Globalization and the Multinational Firm

Chapter One

Copyright 2012 by the McGraw-Hill Companies, Inc. All rights reserved.

Chapter One Outline

Whats Special about International Finance? Goals for International Financial Management Globalization of the World Economy Multinational Corporations Organization of the Text Summary

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Whats Special about International Finance?

Foreign Exchange Risk Political Risk Market Imperfections Expanded Opportunity Set

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Whats Special about International Finance?

Foreign Exchange Risk
This is risk that foreign currency profits may evaporate in dollar terms due to unanticipated unfavorable exchange rate movements. Suppose $1 = 100 and you buy 10 shares of Toyota at 10,000 per share. One year later the investment is worth ten percent more in yen: 110,000. But, if the yen has depreciated to $1 = 120, your investment has actually lost money in dollar terms.
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Whats Special about International Finance?

Political Risk Sovereign governments have the right to regulate the movement of goods, capital, and people across their borders. These laws sometimes change in unexpected ways.

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Whats Special about International Finance?

Market Imperfections Legal restrictions on the movement of goods, people, and money Transactions costs Shipping costs Tax arbitrage

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The Example of Nestls Market Imperfection

Nestl used to issue two different classes of common stock bearer shares and registered shares. Foreigners were only allowed to buy bearer shares. Swiss citizens could buy registered shares. The bearer stock was more expensive. On November 18, 1988, Nestl lifted restrictions imposed on foreigners, allowing them to hold registered shares as well as bearer shares.
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Nestls Foreign Ownership Restrictions

12,000 10,000 8,000 SF 6,000 4,000 2,000 0 11 20 31 9 18 24
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Bearer share

Registered share

Source: Financial Times, November 26, 1988 p.1. Adapted with permission.

The Example of Nestls Market Imperfection

Following this, the price spread between the two types of shares narrowed dramatically. This implies that there was a major transfer of wealth from foreign shareholders to Swiss shareholders. Foreigners holding Nestl bearer shares were exposed to political risk in a country that is widely viewed as a haven from such risk. The Nestl episode illustrates both the importance of considering market imperfections and the peril of political risk.
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Whats Special about International Finance?

Expanded Opportunity Set It doesnt make sense to play in only one corner of the sandbox. True for corporations as well as individual investors.

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Goals for International Financial Management

The focus of the text is to equip the reader with the intellectual toolbox of an effective global managerbut what goal should this effective global manager be working toward? Maximization of shareholder wealth? or Other goals?

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Maximize Shareholder Wealth

Long accepted as a goal in the Anglo-Saxon countries, but complications arise. Who are and where are the shareholders? In what currency should we maximize their wealth?

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Other Goals
In other countries shareholders are viewed as merely one among many stakeholders of the firm including:
Employees Suppliers Customers

In Japan, managers have typically sought to maximize the value of the keiretsua family of firms to which the individual firms belongs.
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Other Goals
As shown by a series of recent corporate scandals at companies like Enron, WorldCom, and Global Crossing, managers may pursue their own private interests at the expense of shareholders when they are not closely monitored. These calamities have painfully reinforced the importance of corporate governance, i.e., the financial and legal framework for regulating the relationship between a firms management and its shareholders.
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Other Goals
These types of issues can be much more serious in many other parts of the world, especially emerging and transitional economies, such as Indonesia, Korea, and Russia, where legal protection of shareholders is weak or virtually non-existing. No matter what the other goals, they cannot be achieved in the long term if the maximization of shareholder wealth is not given due consideration.

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Globalization of the World Economy: Major Trends and Developments

Emergence of Globalized Financial Markets Emergence of the Euro as a Global Currency Europes Sovereign Debt Crisis of 2010 Trade Liberalization and Economic Integration Privatization Global Financial Crisis of 2008-2009

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Emergence of Globalized Financial Markets

Deregulation of Financial Markets coupled with Advances in Technology have greatly reduced information and transaction costs, which has led to: Financial Innovations, such as
Currency futures and options Multi-currency bonds Cross-border stock listings International mutual funds
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Emergence of the Euro as a Global Currency

A momentous event in the history of world financial systems. Currently more than 300 million Europeans in 16 countries are using the common currency on a daily basis. In May 2004, 10 more countries joined the European Union. The transaction domain of the euro may become larger than the U.S. dollars in the near future.
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Euro Area
Austria Belgium Cyprus Finland France Germany Greece

Ireland Italy Luxembourg Malta The Netherlands Portugal Slovenia Slovakia Spain
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0.8 1

1.1

1.2

1.4

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0.9

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1/1/1999

5/15/2000

9/27/2001

2/9/2003

6/23/2004

11/5/2005

3/20/2007

8/1/2008

Value of the Euro in U.S. Dollars

12/14/2009

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4/28/2011

Europes Sovereign-Debt Crisis of 2010

In December of 2009 the new Greek government revealed that its budget deficit for the year would be 12.7% of GDP, not the 3.7% forecast. Investors sold off Greek government bonds and the ratings agencies downgraded them to junk. While Greece represents only 2.5% of euro-zone GDP, the crisis became a Europe-wide debt crisis. The challenge remains that fiscal indiscipline of one euro-zone country can escalate to a Europe-wide crisis.
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The Greek Drama

Greece paid no premium above the German rate until late fall 2009. The Greek interest rate rose until the bailout package on May 9.

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Economic Integration
Over the past 50 years, international trade increased about twice as fast as world GDP. There has been a change in the attitudes of many of the worlds governments, who have abandoned mercantilist views and embraced free trade as the surest route to prosperity for their citizenry.

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Liberalization of Protectionist Legislation

The General Agreement on Tariffs and Trade (GATT) is a multilateral agreement among member countries that has reduced many barriers to trade. The World Trade Organization has the power to enforce the rules of international trade. On January 1, 2005, the era of quotas on imported textiles ended. This is an event of historic proportions.
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NAFTA
The North American Free Trade Agreement (NAFTA) calls for phasing out impediments to trade between Canada, Mexico, and the United States over a 15-year period beginning in 1994. For Mexico, the ratio of export to GDP has increased dramatically from 2.2% in 1973 to 29% in 2006. The increased trade has resulted in increased numbers of jobs and a higher standard of living for all member nations.
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Privatization
The selling of state-run enterprises to investors is also known as denationalization. Privatization is often seen in socialist economies in transition to market economies. By most estimates, this increases the efficiency of the enterprise. It also often spurs a tremendous increase in cross-border investment.

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Chinese Privatization
State-owned enterprises have been listed on organized stock exchanges. More than 1,500 companies are currently listed on Chinas stock exchanges. The Chinese government still retains the majority stakes in most public firms. Chinese citizens can buy A shares, while foreigners are limited to B shares.

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Global Financial Crisis of 20082009

The Great Recession was the most serious, synchronized economic downturn since the Great Depression of the 1930s. Factors included: Households and financial institutions borrowed too much and took too much risk. This risk was repackaged with securitization, and so defaults on subprime mortgages in the U.S. came to threaten the solvency of a teachers retirement plans in Norway.
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Global Financial Crisis 20082009

During the course of the crisis, the G-20 emerged as the premier forum for discussing international economic issues and coordinating financial regulations and macroeconomic policies.

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Multinational Corporations
A multinational corporation (MNC) is a firm that has been incorporated in one country and has production and sales operations in other countries. There are about 60,000 MNCs in the world. Many MNCs obtain raw materials from one nation, financial capital from another, produce goods with labor and capital equipment in a third country, and sell their output in various other national markets.
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Top 10 MNCs
1
2 3 4 5 6 7

General Electric
Royal Dutch/Shell Group Vodafone Group PLC British Petroleum Co. PLC Toyota Motor Corporation ExxonMobile Corporation Total

United States
UK/Netherlands United Kingdom United Kingdom Japan United States France

8
9

E.ON AG
Electricit De France

Germany
France

10

ArcelorMittal

Luxembourg
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The following slides cover the appendix to Chapter 1.

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The Theory of Comparative Advantage

A comparative advantage exists when one party can produce a good or service at a lower opportunity cost than another party. The opportunity cost of making one additional unit of a good (or service) can be defined as the value of some other good that you have to give up in order to produce this additional unit.
For example, if you can work as many hours as you like at your current employer and get paid $10 per hour, then the opportunity cost of your leisure is $10 per hour.

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The Geometry of Comparative Advantage

Consider the example where there are two countries, A and B, who can each produce only food and textiles. Initially they do not trade with one another. The graph on the next slide shows the increase in consumption available to the citizens of countries A and B with trade arising from the differences in their opportunity costs of production.
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A production possibilities curve shows quantities of food or textiles each country can make.

The Geometry of Comparative Advantage

Textiles
The production possibilities of Country A are such that if they concentrated 100% of their resources into the production of textiles, they could produce 180 million yards of textiles. If Country A chose to concentrate 100% of their resources into the production of food, they could produce as much as 300 million pounds of food. Country A can produce any combination of food and textiles between these two points.

180

As a practical matter, the citizens of Country A must choose a point along their production possibilities curve.

60
200 300 Suppose they initially choose 200m pounds of food and 60m yards of textiles. Food

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The Geometry of Comparative Advantage

Textiles If Country B chose to concentrate 100% of their resources into the production of textiles, they could produce 240 million yards of textiles. If Country B chose to concentrate 100% of their resources into the production of food, they could produce 900 million pounds of food. The citizens of Country B must also choose a point along their production possibilities curve;

240 180 80 60

Food 200 300 600 900 1,200 Initially they choose 600 million pounds of food, and 80 million yards of textiles.
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The Geometry of Comparative Advantage

Textiles

240 180
80 60

Put another way, country B enjoys a comparative advantage in food because they have to give up textiles at a lower rate than A when making more food. Geometrically, a comparative advantage exists because the slopes of the production possibilities differ. If the countries specialize according to their comparative advantage, then Country A should make textiles and trade for food, while Country B should grow food and trade for textiles.

Food

200 300 600 900 Country A enjoys a comparative advantage in textiles because they have to give up food at a lower rate than B when making textiles. 1-37

The Geometry of Comparative Advantage

Without trade, if both countries make only food, the combined production would be 1,200 million pounds of food = 900 + 300. Textiles

The combined production possibilities curve of country A and B without trade are shown in the green line.
420
Before trade, combined consumption is 800 million lbs of food (= 200 + 600) and 140 million yards of textiles (= 60 + 80).

240 180 140 80 60

Food 200 300 600 800 900 1,200 Without trade, if both countries make only textiles, the combined production would be 420 million yards of textiles = 240 + 180.

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A production possibilities curveadvantage shows the in various amounts of they food have Country A enjoys a comparative textiles because Without trade, if both countries make only textiles, the combined orThe textiles that each country canComparative make. Geometry of Advantage to give up food at a lower rate than B when making textiles. production would be 420 million yards of textiles = 240 + 180. Country A produce textiles at a lower opportunity cost, soth Without trade, if both countries make only food, the combined If country Bcan chose to concentrate 100% of resources The production possibilities country A their are such that if into Put another way, country Bof enjoys a comparative let them produce the first produce 180 million yards of textiles. Textiles production would be 1,200 million pounds of food = textiles 900 + 300. production of textiles, they could 240 million yards of Textiles they concentrated 100% of their resources into the advantage in food because they have to give up The combined production possibilities curve with trade textiles. production of textiles, they could produce 180 million yards at a lower rate than A when making more food. The combined production possibilities curve of country If country B chose to concentrate 100% of as their resources is composed of the original curves joined shown. of textiles. A and B without trade are shown in the green line. If country A chose a to concentrate advantage 100% of their Geometrically, comparative exists because into the production of food, they could produce 900 million 420 420 The gains from trade are shown by the increase inlbs resources into the production of food, they could the slopes of the production possibilities . Before trade, combined consumption is 800 million pounds ofdiffer food. consumption available. produce as much as 300 million pounds of food. If The thecitizens countries specialize country B+ according must also choose their a comparative point along of of food (= 200 600) andto 140 million yards of Country A can produce any combination of food and andcurve; advantage, then country their A should production make possibilities textiles textiles (= 60 trade + 80). 240 240 textiles between these two points. grow food and trade for 180 for food, while country B should 180 initially they the choose 600 of million pounds of 140 As a practical matter, citizens country A must 140 textiles. food, and 80 million yards of textiles. 80 choose a point along their production possibilities curve 80 60 60 Food Food 200 600 800 1,200 200 300 300Suppose 600 800 900 900 1,200 that initially they choose 200 million County B can produce food at a lower opportunity cost, so let B produce the first 900 pounds of food, and 60 million yards of textiles. 1-39 million pounds of food.

Arguments in Favor of Free Trade

Both partners gain from trade; we have more material goods. Freedom is a good thing in and of itself. In this case, consumers have the freedom to choose imported goods and producers have the freedom to choose to sell to foreigners.

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