Module 1: Globalization

Globalization

Globalization is a term used to describe how trade and technology have made the world into a more
connected and interdependent place. It is the free movement of goods, services and people across
the world in a seamless and integrated manner. Globalization can be thought of to be the result of the
opening up of the global economy and the concomitant increase in trade between nations.

Deglobalization on the contrary, is a movement towards a less connected world, characterized by

powerful nation states, local solutions, and border controls rather than global institutions, treaties, and
free movement.

Impact of Globalization

Some would argue that globalisation has spread wealth and led to the improvement of standards of
living in newly-industrialised countries such as India and China. Others claim that it is creating an
unfair world where the rich countries exploit the world's poorest people and it has increased the
development gap.

POSITIVE IMPACT OF GLOBALIZATION

1. Gives Access to a Larger Market

Through globalization countries and companies have access to a bigger consumer base. Instead of
only selling products in their country a business can expand to other regions boosting sales and in the
process making more money.

2. Provides Cheaper Goods for Consumers

Because of globalization a lot of companies are moving to areas where their cost of production is low
they, in turn, offer cheaper products because they are not expensive to make hence lower prices for
consumers.

3. Higher Specialization and Comparative cost advantage

For example, a country can buy cheap steel from another country instead of making its own steel.
They can then focus their efforts on making other things they are good at like computers and export
them to the countries they import cheap steal from.

4. Leads to Better Economies

With many multi nations heading to Africa to tap the consumer base in this part of the world more jobs
are being created helping people in these countries get better wages and improve their stands of
living.

These investments by these multinationals or foreign countries also help strengthen the economies of
these countries with the foreign exchange they bring in. With an increased number of investors
looking for investment opportunities around the globe, country economies will benefit wherever they
invest. Through globalization economies of different countries are becoming more connected to one
another since they depend on each other for trade.

5. Promotes World Peace and Unity

Globalization brings governments together so that they can tackle common goals together. For
example, due to globalization world leaders have seen the impact of pollution and have resolved to
tackle climate change together. Also, it is unlikely that a country trading a lot of products and services
with another will attack it or want to go to war with it.

6. Innovation

The desire to make a profit has always been a spur to expanded trade, innovation, and the
communication of ideas. The great ideas from leaders spread more easily with globalization.
7. Better Quality and Variety

Competition from different countries drives firms to improve their products. Consumers have better
quality products and more variety as a result.

Negative Impact of Globalization

1. Causes Environmental Damage

Globalization has led to increased production for businesses in order to meet global demand.
Increased production means more natural resources are used and this can be used up before they
are regenerated leading to a negative impact on the environment.

Also in developing countries rules and regulations on environmental protection are not as strict as in
developed countries. This has seen some multinationals leave their countries to set up in developing
countries to take advantage of this lax regulation in the process they manufacture products that are
harmful to the environment.

2. Causes Fluctuation of Prices

Increased competition means that businesses with the best prices win. Due to competition prices are
always fluctuating, for example, a country like the US has to reduce its prices often to compete with
prices for the same product coming from China. China’s production costs are lower than the US
hence they can have ridiculously low prices. For the US companies reducing prices will have a
negative effect on their profits which in turn may lead to actions like laying off workers.

3. Job Displacement

Globalization provides a double-edged sword when it comes to jobs. It creates jobs for people in
developing countries who provide cheaper manufacturing jobs. For example, many companies are
setting up in India and China because wages and manufacturing jobs are cheaper there which means
fewer opportunities in developed worlds.

4. Unequal economic growth

While globalization tends to increase economic growth for many countries, the growth isn’t equal—
richer countries often benefit more than developing countries.

5. Increases potential global recessions

When many nations’ economic systems become interdependent, the likelihood of a global recession
increases dramatically—because if one country’s economy starts to struggle, this can set off a chain
reaction that can affect many other countries simultaneously, causing a worldwide financial crisis.

Importance of International Finance – For more text refer Ch. 1 Baekart and Hodrick

How is international finance different from purely domestic finance (if such a
thing exists)? Three major dimensions set international finance apart from domestic
finance. They are:
1. Foreign exchange and political risks.
2. Market imperfections.
3. Expanded opportunity set.
As we will see, these major dimensions of international finance largely stem from the
fact that sovereign nations have the right and power to issue currencies, formulate their
own economic policies, impose taxes, and regulate movements of people, goods, and
capital across their borders. Before we move on, let us briefly describe each of the key
dimensions of international financial management.

1. Foreign exchange risk

Suppose Mexico is a major export market for your company and the Mexican peso depreciates
drastically against the U.S. dollar, as it did in December 1994. This means that your company’s
products can be priced out of the Mexican market, as the peso price of American imports will rise
following the peso’s fall. If such countries as Indonesia, Thailand, and Korea are major export
markets, your company would have faced the same difficult situation in the wake of the Asian
currency crisis of 1997. The preceding examples suggest that when firms and individuals are engaged
in crossborder transactions, they are potentially exposed to foreign exchange risk that they would not
normally encounter in purely domestic transactions. Currently, the exchange rates among such major
currencies as the U.S. dollar, Japanese yen, British pound, and euro fluctuate continuously in an
unpredictable manner. This has been the case since the early 1970s, when fixed exchange rates
were abandoned. Exchange rate volatility has exploded since 1973. Exchange rate uncertainty will
have a pervasive influence on all the major economic functions, that is, consumption, production, and
investment.

2. Political Risk
Another risk that firms and individuals may encounter in an international setting is political risk.
Political risk ranges from unexpected changes in tax rules to outright expropriation of assets held by
foreigners. Political risk arises from the fact that a sovereign country can change the “rules of the
game” and the affected parties may not have effective recourse. In 1992, for example, the Enron
Development Corporation, a subsidiary of a Houston-based energy company, signed a contract to
build India’s largest power plant. After Enron had spent nearly $300 million, the project was canceled
in 1995 by nationalist politicians in the Maharashtra state who argued India didn’t need the power
plant. The Enron episode illustrates the difficulty of enforcing contracts in foreign countries.

3. Market Imperfections
Although the world economy is much more integrated today than was the case 10 or
20 years ago, a variety of barriers still hamper free movements of people, goods, services,
and capital across national boundaries. These barriers include legal restrictions,
excessive transaction and transportation costs, and discriminatory taxation. The world
markets are thus highly imperfect. As we will discuss later in this book, market
imperfections, which represent various frictions and impediments preventing markets
from functioning perfectly, play an important role in motivating MNCs to locate production
overseas. Honda, a Japanese automobile company, for instance, decided to establish
production facilities in Ohio, mainly to circumvent trade barriers. One might
even say that MNCs are a gift of market imperfections.
Imperfections in the world financial markets tend to restrict the extent to which investors
can diversify their portfolios. An interesting example is provided by the Nestlé
Corporation, a well-known Swiss MNC. Nestlé used to issue two different classes of
common stock, bearer shares and registered shares, and foreigners were allowed to
hold only bearer shares. As Exhibit 1.2 shows, bearer shares used to trade for about
twice the price of registered shares, which were exclusively reserved for Swiss residents.
3 This kind of price disparity is a uniquely international phenomenon that is
attributable to market imperfections.
On November 18, 1988, however, Nestlé lifted restrictions imposed on foreigners,
allowing them to hold registered as well as bearer shares. After this announcement, the
price spread between the two types of Nestlé shares narrowed drastically. As Exhibit
1.2 shows, the price of bearer shares declined sharply, whereas that of registered shares
rose sharply. This implies that there was a major transfer of wealth from foreign shareholders
to domestic shareholders. Foreigners holding Nestlé bearer shares were exposed
to political risk in a country that is widely viewed as a haven from such risk. The
Nestlé episode illustrates both the importance of considering market imperfections in
international finance and the peril of political risk.
4. Expanded Opportunity Set

When firms venture into the arena of global markets, they can benefit from an expanded

opportunity set. As previously mentioned, firms can locate production in any

country or region of the world to maximize their performance and raise funds in any

capital market where the cost of capital is the lowest. In addition, firms can gain from

greater economies of scale when their tangible and intangible assets are deployed on a

global basis.

Individual investors can also benefit greatly if they invest internationally rather than

domestically. Suppose you have a given amount of money to invest in stocks. You may

invest the entire amount in U.S. (domestic) stocks. Alternatively, you may allocate the

funds across domestic and foreign stocks. If you diversify internationally, the resulting

international portfolio may have a lower risk or a higher return (or both) than a purely

domestic portfolio. This can happen mainly because stock returns tend to covary much

less across countries than within a given country. Once you are aware of overseas investment

opportunities and are willing to diversify internationally, you face a much expanded

opportunity set and you can benefit from it. It just doesn’t make sense to play

in only one corner of the sandbox.

Managing the MNC – For more text refer Ch. 1 Jeff Madura

The commonly accepted goal of an MNC is to maximize shareholder wealth. Managers

employed by the MNC are expected to make decisions that will maximize the stock price

and thereby serve the shareholders’ interests. Some publicly traded MNCs based outside

the United States may have additional goals, such as satisfying their respective governments,

creditors, or employees. However, these MNCs now place greater emphasis on

satisfying shareholders; that way, the firm can more easily obtain funds from them to

support its operations. Even in developing countries (e.g., Bulgaria and Vietnam) that

have just recently encouraged the development of business enterprise, managers of

firms must serve shareholder interests in order to secure their funding. There would be

little demand for the stock of a firm that announced the proceeds would be used to overpay

managers or invest in unprofitable projects.

The focus of this text is on MNCs whose parents wholly own any foreign subsidiaries,

which means that the U.S. parent is the sole owner of the subsidiaries. This is the most
common form of ownership of U.S.-based MNCs, and it gives financial managers

throughout the firm the single goal of maximizing the entire MNC’s value (rather than

the value of any particular subsidiary). The concepts in this text apply generally also to

MNCs based in countries other than the United States.

Agency Problems

Managers of an MNC may make decisions that conflict with the firm’s goal of maximizing

shareholder wealth. For example, a decision to establish a subsidiary in one location

versus another may be based on the location’s appeal to a particular manager rather than

on its potential benefits to shareholders. A decision to expand a subsidiary may be

motivated by a manager’s desire to receive more compensation rather than to enhance

the value of the MNC. This conflict of goals between a firm’s managers and shareholders

is often referred to as the agency problem.

The costs of ensuring that managers maximize shareholder wealth (referred to as

agency costs) are normally larger for MNCs than for purely domestic firms for several

reasons. First, MNCs with subsidiaries scattered around the world may experience larger

agency problems because monitoring the managers of distant subsidiaries in foreign

countries is more difficult. Second, foreign subsidiary managers who are raised in different

cultures may not follow uniform goals. Some of them may believe that the first priority

should be to serve their respective employees. Third, the sheer size of the larger

MNCs can also create significant agency problems, because it complicates the monitoring

of managers.

Example

Two years ago, Seattle Co. (based in the United States) established a subsidiary in Singapore so
that it could expand its business there. It hired a manager in Singapore to manage the subsidiary.
During the last two years, sales generated by the subsidiary have not grown. Even so, the
manager hired several employees to do the work that he was assigned to do. The managers of
the parent company in the United States have not closely monitored the subsidiary because it is
so far away and because they trusted the manager there. Now they realize that there is an
agency problem. The subsidiary is experiencing losses every quarter, so its management must be
more closely monitored. Lack of monitoring can lead to substantial losses for MNCs. The large
New York–based bank JPMorgan Chase & Co. lost at least $6.2 billion and had to pay more than
$1 billion in fines and penalties after a trader in its office in London, England, made extremely
risky trades. The subsequent investigation revealed that the bank had maintained poor internal
control and failed to provide proper oversight of its employees.
Parent Control of Agency Problems

The parent corporation of an MNC may

be able to prevent most agency problems with proper governance. The parent should

clearly communicate the goals for each subsidiary to ensure that all of them focus on

maximizing the value of the MNC and not of their respective subsidiaries. The parent

can oversee subsidiary decisions to check whether each subsidiary’s managers are satisfying

the MNC’s goals. The parent also can implement compensation plans that reward

those managers who satisfy the MNC’s goals. A common incentive is to provide managers

with the MNC’s stock (or options to buy that stock at a fixed price) as part of

their compensation; thus the subsidiary managers benefit directly from a higher stock

price when they make decisions that enhance the MNC’s value.

Management Structure of an MNC

The magnitude of agency costs can vary with the MNC’s management style. A centralized

management style, as illustrated in the top section of Exhibit 1.1, can reduce agency

costs because it allows managers of the parent to control foreign subsidiaries and thus

reduces the power of subsidiary managers. However, the parent’s managers may make

poor decisions for the subsidiary if they are less informed than the subsidiary’s managers

about its setting and financial characteristics.

Alternatively, an MNC can use a decentralized management style, as illustrated in the

bottom section of Exhibit 1.1. This style is more likely to result in higher agency costs

because subsidiary managers may make decisions that fail to maximize the value of the

entire MNC. Yet this management style gives more control to those managers who are

closer to the subsidiary’s operations and environment. To the extent that subsidiary

managers recognize the goal of maximizing the value of the overall MNC and are compensated

in accordance with that goal, the decentralized management style may be more

effective.

Given the clear trade-offs between centralized and decentralized management styles,

some MNCs attempt to achieve the advantages of both. That is, they allow subsidiary

managers to make the key decisions about their respective operations while the parent’s

management monitors those decisions to ensure they are in the MNC’s best

interests.