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Multinational Corporations (MNCs)

• Firms engage in some form of international business

Why Firms Become Multinational: Three Theories

• Firms become multinational to increase production efficiency through specialization
• Trade benefits both countries involved
• Specialization offers tech advantages
• Specialization offers low labor costs advantages
• Specialization advantages involve goods produced with relative efficiency
• Trade is essential, even if one country doesn't specialize in a product another does
• Specialization allows firms to penetrate foreign markets

Imperfect Markets Theory

• Imperfect markets offer firms the incentive to find foreign opportunities due to immobile production factors
• International business wouldn't exist if markets were entirely closed
• International trade needs comparative cost advantage, which is eliminated in perfect markets
• Real-world markets are imperfect, so costs and restrictions affect the transfer of labor/resources for production
• Imperfect markets provoke firms to seek foreign opportunities in places like Silicon Valley

Product Cycle Theory

• Firms recognize opportunities outside their domestic market when they mature
• Expanding internationally is an option for firms with a highly established domestic market

Main Goals of MNCs

• MNCs stock price is maximized through managerial decisions
• Specifically, MNCs whose patents fully own foreign subsidiaries, where the U.S. patent is the sole owner

Agency Problems in International Business

• Unique agency problems MNCs face include business risk, country risk, currency risk, operation risks, and agency costs
• Agency costs are the deviation between agency and principal, where agents run the firm and principals are shareholders
• Agency issues involve discontinuing operations, pursuing new business, expanding business, and financing expansion (based on marketing, management, accounting/IT)
• Agency costs are the costs of ensuring managers (agents) maximize shareholder wealth
• Agency costs are higher for MNCs than domestic firms
• Higher costs are due to the difficulty of monitoring managers of distant subsidiaries in foreign countries
• Foreign managers with different cultures may not follow uniform goals
• Larger MNCs face larger agency problems

Controlling Agency Problems

• Parent control of agency problems involves clear communication of goals for each subsidiary to ensure managers focus on maximizing subsidiary value
• Corporate control of agency problems involves management focusing on maximizing shareholder wealth
• The Sarbanes-Oxley Act (SOX) ensures transparent processes for managers to report on productivity and the financial condition of the firm
• SOX establishes a centralized database of all reported data, with no private information
• SOX ensures data is consistently reported among subsidiaries and has a system for automatically checking discrepancies
• SOX speeds up the process by which departments and subsidiaries access data and makes executives more accountable for financial statements
• Corporate Governance plays a role in incentives (stock options) vs. punitive measures

MNC Structure: Centralized vs. Decentralized

• Centralized structures help managers control foreign subsidiaries, reducing the power of subsidiary managers and agency costs
• Decentralized structures give more control to subsidiary managers closer to operations/environment, increasing agency costs

Methods of International Business

• Key concept to master is LIFAJE (Licensing, International trade, Foreign Direct Investment, Acquisitions, Joint ventures, Exporting)
• Licensing is lower risk, while mergers and acquisitions (M&A) are higher risk in this scale, with foreign direct investments (FDI) even higher risk (not always successful).

International Trade Basics

• International trade is relatively conservative
• International trade penetrates markets by exporting and obtains supplies at low costs by importing, with minimal/no capital risk

Licensing

• Licensing obligates firms to provide tech (copyrights/patents) in exchange for fees/benefits
• Licensing allows firms to generate revenue from foreign countries without establishing production plants or transporting goods
• AMD and Intel reinvent themselves through licensing

Franchising

• Franchising obligates firms to provide specialized sales/strategies in exchange for periodic fees
• It requires direct investments in foreign operations
• Starbucks is an example

Joint Ventures

• A joint venture is jointly owned/operated by 2+ firms
• Firms can enter a foreign market by joining a joint venture with firms residing in foreign markets
• Joint ventures allow firms to apply cooperative advantages
• FDA is an example

Foreign Acquisitions

• Foreign acquisitions of firms in foreign countries allows them to have full control over foreign businesses and quickly obtain large foreign market share
• Higher investments result in higher risks
• Liquidation may be hard if a foreign subsidiary performs badly
• Partial internal acquisitions require smaller investment and limit potential loss if a project fails
• Firms won't have complete control over foreign operations that are only partially required
• Liquidation is difficult and doesn't compete for control

Establishing Foreign Subsidiaries

• Firms can penetrate markets by establishing new operations in foreign countries
• Large investments are needed
• Operations can be tailored to the firm's needs
• Firms won't be rewarded until the subsidiary is built and a customer base is established
• typically exponentially

Agency Costs

• Agency costs are the costs of ensuring that managers maximize shareholder wealth
• An agent is a manager

Principal

• A principal represent the shareholders

Direct Foreign Investment (DFI)

• DFI involves any method that increases international business requiring a direct investment in foreign operations, mostly involving foreign acquisitions and establishments

Balance of Payments (BOP)

• BOP summarizes transactions between domestic and foreign residents for a specific country over a specified period, tracking funds going in and out
• Funds are allocated such that funds going to country B from country A buying its goods is a negative outflow, reducing funds

BOP Framework

• The framework includes the current account, capital account, and financial account
• The current account summarizes the flow of funds due to purchases of goods/services and the provision of income of financial assets
• Capital accounts (real assets) summarize the flow of funds from the sale of assets between one country and another over a specific time
• The financial account (financial assets) refers to special types of investments like DFI and portfolio investments

Current Account

• Payments of goods and services cover merchandise exports and imports, tangible products transported between countries, service imports, and exports representing tourism
• The balance of trade is exports minus imports
• Primary income payments cover income earned on direct foreign investments and income earned by investors on portfolio investments
• Secondary income includes aids, grants, and gifts from one country to another
• Importing more than exporting

EXAMPLE

• Outflow = debit, inflow = credit | walmart buys clothes in Indonesia that it sells in U.S. stores (outflow/ debit) vise versa example
• Direct foreign investment involves nee direct foreign investment over period

Financial Account

• Summarizes portfolio investments (stocks/bonds)
• Other capital investment: transactions with short-term financial assets (money market securities) between countries
• Financial assets = amount (long-term effects are = short-term income (dividend, interest payments))
• Summarizes flow of funds between one country and all other countries because financial assets traversed across country borders by people who move to diff the country (sales/trademarks

Events that Increase Trade Volume

• The fall of the Berlin Wall caused reductions of trade barriers in eastern Europe
• The single European act 1978 improved access to supplies from firms in different European countries
• NAFTA allowed U.S. firms to penetrate product and labor markets previously inaccessible
• GATT: reduction/ elimination of trade barriers on specific imported goods over 10yr. period

European Union

• the European Union = free movement of products/ services/ capital
• the inception of the Euro: avoid exposure to exchange rate risk
• U.S. established trade agreements with other countries

Impact of Outsourcing on Trade

• Outsourcing involves subcontracting to a third party in a different country to provide supplies or services that were previously produced internally
• Two benefits of outsourcing are increased international trade activity because MNCs can buy from other countries, and lower operation costs and job creation

Managerial Decisions About Outsourcing

• Managers of US MNCs argue that they create jobs for U.S. workers
• Shareholders suggest managers are not maximizing MNCs value as a result of commitment to creating U.S. jobs
• Managers can consider potential savings of outsourcing
• Managers should consider publicity/morales that could occur among U.S. workers

Trade Volume

• 10-20% of international trade volume is based on annual GDP, mostly Canada

Why is the BOP Important for MNCs?

What Affects International Trade Flows?

• The cost of labor varies, with countries with low labor costs having a competitive global advantage
• Relative inflation causes the current account to decrease if inflation increases relative to trade partners
• If a country with low inflation, another country would have low products and pricing, so they are buying goods from the country with low inflation, which would have a higher current account
• National income decreases the current account if national income increases
• Restrictive credit conditions mean MNCs could reduce corporate spending and demand for imported supplies

How do Exchange Rates Impact Trade?

• The exchange rate's current account decreases if a currency appreciates relative to other currencies
• the exchange rate between US (USD) and UK (GBP) would look like GBPUSD fluctuating over a 30-day period, so GBP is increasing in value and US is decreasing in value and then GBP appreciates related to relative inflation
• If value increases, a US citizen is purchasing goods from GBP at a higher value than 30 days prior, but UK citizens suffer because currency exchange increased so they're losing more money in the current account
• Depreciating value occurs by manipulating currency exchange, enticing people to buy more goods and increases the current account

Why Does This Not Work Though?

• There are severe limitations
• The dollar is in high demand/is a safe haven
• The U.S. can’t manipulate currency because the U.S. has no reserves
• The U.S. is an import country

Solutions for a Weak Home Currency

• Competition: Foreign companies can lower prices to be competitive
• Impact of currencies: A country with a balance of trade deficit with a lot of countries isn’t likely to solve all defects at the same time
• Prearranged international trade transfers: International transactions can’t be adjusted immediately (18+ month lag = J curve)
• Intracompany trade: Firms can't be busy with goods produced by subsidiaries and are not affected by currency fluctuations
• J Curve: surplus if J curve above 0, under 0 = deficit (18 months before you see change, worse before better)

Exchange Rates/Internal Infliction

• All governments can’t weaken home currencies at the same time
• Actions by one government to weaken a currency causes another country's currency to strengthen

Gov Attempts to Influence Exchange Rates

• Gov attempts = international disputes
• Currency manipulation stimulates import = export = disputes

How do Exchange Rates Correct the Balance of Trade Deficit?

• When a home currency is exchanged for foreign currency to buy foreign goods, the home currency faces downward pressure and increases foreign demand for the country's products

Role of Government Policy

• Focus Areas: Types of trade restrictions
• Imports, subsidies for exports, labor laws, country security laws, and piracy restrictions

Impact of Government Controls

• Restrictions on imports (taxes/tariffs on imported goods increase prices & limit consumption; quotas limit volume)
• Subsidies for exporters (government subsidies help firms produce at a lower cost than global competitors)
• Restrictions on Piracy (governments can affect trade flows by lack of piracy restrictions)
• Environmental restrictions impose higher costs on local firms
• Labor laws: more labor laws increase expenses for labor
• Business laws: more restrictive bribery laws make it harder to compete globally
• Tax breaks are government financial support that could benefit firms that export products
• Government ownership of subsidies: some governments maintain ownership in firms that are major exporters
• Country security laws: governments may impose restrictions when national security is a concern
• Policies to punish country governments: many expect countries to restrict imports from countries that fail to comply with environmental/child labor laws

International Financial Markets

• Finance has three main levels: equity, debt/fixed income, derivatives/options/forwards/futures
• The shadow market is the foreign exchange market, the catalyst for foreign exchange
• The global market is 30% equity, 60% fixed income, and 10% derivatives; outside these is the foreign exchange market
• Market participants include speculators (looking for value), hedgers (looking for stability), and arbitrageurs (looking for fair pricing)

Arbitrage

• Arbitrage is simultaneous buying and selling of the same asset (separate int assets into two buying and selling within the market), the fair price is in the middle

Golden Standard

• Each currency convertible into gold at a specified rate, weight would be the exchange rate – weight gold in dollars / weight gold in pounds

Fixed Change Rates

• They must be kept within bounds (1% on each side of the bound)
• If it fluctuates, there needs to be intervention to get it back into bounds
• Bounds started changing

Floating Exchange Rate System

• Widely traded currencies can fluctuate in accordance with market forces
• Over-the-counter telecommunications network where companies exchange one currency for another

Foreign Exchange Dealers

• There are intermediaries in the foreign exchange market

Spot Market

• There are foreign exchange transactions for immediate exchange where the change rate equals the spot rate
• The structure includes trading between banks (interbank market)
• Spot prices are constantly changing
• Spot market zones are open only during normal business hours
• Spot market liquidity occurs when more buyers + more sellers which equals more liquidity (easy to convert currency into cash)
• At any given time, banks' bid (buy) quotes for a foreign currency will be less than the ask (sell) quote - the spread covers banks cost of conducting foreign exchange transactions
• The difference between the bid quote and the ask quote will be smaller for lesser value currencies
• Bid/ask spread (ask rate – bid rate) / ask rate

Factors That Affect the Spread

Spreads cover order costs, inventory costs, competition, volume, and currency risk

• Order costs are the cost of processing orders (clearing/recording transactions)
• Inventory costs are the costs of maintaining currency inventory
• Competition: more competition = smaller spread quoted by intermediaries
• Volume: currencies with a large trading volume are more liquid because there are lots of buyers/sellers
• Currency risk is caused by economic/political conditions that cause supply and demand for currency to change

Direct vs. Indirect

• The direct quote = if in U.S. and looking at GBPUSD for 1.4612
• The indirect quote = when in U.S. and looking at USDGBP for 1/1.4612 = .6844 (indirect because you are not in country, using that currency for it)

International Money and Credit Markets

• Credit Markets: After the credit crisis, institutions are cautious with their funds and less willing to lend funds to MNCs
• Short-term is denominated in a currency different from the home currency
• The international market is composed of firms that may need to borrow funds for imports denominated in foreign currency, may choose to borrow currency with lower interest rate, and may choose to borrow in currency that’s expected to depreciate against the home currency

Role of Interest Rates – Money Market Interest Rates

• Money market interest rates are dependent on the demand for short-term funds by borrowers relative to the supply of available short-term funds provided by savers
• Money market rates vary because of differences in the interaction of the total supply of short-term funds available in the different country versus the total demand for short-term borrowers in that country
• The impact of Country risk = the role of interest rates

International Stock Markets:

• Issuance of foreign stock in U.S. markets: Yankee stock offerings for non-U.S. Corps that need large funds issued in stock in U.S.
• Different ways exists to invest internationally is via American depository receipts (certs representing bundles of stock (like stock shares) cross-listing, expensive, investors buying stocks outside of home country)

Forward Exchange Rates

• The forward rate equals the exchange rate specified by the foreign contract
• The future price is a negotiated price into the future (30 months)
• A currency call provides the right to sell/buy specific currency is a specific period at a specific price
• The exchange rate specifies the rate that one currency can be exchanged for another

Cross Rates

• Cross Rates create a new quote based on two existing ones (the amount of one foreign currency per unit of another foreign currency)
• A change in exchange rates between currencies change against USD over time, and exchange rate of these currencies can change

Exchange Rate Determination

• Depreciation is a decline in currency value (negative percentage change)
• Appreciation is an increase in currency value (positive percentage change)
• Percentage Change in foreign currency values = (S – St+1) / (St+1)

Factors That Determine Exchange Rates

• Relative Inflation Rates occurs if there is an increase in U.S. inflation = increase in U.S. demand for foreign goods = increase demand for foreign currency = increased exchange rate for foreign currency
• Relative Interest Rates occurs if there is an increase in U.S. rates = increase in demand for U.S. deposits/ decrease in demand for foreign deposits = increased demand for dollar/ increased exchange rate for dollar
• Fisher Effect states that real interest rate equals nominal – inflation
• Government controls are foreign exchange/ trade barriers, and intervening in foreign exchange markets, and affecting macro variables (inflation/interest)

How Do Supply and Demand Affect Rates?

• Demand for currency increases when the value of currency decreases, which is a downward-sloping demand schedule

• Supply of currency (for sale) increases when the value increases, which is an upward-sloping supply schedule

• If currency A and currency B move in the same direction, there is no change across exchange rates.

• If equilibrium occurs when the quantity of pounds is demanded with supply of pounds for sale, this is why rates change over time.

• The key exchange rate is an influence to remember these factors: Inflation, Interest rates, Income levels,Government Controls and Market Expectation