International Business and Trade PDF

International Business and Trade _ Handout 1 INTERNATIONAL BUSINESS AND TRADE approaching the global business landscape, and how to build your knowledge....

International Business and Trade _ Handout 1 INTERNATIONAL BUSINESS AND TRADE approaching the global business landscape, and how to build your knowledge. GLOBALIZATION Understanding Globalization The spread of humans, information, knowledge, culture, wealth, goods, and services around the world can be thought of as globalization. Of course, Corporations gain a competitive advantage on multiple fronts through there are more that moves around the world and the globalization keeps globalization. They can reduce operating costs by manufacturing abroad, producing more and more endeavors to be explored and researched. With buy raw materials more cheaply because of the reduction or removal of that in mind, this book is a collection of well researched articles produced tariffs, and most of all, they gain access to millions of new consumers. not by a single source, but by a global pool of academics and practitioners, Globalization is a social, cultural, political, and legal phenomenon. thus adding a true meaning to the word “globalization.” Jay Rajasekera and Nyi Nyi Aung (2018) ✓ Socially, it leads to greater interaction among various populations. ✓ Culturally, globalization represents the exchange of ideas, values, and artistic expression among cultures. Globalization also WHAT IS GLOBALIZATION? represents a trend toward the development of a single world culture. ✓ Politically, globalization has shifted attention to intergovernmental Globalization refers to the spread of the flow of financial products, goods, organizations like the United Nations (UN) and the World Trade technology, information, and jobs across national borders and cultures. In Organization (WTO). economic terms, it describes an interdependence of nations around the ✓ Legally, globalization has altered how international law is created globe fostered through free trade. and enforced. Globalization is the increase in the flow of goods, services, capital, people, and ideas across international boundaries, according to the online course Global Business. INTERNATIONAL BUSINESS “We live in an age of globalization,” says Harvard Business School What does it mean to be an International Business? Professor Forest Reinhardt, who teaches Global Business. “That is, national An international business is any company that operates and produces or economies are ever more tightly connected with one another than ever sells goods between two or more countries. There are three ways a before.” business can be considered international: Whether you’re looking to learn more about your international company or It produces goods domestically and sells domestically and thinking of expanding your business into other countries, you need a strong internationally. foundation in the basics of globalization in business. Here’s a primer on It produces goods in a different country but sells domestically. what it means to be an international business, factors to consider when Page 1 of 25  International Business and Trade _ Handout 1 It produces goods in a different country and sells domestically and Politics and laws: International politics can color relationships between internationally. nations and regulate what products are allowed in and out of their borders. If your business falls into one of these categories, there are two types Keeping up with current events can help you prepare for the business of international business models to consider: transnational and impacts of shifts in policy and foreign affairs. multinational. The environment: There’s no global issue more pressing than climate Transnational corporations have offices in multiple countries, each change. Unfortunately, globalization can contribute significantly to its responsible for a different facet of the organization. For instance, marketing negative effects due to increased transportation of materials and products, may be based in London, research and development in Bogota, and business travel, and the number of factories. If you’re engaging in global software development in New York. business, keep sustainability in mind to avoid contributing to climate change. An example of a successful transnational corporation is Nestlé, which splits business operations for each of its brands by region. There are over 100 Macroeconomics: Principles of macroeconomics can allow you to compare Nestlé offices worldwide with distinct responsibilities. For instance, the countries’ financial health on a one-to-one basis and draw connections Nestlé Research Center is located in Switzerland, which acts as the hub between trends. Some metrics to know include: that oversees each brand-specific research and development center, of Gross domestic product (GDP) which there are 23. All Nestlé offices operate under the company’s Unemployment rate headquarters in Switzerland. Inflation rate Multinational corporations also have offices in multiple countries, but unlike Degree of income inequality transnational corporations, each is a microcosm of the larger organization. Currency exchange rate This means each office has, for example, its own leadership, marketing, sales, research and development, technology, and human resources Human rights: Because laws dictating human rights—including labor laws— teams. An example of a multinational corporation is PepsiCo, which has 32 differ from country to country, operating as a global business requires offices across 24 countries. research and critical thought to ensure you’re not exploiting people for labor, even if it’s technically legal. Ethics are required for making decisions that Facets of Global Business To Consider may cost your business money at the expense of protecting human rights. Globalization doesn’t just refer to the location of a firm’s offices and Cultural differences and language barriers: Operating a global business customers—it also encompasses the nuances and economic factors of requires knowing and respecting other cultures. Without understanding the conducting business internationally and existing in a global economy. Even areas, you do business in, you could unintentionally offend someone and if your company operates domestically, globalization can influence the way harm your working relationships. In the case of language barriers, this may you do business. Here are a few factors to consider when thinking about require you to hire translators and multilingual employees to bridge the gap. how global business impacts your organization: The key elements in the international business environment are Page 2 of 25  International Business and Trade _ Handout 1 One key factor in an international business environment is economic Conducting International Business can help organisations become stability. This includes an analysis of GDP growth rates, inflation, currency more efficient and cost-effective. It allows them to benefit from exchange rates, and trade barriers. Companies must consider how a economies of scale, obtain lower-cost resources, and utilise the country’s economy might affect its cost structures and profitability when latest technologies available in different markets. choosing which nations to target for operations or investment. Companies can expand their brand visibility and reach a more extensive customer base by conducting business globally. This can Political instability can be another significant factor when making increase sales and brand recognition in the global market. decisions about expanding abroad. Companies must be aware of uprisings, war, and other forms of conflict that can disrupt business operations. The By operating in different markets, companies can access new policies of a country’s government also need to be considered in terms of opportunities and gain valuable insights into customer behavior and taxes, regulations, and labor laws. preferences. This can help them develop better products/services and make more informed decisions. Geography is another key factor as it affects the logistics of transporting It allows companies to explore different markets and expand their goods, accessing new markets, and recruiting staff. Accessibility to natural operations. resources such as oil or minerals should also be considered depending on This helps organisations identify growth opportunities and plan their the industry involved. strategies accordingly. Technology plays an increasingly important role in international business International businesses can benefit from the economies of scale operations today due to advances in communication and digital that come with operating in multiple markets. infrastructure. Businesses must understand how adopting new technologies Companies have access to a broader pool of resources due to might affect their competitive landscape or open up new product or service international trade, which may not be available locally. opportunities. International businesses can benefit from competitive advantages such as lower production costs, tax incentives, etc., due to differences in the economic environment across countries. The Benefits of the International Business By understanding the international business environment better, companies can reduce risks such as foreign exchange rate There are various benefits associated with conducting International fluctuation, political instability, etc. Business, as follows: The international business environment also helps organisations to By expanding into different markets, companies can gain access to become more innovative and flexible in their operations, which is new customers and increase their profits. It also allows them to essential for staying ahead of the competition. diversify their operations to reduce risk and capitalise on International businesses can leverage cultural diversity to create opportunities in other markets. unique products and services that capture more extensive markets. The Challenges of the International Business Environment Page 3 of 25  International Business and Trade _ Handout 1 The international business environment is complex and dynamic, making it Understanding the scope of the international business environment enables difficult for companies to predict the outcomes of their decisions accurately. companies to identify opportunities for growth and devise strategies accordingly. International trade regulations and policies can vary from country to country, making it hard for companies to comply with them at once. Companies can benefit from economies of scale and resource access due to international trade. International markets tend to be more competitive due to differences in the economic environment, political stability, and cultural preferences across Companies may benefit from competitive advantages such as lower different countries. production costs or tax incentives if they operate in multiple markets. Language barriers can become a significant obstacle when conducting Knowledge about the international business environment also helps International Business, especially if the company doesn’t have organisations reduce risks associated with foreign exchange rate knowledgeable personnel about different cultures and languages. fluctuations, political instability, etc. International businesses may face higher costs associated with production It can help organisations become more innovative and flexible in their or transportation due to exchange rate fluctuations or taxes imposed by operations, allowing them to stay ahead of the competition. foreign countries on imported goods. Cultural diversity can be leveraged to create unique products and services International businesses may also face difficulties regarding intellectual that can capture larger markets property protection in foreign markets as laws vary from country to country. INTERNATIONAL TRADE It is subject to political instability and other external factors that can What Is International Trade? negatively affect a company’s operations. International trade theories are simply different theories to explain The international business environment is complex and dynamic, making it international trade. Trade is the concept of exchanging goods and services difficult for companies to predict outcomes accurately. Companies must between two people or entities. International trade is then the concept of have a thorough knowledge of the international business environment this exchange between people or entities in two different countries. before entering any foreign market to better understand the local regulations, cultural environment, and competitive landscape. People or entities trade because they believe that they benefit from the exchange. They may need or want the goods or services. While at the This will enable them to reduce risks associated with International Business surface, this many sound very simple, there is a great deal of theory, policy, and take advantage of potential opportunities that come with operating in and business strategy that constitutes international trade. multiple markets. “Around 5,200 years ago, Uruk, in southern Mesopotamia, was probably the first city the world had ever seen, housing more than 50,000 people within Scope of the International Business its six miles of wall. Uruk, its agriculture made prosperous by sophisticated Page 4 of 25  International Business and Trade _ Handout 1 irrigation canals, was home to the first class of middlemen, trade Although mercantilism is one of the oldest trade theories, it remains part of intermediaries…A cooperative trade network…set the pattern that would modern thinking. Countries such as Japan, China, Singapore, Taiwan, and endure for the next 6,000 years.”13 even Germany still favor exports and discourage imports through a form of neo-mercantilism in which the countries promote a combination of Mercantilism protectionist policies and restrictions and domestic-industry subsidies. Developed in the sixteenth century, mercantilism was one of the earliest Nearly every country, at one point or another, has implemented some form efforts to develop an economic theory. This theory stated that a country’s of protectionist policy to guard key industries in its economy. While export- wealth was determined by the amount of its gold and silver holdings. In it’s oriented companies usually support protectionist policies that favor their simplest sense, mercantilists believed that a country should increase its industries or firms, other companies and consumers are hurt by holdings of gold and silver by promoting exports and discouraging imports. protectionism. Taxpayers pay for government subsidies of select exports in In other words, if people in other countries buy more from you (exports) than the form of higher taxes. Import restrictions lead to higher prices for they sell to you (imports), then they have to pay you the difference in gold consumers, who pay more for foreign-made goods or services. Free-trade and silver. The objective of each country was to have a trade surplus, or a advocates highlight how free trade benefits all members of the global situation where the value of exports are greater than the value of imports, community, while mercantilism’s protectionist policies only benefit select and to avoid a trade deficit, or a situation where the value of imports is industries, at the expense of both consumers and other companies, within greater than the value of exports. and outside of the industry. A closer look at world history from the 1500s to the late 1800s helps explain why mercantilism flourished. The 1500s marked the rise of new nation- Absolute Advantage states, whose rulers wanted to strengthen their nations by building larger armies and national institutions. By increasing exports and trade, these In 1776, Adam Smith questioned the leading mercantile theory of the time rulers were able to amass more gold and wealth for their countries. One in The Wealth of Nations.Adam Smith, An Inquiry into the Nature and way that many of these new nations promoted exports was to impose Causes of the Wealth of Nations (London: W. Strahan and T. Cadell, 1776). restrictions on imports. This strategy is called protectionism and is still used Recent versions have been edited by scholars and economists. Smith today. offered a new trade theory called absolute advantage, which focused on the ability of a country to produce a good more efficiently than another nation. Nations expanded their wealth by using their colonies around the world in Smith reasoned that trade between countries shouldn’t be regulated or an effort to control more trade and amass more riches. The British colonial restricted by government policy or intervention. He stated that trade should empire was one of the more successful examples; it sought to increase its flow naturally according to market forces. In a hypothetical two-country wealth by using raw materials from places ranging from what are now the world, if Country A could produce a good cheaper or faster (or both) than Americas and India. France, the Netherlands, Portugal, and Spain were Country B, then Country A had the advantage and could focus on also successful in building large colonial empires that generated extensive specializing on producing that good. Similarly, if Country B was better at wealth for their governing nations. producing another good, it could focus on specialization as well. By Page 5 of 25  International Business and Trade _ Handout 1 specialization, countries would generate efficiencies, because their labor both skill sets, should she do both jobs? No. For every hour Miranda decides force would become more skilled by doing the same tasks. Production to type instead of do legal work, she would be giving up $460 in income. would also become more efficient, because there would be an incentive to Her productivity and income will be highest if she specializes in the higher- create faster and better production methods to increase the specialization. paid legal services and hires the most qualified administrative assistant, who can type fast, although a little slower than Miranda. By having both Smith’s theory reasoned that with increased efficiencies, people in both Miranda and her assistant concentrate on their respective tasks, their countries would benefit and trade should be encouraged. His theory stated overall productivity as a team is higher. This is comparative advantage. A that a nation’s wealth shouldn’t be judged by how much gold and silver it person or a country will specialize in doing what they do relatively better. In had but rather by the living standards of its people. reality, the world economy is more complex and consists of more than two countries and products. Barriers to trade may exist, and goods must be transported, stored, and distributed. However, this simplistic example Comparative Advantage demonstrates the basis of the comparative advantage theory. The challenge to the absolute advantage theory was that some countries may be better at producing both goods and, therefore, have an advantage in many areas. In contrast, another country may not have any useful Modern or Firm-Based Trade Theories absolute advantages. To answer this challenge, David Ricardo, an English In contrast to classical, country-based trade theories, the category of economist, introduced the theory of comparative advantage in 1817. modern, firm-based theories emerged after World War II and was Ricardo reasoned that even if Country A had the absolute advantage in the developed in large part by business school professors, not economists. The production of both products, specialization and trade could still occur firm-based theories evolved with the growth of the multinational company between two countries. (MNC). The country-based theories couldn’t adequately address the Comparative advantage occurs when a country cannot produce a product expansion of either MNCs or intraindustry trade, which refers to trade more efficiently than the other country; however, it can produce that product between two countries of goods produced in the same industry. For better and more efficiently than it does other goods. The difference between example, Japan exports Toyota vehicles to Germany and imports these two theories is subtle. Comparative advantage focuses on the relative Mercedes-Benz automobiles from Germany. productivity differences, whereas absolute advantage looks at the absolute Unlike the country-based theories, firm-based theories incorporate other productivity. product and service factors, including brand and customer loyalty, Let’s look at a simplified hypothetical example to illustrate the subtle technology, and quality, into the understanding of trade flows. difference between these principles. Miranda is a Wall Street lawyer who charges $500 per hour for her legal services. It turns out that Miranda can also type faster than the administrative assistants in her office, who are paid Country Similarity Theory $40 per hour. Even though Miranda clearly has the absolute advantage in Page 6 of 25  International Business and Trade _ Handout 1 Swedish economist Steffan Linder developed the country similarity theory example, global companies even conduct research and development in in 1961, as he tried to explain the concept of intraindustry trade. Linder’s developing markets where highly skilled labor and facilities are usually theory proposed that consumers in countries that are in the same or similar cheaper. Even though research and development is typically associated stage of development would have similar preferences. In this firm-based with the first or new product stage and therefore completed in the home theory, Linder suggested that companies first produce for domestic country, these developing or emerging-market countries, such as India and consumption. When they explore exporting, the companies often find that China, offer both highly skilled labor and new research facilities at a markets that look similar to their domestic one, in terms of customer substantial cost advantage for global firms. preferences, offer the most potential for success. Linder’s country similarity theory then states that most trade in manufactured goods will be between countries with similar per capita incomes, and intraindustry trade will be Global Strategic Rivalry Theory common. This theory is often most useful in understanding trade in goods where brand names and product reputations are important factors in the Global strategic rivalry theory emerged in the 1980s and was based on the buyers’ decision-making and purchasing processes. work of economists Paul Krugman and Kelvin Lancaster. Their theory focused on MNCs and their efforts to gain a competitive advantage against other global firms in their industry. Firms will encounter global competition in their industries and in order to prosper, they must develop competitive Product Life Cycle Theory advantages. The critical ways that firms can obtain a sustainable Raymond Vernon, a Harvard Business School professor, developed the competitive advantage are called the barriers to entry for that industry. The product life cycle theory in the 1960s. The theory, originating in the field of barriers to entry refer to the obstacles a new firm may face when trying to marketing, stated that a product life cycle has three distinct stages: (1) new enter into an industry or new market. The barriers to entry that corporations product, (2) maturing product, and (3) standardized product. The theory may seek to optimize include: assumed that production of the new product will occur completely in the ✓ research and development, home country of its innovation. In the 1960s this was a useful theory to ✓ the ownership of intellectual property rights, explain the manufacturing success of the United States. US manufacturing ✓ economies of scale, was the globally dominant producer in many industries after World War II. ✓ unique business processes or methods as well as extensive It has also been used to describe how the personal computer (PC) went experience in the industry, and through its product cycle. The PC was a new product in the 1970s and ✓ the control of resources or favorable access to raw materials. developed into a mature product during the 1980s and 1990s. Today, the PC is in the standardized product stage, and the majority of manufacturing Porter’s National Competitive Advantage Theory and production process is done in low-cost countries in Asia and Mexico. In the continuing evolution of international trade theories, Michael Porter of The product life cycle theory has been less able to explain current trade Harvard Business School developed a new model to explain national patterns where innovation and manufacturing occur around the world. For Page 7 of 25  International Business and Trade _ Handout 1 competitive advantage in 1990. Porter’s theory stated that a nation’s Governments want to be able to control and regulate the flow of FDI so that competitiveness in an industry depends on the capacity of the industry to local political and economic concerns are addressed. Global businesses are innovate and upgrade. His theory focused on explaining why some nations most interested in using FDI to benefit their companies. As a result, these are more competitive in certain industries. To explain his theory, Porter two players—governments and companies—can at times be at odds. It’s identified four determinants that he linked together. The four determinants important to understand why companies use FDI as a business strategy and are (1) local market resources and capabilities, (2) local market demand how governments regulate and manage FDI. conditions, (3) local suppliers and complementary industries, and (4) local firm characteristics. Factors That Influence a Company’s Decision to Invest FOREIGN DIRECT INVESTMENT Let’s look at why and how companies choose to invest in foreign markets. Understand the Types of International Investments Simply purchasing goods and services or deciding to invest in a local market There are two main categories of international investment—portfolio depends on a business’s needs and overall strategy. Direct investment in a investment and foreign direct investment. Portfolio investment refers to the country occurs when a company chooses to set up facilities to produce or investment in a company’s stocks, bonds, or assets, but not for the purpose market their products; or seeks to partner with, invest in, or purchase a local of controlling or directing the firm’s operations or management. Typically, company for control and access to the local market, production, or investors in this category are looking for a financial rate of return as well as resources. Many considerations influence its decisions: diversifying investment risk through multiple markets. Foreign direct investment (FDI) refers to an investment in or the acquisition Cost. Is it cheaper to produce in the local market than elsewhere? of foreign assets with the intent to control and manage them. Companies can make an FDI in several ways, including purchasing the assets of a Logistics. Is it cheaper to produce locally if the transportation costs foreign company; investing in the company or in new property, plants, or are significant? equipment; or participating in a joint venture with a foreign company, which Market. Has the company identified a significant local market? typically involves an investment of capital or know-how. FDI is primarily a Natural resources. Is the company interested in obtaining access to long-term strategy. Companies usually expect to benefit through access to local resources or commodities? local markets and resources, often in exchange for expertise, technical Know-how. Does the company want access to local technology or know-how, and capital. A country’s FDI can be both inward and outward. As business process knowledge? the terms would suggest, inward FDI refers to investments coming into the Customers and competitors. Does the company’s clients or country and outward FDI are investments made by companies from that competitors operate in the country? country into foreign companies in other countries. The difference between Policy. Are there local incentives (cash and noncash) for investing inward and outward is called the net FDI inflow, which can be either positive in one country versus another? or negative. Page 8 of 25  International Business and Trade _ Handout 1 Ease. Is it relatively straightforward to invest and/or set up operations infrastructure of a country—that is, energy, communications, and in the country, or is there another country in which setup might be transportation) industries are good examples of this. Firms from these easier? industries invest in production or plant facilities in a country in order to Culture. Is the workforce or labor pool already skilled for the supply raw materials, parts, or finished products to their home country. In company’s needs or will extensive training be required? recent years, these same industries have also started to provide forward Impact. How will this investment impact the company’s revenue and FDI by supplying raw materials, parts, or finished products to newly profitability? emerging local or regional markets. Expatriation of funds. Can the company easily take profits out of the country, or are there local restrictions? Exit. Can the company easily and orderly exit from a local There are different kinds of FDI, two of which—greenfield and brownfield— investment, or are local laws and regulations cumbersome and are increasingly applicable to global firms. Greenfield FDIs occur when expensive? multinational corporations enter into developing countries to build new factories or stores. These new facilities are built from scratch—usually in an These are just a few of the many factors that might influence a company’s area where no previous facilities existed. The name originates from the idea decision. Keep in mind that a company doesn’t need to sell in the local of building a facility on a green field, such as farmland or a forested area. In market in order to deem it a good option for direct investment. For example, addition to building new facilities that best meet their needs, the firms also companies set up manufacturing facilities in low-cost countries but export create new long-term jobs in the foreign country by hiring new employees. the products to other markets. Countries often offer prospective companies tax breaks, subsidies, and There are two forms of FDI—horizontal and vertical. Horizontal FDI occurs other incentives to set up greenfield investments. when a company is trying to open up a new market—a retailer, for example, A brownfield FDI is when a company or government entity purchases or that builds a store in a new country to sell to the local market. Vertical FDI leases existing production facilities to launch a new production activity. One is when a company invests internationally to provide input into its core application of this strategy is where a commercial site used for an “unclean” operations—usually in its home country. A firm may invest in production business purpose, such as a steel mill or oil refinery, is cleaned up and used facilities in another country. When a firm brings the goods or components for a less polluting purpose, such as commercial office space or a residential back to its home country (i.e., acting as a supplier), this is referred to as area. Brownfield investment is usually less expensive and can be backward vertical FDI. When a firm sells the goods into the local or regional implemented faster; however, a company may have to deal with many market (i.e., acting as a distributor), this is termed forward vertical FDI. The challenges, including existing employees, outdated equipment, entrenched largest global companies often engage in both backward and forward processes, and cultural differences. vertical FDI depending on their industry. You should note that the terms greenfield and brownfield are not exclusive Many firms engage in backward vertical FDI. The auto, oil, and to FDI; you may hear them in various business contexts. In general, infrastructure (which includes industries related to enhancing the Page 9 of 25  International Business and Trade _ Handout 1 greenfield refers to starting from the beginning, and brownfield refers to preserve the national and local culture, protect segments of their domestic modifying or upgrading existing plans or projects. population, maintain political and economic independence, and manage or control economic growth. A government use various policies and rules: Ownership restrictions. Host governments can specify ownership Why and How Governments Encourage FDI restrictions if they want to keep the control of local markets or industries in their citizens’ hands. Some countries, such as Malaysia, go even further and encourage that ownership be maintained by a person of Malay origin, Many governments encourage FDI in their countries as a way to create jobs, known locally as bumiputra. Although the country’s Foreign Investment expand local technical knowledge, and increase their overall economic Committee guidelines are being relaxed, most foreign businesses standards. Countries like Hong Kong and Singapore long ago realized that understand that having a bumiputrapartner will improve their chances of both global trade and FDI would help them grow exponentially and improve obtaining favorable contracts in Malaysia. the standard of living for their citizens. As a result, Hong Kong (before its return to China) was one of the easiest places to set up a new company. Tax rates and sanctions. A company’s home government usually imposes Guidelines were clearly available, and businesses could set up a new office these restrictions in an effort to persuade companies to invest in the within days. Similarly, Singapore, while a bit more discriminatory on the size domestic market rather than a foreign one. and type of business, offered foreign companies a clear, streamlined process for setting up a new company. How Governments Encourage FDI In contrast, for decades, many other countries in Asia (e.g., India, China, Pakistan, the Philippines, and Indonesia) restricted or controlled FDI in their Governments seek to promote FDI when they are eager to expand their countries by requiring extensive paperwork and bureaucratic approvals as domestic economy and attract new technologies, business know-how, and well as local partners for any new foreign business. These policies created capital to their country. In these instances, many governments still try to disincentives for many global companies. By the 1990s (and earlier for manage and control the type, quantity, and even the nationality of the FDI China), many of the countries in Asia had caught the global trade bug and to achieve their domestic, economic, political, and social goals. were actively trying to modify their policies to encourage more FDI. Some Financial incentives. Host countries offer businesses a were more successful than others, often as a result of internal political combination of tax incentives and loans to invest. Home-country issues and pressures rather than from any repercussions of global trade. governments may also offer a combination of insurance, loans, and tax breaks in an effort to promote their companies’ overseas investments. The opening case on China in Africa illustrated these How Governments Discourage or Restrict FDI types of incentives. In most instances, governments seek to limit or control foreign direct Infrastructure. Host governments improve or enhance local investment to protect local industries and key resources (oil, minerals, etc.), infrastructure—in energy, transportation, and communications—to Page 10 of 25  International Business and Trade _ Handout 1 encourage specific industries to invest. This also serves to improve may induce smuggling of goods through nontraditional entry points, but we the local conditions for domestic firms. will ignore that problem here.) Administrative processes and regulatory environment. Host- Tariffs represent the primary way in which countries either liberalize trade country governments streamline the process of establishing offices or protect their economies. It isn’t the only way, though, since countries also or production in their countries. By reducing bureaucracy and implement subsidies, quotas, and other types of regulations that can affect regulatory environments, these countries appear more attractive to trade flows between countries. When people talk about trade liberalization, foreign firms. they generally mean reducing the tariffs on imported goods, thereby Invest in education. Countries seek to improve their workforce allowing the products to enter at a lower cost. Since lowering the cost of through education and job training. An educated and skilled trade makes it more profitable, it will make trade freer. Complete elimination workforce is an important investment criterion for many global of tariffs and other barriers to trade is what economists and others mean by businesses. free trade. In contrast, any increase in tariffs is referred to as protection or Political, economic, and legal stability. Host-country governments protectionism. Because tariffs raise the cost of importing products from seek to reassure businesses that the local operating conditions are abroad but not from domestic firms, they have the effect of protecting the stable, transparent (i.e., policies are clearly stated and in the public domestic firms that compete with imported products. These domestic firms domain), and unlikely to change. are called import competitors. There are two basic ways in which tariffs may be levied: specific tariffs and UNDERSTANDING TARIFFS ad valorem tariffs. A specific tariff is levied as a fixed charge per unit of imports. For example, the U.S. government levies a $0.51 specific tariff on The most common way to protect one’s economy from import competition every wristwatch imported into the United States. Thus, if one thousand is to implement a tariff: a tax on imports. Generally speaking, a tariff is any watches are imported, the U.S. government collects $510 in tariff revenue. tax or fee collected by a government. Sometimes the term “tariff” is used in In this case, $510 is collected whether the watch is a $40 Swatch or a a nontrade context, as in railroad tariffs. However, the term is much more $5,000 Rolex. commonly used to refer to a tax on imported goods. An ad valorem tariff is levied as a fixed percentage of the value of the commodity imported. “Ad valorem” is Latin for “on value” or “in proportion Tariffs have been applied by countries for centuries and have been one of to the value.” The United States currently levies a 2.5 percent ad valorem the most common methods used to collect revenue for governments. tariff on imported automobiles. Thus, if $100,000 worth of automobiles is Largely this is because it is relatively simple to place customs officials at the imported, the U.S. government collects $2,500 in tariff revenue. In this border of a country and collect a fee on goods that enter. Administratively, case, $2,500 is collected whether two $50,000 BMWs or ten $10,000 a tariff is probably one of the easiest taxes to collect. (Of course, high tariffs Hyundais are imported. Page 11 of 25  International Business and Trade _ Handout 1 Occasionally, both a specific and an ad valorem tariff are levied on the same product simultaneously. This is known as a two-part tariff. For example, Generally speaking, average tariff rates are less than 20 percent in most wristwatches imported into the United States face the $0.51 specific tariff countries, although they are often quite a bit higher for agricultural as well as a 6.25 percent ad valorem tariff on the case and the strap and a commodities. In the most developed countries, average tariffs are less than 5.3 percent ad valorem tariff on the battery. Perhaps this should be called a 10 percent and often less than 5 percent. On average, less-developed three-part tariff! countries maintain higher tariff barriers, but many countries that have As the above examples suggest, different tariffs are generally applied to recently joined the WTO have reduced their tariffs substantially to gain different commodities. Governments rarely apply the same tariff to all goods entry. and services imported into the country. Several countries prove the Problems Using Average Tariffs as a Measure of Protection exception, though. For example, Chile levies a 6 percent tariff on every imported good, regardless of the category. Similarly, the United Arab The first problem with using average tariffs as a measure of protection in a Emirates sets a 5 percent tariff on almost all items, while Bolivia levies tariffs country is that there are several different ways to calculate an average tariff either at 0 percent, 2.5 percent, 5 percent, 7.5 percent, or 10 percent. rate, and each method can give a very different impression about the level Nonetheless, simple and constant tariffs such as these are uncommon. of protection. Thus, instead of one tariff rate, countries have a tariff schedule that specifies The tariffs in Table 2.1 “Average Tariffs in Selected Countries (2009)” are the tariff collected on every particular good and service. In the United States, calculated as a simple average. To calculate this rate, one simply adds up the tariff schedule is called the Harmonized Tariff Schedule (HTS) of the all the tariff rates and divides by the number of import categories. One United States. The commodity classifications are based on the international problem with this method arises if a country has most of its trade in a few Harmonized Commodity Coding and Classification System (or the categories with zero tariffs but has high tariffs in many categories it would Harmonized System) established by the World Customs Organization. never find advantageous to import. In this case, the average tariff may overstate the degree of protection in the economy. This problem can be avoided, to a certain extent, if one calculates the trade- Measuring Protectionism: Average Tariff Rates around the World weighted average tariff. This measure weighs each tariff by the share of One method used to measure the degree of protectionism within an total imports in that import category. Thus, if a country has most of its economy is the average tariff rate. Since tariffs generally reduce imports of imports in a category with very low tariffs but has many import categories foreign products, the higher the tariff, the greater the protection afforded to with high tariffs and virtually no imports, then the trade-weighted average the country’s import-competing industries. At one time, tariffs were perhaps tariff would indicate a low level of protection. The simple way to calculate a the most commonly applied trade policy. Many countries used tariffs as a trade-weighted average tariff rate is to divide the total tariff revenue by the primary source of funds for their government budgets. However, as trade total value of imports. Since these data are regularly reported by many liberalization advanced in the second half of the twentieth century, many countries, this is a common way to report average tariffs. To illustrate the other types of nontariff barriers became more prominent. difference, the United States is listed in Table2.1 “Average Tariffs in Page 12 of 25  International Business and Trade _ Handout 1 Selected Countries (2009)” with a simple average tariff of 3.6 percent. captured using any of the average tariff measures. Nevertheless, these However, in 2008 the U.S. tariff revenue collected came to $29.2 billion from nontariff barriers can have a much greater effect on trade flows than tariffs imports of goods totaling $2,126 billion, meaning that the U.S. trade- themselves. weighted average tariff was a mere 1.4 percent. GLOBAL FOREIGN EXCHANGE AND CAPITAL MARKET Nonetheless, the trade-weighted average tariff is not without flaws. For example, suppose a country has relatively little trade because it has prohibitive tariffs (i.e., tariffs set so high as to eliminate imports) in many Understanding International Capital Markets import categories. If it has some trade in a few import categories with relatively low tariffs, then the trade-weighted average tariff would be What Are International Capital Markets? relatively low. After all, there would be no tariff revenue in the categories A capital market is basically a system in which people, companies, and with prohibitive tariffs. In this case, a low average tariff could be reported for governments with an excess of funds transfer those funds to people, a highly protectionist country. Also, in this case, the simple average tariff companies, and governments that have a shortage of funds. This would register as a higher average tariff and might be a better indicator of transfer mechanism provides an efficient way for those who wish to the level of protection in the economy. borrow or invest money to do so. For example, every time someone Of course, the best way to overstate the degree of protection is to use the takes out a loan to buy a car or a house, they are accessing the capital average tariff rate on dutiable imports. This alternative measure, which is markets. Capital markets carry out the desirable economic function of sometimes reported, only considers categories in which a tariff is actually directing capital to productive uses. levied and ignores all categories in which the tariff is set to zero. Since many There are two main ways that someone accesses the capital markets - countries today have many categories of goods with zero tariffs applied, this either as debt or equity. While there are many forms of each, very simply, measure would give a higher estimate of average tariffs than most of the debt is money that's borrowed and must be repaid, and equity is money other measures. that is invested in return for a percentage of ownership but is not guaranteed in terms of repayment. The second major problem with using average tariff rates to measure the In essence, governments, businesses, and people that save some degree of protection is that tariffs are not the only trade policy used by portion of their income invest their money in capital markets such as countries. Countries also implement quotas, import licenses, voluntary stocks and bonds. The borrowers (governments, businesses, and export restraints, export taxes, export subsidies, government procurement people who spend more than their income) borrow the savers' policies, domestic content rules, and much more. In addition, there are a investments through the capital markets. When savers make variety of domestic regulations that, for large economies at least, can and investments, they convert risk-free assets such as cash or savings into do have an impact on trade flows. None of these regulations, restrictions, risky assets with the hopes of receiving a future benefit. Since all or impediments to trade, affecting both imports and exports, would be investments are risky, the only reason a saver would put cash at risk is Page 13 of 25  International Business and Trade _ Handout 1 if returns on the investment are greater than returns on holding risk-free International capital markets are the same mechanism but in the global assets. Basically, a higher rate of return means a higher risk. sphere, in which governments, companies, and people borrow and invest across national boundaries. In addition to the benefits and For example, let's imagine a beverage company that makes $1 million purposes of a domestic capital market, international capital markets in gross sales. If the company spends $900,000, including taxes and all provide the following benefits: expenses, then it has $100,000 in profits. The company can invest the $100,000 in a mutual fund (which are pools of money managed by an Higher returns and cheaper borrowing costs. These allow investment company), investing in stocks and bonds all over the world. companies and governments to tap into foreign markets and Making such an investment is riskier than keeping the $100,000 in a access new sources of funds. Many domestic markets are too savings account. The financial officer hopes that over the long term the small or too costly for companies to borrow in. By using the investment will yield greater returns than cash holdings or interest on a international capital markets, companies, governments, and even savings account. This is an example of a form of direct finance. In other individuals can borrow or invest in other countries for either higher words, the beverage company bought a security issued by another rates of return or lower borrowing costs. company through the capital markets. In contrast, indirect finance Diversifying risk. The international capital markets allow involves a financial intermediary between the borrower and the saver. individuals, companies, and governments to access more For example, if the company deposited the money in a savings account, opportunities in different countries to borrow or invest, which in and then the savings bank lends the money to a company (or a person), turn reduces risk. The theory is that not all markets will the bank is an intermediary. Financial intermediaries are very important experience contractions at the same time. in the capital marketplace. Banks lend money to many people, and in so doing create economies of scale. This is one of the primary purposes of The structure of the capital markets falls into two components - primary the capital markets. and secondary. The primary market is where new securities (stocks and bonds are the most common) are issued. If a corporation or Capital markets promote economic efficiency. In the example, the government agency needs funds, it issues (sells) securities to beverage company wants to invest its $100,000 productively. There purchasers in the primary market. Big investment banks assist in this might be a number of firms around the world eager to borrow funds by issuing process as intermediaries. Since the primary market is limited to issuing a debt security or an equity security so that it can implement a issuing only new securities, it is valuable but less important than the great business idea. Without issuing the security, the borrowing firm has secondary market. no funds to implement its plans. By shifting the funds from the beverage company to other firms through the capital markets, the funds are The vast majority of capital transactions take place in the secondary employed to their maximum extent. If there were no capital markets, the market. The secondary market includes stock exchanges (the New beverage company might have kept its $100,000 in cash or in a low- York Stock Exchange, the London Stock Exchange, and the Tokyo yield savings account. The other firms would also have had to put off or Nikkei), bond markets, and futures and options markets, among others. cancel their business plans. All these secondary markets deal in the trade of securities. The term securities include a wide range of financial instruments. You're probably Page 14 of 25  International Business and Trade _ Handout 1 most familiar with stocks and bonds. Investors have essentially two access to more resources. One of the fundamental purposes of the broad categories of securities available to them: equity securities, which capital markets, both domestic and international, is the concept of represent ownership of a part of a company, and debt securities, which liquidity, which basically means being able to convert a noncash asset represent a loan from the investor to a company or government entity. into cash without losing any of the principal value. In the case of global capital markets, liquidity refers to the ease and speed by which Creditors, or debt holders, purchase debt securities and receive future shareholders and bondholders can buy and sell their securities and income or assets in return for their investment. The most common convert their investment into cash when necessary. Liquidity is also example of a debt instrument is the bond. When investors buy bonds, essential for foreign exchange, as companies don't want their profits they are lending the issuers of the bonds their money. In return, they will locked into an illiquid currency. receive interest payments usually at a fixed rate for the life of the bond and receive the principal when the bond expires. All types of organizations can issue bonds. Major Components of the International Capital Markets Stocks are the type of equity security with which most people are International Equity Markets familiar. When investors buy stock, they become owners of a share of a company's assets and earnings. If a company is successful, the price Companies sell their stock in the equity markets. International equity that investors are willing to pay for its stock will often rise; shareholders markets consists of all the stock traded outside the issuing company's who bought stock at a lower price then stand to make a profit. If a home country. Many large global companies seek to take advantage of company does not do well, however, its stock may decrease in value the global financial centers and issue stock in major markets to support and shareholders can lose money. Stock prices are also subject to both local and regional operations. general economic and industry-specific market factors. For example, ArcelorMittal is a global steel company headquartered in Luxembourg; it is listed on the stock exchanges of New York, Amsterdam, Paris, Brussels, Luxembourg, Madrid, Barcelona, Bilbao, The key to remember with either debt or equity securities is that the and Valencia. While the daily value of the global markets changes, in issuing entity, a company or government, only receives the cash in the the past decade the international equity markets have expanded primary market issuance. Once the security is issued, it is traded; but considerably, offering global firms increased options for financing their the company receives no more financial benefit from that security. global operations. The key factors for the increased growth in the Companies are motivated to maintain the value of their equity securities international equity markets are the following: or to repay their bonds in a timely manner so that when they want to borrow funds from or sell more shares in the market, they have the Growth of developing markets. As developing countries credibility to do so. experience growth, their domestic firms seek to expand into global markets and take advantage of cheaper and more flexible For companies, the global financial, including the currency, markets (1) financial markets. provide stability and predictability, (2) help reduce risk, and (3) provide Page 15 of 25  International Business and Trade _ Handout 1 Drive to privatize. In the past two decades, the general trend in expanding its operations in one or more countries. There are several developing and emerging markets has been to privatize formerly types of international bonds, which are detailed in the next sections. state-owned enterprises. These entities tend to be large, and when they sell some or all of their shares, it infuses billions of dollars of new equity into local and global markets. Domestic and Foreign Bond global investors, eager to participate in the growth of the local A foreign bond is a bond sold by a company, government, or entity in economy, buy these shares. another country and issued in the currency of the country in which it is Investment banks. With the increased opportunities in new being sold. There are foreign exchange, economic, and political risks emerging markets and the need to simply expand their own associated with foreign bonds, and many sophisticated buyers and businesses, investment banks often lead the way in the issuers of these bonds use complex hedging strategies to reduce the expansion of global equity markets. These specialized banks risks. For example, the bonds issued by global companies in Japan seek to be retained by large companies in developing countries denominated in yen are called samurai bonds. As you might expect, or the governments pursuing privatization to issue and sell the there are other names for similar bond structures. Foreign bonds sold in stocks to investors with deep pockets outside the local country. the United States and denominated in US dollars are called Yankee Technology advancements. The expansion of technology into bonds. In the United Kingdom, these foreign bonds are called bulldog global finance has opened new opportunities to investors and bonds. Foreign bonds issued and traded throughout Asia except Japan, companies around the world. Technology and the Internet have are called dragon bonds, which are typically denominated in US dollars. provided more efficient and cheaper means of trading stocks and, Foreign bonds are typically subject to the same rules and guidelines as in some cases, issuing shares by smaller companies. domestic bonds in the country in which they are issued. There are also regulatory and reporting requirements, which make them a slightly more expensive bond than the Eurobond. The requirements add small costs International Bond Markets that can add up given the size of the bond issues by many companies. Bonds are the most common form of debt instrument, which is basically a loan from the holder to the issuer of the bond. The international bond market consists of all the bonds sold by an issuing company, Eurobond government, or entity outside their home country. Companies that do not A Eurobond is a bond issued outside the country in whose currency it is want to issue more equity shares and dilute the ownership interests of denominated. Eurobonds are not regulated by the governments of the existing shareholders prefer using bonds or debt to raise capital (i.e., countries in which they are sold, and as a result, Eurobonds are the most money). Companies might access the international bond markets for a popular form of international bond. A bond issued by a Japanese variety of reasons, including funding a new production facility or company, denominated in US dollars, and sold only in the United Kingdom and France is an example of a Eurobond. Page 16 of 25  International Business and Trade _ Handout 1 Global Bond "More worrying still, the rules for Islamic finance are not uniform around the world. A Kuwaiti Muslim cannot buy a Malaysian sukuk (sharia- A global bond is a bond that is sold simultaneously in several global compliant bond) because of differing definitions of what constitutes financial centers. It is denominated in one currency, usually US dollars usury (interest). Indeed, a respected Islamic jurist recently denounced or Euros. By offering the bond in several markets at the same time, the most sukuk as godless. Nor are banking licenses granted easily in most company can reduce its issuing costs. This option is usually reserved for Muslim countries. That is why big Islamic banks are so weak. Often they higher rated, creditworthy, and typically very large firms. are little more than loose collections of subsidiaries. They also lack home-grown talent: most senior staff are poached from multinationals". But in 2009, one entrepreneur, Adnan Yousif, made headlines as he tried to change that and create the world's biggest Islamic bank. While Did You Know? his efforts are still in progress, it's clear that Islamic banking is a growing and profitable industry niche". As the international bond market has grown, so too have the creative variations of bonds, in some cases to meet the specific needs of a buyer and issuer community. Sukuk, an Arabic word, is a type of financing Eurocurrency Markets instrument that is in essence an Islamic bond. The religious law of Islam, Sharia, does not permit the charging or paying of interest, so Sukuk The Eurocurrency markets originated in the 1950s when communist securities are structured to comply with the Islamic law. "An IMF study governments in Eastern Europe became concerned that any deposits of released in 2007 noted that the Issuance of Islamic securities (sukuk) their dollars in US banks might be confiscated or blocked for political rose fourfold to $27 billion during 2004–06. While 14 types of sukuk are reasons by the US government. These communist governments recognized by the Accounting and Auditing Organization of Islamic addressed their concerns by depositing their dollars into European Finance Institutions, their structure relies on one of the three basic forms banks, which were willing to maintain dollar accounts for them. This of legitimate Islamic finance, murabahah (synthetic loans/purchase created what is known as the Eurodollar - US dollars deposited in orders), musharakah/mudharabah (profit-sharing arrangements), and European banks. Over the years, banks in other countries, including ijara (sale-leasebacks), or a combination thereof". Japan and Canada, also began to hold US dollar deposits and now Eurodollars are any dollar deposits in a bank outside the United States. The Economist notes "that by 2000, there were more than 200 Islamic (The prefix Euro- is now only a historical reference to its early days). An banks…and today $700 billion of global assets are said to comply with extension of the Eurodollar is the Eurocurrency, which is a currency on sharia law. Even so, traditional finance houses rather than Islamic deposit outside its country of issue. While Eurocurrencies can be in any institutions continue to handle most Gulf oil money and other Muslim denominations, almost half of world deposits are in the form of wealth". Eurodollars. Page 17 of 25  International Business and Trade _ Handout 1 International monetary system refers to a system that forms rules and standards for facilitating international trade among the nations and helps in The Euroloan market is also a growing part of the Eurocurrency market. relocating the capital and investment from one nation to another. Moreover, The Euroloan market is one of the least costly for large, creditworthy it’s the worldwide network of the government and financial institutions that borrowers, including governments and large global firms. Euroloans are determine the exchange rate per currency. It is amazing how the monetary quoted on the basis of LIBOR, the London Interbank Offer Rate, which system has evolved from centuries ago where gold coins where used as a is the interest rate at which banks in London charge each other for short- way of currency, and where people had to barter products or goods to term Eurocurrency loans. receive something in exchange. The primary appeal of the Eurocurrency market is that there are no regulations, which results in lower costs. The participants in the Eurocurrency markets are very large global firms, banks, governments, The international monetary system, aids countries by loaning them money and extremely wealthy individuals. As a result, the transaction sizes tend so they can overcome poverty, and debts. Some countries struggle with to be large, which provides an economy of scale and nets overall lower inflation which means that there is too much product and no demand for it. transaction costs. The Eurocurrency markets are relatively cheap, short- term financing options for Eurocurrency loans; they are also a short-term investing option for entities with excess funds in the form of Importance of Currency Management Eurocurrency deposits. It is important to understand currency management because companies need to know that volatility in exchange rates can significantly affect their bottom line. Offshore Centers Why do economies need money? This module defines money as a unit of The first tier of centers in the world are the world financial centers, which account, that is used as a medium of exchange in transactions. Without are in essence central points for business and finance. They are usually money, individuals and businesses would have a harder time obtaining home to major corporations and banks or at least regional headquarters (purchasing) or exchanging (selling) what they want, need, or make. Money for global firms. They all have at least one globally active stock provides us with a universally accepted medium of exchange. exchange. While their actual order of importance may differ both on the ranking format and the year, the following cities rank as global financial Whenever a country or empire has regional or global control of trade, its centers: New York, London, Tokyo, Hong Kong, Singapore, Chicago, currency becomes the dominant currency for trade and governs the Zurich, Geneva, and Sydney. monetary system of that time. International Monetary System With the growing complexity in the international trade and financial market, the international monetary system is necessary, to assign a standard value of the international currencies. The rules and regulations set by the Page 18 of 25  International Business and Trade _ Handout 1 international monetary system to regulate and control the exchange value International Monetary Fund of the currencies are agreed upon by the respective governments of the The International Monetary Fund (IMF) is the central institution embodying nations. Thus, the government’s stand may affect the decision making of the international monetary system and promotes balanced expansion of the international monetary system. For example, change in the trade policy world trade, reduced trade restrictions, stable exchange rates, minimal of a government may affect the international trade of goods and services. trade imbalances, avoidance of currency devaluations, and the correction The aim of new international monetary system is to create a stabilized of balance-of-payment problems. The IMF’s goal is to prevent and remedy international currency system and ensure a monetary stability for all the international financial crises by encouraging countries to maintain sound nations. economic policies. Because of its size, the IMF is also a forum for discussion of global economic policies. The central banks of nations were given the task of maintaining fixed exchange rates with respect to the dollar for each currency. The IMF is headquartered in Washington, D.C., but has offices in Paris, Tokyo, New York, and Geneva. The IMF promotes itself as “an organization of 188 countries, working to Exchange Rates foster global monetary cooperation, secure financial stability, facilitate Exchange rate is the ratio at which one currency is converted into another international trade, promote high employment and sustainable economic currency: growth, and reduce poverty around the world.” Fixed Exchange Rate: The government manipulates the value of a The organization’s primary purpose is to “ensure the stability of the country’s currency. international monetary system—the system of exchange rates and Floating Exchange Rate: The value of a country’s currency changes international payments that enables countries (and their citizens) to transact based on market forces. with each other.” Most countries operate under a freely floating exchange rate system. In essence, the IMF’s initial primary purpose was to help manage the fixed rate exchange system; it eventually evolved to help governments correct A flexible exchange rate, which is the same as the floating exchange rate temporary trade imbalances (typically deficits) with loans. system is a system wherein the value of a currency changes with market demands. When the demand for a particular currency is high, the value of Lending money to poor countries is also a major initiative at the IMF. The that currency goes up. When demand is low, the value goes down. organization provides financing to help troubled nations avoid or recover from economic challenges. The opposite of this is a fixed exchange rate wherein a currency has a fixed value relative to another currency or commodity. Market demand has no IMF Advantages influence on the value of the currency. The IMF assists member nations in several different capacities. If a country has a balance of payment deficit, the IMF can step in to fill the gap. It serves Page 19 of 25  International Business and Trade _ Handout 1 as a council and adviser to countries attempting a new economic policy. It International Finance Corporation: provides monetary and advice to also publishes papers on new economic topics. private sector entities. Multilateral Investment Guarantee Agency: Seeks to encourage Its most important function is its ability to provide loans to member nations foreign direct investment in developing nations. in need of a bailout. The IMF can attach conditions to these loans, including prescribed economic policies, to which borrowing governments must International Centre for Settlement of Investment Disputes: Provides comply. physical facilities and procedural expertise to help resolve inevitable disputes that arise when money is at the heart of a disagreement IMF Disadvantages between two parties association investment. Despite its lofty status and commendable objectives, the IMF is attempting GOLD STANDARD to pull off a nearly impossible economic feat: perfectly timing and sizing economic intervention on an international scale. The gold standard is a monetary system in which the value of a country's currency is directly linked to gold. With the gold standard, countries agree The IMF has been criticized for not doing much and for overreaching. It has to convert paper money into a fixed amount of gold. A country that uses the been criticized for being too slow or too eager to assist failing national gold standard sets a price for gold, and it buys and sells gold at that price. policies. Since the United States, Japan and Great Britain feature prominently in IMF policies, it has been accused of being a tool for free- That fixed price is in turn used to determine the value of its currency. For market countries only. example, if the U.S. hypothetically set the price of gold at $500 an ounce, the value of the dollar would be 1/500th of an ounce of gold. The World Bank Use of the Gold Standard The gold standard is not currently used by any government. Britain stopped The World Bank Group, like the IMF, was created at Bretton Woods in 1944. using the gold standard in 1931, and the U.S. followed suit in 1933, finally Its goal is to provide “financial and technical assistance to developing abandoning remnants of the system in 1973. countries around the world to reduce poverty and support development.” This consists of five underlying institutions, the first two of which are The gold standard was completely replaced by fiat money, a term to collectively referred to as The World Bank. describe currency that is used because of a government's order, or fiat, that the currency must be accepted as a means of payment. In the U.S., for instance, the dollar is fiat money, and in Nigeria, the naira is. International Bank for Reconstruction and Development: provides Gold Standard System vs. Fiat System financial assistance to credit-worthy, middle-and low-income nations. A fiat system, by contrast, is a monetary system in which the value of a International Development Association: provides loans and grants to currency is not based on any physical commodity but is instead allowed to poor countries. Page 20 of 25  International Business and Trade _ Handout 1 fluctuate dynamically against other currencies on the foreign exchange Why Did the U.S. Abandon the Gold Standard? markets. The U.S. abandoned the gold standard in 1971 to curb inflation and prevent The term "fiat" is derived from the Latin fieri, meaning an arbitrary act or foreign nations from overburdening the system by redeeming their dollars decree. In keeping with this etymology, the value of fiat currencies is for gold. ultimately based on the fact that they are defined as legal tender by way of METHODS OF PAYMENT government decree. To succeed in today’s global marketplace and win sales against foreign In the decades before the First World War, international trade was competitors, exporters must offer their customers attractive sales terms conducted based on what has come to be known as the classical gold