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EDUCATION
Unit-I
International Business : An overview-types of international business;
the external environment; the economic and political environment, the
human cultural environment; influence on trade and investment
patterns; recent world trade and foreign investment-trends, country
risk.
Ans. Apart from the political and legal environment, the economic environment also
influences international business decision. This is because the decision to trade or locate
manufacturing operations varies from one host country to other, depending upon the form
of economic system existing there and various economic parameters prevailing there, for
example, level of income and inflation, health of industrial, financial and external sector
and many others.
Types : There are three types of economic system :
(a) Centrally Planned Economy : It is an economy where production and
distribution system is owned by the Government. The Govt designs the investments and
coordinates the activities of different economic sectors. Ownership of the means of
production and the whole process of production lies in the hands of Govt. the former
USSR and other Eastern countries were examples of these types of economic system. In
international trade, normally the state trading corporation participates that highly
influences the consumers and business.
(b) Market Based Economy : It is an economy where the decision to produce and
distribute goods is taken by individual firm based on the forces of demand and supply.
They take such decision for the purpose of maximising profit or wealth. Consumers are
free to decide what they want to buy. The United States of America and Western
European countries are example of market based economy. In market based economy,
trade is handled by individual firms that affect the international business.
(c) Mixed Economy : It is a compromise between CPE and market based economy
where private and public sectors exist side by side. There is no country that represents
any of the two systems in its purest form. Indian economy system represents mixed
economic system. Economic activities that are fraught with social considerations are
owned and regulated by the Govt. The others are owned and performed by private
sectors.
Germany under the rule of Hitlor and Stalin;s Soviet Union were historical examples of
totalitarianism regime. Myanmar is the example of totalitarianism Government.
Political Risk : Political risk is unexpected changes in political set up in the host
country leading to unexpected discontinuities that bring about changes in very business
environment. For example, if a rightist party wins election in the country and the policy
towards the foreign investment turns liberal, it would create appositive impact on the
operation of MNCs. On the other hand, if a left party comes in power in the host country,
it will have a negative impact on the operation of MNCs.
Types of Political Risk : Stephen Kobrin classifies political risk as :
(1) Macro Risk : It is also called country specific risk that affects all foreign firms in the
country.
(a) Expropriation : It means seizure of private property by the Govt. it involves
payment of compensation. The reason behind expropriation has mainly been political
turmoil. In the post war period, foreign and domestic firms were nationalized in China in
1960. The Swedish Govt nationalized the ship building industry at a time when this
industry was hit by world wide recession. an estimate revels that around 12 % of all
foreign investment made in 1967 was nationalised within less than a decade.
(b) Currency Inconvertibility : Sometimes the host Govt enacts law prohibiting
foreign companies from taking their money out of the country or exchanging the host
country currency for any other currency. The reason is both economic and political. The
Govt of Nigeria imposed such restrictions a couple of decades back in order to serve its
economic and political objectives.
(c) Credit Risk : Credit risk is refusal to honour a financial contract with a foreign
company or foreign debts. For example when Khomeini came into power in Iran, the
Iranian Govt refuse to pay its debts on grounds that loans were taken during Shah’s
regime.
(d) Ethnic, Religious or Civil Strife : Macro political risk arises on account of war and
violence and racial, ethnic, religious and civil strife within a country. Recent example of
these risks is slaughter in Bosnia and Herzegovina, breakdown of local authority in
Somalia and Rwanda, the upsurge of Islamic fundamentalism in Algeria and Egypt. Such
risks become major political risks for MNCs operating in these countries.
(2) Micro Risk : The micro or firm specific risk affecting a particular industry or firm.
The micro risks are :
(a) Conflict of interest : The host Govt desires to have a sustainable growth rate, price
stability, comfortable balance of payment, and so on, but the policy of MNCs operating
there is to maximize corporate wealth. For example, transfer of funds by MNCs may
influence the money supply and may cause inflation or deflation. MNCS may adopt
transfer pricing techniques that may cause loss of tax revenue. It is not simply economic
issues that cause conflicts but also non-economic issues like national security. The US
Govt did not permit the Japanese purchase of Fairchild Industries on the grounds of
national security.
(b) Corruption : It is endemic in many countries, as a result MNCs have to face
serious problems. Foreign firms in Kenya had to sell a part of equity to powerful
politician. Transparency International has surveyed 85 countries and has brought about
the corruption perception index. Many countries rank high in the index. In 1999 34
countries, including OECD members and five other signed a convention to ban bribery of
foreign public officials in international business transaction.
Evaluation of Political risk : Assessment of political risk is first step before a firm moves
to abroad. It is because if such risks are very high, the firm would no like to operate in
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that country. If the risk is moderate or low, the firm will operate in that country but with a
suitable political risk management. There are two ways of risk assessment:
(a) Qualitative Approach : It involves inter-personal contacts. Person may come
from within the enterprise or may come from out side the firm. Those persons are often
well acquainted with the political structure of a particular country or region. Kraar has
cited the example of Gulf Oil, which hired person in Govt since and from universities to
find out whether investment in Angola would be safe.
Sometimes company sends a team of experts for on-the spot study of the political
situation of a particular country. This step is only taken after a preparatory study yields
favorable features. This method always gives a more reliable picture subject to availability
of correct information from the local people.
This approach also involves the examination and interpretation of diverse
secondary facts and figures. For this purpose, companies maintain an exclusive risk
analysis division.
(b) Quantitative Approach ; Quantitative tools are also used to estimate political risk.
American Can uses a computer programme known as primary risk investment screening
matrix involving about 200 variables and reducing them to two numbers. It represents an
index economic variability as also an index of political stability. The variables includes, in
general, frequency of change of Govt, level of violence in the country, number of armed
insurgencies, conflicts with other nations and economic factors such as inflation rate,
external balance deficit, growth rate of economy and so on.
Management of political Risk : The political risk management strategy depends upon
the types of the risk and the degree of risk the investment carries. It also depends upon
the timing of the steps taken. There are two types of strategies :
(a) Management Prior to Investment : there are five ways to manage it :
(i) Capital budgeting: in this method , the factor of political risk is included in
the very process of capital budgeting and the discount rate is increased.
(ii) By Reducing the Investment Flow : The risk can be reduced by reducing
the investment flow from the parent to the subsidiary and filling the gap through
local borrowing in the host country. In this strategy, it is possible that the firm may
not get the cheapest fund, but the risk will be reduced.
(iii) Agreement : The political risk can also be reduced by negotiating
agreements with the host Govt. prior to making any investment.
(iv) Planned Divestment : It is yet another method of reducing risk. If the
company plans to orderly shifting of ownership and control of business to the local
shareholders and it implements the plan, the risk of expropriation will be minimal.
(v) Insurance of Risk : The investing firm can be insured against political risk.
Insurance can be purchased from governmental agencies, private financial service
organisation or from private property-centred insurers.
(b) Risk Management during the Life Time of the Project : Management of risk during
pre-investment phase reduces the intensity of risk, but does not eliminate it. There are
four ways to handle the risk in this phase :
(i) Joint Venture and Concession Agreement : In a joint venture agreement,
the participants are local shareholders who have political power to pressurize the
govt to take a decision in their favour or in favour of enterprise. The govt is
interested in earning from the venture and so it does not cancel the agreement
(ii) Political Support : Risk can be managed with political support. International
companies act sometimes as a medium through which the host govt fulfills its
political needs.
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Qu. 4 Write note on recent world trade and foreign investment trends.
Ans. World Trade : For quite a long time, global trade has grown faster than word
output and the trend is likely to continue in future. Exports of developing countries have
been growing faster than those of the developed. The growing faster means growing
proportion of the national output is traded internationally.
For more than two and half decade until the oil stock of the early 1970’s there was
a tremendous of world trade propelled by the progressive trade liberalization and high
growth rates of output. There after there has been a substantial growth of non-tariff
barriers and a fall in the growth rates of the developed economies causing a slow down of
the pace of trade growth. However, the growth of the world trade has been significantly
higher than that of the world output.
A trade growth continued to exceed output growth, the ratio of the world trade in
goods and services to world GDP reached 29% in 2000. Since, 1990, this ratio has been
increased 10% points, more than in two preceding decades combined.
The first rank in terms of the value of exports had been occupied by US, with
Germany and Japan in second and third position respectively, followed by France, UK
and Italy in that order. An important aspect of global trade is the large intra-regional
trade. India’s share in global exports was 0.4% in 1980. Since around the mid 1980’s
there has been a slightly improvement.
Export of developing countries, as a group, has been growing faster than those of
the developed countries. As a result their share in the global exports increased very
significantly so that their share in world trade exports today is merely 30% while their
share in global GNP is about 20%. Many countries have been marginalized by global
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trading system. The share of the 50 least developed countries (LDC) in the global trade
is very dismal about 0.5%. A major part of this is the contribution of a small number
among them.
In short, developing countries present a mixed picture of trade performance. On
the one side there is a picture of spectacular performance of some countries and on the
other there is a dismal presented by many. One is therefore tempted to draw a
hypothesis that trade performance has something to do with the domestic economic
factors, including the development and trade strategies.
Foreign Investment : Foreign investment takes two forms :
(1) Foreign Portfolio Investment : It is an investment in the share and debt
securities of companies abroad in the secondary market nearly for sake of returns and
not in the interest of the management of the company. It does not involve the production
and distribution of goods and services. It simply gives the investors, a non-controlling
interest in the company. Investment in the securities on the stock exchange of foreign
country or under the global depository receipt mechanism is an example.
(2) Foreign Direct Investment : It is very much concerned with the operations and
ownership of the host country. It is an investment in the equity capital of a company
abroad for the sake of the management of the company or investment abroad through
opening of branches. It is found inform of :
(a) Green-field Investment : It takes place either through opening of branches in
foreign countries or through foreign financial collaboration. If the firm buys entire equity
shares of a foreign company, the later is known as wholly-owned subsidiary of the buying
firm. In case of purchase of more than 50% shares, the later is known as subsidiary of
the buying firm. In case of less than 50%, the later is known as equity alliances. General
Motors of USA has 20% shares in the equity of the Italian firm Fiat and Fiat maintains 5%
shares in equity of General Motors.
(b) Merger and Acquisition : M &A are either out right purchase of running company
abroad or an amalgamation with a running foreign company. There are three forms of M
&A:
(i) Based on corporate structure : Acquisition, where one firm acquire or
purchase another firm. Amalgamation, in this two merging firms lose their identity
into a new firm that comes into exist representing the interest of the two.
(ii) Based on Financial Relationship: It can be vertical, horizontal and
conglomerate. In horizontal, two or more firms are engaged in similar lines of
activities join hands. Horizontal m & A helps to create economies of scales in
occurs among firms involved in different stages of production of a single final
product. If oil exploration and refinery firms merge, it will be called a vertical
integration. Conglomerate merger involves two or more firms in unrelated
activities. There are financial conglomerates where a company manages the
financial function of other companies in the group. Similarly, there are
managerial conglomerates combining the management of several companies
under one roof.
(iii) Based on techniques : M & A are either Hostile or Friendly. In the
hostile takeovers, the time devoted to negotiations is minimized as much as
possible because it is just the discreet purchase of shares of the target company.
In friendly takeovers, there are a lot of negotiations. The takeover deal is not
disclosed until it is finalised. To this end, the acquiring company signs the
confidentiality letter whereby it promises not to disclose the fact to third party.
Finally, after the announcement is made to the press, a contract is signed.
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Motivation of Merger & Acquision : There are following motives behind M & A :
(a) M & A provides synergistic advantages. For example, when the fixed costs in firm
A does not cross the relevant range even after it acquires firm B, the combination will lead
to saving of fixed costs that firm B was previously incurring.
(b) It enables the overnight growth of firm. At the same time very risk of competition
reduces after merger.
(c) It reduces financial risks through greater amount of diversitification. More
particularly in case of conglomerates, assets of completely differently risk classes are
acquired and there are possibilities of negative correlation between the rates of return.
(d) It leads to diversification, which raises the debt capacity of the firm. It helps the
cost of capital to move downward and raises the value of corporate wealth.
(e) The tax savings sometimes leads firms to combine.
In international business, M & A are very common now a day because of above
said reasons. However, international M & A sometimes becomes an essential step when
the domestic market is saturated and firm is desirous of further expansion for reaping
gains from external economies.
Unit – II
The excess of debit is wiped out. Thus the concept of BOP is based on the concept of
accounting equilibrium, that is :
Current account + capital account +0
The accounting balance is ex post concept that describes what has happened over a
specific past period.
Disequilibrium : In economic terms, BOP equilibrium occurs when surplus or deficit is
eliminated from the balance of payments. In real such equilibrium is not found, rather
disequilibrium in the BOP which is a normal phenomenon. There are external economical
variables influencing the BOP and giving rise to disequilibrium. Some important variables
are :
(i) National Output and Spending : If the national income exceeds spending, the
excess amount will be invested abroad, resulting in capital account deficit. Excess of
spending over income causes borrowings from abroad, pushing the capital account into
surplus zone.
(ii) Money Supply : Increase in money supply rises the price level and export turn
uncompetitive. Fall in export earnings leads to deficit in current account. The higher
price of domestic goods makes the price of imported commodities competitive and import
rise, leading to enlargement in the current account.
(iii) Exchange Rate : If the currency of a country depreciates, export becomes
competitive. Export earnings improve. On the other hand import becomes costlier. If as
a result import is restricted, the trade account balance will improve. But if imports are not
restrained, deficit will appear in the trade account. The net effect depends upon how far
the demand for export and import is price elastic.
(iv) Interest Rate : The increase in domestic interest rate causes capital inflow in lure
of higher returns. Capital account runs surplus. The reverse is the case when the
interest rate falls.
Adjustments : Disequilibrium becomes a cause of concerns when it is associated with
the current account. This is because current account represents shift in real income and
at the same time any adjustments in this account is not very easy. If balance of trade is in
surplus, its correction is not difficult. The surplus amount is used in meeting the deficit on
invisible account or it may be invested abroad. But if the balance of trade is in deficit and
the deficit is large, so as not to be covered by invisibles trade surplus, current account
deficit will occur. If the deficit on the current account continues to persist, official reserve
will be eroded. If a country borrows large amount to meet the deficit, it may fall to a
vicious debt trap. This is why adjustment measures are primarily aid at correcting
disequilibrium in the trade account.
Ans. There have been a number of theoretical explanations on international trade and
investment.
TRADE THEORY :
Following are the trade theories:
Classical theory : there are two classical theories :
(i) Theory of Absolute Cost Advantage : Adam Smith compounded this theory of
international trade in 1976. He was of the opinion that productive efficiency differed
among different countries because of diversity in natural and acquired resources
possessed by them. The theory explains that a country having absolute cost advantage in
the production of a product on the account of greater efficiency should specialize in its
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production and export. For example, suppose country ‘A’ produces 1 kg of rice with 10
units of labour or it produces 1 kg of wheat with 20 units of labour. Country ‘B’ produces
the same amount of rice with 20 units of labour and same amount of wheat with 10 units
of labour. Each of countries has 100 units of labour. Equal amount of labour is used for
the production of two goods in the absence of trade between them. But when the trade is
possible between two countries, ‘A’ will produce only rice and exchange a part of rice
output with wheat from country ‘B’. Similarly country ‘B’ will do. The total output of both
the countries will rise because of trade.
(ii) Theory of Comparative Cost Advantage : This theory is compounded by David
Ricardo. The theory explains that a country should specialize in the production and
export of a commodity in which it possesses greatest relative advantage. For example,
Bangladesh and India, each of the two has 100 units of labour. In Bangladesh, 10 units
of labour are required to produce to produce either one kg of rice or one kg of wheat. On
the contrary, in India, 5 units are required to produce one kg of wheat and 8 units are
required to produce one kg of rice. From the viewpoint of absolute cost advantage, there
will be no trade as India possesses absolute cost advantage in the production of both the
commodities. But Ricardo is of the view that from the viewpoint of comparative cost
advantage, there will be trade, because India possesses comparative cost advantage in
the production of wheat. This is because the ratio of cost between Bangladesh and India
is 2:1 in case of wheat, while it is 1.25: 1 in case of rice. Because of this comparative
cost advantage, India will produce 20 kg of wheat with 100 units of labour and export
apart of wheat to Bangladesh. On the other hand, Bangladesh will produce 10 kg of rice
with 100 units of labour and export apart of rice to India. The total output of foodgrain in
the two rises because of trade.
Limitations : Despite of being simple, the classical theory of international business
suffers of following limitations :
(i) It takes into consideration only one factor of production that is labour. But in real
world, there are other factors that play a decisive role in production.
(ii) The theory assumes the existence of full employment, but in practical, full
employment is not possible.
(iii) Theory stress too much on specialization that is expected to improve efficiency.
But it is not always the case in real life.
(iv) Classical economist feel that resources are mobile domestically and immobile
internationally. But neither of the two assumptions is correct
Summary : The Classical theory holds good even today insofar as it suggest how a
nation could achieve the consumption level beyond what it would in absence of trade.
Factor Proportions Theory or Heckschar and Ohlin Model
The theory was compounded by two Swedish economists, Eli Heckscher and Bertil
Ohlin. The theory explains that a country should produce and export a commodity that
primarily involves a factor of production abundantly available in the country. For example,
country ‘A’ has large population and large labour resources. Thus it will be able to
produce the goods at a lower cost using a labour intensive mode of production. Country
‘B’ has abundance of capital but is short of labour resources and will specialize in goods
that involve a capital intensive mode of production. After the trade, both the countries will
have two types of goods at the lest cost. Mr. Samuelson went a few steps ahead saying
that in this way the prices of factors of production tend to equalize among different
countries. Leontief found in his empirical study that the USA being the capital abundant
economy, exported labour intensive goods. But he was of this view that such possibilities
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could not be ruled out because the USA was able to produce labour intensive goods in a
capital intensive fashion.
Neo-Factor proportion Theory
Extending Leontief’s view, some of the economist emphasis on the point that it is
not only the abundance of a particular factor, but also the quality of that factor of
production that influences the pattern of international trade. The quality is so important in
their view that they analysis the trade theory in a three-factor framework :
(a) Human capital : It is the result of better education and training. Human capital
should be treated as a factor input like physical labour and capital. A country with human
capital maintains an edge over other countries with regards to the export of commodities
produces with the help of improved human capital.
(b) Skill Intensity : The skill intensity hypothesis is similar to human capital hypothesis
as both of them explain the capital embodied in human beings. It is only empirical
specification that differs.
(c) Economies of Scale : It explains that with rising output, unit cost decreases. The
producers achieve internal economies of scales. A country with large production
possesses an edge over other countries with regards to export. However, a small country
can reap such advantages if it produces exportable in large quantities.
National Competitive Advantage
The theory is compounded by Porter. This theory explains that countries seek to
improve their national competitiveness by developing successful industries. The success
of targeted industries depends upon a host of factors that are termed the diamond of
national advantage. The factors are :
(a) Factor Conditions : It show how far the factors of production in a country can be
utilised successfully in a particular industry. This concept goes beyond the factor
proportion theory and explains that an availability of the factor of production per se is not
important, rather their contribution to the creation and upgradation of products is crucial
for competitive advantages.
(b) Demand Condition : The demand for the product must be present in the domestic
market from the very beginning of production. Porter is of view that it is not merely size of
the market that is important, but it is intensity and sophistication of demand that is
significant for competitive advantage.
(c) Related and Supported Industries : The firm operating along with its competitors
as well as its complementary firms gathers benefit through a close working relationship in
form of competition or backward and forward linkage.
(d) Firm Strategy, Structure and Rivalry : The firm’s own strategy helps in augmenting
export. There is no fixed rule regarding the adoption of a particular strategy. It depends
on the numbers of factors present in the home country or the importing country.
Limitations : There are various criticism put forth against Porter’s theory :
(a) There are cases when absence of any factors embodied in Porters diamond does
not affect the competitive advantage. For example, when a firm is exporting its entire
output, the intensity of demand at home does not matter.
(b) If the domestic supplier of input is not available, the backward linkage will be
meaningless.
(c) Porter’s theory is based on empirical findings covering 10 countries and four
industries. A majority of countries in the sample have different economic background and
don’t necessarily support the findings.
(d) Availability of natural resources, according to Porter are not the only conditions for
attaining competitive advantage. And there must be other factors too for it. But in 1985,
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some Canadian industries emerged on the global map only on the basis of natural
resources.
(e) Porter feels that sizable domestic demand must be present for attaining
competitive advantage. But there are industries that have flourished because of demand
from foreign sales.
Summary: Nevertheless these limitations do not undermine the significance of Porter’s
theory.
INVESTMENT THEORY
There are a number of investment theories. Except for MacDougall hypothesis,
investment theories are primarily based on imperfect market conditions. A few of them are
based on imperfect capital market.
MacDougall-Kemp Hypothesis: Assuming a two-country model- one being the investing
and other being the host country and the price of capital being equal, the investment
flows from abundant economy to a capital scare economy until the marginal productivity
of capital in both the countries are equal or till the returns from investment is greater than
the loss of output in home country.
Industrial Organisation Theory : The theory is based on oligopolistic or imperfect market
in which the investing firm operates. Market imperfection arises in many cases, such as
product differentiation, market skills, proprietary technology, managerial skills, better
access to capital, economies of scales, government imposed market distortion and so on.
Such advantages confer MNCs an edge over their competitors in foreign locations and
thus helps in compensate the additional cost of operating in an unfamiliar environment. It
refers to technological and similar other advantages possessed by a firm that enable it to
produce new and differentiated products.
Location Specific Theory : This theory is compounded by hood and Young. It refers to
advantages like cheap labour, abundantly available raw material, and so on for the
production of a commodity to be established in a particular location or country. Since real
wage cost varies among countries, firms with low cost technology move to low wage
country.
Product Cycle Theory : Raymond Vernon feels that most product follow a life cycle that
is divided into three stages :
(a) Innovation Stage: It is a stage in the product cycle when the product is in demand
because of its new and improved quality, irrespective of its price. The product is
manufactured in the home country primarily to meet the domestic demand but a portion of
the output is exported to the other developed countries.
(b) Maturing Product Stage : At this stage, the demand for the new product grows
and it turns price elastic. Rival firms in the host country begin to supply similar product at
a lower price owing to lower distribution cost, whereas the product of innovator is costlier
as it involves transportation cost and tariff that is imposed by the importing government.
Thus to compete with the rival firms, innovator decides to set up a production unit in host
country itself which would lead to internationalization of product.
(c) Standardised Product ; It is the stage in the product cycle when technology
does not remain the exclusive possession of innovator and competition turns stiffer. At
this stage price competitiveness becomes even more important and the innovator shifts
the production to a low cost location, preferably a developing country where labour is
cheap.
(d) Denaturing Stage : It is the stage when development in technology or in
consumer’s preference breaks down product standradisation. Cheap labour does not
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Unit- III
Qu. 7 Explain various types of tariff and non-tariff barriers. What are
the objectives of these barriers?
Ans. International trade is affected by a number of factors including government policies.
The government endeavor to promote export and import in many countries are hit by
protectionism and trade barriers.
Types : There are two types of barriers :
(a) Tariff Barriers : Tariff in international trade refers to the duties or taxes imposed on the
import traded goods when they cross the national borders. After Second World War,
there has been a reduction in the average level of Tariffs in the advanced countries. Tariff
rates are generally high in developing countries. With the recent economic liberalization
across the world, many developing countries have reduced the tariff as a part of their
trade liberalization. in most economies and organisation like WTO prefers tariff to non-
tariff barriers because tariff are transparent and less regressive than non-tariff barriers.
The developed countries tariff continues to be very strenuously loaded against the
developing ones.
Characteristic:
• Tariff applied on to consumer goods are often higher than on the cheaper goods of
luxury version.
• There is also tariff escalation, when tariff increases with degree of processing
involved in the product.
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(b) Non-Tariff Barriers : Non-tariff barriers are new protectionism measures that have
grown considerably, particularly since around the beginning of 1980s. The export growth
of many developing countries has been seriously affected by non-tariff barriers.
Categories of NTBs :
(i) Those which are generally adopted by developing countries to prevent foreign
outflow or result from their chosen strategy of economic development. These are mostly
traditional NTBs like import licensing, import quotas, foreign exchange regulations and
canalization imports.
(ii) Those which are mostly used by developed countries to protect domestic
industries which have lost international competitiveness or which are politically sensitive
for government. For example Import Prohibition, Quantitative Restrictions, Variable
Levi’s, Multi-Fiber Arrangements, Voluntary Export Restraint and Non-Automatic
Licensing. Example of NTBs excluded from the group includes technical barriers
(including health and safety restriction and standards), Minimum Pricing Regulations and
Use of Price Investigation and Pricing Surveillance.
Ans The theories of exchange rate are divided into following categories :
DETERMINANTS OF EXCHANGE RATE IN SPOT MARKET There are following two
theories under this category :
(a) Process of determination : It is the interplay of demand and supply that determines
the exchange rate between two countries in a floating rate-regime. For example, the
exchange rate of Indian rupee and the US dollar depends upon the demand for the US
dollar and supply of dollar in Indian foreign exchange market. The demand for foreign
currency comes from individuals and firms who have to make payments to foreigners in
foreign currency, mostly on account of import exchange result, services and purchase of
securities. The supply of foreign exchange results from the receipt of foreign currency,
normally on account of export or sale of financial securities to the foreigners.
In the following figure, the demand curve slopes downwards to the right because
the higher the value of US dollar, the costlier the imports and the importers curtails the
demand for higher value of the US dollar makes export cheaper and thereby, stimulates
the demand for export. The supply of US dollar increases in the form of export earnings.
This why, the supply curve of US dollar moves downwards to the right with a rise in its
value. The equilibrium exchange rate arrives where the supply curve intersects the
demand curve at Q1. This rate, as shown in the figure, is Rs 40/US $.
S
Rs/US$
S1
42
40
D1
D
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Q1 Q2 Q3
Demand for and supply of US$
If the demand for import rises owing to some factors at home, the demand for the
US dollar will rise to D1 and intersect the supply curve at Q2. The exchange rate will be
Rs 42/US$. But if the export rises as a result to decline in value of rupee and supply of
the dollar increase to S1, the exchange rate will again be Rs 40/US$. So the frequent
shifts in demand and supply condition cause the exchange rate to adjust to a new
equilibrium.
(b) Purchasing Power Parity Theory (PPP) : This theory was compounded by Cassel
in 1921. There are two version of this theory :
(i) Absolute Version ; The theory suggest that at any point of time, the rate of
exchange between two currencies is determined by their purchasing power. If e is the
exchange rate and Pa and Pb are the purchasing power of the currencies in the two
countries, A and B, the equation can be written as :
e = Pa / Pb
This theory is based on the theory of one price in which the domestic price of any
commodity equals its foreign quoted in the same currency. For example, if the exchange
rate is Rs 2/US$, the price of a particular commodity must be US $ 50 in the USA if it is
Rs 100 in India.
US$ price of commodity x price of US$ = Rupee price of the commodity
The exchange rate adjustment resulting from inflation may be explained further. If the
Indian commodity turns costlier, its export will fall. At the same time, its import from the
USA will expand as the import gets cheaper. Higher import will raise the demand for the
US dollar raising, in turn its value vis-à-vis.
Limitation : however this theory holds good if the same commodity are included in the
same proportion in the domestic market and world market. Since it is normally not so, the
theory faces a serious limitation as it does not cover non-traded goods and services,
where the transaction costs are significant.
(ii) Relative version : To overcome the limitation of absolute version, this theory has
evolved. This version of PPP theory states that the exchange rate between the currencies
of two countries should be constant multiple of the general price indices prevailing in the
two countries. In other words, the percentage change in the exchange rates should equal
the percentage change in the ratio of price indices in the two countries. For example, if
India has inflation rate of 5% and the USA has a 3% rate of inflation and if the initial
exchange rate is Rs 40/US$, the value of the rupee in two years period will be
e2 = 40[1.05/1.03]2 or Rs 41.75/US$
The theory suggests that a country with a high rate of inflation should devalue its currency
relative to the currency of the countries with lower rate of inflation.
Assumption : The theory holds good if :
• Changes in the economy originate from the monetary sector.
• The relative price structure remains stable in different sectors in view of the fact
that change in the relative price of various goods and services may lead differently
constructed indices to deviate from each other.
• There is no structural change in the economy, such as change in tariff, in
technology and in autonomous capital flow.
ODM COMPUTER MGT.EDUCATION
Limitation of PPP : A number of studies have empirically tested the two version of the
PPP theory. There are three factors why this theory does not hold good in real life :
• The assumptions of this theory do not necessarily hold well in real life.
• There are other factors such as interest rate, governmental interference and so on
that influences the exchange rate. In 1990, some of the European Countries
experienced a higher inflation rate than in the USA, but their currency did not
depreciate against dollar in view of high interest rate attracting capital from the
USA.
• When no domestic substitute is available for import, goods are imported even after
their prices rise in the exporting countries.
DETERMINANTS OF EXCHANGE RATE IN FORWARD MARKET
Forward exchange rates are normally not equal to the spot rate. There are two
theories :
(i) Interest Rate Parity Theory (IRP): The determination of exchange rate in a forward
market finds an important in the theory of Interest Rate Parity (IRP). The IRP theory
states that equilibrium is achieved when the forward rate differential is approximately
equal to the interest rate differential. In other word, the forward rate differs from the spot
rate by an amount that represents the interest rate differential. In this process, the
currency of a country with lower interest rate should be at forward premium in relation to
the currency of a country with higher rate of interest rate. On the basis of IRP theory, the
forward exchange rate can easily be determined. One has simply to find out the value of
the forward rate (F) in the equation. The equation should be :
For example, suppose interest rate in India and the USA is, respectively, 10% and 7%.
The spot rate is Rs 40/US$. The 90-days forward rate can be calculated as follows :
F = 40/4[1.10/1.07-1]+40
= Rs 40.28/US$
it means a higher interest rate in India will push down the forward value of the rupee from
40 a dollar to 40.28 a dollar.
(ii) Covered Interest Arbitrage : This theory states that if interest rate differential is
more than forward rate differential, covered interest arbitrage manifests in borrowing in a
country with low interest rate and investing in a country with high interest rate so as to
reduce the interest rate differential. For example, suppose the spot rate is Rs 40/US$
and three month forward rate is Rs 40.28/US$ involving a forward differential of 2.8%.
Interest rate is 18% in India and 12% in the USA, involving an interest rate differential of
5.37%. Since the two differentials are not equal, covered interest arbitrage will begin. So
long as the inequality continues between the forward rate differential and the interest rate
differential, arbitrageurs will reap profit and the process of arbitrage will go on. However,
with this process, the differential will be wiped out because:
• Borrowings in USA will raise the interest rate there.
• Investing in India shall increase the invested funds and thereby lower the interest
rate there.
ODM COMPUTER MGT.EDUCATION
• Buying rupees at spot rate will increase the spot rate of rupee
• Selling rupee in forward will depress the forward rate of rupee.
Limitation : The study of Martson shows that the theory held good with greater
accuracy in the Euro-currency in view of the fact that there exist ed complete freedom
from controls and restrictions. But there are some limitations that as follows:
• Since different rates prevails in bank deposits, loans, treasury bills, and so on, the
short term interest rate can not be specific and chosen rate can hardly be the
definite rate of formula.
• Marginal rate of interest applicable to borrowers and lenders differs from the
average rate of interest in view of the fact that interest rate changes with
successive amount of borrowing.
• The investment in foreign assets is more risky than that of domestic assets.
• There are cases when interest rate parity is disturbed owing to the play of
extraordinary forces which leads to speculation. It is basically the market
expectation of future spot that influences the spot rate that influences the forward
the forward rate.
• The proponents of modern theory feel that it is not only the role of arbitrageurs but
of all participants in foreign exchange market, such as traders, hedgers and
speculators that influences the forward rate.
•
Qu. 9 Write short note on Euro-currency, IMF, IDA and IBRD.
deposit, but also to some extent by swapping other currencies into dollar, and the re-
landing of these dollars, often after redepositing with other banks, to non-bank borrows
any where in the world.
(d) The currencies involved in Eurodollar market are not in any way different from the
currencies deposited with banks in the respective home countries. But the Euro-dollar is
out side the orbit of this monetary policy whereas the currency deposited with banks in
the respective home country is enveloped by the national monetary policy.
INTERNATIONAL MONETARY FUND (IMF)
It was created in 1945 to help and promote the health of world economy. It has its
Headquarters in Washington DC. It is governed by and accountable to the governments
of 184 countries. It was conceived at a United Nations conference in Bretton Woods,
New Hampshire, US in July 1944. the 45 countries govt represented at that conference
and sought to build a framework for economic cooperation that would avoid a repetition of
the disastrous economic policies that had contributed to great depression in 1930s.
About IMF :
• Current membership : 184 countries
• Staff : approximately 2680 from 139 countries.
• Total Quotas : $321 Billion (as of 31/8/2005)
• Loans Outstanding: $71 billion to 82 countries, of which $10 billion to 59 on
concessional terms.
• Technical Assistance provided: 381 person year during FY 2005
• Surveillance consultations concluded: 129 countries during FY-2005, of which
118 voluntarily published information on their consultation.
Responsibilities of IMF : The main responsibilities of IMF as per article 1 of ‘Article of
Agreement’ are as follows :
• To promote international monetary cooperation.
• Facilitating the expansion and balanced growth of international trade
• To promote exchange stability.
• Assisting in the establishment of multilateral system of payments.
• T make its resources available to members experiencing balance of payments
difficulties.
IMF Activities :
(a) Promote Global Growth And Economic Stability : The IMF works to promote
global growth and economic stability and thereby prevent economic crisis by encouraging
countries to adopt sound economic policies.
(b) Help In Recovery : Whenever member countries experience difficulty to finance
their balance of payments, the IMF is the fund that can be tapped to help in recovery.
(c) Reduce Poverty : The IMF is also working actively to reduce poverty in
countries around the globe, independently and in collaboration with World Bank and other
organisations.
(d) Poverty Reduction strategy Papers : In most low-income countries, these papers
are prepared by country authorities in consultation with civil society and external
development partners to describe comprehensive economic, structural and social policy
framework that is being implemented to promote growth and reduce poverty in the
country.
IMF Governance and Organisation : The IMF is accountable to the governments of its
member countries. At apex of its organizational structure is its Board of Governors that
consists of one Governor from each of the IMF’s 184 countries. All Governors meet once
ODM COMPUTER MGT.EDUCATION
each year at IMF-World Bank Annual Meeting, 24 of Governors sit on The International
Monetary and Finance Committee (IMFC) and meet twice each year. The day-to-day
work of the IMF is conducted at Washington DC headquarters by its 24-members
Executive Board. This work is guided by the IMFC and supported by the IMF’s
professional staff. The Managing Director is Head of IMF staff and Chairman of Executive
Board and assisted by three Deputy Managing Directors.
INTERNATIONAL DEVELOPMENT ASSOCIATION (IDA)
It is an affiliate of IBRD. It was established in 1960 to provide assistance for the same
purpose as the IBRD, but primarily in the poorer developing countries and on terms that
would bear less heavily on their balance of payments than IBRD loans. IDA’s assistance
is therefore concentrated on the very poor countries.
The funds used by IDA, called credits to distinguish them from IBRD loans, come
mostly in the form of subscriptions, general replenishment from IDA is more industrialized
and developed members and transfers from the net earnings of the IBRD.
The term of IDA credits that are made to governments only, are ten years grace
period, fifth year maturities and no interests. The IDA provides soft loans to member
countries. Its object is to provide loan to member countries on liberal terms in so far as
these relate to the rate of interest and the period of repayment. Another attraction of Ida
loans is that they can be repaid in currency of member countries.
Developing countries can avail themselves of IDA loans on very liberal terms for
projects which are not eligible for assistance from the World Bank either because loans
for such projects do not carry the guarantee of the government of the borrowing country
or because such projects do not contribute directly and immediately to the productive
capacity of the borrowing country.
IDA Credit Approval : In approving an IDA credit following criteria are observed :
(a) Poverty Test : IDA’s assistance is limited to poorest countries and which continue
to face such severe handicap as excessive dependence on volatile primary product
market, heavy debt servicing burdens and often rate of population growth that outweighs
the gains of production.
(b) Performance Test : Within the range of difficulties of establishing objectives
standards of performance, these factors serve as the yardstick for an adequate
performance test. Satisfactory overall economic policies and past success in project
execution.
(C) Project Test : The purpose of IDA is to advance soft loans , not finance soft
projects. IDA projects are appraised according to the same standard as that applied to
bank projects. The test essentially requires that the proposed projects yield financial and
economic returns, which are adequate to justify the use of scare capital.
IBRD OR WORLD BANK
The international Bank for Reconstruction and Development (IBRD) or the World Bank,
one of the Bretton Woods Twin, was established in 1945. The IBRD has two affiliates the
International Development Association (IDA) and International Finance Corporation (IFC).
The IBRD whose capital is subscribed by its member countries, finance its lending
operation primarily from its own borrowings in the world capital market. A substantial
contribution to the bank’s resources also comes from its retained earnings and the flow of
repayments on its loan. IBRD loans generally have a grace period of five years and are
repayable over twenty years, or less. They are directed towards developing countries at
more advanced stages of economic and social growth. The interest rate that IBRD
charges on its loan is calculated in accordance with a guideline to its cost borrowing.
Purpose : The purpose of banks as laid down in its articles of agreement, are as under :
ODM COMPUTER MGT.EDUCATION
Unit-IV
Ans. There has been a proliferation of regional economic integration schemes or trade
blocks, designed to achieve economic, social and political purposes. The term economic
integration is commonly used to refer to the type of the arrangements that removes
artificial trade barriers, like tariffs and quantitative restrictions, between the integrating
economies. More than one third of world trade already takes place within the existing
RIAs. There are also a number of other international cooperation schemes.
Benefit : The expected benefits from RIA includes :
(a) Efficiency improvements due to economies of scales arising out of enlarged
market.
(b) Enhanced bargaining strength of members in multilateral trade negotiations.
(c) Promotion of regional infant industries.
(d) Prevention of further damage to trading strength due to further trade diversion from
third countries.
(e) Ensure increased security of market access for smaller countries by forming
regional trading blocks with larger countries.
(f) To peruse non-economic objectives such as strengthening political ties and
managing migration flows.
Types : It is used to refer the types of arrangements that removes artificial trade
barriers, like tariffs and quantitative restrictions between integrating economies.
Following are the few types of integration :
(a) Free trade Area : in this free trade is carried out among members.
(b) Custom Union : Beside free trade among members, common external commercial
activities are also occurs in this type.
(c) Common Market : Free trade, common external commercial activities and free
mobility within the market.
(d) Economic Union : Free trade, common external commercial activities, free
mobility within the market and harmonized economic policy.
(e) Economic Integration : Free trade, common external commercial activities, free
mobility within the market, harmonized economic policy and supranational organizational
structure.
Examples : Industrial and Developing economies such as European Union (EU), The
North American Free Trade and Agreement (NAFTA) and Asia Pacific Cooperation
(APEC). Latin American and Caribbean.
(c) Finance : Finance measures how efficiently the financial intermediaries channels
savings into productive investments, the level of competition in financial market, the
perceived stability and solvency of key institutions, level of national saving and investment
and credit ratings given by outside observers.
(d) Infrastructure : It measures the quality of roads, railways, ports,
telecommunications, cost of air transportation and overall infrastructure investments.
(e) Technology : This factor measures computer uses, the spread of new technology,
the ability of the economy to absorb new technologies and the level and quality of
research and developments.
(f) Management : Management measures overall management quality, marketing,
staff training and motivation practice, efficiency of compensation schemes and the quality
of internal financial control system.
(g) Labour : This factor measures the efficiency and competitiveness of the domestic
labour market. It combination of the level of country’s labour costs relative to international
norms, together with measures of labour market efficiency, the level of basic education
and skills and the extent of distortionary labour taxes.
(h) Institutions : This factor measures the extent of business competition, quality of
legal institution and practice, the extent of competition and vulnerability to organised
crime.
ODM COMPUTER MGT.EDUCATION
MBA
(SAM-3)