THE WILLIAM DAVIDSON INSTITUTE

note 1-428-651

07 August 2004

The Global Business Environment

Globalization has changed us into a company that searches the world, not just to sell or to source, but to find intellectual capital - the worlds best talents and greatest ideas. Jack Welch, former General Electric CEO We are moving toward a global economy. One way of approaching that is to pull the covers over your head. Another is to say: It may be more complicated - but thats the world I am going to live in, I might as well be good at it. Phil Condit, former CEO and Chairman of Boeing The global economy has undergone a vast transformation in the past 20 years: Economic linkages among countries are growing rapidly. Since World War II, the growth rates of both trade and cross-border investment have consistently exceeded the growth of economic output at the global and regional levels, and for nearly all countries. Since the late-1980s, economic liberalization has spread around the world. After decades of economic isolation, countries such as China, India, Russia, Brazil, Egypt, Mexico, and others have joined the global economy (see Figure 1 on page 5 for a graphical depiction of this phenomenon). Nearly half of global Gross Domestic Product (GDP) growth is projected to occur in developing countries in the next 25 years (see Table 5 on page 7). In a recent study, Goldman Sachs projected that China, India, Russia, and Brazil will all be among the worlds six largest economies by 2050 (this study is discussed in more detail below). The past decade has witnessed the rise of developing country-based multinational firms in sectors as diverse as pharmaceuticals, brewing, banking, white goods, and information technology. Until recently, nearly all global firms were based in the United States, European Union, or Japan (see the Going Global case series for several examples). Globalization is now occurring rapidly in service activities. Globalization has traditionally been concentrated in the natural resources and manufacturing sectors, which employ about 16% of U.S. workers. The services sector provides 78% of employment. (See Exhibit 3 for a depiction of cost savings from moving an activity offshore.) The globalization of services is causing firms to actively reengineer their global operations to better access and leverage global resources. To provide context, Exhibits 1 and 2 present world maps scaled by, respectively, economic output and population. The patterns evident in these maps indicate the challenge and opportunity that globalization

Professor Robert E. Kennedy developed this note. 2008, Robert E. Kennedy.

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creates for managers. For example, the United States has only 4.6% of the worlds population but produces about 26% of global economic activity. At the other extreme, India has about 16.5% of the global population, but produces only about 1.4% of global output. As India enters the global economy through closer trade and investment linkages, it will affect the global economy in many ways. Its customers represent vast potential markets. Its workers are skilled and very low cost. And its firms will create tremendous pressures for global industries to restructure. These effects will unfold over decades and will have a profound impact on nearly all sectors of the economy and every prominent managers career. This note provides a brief profile of the global business environment. It is organized into four sections. The first discusses how economic performance is measured and presents comparative figures for a sample of countries. The second reviews why firms trade and invest across borders and why governments generally encourage such activity. The third section discusses global economic trends. The fourth presents several projections for how the global economy will evolve in the next few decades.

Measuring Economic Performance

Economic performance is often discussed using a concept called Gross Domestic Product (GDP). GDP is defined as the total value of all final goods and services produced within a country during a specified period (most commonly one year). GDP is defined as: GDP = consumption + investment + government expenditures + (exports imports) GDP measures current economic activity within a country. A closely related concept is Gross National Product (GNP), which measures economic activity by a countrys factors of production (people and capital). In practice, the measures track closely for most countries. GDP is by no means a perfect measure of well being. It measures only currently produced goods and services exchanged in market transactions. It ignores non-market events that may improve or subtract from the quality of life. Examples include childrearing, enjoying nature, depleting natural resources, and religious observances. As a stand-alone measure, GDP doesnt provide much insight. To understand a countrys economic performance, the analyst must compare either levels or growth rates across countries. To do so, a countrys GDP must be converted to a common standard - typically the U.S. dollar - using some rate of exchange. At market exchange rates, the United States has by far the worlds largest GDP, with more than twice the aggregate output of Japan (see Table 1). GDP comparisons using official exchange rates offer a good indication of a countrys purchasing power and relative position as a supplier in international markets for goods and services. While quite logical, using official exchange rates can understate the effective domestic purchasing power of the average producer or consumer in less-developed countries. This is because the relative prices or goods and services within a country varies widely across countries. For example, compared with energy or entertainment, domestic help is extremely cheap in India. In the United States, personal services are relatively expensive, while energy is relatively cheap. Someone with an income equivalent to US $20,000 in India can live very well, while that income in the United States would be near the poverty line for a family of four. One measure that attempts to correct for this distortion is the so-called Purchasing Power Parity (PPP) exchange rate. The PPP exchange rate is the rate which equalizes the purchase price of a pre-defined basket of goods. PPP rates often vary substantially from market rates. For example, in India, the PPP GDP

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is more than five times GDP measured at official exchange rates. In very rough terms, this tells us that an Indian worker earning the equivalent of $20,000 lives about as well as a U.S. citizen earning $100,000. When PPP exchange rates are used to rank GDPs, China jumps from the seventh to the second largest economy in the world. India moves from #12 to #4. Table 1

Global Rankings
Ranking 1 2 3 4 5 6 7 8 9 10 Population (millions) China India United States Indonesia Brazil Pakistan Russia Bangladesh Nigeria Japan Luxembourg Bermuda Cayman Islands
Source: World Bank Quick Reference Tables

Aggregate GDP (billion USD) United States Japan Germany United Kingdom France Italy China Spain Canada Mexico India Brazil Nigeria 10,881 4,326 2,400 1,794 1,747 1,465 1,409 836 834 626 586 492 50

PPP GDP United States China Japan India Germany France United Kingdom Italy Brazil Russia Canada Turkey Nigeria 10,871 6,435 3,582 3,096 2,279 1,632 1,606 1,559 1,371 1,318 963 477 139

Per Capita GDP Luxembourg United States Norway Bermuda 55,100 37,800 37,700 36,000

1,288 1,064 291 214 176 148 143 138 135 127 0.45 0.06 0.04

Cayman Islands 35,000 San Marino Switzerland Denmark Iceland Austria Russia India Nigeria 34,600 32,800 31,200 30,900 30,000 8920 520 320

A final measureperhaps most closely related to living standardsis per capita GDP. This measures economic output per person. As the table indicates, many of the countries with the highest GDP per capita are small, relatively specialized economies like Luxembourg, Bermuda, and the Cayman Islands. There is no single best measure of economic performance. Per capita GDP is a reasonable approximation of standard of living. Market rate GDP indicates a countrys aggregate influence in global markets. The United States is unique in that it appears near the top of all four lists. As we will see later, several prominent analysts predict that large developing countriesspecifically Brazil, Russia, India, and China (the so-called BRICs)will become much more predominant in global GDP rankings in the next few decades. Table 2

GDP Growth Rates 1990-2002 (selected countries)

Low/Middle Income Countries China India Poland Argentina Malaysia South Africa (%) 9.7 5.8 4.3 2.7 6.2 2.2 4.3 High Income Country United States Germany Norway France Japan Australia High income countries (%) 3.3 1.6 3.6 1.9 1.3 3.8 2.5

Low/Middle income countries

Source: Global Economic Indicators

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Economic performance over time is generally measured in terms of growth rates. As a general rule, wellmanaged developing countries grow at faster rates than developed countries. This is because they can import capital and technology and follow a development path already blazed by more developed countries. (Table 2 summarizes 12-year growth rates for a selection of countries.)

Why Trade and Invest Across Borders?

History shows that embracing the global economy is crucial to economic growth in rich countries and for development in poor ones. Scan the list of the worlds most successful countries over the past 50 yearsthe United States, Germany, France, Japan, China, Chile, and South Korea. In every case, encouraging cross-border trade and investment flows has been a central element of the countrys economic strategy. At the other extreme, countries that have resisted globalization have generally lagged their more open neighborsfor example, Burma, Tanzania, Afghanistan, the USSR prior to 1989, Venezuela, Zimbabwe after 1997, and India prior to 1991. Engagement in international trade and investment is integral to economic growth because it increases the productivity of local resources, which invariably leads to higher productivity, wages, and living standards. Free trade encourages a country to focus on those things it does relatively well, and to stop doing things it does relatively poorly (economists refer to this as comparative advantage). A countrys standard of living can rise only when the efficiency with which it uses its resources (people, capital, etc.) improves. Tradealong with education, investment, and technological progressare important drivers of productivity growth. Trade has a second important benefit. It increases the range and quality of options available to local consumers and forces local producers to improve their offerings in order to compete more effectively. This pressure is inconvenient for local producers but it benefits consumers. Countries that have lowered their tariff barriers and increased the intensity of competition in the local market often see rapid improvements in productivity as local producers rush to upgrade their products and processes. Much of the discussion around trade policy focuses on the fate of specific workers who are displaced from trade-exposed industries. For example: How are North Carolina textile workers supposed to compete with Sri Lankan workers making one dollar a day? Framing the issue this way ignores the wider benefits of trade. Everyone in a country benefits from the productivity improvements generated by tradeboth those engaged in tradable activities and those in so-called non-tradable sectors such as education, security services, healthcare, construction, hospitality, and personal services. Increasing productivity is always accompanied by the dislocation and reallocation of productive resources, but the overall benefits to the economy vastly outweigh the costs to individual dislocated workers. Consider restaurant workers. U.S. bartenders and wait staff earn 50-70 times more than their counterparts in India. They dont work 50 times as hard, nor are they 50 times more productive. They enjoy high wages because the overall U.S. economy is 50-70 times more productive than Indias and a significant portion of that wealth flows to hospitality workers, teachers, etc. A displaced textile worker may be individually worse off, but those costs are vastly outweighed by the cost, quality, and income improvements for society as a whole. FDI Foreign direct investment (FDI) also leads to an array of benefits. In addition to providing capital to fund investment, direct investors (that is, those that invest directly in firms or physical assets, not publicly traded securities) typically provide technology, links to supply and distribution chains, and management. These factors all raise the productivity of local resources, thus raising wages and the standard of living. Much of Chinas export growth in the past two decades has been driven by foreign-invested production facilities. Investment capital was necessary, but other factors were just as important. Nearly all academic studies indicate that recipient countries realize many and varied benefits from FDI.

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Many factors beyond trade influence a countrys standard of living, including history, natural endowments, and proximity to developed country markets. Most of these factors are fixed, whereas trade and investment policy are decision variables. Experience and numerous academic studies indicate that openness to international trade and investment flows are critical ingredients for development.

Global Economic Trends

The global economy is in the midst of a vast transformation. Globalization can be measured in many waysby exploring government policies, with actual trade and investment flows, or with many other methods. Nearly every measure, however, shows that economic linkages among countries have become more extensive. We review three measures here. The first explores a countrys openness to international trade and investment. First suggested by Sachs and Warner (1994) and updated by Ghemawat and Kennedy (2000), this methodology uses seven factors to calculate a policy openness index for 192 countries. Factors include: average tariff rates, regulatory restrictions on FDI, the presence or absence of a two-tiered foreign exchange system, etc. Figure 1 charts the global shares of market GDP, purchasing power parity GDP, and population in countries that are considered open to the global economy. This doesnt mean that all, or even most, citizens in these countries are engaged in global commerce, just that their national governments are not preventing them from doing so. As the chart illustrates, the share of global population living in open economies was fairly steady from the early 1960s through the mid-1980s. Then, starting around 1986 and accelerating in the early 1990s, dozens of countries implemented programs of economic liberalization that deregulated domestic markets and lowered barriers to trade and investment. In a period of just 13 years (1985 - 1998), the percentage of people living in open economies rose from 23% to 78%. Global shares of GDP and PPP-GDP follow a similar, but less dramatic pattern. Figure 1

Global Openness Shares

1 0 0% 9 0% 8 0% 7 0% 6 0% 5 0% 4 0% 3 0% 2 0% 1 0% 0%

Population

Market GDP

PPP GDP

Measures of trade and foreign direct investment as a percentage of economic activity follow a similar pattern. Since the end of World War II, global GDP growth has averaged around 3.7%, with wide variation across countries and regions of the world. Global trade has grown at a 7.2% compound annual rate, and foreign direct investment flows have grown at a 9.6% rate. Measured as a percentage of country or global economic output (see Table 3) exports and imports (not reported here) have steadily increased.

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Table 3

Global Merchandise Exports as a Percentage of GDP

Country United States Germany Japan China India World 1950 3.0 6.2 2.3 1.2 2.6 7.0 1973 5.0 23.8 7.9 2.1 4.2 11.2 1992 8.2 32.6 12.4 17.5 9.0 13.5 2000 11.7 34.5 10.8 27.6 11.2 20.1

Source: World Bank Global Economic Indicators

A similar pattern is evident with foreign direct investment. While the year-to-year flows of FDI are quite volatile, the cumulative stock of FDI has shown a steady increase since 1960. The rate of increase appears to have accelerated since the early 1980s. Table 4

World FDI Stock as a Percentage of World Output

1960 4.4 1975 4.5 1980 4.8 1985 6.4 1991 8.5 1997 11.8

It is, of course, possible that these trends will reverse. But this seems unlikely. A consensus has developed among development professionals and the vast majority of national economic policymakers regarding how best to help poor countries develop. This view holds that relatively free prices, investment in education, decentralized capital allocation, and openness to the global economy are the best paths out of poverty. After decades of stop-go policy experimentation, the overwhelming majority of low- and middle-income countries have implemented programs of economic liberalization. For those that stay the course, the future looks brighter than the recent past.

Projections
Over the next five years, our experts project that eight developing countries - Brazil, China, India, Mexico, Poland, Russia, South Korea and Thailand - will account for about 50 percent of global auto-industry growth. Rick Wagoner, CEO General Motors Corporation, Jan. 2003 World Bank Projections Every year, the World Bank publishes an in-depth study entitled, Global Economic Prospects and the Developing Countries. This book explores a variety of issues facing developing countries and, based on current and anticipated policies, projects GDP growth by income group and region. Table 5 is adapted from the 2002 edition of the publication. As of 2000, high income countries accounted for about 78% of global GDP and were forecast to grow at their historical rate of 2.6% in the decades to come. The projections for the low- and middle-income

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countries, however, were a revelation. The World Bank projected that low- and middle-income countries would grow at more than twice the rate of high-income countries (5.5% vs. 2.6%) and that low-income countries in every geographic region would outperform the high income countries as a group. For the first time, the World Bank was projecting across the board convergence in income levels. The projections indicate that nearly half of global GDP growth over the next 25 years will occur in developing countries. As a group, these countries will grow their share of global GDP from 22% to 37%. This is a development that few international firms can afford to ignore. Table 5

Projected GDP Growth by Income Level and Region

GDP Growth 1974-98 High Income Countries Low - and Middle Income East Asia South Asia Latin Am and Caribbean Cent. Europe/ Cent. Asia Middle East / N. Africa Sub-Saharan Africa 2.6% 3.6 6.9 5.3 2.9 1.4 1.9 2.3 Projected Growth 2.6% 5.5 7.5 5.9 4.4 5.2 3.7 4.2 GDP Share 2000 78.0% 22.0 6.3 2.0 7.0 3.7 1.9 1.1 GDP Share in 2025 62.6% 37.4 17.9 3.7 9.0 5.8 2.0 1.3 % Incremental Growth 52.3% 47.7 25.6 4.9 10.4 7.2 2.1 1.5

Goldman Sachs BRICs Analysis Goldman Sachs, the well respected investment bank, issued a widely influential study in October 2003 that changed the way many managers view the future of the global economy. The paper, Dreaming the BRICs: The Path to 2050, projected economic growth for the six largest economies today (the G6, which includes the United States, Japan, Germany, the U.K., France, and Italy) with projected growth for four large developing countries it labeled the BRICs (Brazil, Russia, India, and China). The study built an economic model that considered current economic policies, capital accumulation, demographics, and technical innovation. The conclusions are interesting and have caused a fundamental reassessment of emerging market strategies in many leading companies. Conclusions include: Over the next 50 years, the BRICs will become a much larger force in the world economy. Of todays G6, only the United States and Japan will remain among the six largest economies in 2050. As early as 2009, incremental GDP growth in the BRICs will exceed growth in the G6. Total GDP for the BRICs will surpass the current G6 by 2039. The list of the worlds largest economies will look much different in 2050. Many of the largest economies will no longer be among the richest. This will make strategic planning and choices much more complex for international firms. Table 6 summarizes the aggregate GDP projections for each group of countries over the next 50 years. By 2050, the four BRICs will account for more than 60% of these 10 countries output.

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Table 6

Projected GDP (billions of 2004 USD)

2005 Current G6 BRICs 22,548 3,330 2010 24,919 5,441 2020 29,928 12,248 2030 35,927 24,415 2040 44,072 47,013 2050 54,433 84,201

The projections are that the United States will continue to have the highest per capita GDP, but that China will become the largest economy, with India a close third and every other country far behind. The study also projected development paths for individual countries. All four BRICs are projected to close the per capita GDP gap with todays leaders, with Russia forecast to catch and surpass Germany by the end of the period. Table 7 summarizes the current and projected GDP measures for a selection of countries. Table 7

Current and Projected GDP Measures (billions of 2004 USD)

United States 2000 GDP per capita GDP 2050 GDP per capita GDP 35,165 83,710 3,603 48,954 6,074 26,592 5,870 49,646 27,803 17,366 44,453 31,357 9,825 34,797 1,875 22,814 762 4,338 391 2,675 469 468 1,078 854 Germany Brazil Russia India China

Conclusion
The global economy has undergone substantial changes in the past 20 years. It is likely to change even more over the next 50 years. The engines of growth in the new global economy are increasingly located in developing countries. How managers seize these opportunities and manage the challenges these trends create will determine the success or failure of their companies, and of their careers.

Exhibits
Exhibit 1

The Global Business Environment

GDP-Weighted Map of the World

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Exhibit 2

The Global Business Environment

Population-Weighted Map of the World

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Exhibit 3

Total Delivered Cost as a Percentage of US Cost

100%

80%

"Manufacturing"
65% 55%

"Services"

75% Potential for Trade

48% 40% 40% 35%

50%

25%

0% Auto Parts Textiles SW - Detailed Design SW-Testing Coding SW Maintenance Call Center Payment Sevices

% US Employment <--------- 16% --------->

<--------- 78% ----- ----->

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