responsibility of ensuring that all
employees are trained to be ethically aware, that the companys code of ethics is
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adhered to, and that ethical considerations enter the business decision-making process.
Ethics officers may also audit decisions to ensure that they are consistent with the
code of ethics. In many businesses, ethics officers act as an internal ombudsperson with
the responsibility of handling confidential inquiries from employees, investigating
complaints, reporting findings, and making recommendations for change.
6.5 Moral Courage

It is crucial to recognize that employees in an international business may be in
significant need of moral courage. Moral courage helps a manger to walk away from a
decision that seems to be profitable but unethical. It gives an employee the strength to
say no to a superior who instructs him/her to pursue an action that is unethical. Moral
courage gives employees the integrity to go to the media and publicly display the
unethical behavior in a company.
Companies can encourage the moral courage of employees by committing themselves
to not retaliating against employees who exercise moral courage, say no to superiors,
or complain about their unethical actions.
7. Summary
The most common ethical issues in an international business setting are
employment practices, human rights, environmental pollution, corruption, and
moral obligations.
Managers need to confront real ethical dilemmas though real-world decisions are
complex and difficult to frame. Doing the right thing or even knowing what the
right thing may be is often not very easy.
Managers behave in an unethical manner for several reasons. First, business
ethics is not dissociated from personal ethics, which are the generally accepted
principles of right and wrong that govern the conduct of individuals. Second,
many studies of unethical behavior in a business setting conclude that
businesspeople sometimes do not realize that they are behaving unethically,
chiefly because they fail to ask whether the decision or action is ethical. Third,
the climate in some business settings does not encourage people to think through
the ethical consequences of business decisions.
The different approaches to business ethics are straw men, utilitarian and kantian
ethics, rights theories, and justice theories.
International business and managers can focus on several things to ensure that
ethical issues are considered in business decisions. They are hiring and
promotion, organization culture and leadership, decision-making processes, ethics
officers, and moral courage.
Example: Dow Chemical causing Environmental Pollution in India

The Dow Chemical Company (Dow) since its inception in the 1890s had been
criticized for polluting many properties and poisoning thousands of people. One of
the criticisms against the company was that it had created Agent Orange and
Napalm during the Vietnam War. Agent Orange had reportedly made its way into
the food chain and was associated with birth defects in the Vietnamese people and
Contd
222
Contd
American soldiers while the usage of Napalm by the US troops had led to horrific
deaths of thousands of Vietnamese people. Another major criticism faced by the
company was that its subsidiary Union Carbide Corporation (UCC), which it
acquired in 2001, was responsible for the worst industrial disaster in the world in
Bhopal, India. Tragedy struck on December 3, 1984, after water entered the Methyl
Isocyanate (MIC) storage tank No. 610 at the plant. MIC is one of the deadliest
gases produced in the chemical industry and is known to react violently when it
comes into contact with water or metal dust. What followed was a catastrophe that
killed nearly 10,000 people within 72 hours of the gas leak and left hundreds of
thousands of people with eye irritation, acute breathlessness, and vomiting.
Moreover, the plant site was surrounded by hazardous chemicals that contaminated
the soil and water, posing a major threat to people residing in the vicinity. Several
studies also found that the groundwater near the plant area contained toxic heavy
metals and organic chemicals which made it unsafe for drinking. The victims held
Dow responsible for cleaning up the site since it had acquired UCC.
In the months, years, and decades that followed the disaster, thousands of survivors
and their next generations suffered from ill health and multiple symptoms while
their livelihood and future were severely affected. By the end of 2009, it was
estimated that 25,000 had died and around 600,000 people were affected due to
gas-related disorders.
Though the plant was shut down soon after the incident, the toxic remains at the
factory left it in a state to create even more havoc with each passing day. Toxic
chemicals lay in the vicinity and children who played near the site and livestock
grazing on the ground were fully exposed to it. In addition to the surroundings, the
walls of the UCIL plant and the roof remained covered with toxic materials which
far exceeded safety standards. Moreover, sacks of chemicals and pesticides lay
scattered in a state of decomposition around the abandoned factory. Some sources
estimated that nearly 25,000 tons of contaminated material were present at the
plant. Despite this, the people residing in the surroundings of the plant could not
abandon the site and move to safer places as the compensation due to them was
delayed for many years. This was because UCC, the parent company of UCIL,
evaded responsibility for the disaster and engaged in lengthy litigation.
Subsequently, some victims did get a paltry amount as compensation but many did
not get even this.
Experts around the world believed that UCILs lack of information about
toxicology and disaster mitigation measures had led to an increased number of
casualties since the disaster. The catastrophic event had also contaminated the soil
and made the land infertile, as was clear from the fact that there was no grass
growing on the land. Several rounds of laboratory analysis carried out by
governmental and non-governmental organizations (NGOs) found that the
contamination levels of the soil and water near the plant were far in excess of
permissible limits. It was reported that after a heavy rainfall, heavy metals and
solvents had seeped into the groundwater resources, contaminating them. The
residents used this water for drinking, cooking, and washing and this had led to
physical disabilities and stunted growth in children.
Contd
223
Contd
The survivors made several attempts to get access to potable water but these proved
futile. On December 3, 2009, the 25th anniversary of the tragedy, just as they had
in all the previous years, hundreds of citizens of Bhopal marched with torches
demanding that the government take steps to clean up the site. As the people
marched toward the UCIL plant, they chanted slogans like Down with the
government and Down with Union Carbide.
Even as the victims continued to suffer, business ethicists and people around the
world were disgusted to see that the company responsible for the disaster refused to
be held accountable. People also wondered how the regulators had failed to bring
the perpetrators to book even after 25 long years. The Indian government too drew
a lot of flak from critics who felt that it was siding with the multinational
corporation.
Despite protests from activists and survivors, UCC consistently refused to accept
any liability for the clean-up of the site, saying the plant had been sold to The Dow
Chemical Company (Dow) in 2001. It also pointed out it had paid a heavy onetime compensation of US$ 470 million. Dow too contended that the matter had
been resolved and added that the company had insulated itself from UCCs Bhopal
liabilities by virtue of how it had structured the acquisition.
As the after-effects of the worlds worst industrial disaster threatened to affect the
next generations in Bhopal, business ethicists and social activists intensified their
efforts to make Dow realize that it was also the companys responsibility to clean
up the mess and provide at least some relief to the victims. But industry observers
wondered whether Dow would ever look beyond the concerns of its shareholders
and address this issue.
Example: BPs Continuing Safety Problems: The Gulf of Mexico

Crisis
On April 20, 2010, an explosion aboard the drilling rig Deepwater Horizon, leased
by the British oil company BP Plc (BP) in the Gulf of Mexico, left 11 workers
missing and 17 injured. Two days later, oil began leaking from the broken pipes of
the rig, which sank about 50 miles off the Louisiana coast. According to
investigators, an estimated 5,000 barrels (210,000 gallons) of oil per day had been
leaking from the well since then, endangering wildlife, leading to the suspension of
commercial fishing, and affecting coastal tourism in Louisiana, Mississippi,
Alabama, and Florida states in the US. As of May 10, 2010, an estimated 3.5
million gallons of oil had spilled into the Gulf of Mexico, 50 miles off the
Louisiana coast.
Because of the oil spill, BP faced unprecedented scrutiny in the US and questions
were raised as to whether there were irregularities at the rig and on the role the
company might have played in creating them. Investigators attributed the explosion
of the rig to several factors including poor engineering, faulty procedures, and
incomplete mud removal at the time of the well being closed. According to experts,
Contd
224
Contd
the incident occurred as the blowout preventer of the oil well failed to activate and
did not shut off oil flow as it was supposed to do during emergencies. It thereby
allowed methane gas to enter, which triggered the deadly explosion in the rig, they
said. Documents showed that the blowout preventer had design flaws, leaks in its
hydraulic system, and a deceased battery in its control pod. While some experts
pinpointed the failure of the blowout preventer as the cause of the explosion, others
said that the drilling mud which had been removed from the well before a cement
seal had been put in place violated best drilling practices and was responsible for
the disaster.
Lawmakers criticized BP for its efforts to seal the well by injecting rubber debris
down the top, including old golf balls and bits of tires. It was reported that in early
March 2010, the Deepwater Horizon rig had experienced trouble as the pressure of
the underground petroleum had temporarily overwhelmed the mud, triggering
alarms on the rig. Experts said that despite knowing that there were some problems
on the rig, BP did not have any back-up systems in place to avert any kind of
disaster except the blowout preventer. Though the Coast Guard named both BP and
Transocean as the parties responsible for the incident, two other companies,
Halliburton and Cameron International, which made the blowout preventer, were
also questioned.
Experts opined that it was a massive struggle for BP to slow down the leak despite
the company having taken all possible measures. More than 1,000 volunteers were
involved in driving off the oil from the ocean surface, dissipating it with chemicals
or simply burning it at sea. As an alternative, BP built three large containment
chambers which were placed over the leaks on the ocean floor, so that the oil could
be diverted to the surface and, from there, pumped into tankers. In addition to the
chambers, the company also begun to drill two relief wells at an angle into the
ocean floor, so that cement could be forced into the boreholes and would thereby
stop the flow of oil. The work on the relief wells started in May 2010. It was
estimated that it would take at least three months from then for the wells to be
completed.
BP also used chemicals and dispersants to break the surface oil slicks into
microscopic droplets that could sink into the sea. However, scientists warned that
such dispersants might have an adverse impact on the environment as they
contained toxins. BP applied more than 400,000 gallons of a dispersant sold under
the trade name Corexit to disperse the oil on the ocean floor. But experts were
worried as Corexit contained 2-butoxyethanol, a compound which at high doses
was associated with headaches, vomiting, and reproductive problems.
BP also used another method called a junk shot to plug the undersea leak. This
involved pumping materials such as torn tires and golf balls into the well at high
pressure. On May 26, 2010, BP started an operation called top kill to stop the
flow of oil from the well. Here, heavy drilling fluids were injected through the
blowout preventer into the well. But all these efforts proved futile as the oil leak
could not be stopped. By the first week of May 2010, the oil slick had reached the
Mississippi delta and the government declared a state of emergency after BP
admitted that it could no longer stop the oil spill on its own.
Contd
225
Contd
Considered to be one of the worst environmental catastrophes in American history,

the incident once again called into question the credibility of the safety systems at
BP. The company, which was responsible for some of the worst oil and gas
tragedies in the US, was criticized for its lack of commitment to overall safety in its
business operations. BP had been convicted three times of environmental disasters.
These included two felonies and the company remained on probation in Alaska and
Texas. Industry analysts said that despite its promises to reform, BP continued to
remain complacent and to overlook safety aspects in its operations.
Over the years, BP had tried to position itself as an environmentally-friendly
company and showcased its commitment to a carbon free environment by investing
in alternative energy sources such as solar and wind. It even redesigned its logo and
introduced a new corporate slogan Beyond Petroleum to highlight the companys
interest in environmental sustainability and in improving the standard of living of
people. But after the Gulf of Mexico incident, critics once again started questioning
BPs environment-friendly stance and its corporate culture. They criticized the
company for spending millions of dollars on projecting a green image, while failing
to take care of basic safety issues. They raised doubts about BPs environmentfriendly image and wondered how a company with such major safety lapses could
make such a claim at all. Some analysts said that BP might have developed an
unhealthy corporate culture where cost-cutting was given more priority than the
safety of workers. At the US Congressional hearings which were held in the first
week of May 2010, lawmakers quizzed BP executives about their overall
commitment to safety.
Though the company accepted responsibility for the spill, experts were of the view
that the oil spill in the Gulf of Mexico had tarnished BPs reputation and would
affect its business prospects in the US. Moreover, the costs associated with the spill
such as clean up costs and fines would affect the bottom line of the company, they
said. As of June 21, 2010, the cost of the response to the oil spill amounted to about
US$ 2.0 billion, including the cost of the spill response, grants to the Gulf states,
claims paid, relief well drilling, and federal costs.
However, BP denied that it had put profits before safety and said that it was taking
steps to contain the spill. Tony Hayward (Hayward), CEO of BP, was positive that
the company would successfully deal with the crisis. Industry critics, on the other
hand, pointed out that the company had failed in its efforts to stop the leakage and
that most of its endeavors were failures.
226

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International Business

International Business and Globalization ......................................... 1-20

International Trade Theories and Application ................................ 21-66

Entry Strategy and Strategic Alliances ........................................... 67-94

International Monetary System..................................................... 95-120

Foreign Exchange Markets ....................................................... 121-130

Global Marketing and Supply Chain ........................................... 131-144

Global Human Resource Management ...................................... 145-156

Global Research and Development ........................................... 157-168

Accounting in the International Business ................................... 169-180

10. Financial Management in International Business....................... 181-192

International Business and Globalization

3. The Face of Globalization

3.2 Globalization and the Monopoly Power of Corporations

3.3 Globalization and the Environment

3.4 Striking a social balance with globalization

International Business and Globalization

Globalization also exposes national economies to the global economic uncertainties.

4. Globalization and International Business

4.2 International versus Domestic business

5.1 Market Motives

International Business and Globalization

5.2 Economic Motives

5.3 Strategic Motives

Example: Globalization and its effect on the German Economy

German carmaker, Volkswagen, also planned to cut labor costs by 30 percent by

International Business and Globalization

Example: India & China- Threat to the US Economy

International Business and Globalization

Culture and International Business

National Culture Classifications

International Business and Globalization

Autonomy is of two kinds intellectual autonomy (creativity, self-direction) and

International Business and Globalization

Key Cultural Issues

The Political Environment

International Business and Globalization

The Mne-Government Relationship

The Legal Environment

International Business and Globalization

International Business and Globalization

Example: The Goodyear Sumitomo Alliance

Example: Microsofts Illegal Trade Practices

The decision of the EU on March 24, 2004, represented a milestone in EU history.

International Trade Theories and Application

2. International Trade Theories

2.1 The Mercantilist Doctrine

2.2 Absolute Advantage Theory

2.3 Comparative Advantage Theory

International Trade Theories and Application

2.4 Heckscher-Ohlin Theorem

Countries should be exporting goods making use of their relatively abundant

The differences in factor endowments stimulate international investment and

2.5 The Leontief Paradox

2.6 Human Skills and Technology-based Views

International Trade Theories and Application

2.7 The Product Life-Cycle Model

The US has an export monopoly in a new product;

Foreign production of this product begins;