Updated Test 2

Ch 6-11

Country Risk aka Political Risk

Country Risk aka Political Risk

Exposure to potential loss

Ex. Current assets/intellectual property

Dimensions of Country Risk/Political Risk

• harmful or unstable political system

• Laws and regulations unfavorable to foreign films

• Inadequate or underdeveloped to foreign firms

• Bureaucracy and red tape

• Corruption and other ethical blunders

• Gov intervention, protectionism, and barriers to trade and investment

• Mismanagement or failure of the national economy

• Seizure of foreign assets

Political system

A set of formal institutions that constitute a government. It includes legislative bodies, political parties, lobbying groups, and trade unions. The system also defines how these groups interact with each other

Three major types of political systems

1. Totalitarianism

2. Socialism

3. Democracy aka Capitalist

Functions of political systems

• provide protection from external threats

• Ensure stability based on laws

• Govern the allocation of valued resources among the members of a society

• Define how society’s members interact with each other

  • external and internal protection ex. Army, FBI, police

Legal system

Creates, interprets and enforces laws

4 major types of legal systems

1. Common Law

2. Civil Law

3. Religious Law

4. Mixed Systems

Totalitarianism

• Government controls all economic and political matters

• Led by a dictator

• Ppl are poor → no middle class

• Lots of corruption

• Associated with command economies

What is a religion based totalitarian states called?

Theocratic

Socialism

• gov taxes the ppl, uses the tax for social welfare

• Tax rate high → many free things

• Capital is vested in the state and used primarily as a means of production for use rather than for profit

• Redistribution of wealth

  • Take money of those who have it and redistribute it for the common welfare

  • Brain drain

  • Squashed competitiveness in that country

• Associated with mixed economies

Democracy/Capitalism

• limited government intervention

• Private property rights

• “You earn it, you keep it”

  • You do pay taxes but not nearly as much as socialism

• Associated with market economies

Totalitarianism countries

• Cuba

• North Korea

• Several countries in Africa such as

  • Eritrea, Sudan, Equatorial Guinea, Zimbabwe

Socialism Countries

• Bolivia

• China

• Egypt

• India

• Romania

• Russia

• Venezuela

• Canada (between this and capitalism)

Capitalism Countries

• Australia

• Canada (between this and socialism)

• Japan

• New Zealand

• United States

• Most European countries

• Most Latin America countries

The Rule of Law

Existence of a legal system where rules are clear, publicly disclosed, fairly enforced, and widely respected by individuals, organizations, and the government

Common Law

• aka case law

• Basis of law is tradition, past practices, and legal precedents set by courts via interpretation of statutes, legislation, and past rulings → made by precedent

• Judges have much power to interpret laws

• Relatively flexible

Civil Law

• code of law

  • Codified → clearly written by legislative bodies

• not strongly subject to interpretation by courts

• Common law is mainly judicial whereas civil law is mainly legislative

Religious Law

• Strongly influenced by religious beliefs, ethical codes, and moral values, viewed as mandated by a supreme being

Mixed Systems

• Two or more legal systems operating together

  • Democracy is associated with common law, civil law, and mixed systems

Actors in Political and Legal Systems

• Activist groups

• Strongest actor → labor unions

  • Regional economic blocs such as EU and NAFTA

Government Takeover of Corporate Assets

• Confiscation

• Expropriation

• Nationalization

Confiscation

Seizure of corporate assets without compensation

Expropriation

Asset seizure with compensation

• pay market price

• Public domain takeover

Nationalization

(Coup)

Takeover of an entire nation or industry

Creeping Expropriation

Government gradually modifies regulations and laws

Country risk arising from the host country legal environment

• foreign investment laws

• Controls on operating forms and practices

• Marketing and distribution laws

• Laws regarding income repatriation

• Environmental laws

• Contract laws

• Inadequate or underdeveloped legal systems

  • Internet and e-commerce regulations

Country risk arising from the home country legal environment

• The Foreign Corrupt Practices Act (FCPA)

• Anti boycott regulations

• Accounting and reporting laws

• Transparency in financial reporting

Government Intervention

alters the competitive landscape by hindering or helping the ability of firms to compete internationally

• the more involved the gov is, the higher the risk of doing business in that country

• gov intervention is an important dimension of country risk

Key rationales for gov intervention

• Tariffs can generate substantial government revenue

• Helps ensure the safety, security, and welfare of citizens

Economic Freedom

the absence of government intervention

Regional Economic Integration

The growing economic interdependence that results when nations within a geographic region form an alliance aimed at reducing barriers to trade and investment

Economic Bloc

A geographic area consisting of two or more countries that agree to pursue economic integration by reducing tariffs and other barriers to the cross-border flow of products, services, capital, and , in more advanced cases, labor

5 Potential Levels of Regional Integration

1. Free Trade Area

2. Customs Union

3. Common Market

4. Economic and (sometimes) Monetary Union

5. Political Union

Free Trade Area (5 Potential Levels of Regional Integration)

Members agree to eliminate tariffs and non-tariff trade barriers with each other but maintain their own trade barriers with non-member countries (ex. NAFTA)

Customs Union (5 Potential Levels of Regional Integration)

Restricts imports but no customs duty (ex. MERCOSUR)

Common Market (5 Potential Levels of Regional Integration)

Free movement of product, labor and capital

Economic and (sometimes) Monetary Union

Unified monetary and fiscal policy by a central authority

• Don’t have to worry about fluctuation of currency

(ex. the EU)

Political Union (5 Potential Levels of Regional Integration)

No such thing!!

• submersion of all separate national institutions

• Countries run by one gov (ex. if the states were countries in the US)

Why do nations pursue economic integration?

businesses and consumers win!

• expand market size

• achieve economies of scale and productivity

• attract direct investment from outside the bloc

• acquire stronger defensive and political posture

Advanced Economies

Post industrial countries with high per capita income, competitive industries, and developed commercial infrastructure. Typically the richest countries

Developing Economies

Low income countries characterized by limited industrialization and stagnant economies

• low GDP

• corruption/bribery

• Moderate to high trade barriers

Emerging market economies

Former developing economies that achieved substantial industrialization, modernization, and remarkable economic growth

• opened borders to trade

• becoming richer

• middle class growing

BRIC countries are an example of what type of economy

Emerging economies

Look at the key differences among the 3 major country groups slide

ch 8 slide 8

Trade barriers in advanced economies

Minimal

Trade barriers in developing economies are…

Moderate to high

Trade barriers in emerging markets are…

Rapidly liberalizing

What makes emerging markets attractive?

1. Target markets

   1. cheap labor

   2. lots of ppl

2. Manufacturing bases

3. Sourcing destinations

Outsourcing

The procurement of selected value-chain activities, including production of intermediate goods or finished products, from independent suppliers

Global Sourcing

The procurement of products or services from independent suppliers or company-owned subsidiaries located abroad for consumption in the home country or a third country

Purchasing Power Parity (PPP)

PPP adjusted per capita GDP represents the amount of products that consumers can buy in a given country, using their own currency and consistent with their own standard of living

• “Cost of living”

• “What ppl can buy given their income”

Challenges of doing business in emerging markets

• Political instability

• Weak intellectual property protection

• Bureaucracy, red tape, and lack of transparency

• Poor physical infrastructure

• Partner availability and qualifications

• Resistance from family conglomerates

Speculation

People think a stock is going to go up, ppl buy it, then the stock goes up

Long term reason to buy stock

Quarterly earnings

Short term reason to buy stock

Speculation

When demand increases and supply doesn’t…

Prices go up

When there is an excess supply with no demand…

Prices go down

Pegged

Peg currency to a basket of goods

Floats

Floats based on supply and demand

• determined by speculation and factors such as GDP

Exchange rate

Price of one currency in terms of another

• determined by supply and demand

(If 1 Euro = 1.07 dollar) If you think the dollar is going to go down…

You want to buy the Euro

Spot rate

Exchange rate based on the current rate of exchange

“What the currency is now”

Future/Forward rate

Exchange rate applicable at some future date, but specified at time of the transaction

“What the currency will be later at that time”

Exposed

Exposed to risk

Leveraged

Lots of debt

Foreign exchange market

The global marketplace for buying and selling national currencies

When the dollar gets stronger:

• Imports ↑ b/c you can buy more with the dollar

• Exports ↓ b/c it becomes more expensive for others

• Balance of trade becomes negative

• Int rates ↓

• Inflation ↓

• Stock market ↑

• GDP ↑

When the dollar gets weaker:

• Imports ↓ b/c foreign goods are more expensive

• Exports ↑ b/c goods are cheaper since the dollar is down

• Balance of trade becomes positive (selling more than we are buying)

• Int rates ↑

• Inflation ↑

• Stock market ↓

• GDP ↓

Dollar gets weaker because:

• Inflation goes up

• Unemployment goes up

• Stock market goes down

• Federal Reserve prints more money

• American crisis (like a terrorist attack)

• GDP goes down

• Anytime ppl lose confidence in the gov

Dollar gets strong because:

• Inflation goes down

• Unemployment goes down

• Stock market goes up

• Federal Reserve buys money (which means they are taking money out of circulation

• America is at peace (no terrorist attacks)

• GDP goes up

• Anytime ppl gain confidence in the gov

How does gov intervention affect supply and demand?

Gov intervention messes w/supply and demand

Trade surplus

Exports exceed imports; may result when the exporter’s currency is undervalued

Trade deficit

Imports exceed exports

• positives: more choice for the consumers

Balance of trade

The difference between the value of a nation’s exports and imports

Bretton Woods

Established a fixed exchange rate system in which the US dollar was pegged to a set value for gold, and other major currencies were pegged to the dollar (dissolved in 1971)

International Monetary Fund (IMF)

Agency that promotes exchange rate stability, monitors exchange systems, provides funding to developing economies

• goal: to have stability amongst currency and to help economies more from developing to emerging to advanced

World Bank

Agency that provides loans and technical assistance to combat global poverty around the world

International monetary system

The institutional framework, rules, and procedures by which national currencies are exchanged for one another

Key participants in the monetary and financial systems

• Firms

• Commercial Banks (set int rates)

• Central banks

What happens to inflation if the US Federal reserve increases interest rates?

Inflation increases because money becomes more expensive and the dollar becomes weaker

International Financial Management

“Moving money”

The acquisition and use of funds for cross-border trade, investment, and other commercial activities

Ways to make money:

1. Equity financing

2. Debt financing

Equity financing

Sell/distribute more stocks (dilution of stock)

• negatives: stock price goes down b/c more ppl involved

• positives: get money right away

Debt financing

1. get a loan (institutional financing)

2. issue a bond (public can buy it)

pos: you retain control of your company

neg: you have to pay it back, so if you can’t pay it back and have interest it could be more expensive

Working Capital

Basically the money you use when operating your business

-must make enough money to pay off your bills

-ex. payroll expense

Market capitalization

How much a company is worth

• #of shares x stock price

***As soon as a firm decides to do equity financing…

Market capitalization drops

International Financial Management Tasks

1. Choose a capital structure - determine the ideal long-term mix of debt versus equity financing

2. Raise funds for the firm

3. Working capital and cash flow management

4. Capital budgeting

5. Managing currency risk

6. Manage the diversity of international accounting and tax practices

Capital Structure

Mix of long term equity and debt financing firms use to support their activities

Examples of short term, intermediate, and long-term financing

Short-term: debt

Intermediate-term: bonds, debt/equity

Long-term: Equity

What are the major financial centers

• New York

• London

• Tokyo

One cause of rapid rise in global capital markets

Government’s deregulation of financial markets made capital easier to move across national borders

***Why has China become a global power?

Because of their massive balance of trade

• Their big trade surplus and foreign investment inflows together have created massive reserves of foreign exchange

Foreign bonds

Sold outside the bond issuer’s country and denominated in the currency of the country in which they are issued

Intracorporate financing (aka Transfer Pricing)

• Prices that subsidiaries and affiliates charge one another as they transfer goods and services within the same MNE

• Obtaining funds from within firm’s network of subsidiaries and affiliates

ex. GE locomotive might borrow from GE appliance

****regulated because of predatory pricing

Cash Flow management

Ensures cash is available where and when it is needed

Restraint of Trade

Against the law for an MNE to sell stuff to their affiliates (ex. GE locomotive selling to GE appliances) at a lower price than other companies

Currency Risk

Concerns exchange rate fluctuations that harm business profits

Direct Quote

“current exchange rate”

The number of units of domestic currency needed to acquire one unit of the foreign currency

ex. it costs $1.42 to acquire one euro

Indirect Quote

The number of units of the foreign currency obtained for one unit of the domestic currency

ex. for $1, I can receive .74 euros