MODULE 4.1 A. 4.

LOCAL CONTENT REQUIREMENTS a requirement that some specific fraction

FREE TRADE refers to a situation in which a government does not attempt to of a good be produced domestically.
restrict what its citizens can buy from or sell to another country. LOCAL CONTENT REGULATIONS provide protection for a domestic producer of
parts in the same way an import quota does: by limiting foreign competition.
A. Instruments of Trade Policy
Trade policy uses seven main instruments: tariffs, subsidies, import quotas,
voluntary export restraints, local content requirements, administrative policies, and A.5. Administrative Policies
antidumping duties. ADMINISTRATIVE TRADE POLICIES are bureaucratic rules designed to make it
A.1. TARIFFS is a tax levied on imports (or exports). difficult for imports to enter a country.

Tariffs fall into two categories.

A.6. Antidumping Policies
 SPECIFIC TARIFFS are levied as a fixed charge for each unit of a good
 DUMPING is variously defined as selling goods in a foreign market at
imported (for example, $3 per barrel of oil).
below their cost of production or as selling goods in a foreign market at
 AD VALOREM TARIFFS are levied as a proportion of the value of the below their “fair” market value.
imported good.
 There is a difference between these two definitions; the fair market
value of a good is normally judged to be greater than the costs of
A.2.Subsidies
producing that good because the former includes a “fair” profit
SUBSIDY is a government payment to a domestic producer. It is a form of direct
margin.
assistance to companies to boost competitiveness.
 SUBSIDIES take many forms, including cash grants, low-interest loans, tax
breaks, and government equity participation in domestic firms. ANTIDUMPING POLICIES are designed to punish foreign firms that engage in
 AGRICULTURE tends to be one of the largest beneficiaries of subsidies in dumping.
most countries.
 NONAGRICULTURAL SUBSIDIES are much lower, but they are still B. Arguments for Government Intervention
significant. Arguments for government intervention take two paths: political and economic.

A.3. Import Quotas and Voluntary Export Restraints B.1. POLITICAL ARGUMENTS for intervention are concerned with protecting the
 IMPORT QUOTA is a direct restriction on the quantity of some good that interests of certain groups within a nation (normally producers), often at the
may be imported into a country. expense of other groups (normally consumers).
B.2. ECONOMIC ARGUMENTS typically concerned with boosting the overall wealth
 TARIFF RATE QUOTA common hybrid of a quota and a tariff
of a nation (to the benefit of all, both producers and consumers).

 INFANT INDUSTRY ARGUMENT is by far the oldest economic argument

for government intervention.
Figure 2. Hypothetical Tariff Rate Quota
 Alexander Hamilton proposed it in 1792. According to this argument,
VOLUNTARY EXPORT RESTRAINT (VER) is a quota on trade imposed by the
many developing countries have a potential comparative advantage in
exporting country, typically at the request of the importing country’s government.
manufacturing, but new manufacturing industries cannot initially compete
with established industries in developed countries.
STRATEGIC TRADE POLICY ARGUMENT. The new trade theory argues that in Levels of Economic Integration:
industries in which the existence of substantial economies of scale implies that the 1. FREE TRADE AREA all barriers to the trade of goods and services among member
world market will profitably support only a few firms. countries are removed.
2. CUSTOMS UNION eliminates trade barriers between member countries and
adopts a common external trade policy.
 But who is to monitor the governments to make sure they are playing
3. COMMON MARKET has no barriers to trade between member countries, includes
by the trade rules? And who is to impose sanctions on a government a common external trade policy, and allows factors of production to move freely
that cheats? Both governments could set up an independent body to act between members.
as a referee. This referee could monitor trade between the countries, 4. ECONOMIC UNION involves the free flow of products and factors of production
make sure that no side cheats, and impose sanctions on a country if it does between member countries and the adoption of a common external trade policy.
cheat in the trade game. 5. FULL POLITICAL UNION through political union in which a central political
apparatus coordinates the economic, social, and foreign policy of the member
The evolution of GATT and WTO is as follows: states.
C.1. Smith to the Great Depression
 TRADE CREATION occurs when high-cost domestic producers are
 The objectives of the Corn Laws tariff were to raise government revenues
replaced by low-cost producers within the free trade area.
and to protect British corn producers.
 TRADE DIVERSION occurs when lower-cost external suppliers are
C.2. General Agreement on Tariffs and Trade / GATT (1947 – 1979)
replaced by higher-cost suppliers within the free trade area.
 The GATT was a multilateral agreement whose objective was to liberalize
trade by eliminating tariffs, subsidies, import quotas, and the like.
EUROPEAN UNION the product of two political factors:
C.4. Uruguay Round and World Trade Organization
(1) the devastation of Western Europe during two world wars and the desire
 in 1986 GATT members embarked on their eighth round of negotiations to for a lasting peace,
reduce tariffs, THE URUGUAY ROUND. (2) the European nations’ desire to hold their own on the world’s political
World Trade Organization (WTO) and economic stage.
 acts as an umbrella organization that encompasses the GATT along with European Union Institutions:
two new sister bodies, one on services and the other on intellectual a. THE EUROPEAN COUNCILS It is the Summit of the heads of state and
property. government of all EU countries.
 WTO’S AGREEMENT ON TRADE-RELATED ASPECTS OF b. THE EUROPEAN PARLIAMENT directly elected by and is the voice of the EU
INTELLECTUAL PROPERTY RIGHTS (TRIPS) is an attempt to narrow the people for a term of office of five years.
gaps in the way intellectual property rights are protected around the c. THE COUNCIL OF MINISTERS (THE COUNCIL OF THE EU)
world and to bring them under common international rules. The voice of the member states. It is the supreme decision-making body of the EU.

Article 2 of the WTO Agreement stipulates the primary function of the WTO as d. THE EUROPEAN COMMISSION - Promoting the common interest
providing 'the common institutional framework for the conduct of trade relations
among its members in matters related to the agreements and associated legal E. COURT OF JUSTICE OF THE EUROPEAN UNION the common judicial institution
instruments included in the annexes to [the] Agreement. of the EU and of the European Atomic Energy Community (EURATOM
E. Regional Economic Integration Agreements  MERCOSUR originated in 1988 as a free trade pact between Brazil and
 means agreements among countries in a geographic region to reduce, and Argentina.
ultimately remove, tariff and nontariff barriers to the free flow of goods,
services, and factors of production between each other.
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  Association of Southeast Asian Nations (ASEANS) Free Trade Area  Conflict of laws on the content of contracts: It is the case where the laws
(AFTA)m Formed in 1967, the Association of Southeast Asian Nations of different countries comprise different rules on the various and
(ASEAN) includes Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, complex issues
Philippines, Singapore, Thailand, and Vietnam. Laos, Myanmar, Vietnam, DOMESTIC LAW, as far as it relates to international treaties, states the freedom of
and Cambodia have all joined recently. the choice of law applied to parties involved in an international business
 ASEAN is to foster freer trade between member countries and to achieve transaction.
cooperation in their industrial policies.
 ASEAN Free Trade Area (AFTA) between the six original members of F.1.2. INTERNATIONAL (TRADE) LAW the law governing international trade.
ASEAN came into full effect. The AFTA has cut tariffs on manufacturing International trade should be understood as international relations at the trade
and agricultural products to less than 5 percent. policy level, such as the tariff and non-tariff policy, offensive or defensive trade
policy, or the economic integration policy, of a state.
MODULE 4.2 o INTERNATIONAL ECONOMIC ORGANIZATIONS involve
International Sale of goods are performed in the forms of export; strongly in international trade relations, among these it should
import; temporary import for re-export; temporary export for re-import; and note the WTO, IMF, WB, EU, ASEAN, etc.
international sales of good without import-export procedures at border-
gates. These are business transactions that usually takes place beyond the o INTERNATIONAL TRADE RULES provide the rules of the game
territory of a country. for the international trade game.
10 Key Clauses of an international Sales Contract
a. Description of goods F.1.2.a. International Treaties
b. Contract price Conflicts of laws may cause disputes in international sales of goods.
c. Delivery terms To prevent these, countries often negotiate the adoption of related
d. Time of delivery international treaties in order to unify certain rules aiming at governing
e. Payment conditions these transactions. There are two types of such international treaties - one to
f. Documents unify the substantive rules, and the other to unify the rules of conflict. These
g. Inspection of good by the buyer treaties may be either bilateral or multilateral.
h. Retention of title
i. Force majeure 1. Treaties to Unify the Substantive Rules
j. Resolution of disputes The UNIFICATION OF THE SUBSTANTIVE RULES occurs when countries
agree to create the substantive rules, in order to govern international sales of goods
F.1. Regulations on International Sales of Goods transactions.
THREE MAIN SOURCES 2. Treaties to Unify the Rules of Conflict
1. domestic law  The national rules of conflict may differ among countries. If there exist
2. international treaties, different national rules of conflict to resolve the same issue, there might
3. international mercantile customs and usages. occur the conflict of rules of conflict.
 The uniform rules of conflict may be specified in bilateral or multilateral
F.1.1. Domestic Law sales contract may be governed simultaneously by the laws of treaties.
many countries.  The bilateral treaties related to this issue are mutual legal assistance
 Conflict of laws on contract forms: It is the case where the laws of agreements.
different countries comprise different rules on the form of the sales  MULTILATERAL INTERNATIONAL AGREEMENTS to unify the rules of
contracts. conflict were usually adopted within the framework of an international

3
 organization, the most important of which was The Hague Conference on
Private International Law. UNIFORM RULES FOR COLLECTION” OR “URC”.
 The relations between the seller and the remittance bank, between
HAGUE CONFERENCE is a permanent institution responsible for the unification of remitting and collecting banks; are usually governed by the ICC's Uniform
private international law on a global scale. Rules for Collection (the latest version is URC 522 published in 1995),.

F.1.2.b. INTERNATIONAL MERCANTILE CUSTOMS AND USAGES F.2.a. Parties in Documentary Collection
 a whole of unwritten rules generated from the acts/behaviors of When payment is to be made by documentary collection, the parties to the
merchants and were considered as the law by them. operation are:
 important source of law governing sales contracts.
 They have been recognized and widely applied to business activities on a a. The principal (usually the drawer) - the seller who prepares the
regional or a global scale. collection documents and delivers them to his/her bank with collection
 The international mercantile customs and usages usually govern specific instructions.
issues, such as the transfer of risk from the seller to the buyer, the b. The remitting bank - normally the seller's bank which forwards the
obligations of each party related to the transport and insurance of goods, documents together with the seller's instructions to the collecting bank.
etc. c. The collecting bank - is any bank (other than the remitting bank)
involved in the processing of the collection and would normally be the
F.1.2.c. Other Legal Sources remitting bank's correspondent in the buyer's country.
MODEL CONTRACTS AND GENERAL PRINCIPLES OF CONTRACT LAW are other d. The presenting bank - normally the buyer's bank, which presents the
sources of law, which are also becoming increasingly important in governing collection to the drawee (buyer) and collects the payment, or obtains
international commercial contracts in general and sales contracts, having a legal the acceptance, from the drawee. The collecting and presenting banks
effect similar to international mercantile customs and usages. are often one and the same bank.
e. The drawee - the buyer to whom the documents are presented for
Firstly, MODEL CONTRACTS it is necessary to distinguish a model contract drafted payment or acceptance.
by a professional association, from one provided to the parties by an independent
organization.  As soon as shipment is made, the seller draws a sight or term bill on
Secondly, GENERAL PRINCIPLES OF CONTRACT LAW, they have been usually the overseas buyer, attaches the shipping documents (usually in
principles extracted from international business practices recognized and applied duplicate), and hands these to his/her bank (remitting bank)
by traders in their international contracts transactions, and have considered together with instructions as to the manner in which the collection is
popular. to be handled. The seller's bank forwards the bill and documents to
the collecting bank according to the instructions passed to it by the
 'DOCUMENTARY BILLS' denotes a bill of exchange accompanied by seller. If the seller draws a sight or an on demand bill, the
shipping documents and is intended to be accepted or paid in exchange instructions would be for documents to be released only against
for those documents. payment (D/P). In the case of a term bill, the instructions would
 'CLEAN' BILL, that is, a bill of exchange. usually be for documents to be released against acceptance of the bill
 DOCUMENTARY BILL is a bill of exchange to which the bill of lading (or (D/A) with subsequent presentment for payment on the due date.
other documents of title) is attached. The collecting bank should keep the remitting bank regularly
informed of the status of the bill. However, collecting banks in some
A BILL OF EXCHANGE (also known as a draft), along with others (for example, countries may be quite lax in their status advices; the remitting bank
cheques) belongs to the class of document known as negotiable instruments. is often required to initiate these enquiries.

4
  ISSUING BANK means the bank that issues a credit at the request of an
BILL OF EXCHANGE is discounted when the bank credits the seller's account with applicant or on its own behalf;
the full amount of the bill (less any banking charges), or when the bank agrees to  HONOUR means:
advance to the seller a percentage of the face value of the bill but withholds the o To pay at sight if the credit is available by sight payment;
balance until the bill is paid by the buyer. o To incur a deferred payment undertaking and pay at maturity if the creditis
available by deferred payment;
DOCUMENTARY CREDITS o To accept a bill of exchange ('draft') drawn by the beneficiary and pay at
 (also known as “commercial credits” or “letters of credit”) are maturity if the credit is available by acceptance.
preferred alternatives to a documentary bill.  COMPLYING PRESENTATION means a presentation that is in accordance
 widely used across the world. Their popularity in international commerce with the terms and conditions of the credit, the applicable provisions of
has led judges to describe them as “the life blood of international these rules and international standard banking practice.
commerce” F.2.b. Types of Documentary Credits
1. Irrevocable and Revocable Credits
From the scope of application above, three legal matters should be a. IRREVOCABLE CREDIT constitutes a definite undertaking by
taken into consideration. the issuing bank that it will honour the credit, provided that there is a complying
presentation of the documents specified in the credit (UCP 600 Articles 2 and 7(a)).
1. UCP Rules Apply to Documentary Credit b. REVOCABLE CREDIT credit that may be cancelled or the terms
The application of the UCP is widely discussed and focuses on what a altered at any time without the consent of the beneficiary. UCP 500, an earlier
'documentary credit' actually means. The UCP also applies to a standby letter of version of the UCP 600 and one that does extend to revocable credits.
credit; the practice of international commerce has indicated, however, that it is
ill-suited to that type of letter of credit and the traders are unwilling to apply
2. Unconfirmed and Confirmed Credits
the UCP to standby letters of credit.
CONFIRMATION definite undertaking of the confirming bank, in addition to that of
2. Applied in the Case where the Text of the Credit Expressly
the issuing bank, to honor or negotiate a complying presentation.”
Indicates that It Is Subject to These Rules
3. The UCP Is Binding on All Parties thereto unless Expressly
3. Sight Payment, Acceptance and Deferred Payment Credits
Modified or Excluded by the Credit
 PAYMENT AT SIGHT - the bank undertakes to pay the seller (the
beneficiary under the credit) upon presentation of the specified
 DOCUMENTARY CREDIT may also be described as an advice issued by a
documents.
bank authorizing the payment of money to a named party, the beneficiary,
 DEFERRED PAYMENT - the bank undertakes to pay the seller at some
against delivery by the beneficiary of specified documents (usually
future date determined in accordance with the terms of the credit,
accompanied by a bill of exchange for the amount to be paid) evidencing
the shipment of described goods.  'DEFERRED PAYMENT' CREDIT future payment by the bank is to be
made other than against an accepted bill of exchange (acceptance credit)
 CREDIT means any arrangement, however named or described, that is
irrevocable and thereby constitutes a definite undertaking of the issuing  ACCEPTANCE CREDIT - the bank undertakes to accept bills of exchange
bank to honor a complying presentation.' drawn on it by the seller.
 DOCUMENTARY CREDITS means credits (within the meaning in this
4. Straight (or Special Advised) Credits and Negotiation Credits
Article 2) that arrange payment by the buyer ('the applicant') to the seller
('the beneficiary') against the presentation of specified documents (that is  STRAIGHT CREDITS, the issuing bank's payment undertaking is directed
why this type of credit is known as 'documentary'). solely towards the seller.

5
  NEGOTIATION CREDITS, the issuing bank's payment undertaking is not  'ON DEMAND' The terms performance bond and performance guarantee.
confined to the seller; it extends to the nominated bank authorized to Performance bond or demand guarantee) (hereinafter the 'demand
negotiate to purchase the bill of exchange drawn by the seller. guarantee').

If the documents conform to the terms of the credit, the advising bank (as a
Article 2 of the UCP reads: nominated bank or confirming bank) will:
 NEGOTIATION means the purchase by the nominated bank of drafts (i) pay the contract price;
(drawn on a bank other than the nominated bank) and/or documents (ii) incur a deferred payment undertaking and pay at maturity;
under a complying presentation, by advancing or agreeing to advance (iii) accept a bill of exchange and pay at maturity;
funds to the beneficiary on or before the banking day on which (iv) negotiate a bill of exchange drawn for the price, and seek reimbursement from
reimbursement is due to the nominated bank. the issuing bank;
F.2.d.The Contracts Arising out of a Documentary Credit Transaction
5. Red Clause and Green Clause Credits Firstly, there is the underlying sales contract between the seller and
 RED CLAUSE CREDITS are those allowing the seller to draw on the buyer.
documentary credit in advance of shipment. Secondly, when the issuing bank agrees to act upon the instructions of the
 GREEN CLAUSE CREDITS came to be used in the coffee trade in Zaire and buyer, a contract comes into existence between them.
operate similarly to 'red clause' credits. Thirdly, when a correspondent bank agrees to act upon the instructions
of the issuing bank, and advises or confirms the credit, there is contractual
6. Revolving Credits relationship between the issuing bank and the correspondent bank.
o Instead of a credit being for a fixed amount or for a fixed time, it Finally, the payment undertakings given to the seller by the issuing and
may revolve around value or time. confirming banks in a documentary credit transaction are contractual in nature.
o enables the beneficiary to present the documents as often as
s/he wishes during the credit period so long as the overall limit  ISSUING BANK is irrevocably bound to honor as of the time it issues the
specified in the credit is not exceeded. credit.

7. Transferable and Non-Transferable Credits F.2.e.The Governing Law of Documentary Credits

 DOCUMENTARY CREDITS are either transferable or are non- There are several different contractual relationships under a documentary
transferable. credit arrangement. Leaving aside the underlying sales contract, there are contracts
 TRANSFERABLE CREDIT allows the seller (the original beneficiary of the between:
credit) to transfer the rights embodied in the credit to a third party. (i) the buyer and the issuing bank;
 (ii) the issuing and the confirming bank;
8. Demand Guarantees and Standby Credits (iii) the confirming bank and the seller; and
STANDBY LETTER OF CREDIT is similar to an ordinary documentary credit in that (iv) the issuing bank and the seller.
it is issued by a bank and embodies an undertaking to make payment to a third
party(the beneficiary) or to accept bills of exchange drawn on his/her, provided MODULE 5.
that the beneficiary tenders conforming documents. DOCUMENTARY CREDIT is a Foreign direct investment (FDI) occurs when a firm invests directly in facilities
primary payment mechanism for discharge of payment obligation contained in the to produce or market a product in a foreign country.
underlying contract. FDI takes on two main forms:
1. The first is a greenfield investment, which involves establishing a new
operation in a foreign country.

6
 2. The second involves acquiring or merging with an existing firm in the BRANCH OF ECONOMIC THEORY known as INTERNALIZATION THEORY (also
foreign country. known as the market imperfections approach)
 seeks to explain why firms often prefer foreign direct investment over
A. Foreign Direct Investment in the World Economy licensing as a strategy for entering foreign markets.
 FLOW OF FDI refers to the amount of FDI undertaken over a given time
period (normally a year). The Pattern of Foreign Direct Investment
 STOCK OF FDI refers to the total accumulated value of foreign-owned 1. STRATEGIC BEHAVIOR
assets at a given time.  One theory is based on the idea that FDI flows are a reflection of strategic
 OUTFLOWS OF FDI, meaning the flow of FDI out of a country rivalry between firms in the global marketplace.
 INFLOWS OF FDI, the flow of FDI into a country.  OLIGOPOLY is an industry composed of a limited number of large firms.
2. THE PRODUCT LIFE CYCLE
FDI has grown more rapidly than world trade and world output for several reasons  Raymond Vernon’s product life-cycle theory also is used to explain FDI.
1. protectionist pressures. Vernon argued that often the same firms that pioneer a product in their
2. the political and economic changes home markets undertake FDI to produce a product for consumption in
foreign markets.
GROSS FIXED CAPITAL FORMATION summarizes the total amount of capital
invested in factories, stores, office buildings, and the like. THE ECLECTIC PARADIGM
 British economist John Dunning champions the eclectic paradigm.
B. The Theory of Foreign Direct Investment  discussed above, location-specific advantages
1. entering a foreign market when two other alternatives, exporting and
licensing, are open to it. PRAGMATIC NATIONALISM political ideology toward FDI within a nation has
2. why firms in the same industry often undertake foreign direct investment ranged from a dogmatic radical stance that is hostile to all inward FDI at one
at the same time extreme to an adherence to the noninterventionist principle of free market
3. third theoretical perspective, known as the eclectic paradigm, attempts economics.
to combine the two other perspectives into a single holistic explanation of
foreign direct investment is eclectic.  THE RADICAL VIEW traces its roots to Marxist political and economic
theory.
 EXPORTING involves producing goods at home and then shipping them to Three reasons seem to account for this trend:
the receiving country for sale. (1) the collapse of communism in Eastern Europe;
 LICENSING involves granting a foreign entity (the licensee) the right to (2) the generally abysmal economic performance of those countries that
produce and sell the firm’s product in return for a royalty fee on every embraced the radical position and a growing belief by many of these
unit sold. countries that FDI can be an important source of technology and jobs and
can stimulate economic growth; and
So why do so many firms apparently prefer FDI over either exporting or (3) the strong economic performance of those developing countries that
licensing? The answer can be found by examining the limitations of exporting embraced capitalism rather than radical ideology.
and licensing as means for capitalizing on foreign market opportunities.  THE FREE MARKET VIEW traces its roots to classical economics and the
international trade theories of Adam Smith and David Ricardo.
LIMITATIONS OF EXPORTING the viability of an exporting strategy is often  PRAGMATIC NATIONALISM many countries have adopted neither a
constrained by transportation costs and trade barriers. radical policy nor a free market policy toward FDI.

7
HOST-COUNTRY BENEFITS  Second, benefits to the home country from outward FDI arise from
 The main benefits of inward FDI for a host country arise from resource- employment effects.
transfer effects, employment effects, balance-of-payments effects, and  Third, benefits arise when the home-country MNE learns valuable skills
effects on competition and economic growth. from its exposure to foreign markets that can subsequently be transferred
back to the home country.
RESOURCE-TRANSFER EFFECTS Foreign direct investment can make a positive Home-Country Cost
contribution to a host economy by supplying capital, technology, and management The home country’s balance of payments may suffer in three ways.
resources that would otherwise not be available and thus boost that country’s  First, the balance of payments suffers from the initial capital outflow
economic growth rate. required to finance the FDI.
 Second, the current account of the balance of payments suffers if the
purpose of the foreign investment is to serve the home market from a low-
EMPLOYMENT EFFECTS Another beneficial employment effect claimed for FDI is cost production location.
that it brings jobs to a host country that would otherwise not be created there.  Third, the current account of the balance of payments suffers if the FDI is
a substitute for direct exports.
BALANCE-OF-PAYMENTS EFFECTS FDI’s effect on a country’s balance-of-
payments accounts is an important policy issue for most host governments. E. Government Policy and FDI
Home-Country Policies
EFFECT OF COMPETITION AND ECONOMIC GROWTH
 ENCOURAGING OUTWARD FDI The types of risks insurable through
 Economic theory tells us that the efficient functioning of markets depends
these programs include the risks of expropriation (nationalization), war
on an adequate level of competition between producers.
 FDI’s impact on competition in domestic markets may be particularly losses, and the inability to transfer profits back home. \
important in the case of services, such as telecommunications, retailing,  RESTRICTING OUTWARD FDI limit capital outflows out of concern for
and many financial services, where exporting is often not an option the country’s balance of payments.
because the service has to be produced where it is delivered. Host-Country Policies
 ENCOURAGING INWARD FDI offer incentives to foreign firms to invest in
Host-Country Costs their countries. Such incentives take many forms, but the most common
Three costs of FDI concern host countries. are tax concessions, low-interest loans, and grants or subsidies.
 ADVERSE EFFECTS ON COMPETITION Host governments sometimes  INCENTIVES are motivated by a desire to gain from the resource-transfer
worry that the subsidiaries of foreign MNEs may have greater economic and employment effects of FDI.
power than indigenous competitors.  RESTRICTING INWARD FDI wide range of controls to restrict FDI in one
 ADVERSE EFFECTS ON THE BALANCE OF PAYMENTS The possible way or another. The two most common are ownership restraints and
adverse effects of FDI on a host country’s balance-of-payments position performance requirements. OWNERSHIP RESTRAINTS can take several
are twofold. forms. In some countries, foreign companies are excluded from specific
 NATIONAL SOVEREIGNTY AND AUTONOMY Some host governments fields.
worry that FDI is accompanied by some loss of economic independence.
MODULE 6.
Home-Country Benefits THE FOREIGN EXCHANGE MARKET
The benefits of FDI to the home (source) country arise from three sources.  FOREIGN EXCHANGE MARKET is a market for converting the currency of
 First, the home country’s balance of payments benefits from the inward one country into that of another country.
flow of foreign earnings.
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  EXCHANGE RATE is simply the rate at which one currency is converted  The rate at which a foreign exchange dealer converts one currency into
into another. another currency on a particular day.
 Changes in spot exchange rates can be problematic for an international
A.1.The Functions of the Foreign Exchange Market business.
1. Currency Conversion CURRENCY SWAP
 Each country has a currency in which the prices of goods and services are  The simultaneous purchase and sale of a given amount of foreign
quoted. exchange for two different value dates.
 When a tourist changes one currency into another, she is participating in 
the foreign exchange market. The exchange rate is the rate at which the A.2.The Nature of the Foreign Exchange Market
market converts one currency into another.  The foreign exchange market is not located in any one place. It is a global
 TOURISTS are minor participants in the foreign exchange market; network of banks, brokers, and foreign exchange dealers connected by
companies engaged in international trade and investment are major ones. electronic communications systems.
Two features of the foreign exchange market are of particular note.
International businesses use foreign exchange markets in four main ways.  the market never sleeps.
First, the payments a company receives for its exports, the income it  the important role played by the U.S. dollar.
receives from foreign investments.
Second, international businesses use foreign exchange markets when they A.3.Economic Theories of Exchange Rate Determination
must pay a foreign company for its products or services in its country’s currency.  exchange rates are determined by the demand and supply of one currency
Third, international businesses also use foreign exchange markets when relative to the demand and supply of another.
they have spare cash that they wish to invest for short terms in money markets.
The Law of One Price
CURRENCY SPECULATION  The law of one price states that in competitive markets free of
 another use of foreign exchange markets. transportation costs and barriers to trade (such as tariffs), identical
 typically involves the short-term movement of funds from one currency to products sold in different countries must sell for the same price when
another in the hopes of profiting from shifts in exchange rates. their price is expressed in terms of the same currency.

CARRY TRADE Purchasing Power Parity

 kind of speculation that has become more common in recent years  If the law of one price were true for all goods and services, the purchasing
 involves borrowing in one currency where interest rates are low, and then power parity (PPP) exchange rate could be found from any individual set
using the proceeds to invest in another currency where interest rates are of prices.
high. Money Supply and Price Inflation
2. Insuring against Foreign Exchange Risk  In essence, PPP theory predicts that changes in relative prices will result
 the possibility that unpredicted changes in future exchange rates will have in a change in exchange rates.
adverse consequences for the firm.  The growth rate of a country’s money supply determines its likely future
SPOT EXCHANGE inflation rate.
 When two parties agree to exchange currency and execute the deal
immediately INFLATION
SPOT EXCHANGE RATES  monetary phenomenon.
 Exchange rates governing such “on the spot” trades.  It occurs when the quantity of money in circulation rises faster than the
stock of goods and services.
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GOVERNMENT POLICY 1. Fundamental Analysis draws on economic theory to construct sophisticated
 determines whether the rate of growth in a country’s money supply is econometric models for predicting exchange rate movements.
greater than the rate of growth in output. 2. Technical Analysis uses price and volume data to determine past trends, which
GOVERNMENT are expected to continue into the future.
 can increase the money supply simply by telling the country’s central bank
to issue more money. A.5. Currency Convertibility
 COUNTRY’S CURRENCY freely convertible
 CURRENCY externally convertible, nonconvertible
 FREE CONVERTIBILITY is not universal.
Interest Rates and Exchange Rates
 ECONOMIC THEORY tells us that interest rates reflect expectations about CAPITAL FLIGHT
likely future inflation rates.  occurs when residents and nonresidents rush to convert their holdings of
 FISHER EFFECT states that a country’s “nominal” interest rate (i) is the domestic currency into a foreign currency
sum of the required “real” rate of interest (r) and the expected rate of  most likely to occur when the value of the domestic currency is
inflation over the period for which the funds are to be lent (I). depreciating rapidly because of hyperinflation, or when a country’s
 INTERNATIONAL FISHER EFFECT states that for any two countries, the economic prospects are shaky in other respects.
spot exchange rate should change in an equal amount but in the opposite COUNTERTRADE
direction to the difference in nominal interest rates between the two  make sense when a country’s currency is nonconvertible.
countries.
B. INTERNATIONAL MONETARY SYSTEM
A.4.Exchange Rate Forecasting  the institutional arrangements that govern exchange rates.
 A company’s need to predict future exchange rate variations raises the  EXCHANGE RATES are determined by market forces and fluctuate against
issue of whether it is worthwhile for the company to invest in exchange each other day to day, if not minute to minute.
rate forecasting services to aid decision making.  PEGGED EXCHANGE RATE means the value of the currency is fixed
relative to a reference currency.
The Efficient Market School
 argues that forward exchange rates do the best possible job of forecasting  DIRTY FLOAT it is a dirty float (as opposed to a clean float) because the
future spot exchange rates, and, therefore, investing in forecasting central bank of a country will intervene in the foreign exchange market to
services would be a waste of money. try to maintain the value of its currency if it depreciates too rapidly
 FORWARD EXCHANGE RATES represent market participants’ collective against an important reference currency.
predictions of likely spot exchange rates at specified future dates.
 EFFICIENT MARKET is one in which prices reflect all available public B.1.The Gold Standard
information.  use of gold coins as a medium of exchange, unit of account, and store of
 INEFFICIENT MARKET SCHOOL argues that companies can improve the value—a practice that dates to ancient times.
foreign exchange market’s estimate of future exchange rates (as contained  Pegging currencies to gold and guaranteeing convertibility.
in the forward rate) by investing in forecasting services.
B.2.The Bretton Woods System
Approaches to Forecasting these statesmen were determined to build an enduring economic order that would
The following are the schools of thought. facilitate postwar economic growth.
Bretton Woods established two multinational institutions:
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 1. INTERNATIONAL MONETARY FUND (IMF) would be to maintain order  The system of fixed exchange rates established at Bretton Woods worked
in the international monetary system well until the late 1960s, when it began to show signs of strain.
2. WORLD BANK promote general economic development.
 Bretton Woods agreement also called for a system of fixed exchange B.4.The Floating Exchange Rate Regime
rates that would be policed by the IMF.  formalized in January 1976 when IMF members met in Jamaica and
agreed to the rules for the international monetary system that are in place
Role of the IMF today.
heavily influenced by the worldwide financial collapse, competitive devaluations,
trade wars, high unemployment, hyperinflation in Germany and elsewhere, and JAMAICA AGREEMENT
general.  to reflect the new reality of floating exchange rates.
FIXED EXCHANGE RATE REGIME
1. the need to maintain a fixed exchange rate puts a brake on competitive B.5.a. The Case for Floating Exchange Rates
devaluations and brings stability to the world trade environment. The case in support of floating exchange rates has two main elements:
2. fixed exchange rate regime imposes monetary discipline on countries, 1. monetary policy autonomy
thereby curtailing price inflation. 2. automatic trade balance adjustments
MONETARY POLICY AUTONOMY
Two major features of the IMF Articles of Agreement fostered this flexibility:  It is argued that under a fixed system, a country’s ability to expand or
1. IMF lending facilities contract its money supply as it sees fit is limited by the need to maintain
2. adjustable parities. exchange rate parity.
FUNDAMENTAL DISEQUILIBRIUM intended to apply to countries that had
suffered permanent adverse shifts in the demand for their products. B.5.b. The Case for Fixed Exchange Rates
 arguments about monetary discipline, speculation, uncertainty, and the
lack of connection between the trade balance and exchange rates.

Role of the World Bank MONETARY DISCIPLINE

 The official name for the World Bank is the International Bank for  advocates of fixed rates argue that governments all too often give in to
Reconstruction and Development (IBRD). political pressures and expand the monetary supply far too rapidly,
 bank’s initial mission was to help finance the building of Europe’s causing unacceptably high price inflation.
economy by providing low-interest loans. SPECULATION
 World Bank was overshadowed in this role by the Marshall Plan,  Critics of a floating exchange rate regime also argue that speculation can
cause fluctuations in exchange rates.
The bank lends money under two schemes: UNCERTAINTY
1. raising money through bond sales in the international capital market.  characterizes floating exchange rate regimes.
“market” rate is lower than commercial banks’ market rate.  dampens the growth of international trade and investment whereas a
2. overseen by the International Development Association (IDA), an arm of fixed exchange rate, by eliminating such uncertainty, promotes it.
the bank created in 1960.
TRADE BALANCE ADJUSTMENTS
B.3.The Collapse of the Fixed Exchange Rate System Critics question the closeness of the link between the exchange rate and the trade
balance.
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PEGGED EXCHANGE RATE REGIME a country will peg the value of its currency to
that of a major currency
CURRENCY BOARD commits itself to converting its domestic currency on demand
into another currency at a fixed exchange rate.

B.7.Crisis Management by the IMF

IMF’s original function was to provide a pool of money from which members could
borrow, short term, to adjust their balance-of payments position and maintain their
exchange rate.

 CURRENCY CRISIS occurs when a speculative attack on the exchange

value of a currency
 BANKING CRISIS refers to a loss of confidence in the banking system that
leads to a run on banks, as individuals and companies withdraw their
deposits.
 FOREIGN DEBT CRISIS is a situation in which a country cannot service its
foreign debt obligations, whether private-sector or government debt.
 CURRENT SYSTEM is a mixed system in which a combination of
government intervention and speculative activity can drive the foreign
exchange market.
 BUSINESS STRATEGY volatility of the present global exchange rate
regime presents a conundrum for international businesses.

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