Government Role and Trading Blocks

■ Credit Information Services. The bank’s repayment records provide credit information to U.S. exporters and commercial lenders. The bank can provide information on a country or specific company abroad. But the bank does not divulge confidential financial data on non-U.S. buyers to whom it has extended credit or confidential information regarding particular conditions in other countries.

■ Credit Insurance. This program helps U.S. exporters develop and expand their overseas sales by protecting them against loss should a non-U.S. buyer or other non-U.S. debtor default for political or commercial reasons. The insurance policy can make obtaining export financing easier because, with approval by the bank, the proceeds of the policy can be used as collateral.

■ Guarantee Program. This program provides repayment protection for private sector loans made to creditworthy buyers of U.S. capital equipment, projects, and services. The bank guarantees that, in the event of default, it will repay the principal and interest on the loan. The non-U.S. buyer must make a cash payment of at least 15 percent. Most guarantees provide comprehensive coverage against political and commercial risks.

■ Loan Program. The bank makes loans directly to non-U.S. buyers of U.S. exports and intermediary loans to creditworthy parties that provide loans to non-U.S. buyers. The program provides fixed-interest-rate financing for export sales of U.S. capital equipment and related services.

Source: Export-Import Bank of the United States Web site (www.exim.gov).

Foreign Trade Zones

Most countries promote trade with other nations by creating what is called a

foreign trade zone (FTZ)

—a designated geographic region in which merchandise is allowed to pass through with lower customs duties (taxes) and/or fewer customs procedures. Increased employment is often the intended purpose of foreign trade zones, with a by-product being increased trade. A good example of a foreign trade zone is Turkey’s Aegean Free Zone, in which the Turkish government allows companies to conduct manufacturing operations free from taxes.

foreign trade zone (FTZ)

Designated geographic region in which merchandise is allowed to pass through with lower customs duties (taxes) and/or fewer customs procedures.

Customs duties increase the total amount of a good’s production cost and increase the time needed to get it to market. Companies can reduce such costs and time by establishing a facility inside a foreign trade zone. A common purpose of many companies’ facilities in such zones is final product assembly. The U.S. Department of Commerce (www.commerce.gov) administers dozens of foreign trade zones within the United States. Many of these zones allow components to be imported at a discount from the normal duty. Once assembled, the finished product can be sold within the U.S. market with no further duties charged. State governments welcome such zones to obtain the jobs that the assembly operations create.

China has established a number of large foreign trade zones to reap the employment advantages they offer. Goods imported into these zones do not require import licenses or other documents nor are they subject to import duties. International companies can also store goods in these zones before shipping them to other countries without incurring taxes in China. Moreover, five of these zones are located within specially designated economic zones in which local governments can offer additional opportunities and tax breaks to international investors.

Another country that has enjoyed the beneficial effects of foreign trade zones is Mexico. Decades ago, Mexico established such a zone along its northern border with the United States. Creation of the zone caused development of companies called maquiladoras along the border inside Mexico. The maquiladoras import materials or parts from the United States duty free, process them to some extent, and export them back to the United States, which charges duties only on the value added to the product in Mexico. The program has expanded rapidly over the five decades since its inception, employing hundreds of thousands of people from all across Mexico who move north looking for work.

Special Government Agencies

The governments of most nations have special agencies responsible for promoting exports. Such agencies can be particularly helpful to small and medium-sized businesses that have limited financial resources. Government trade promotion agencies often organize trips for trade officials and businesspeople to visit other countries to meet potential business partners and generate contacts for new business. They also typically open trade offices in other countries. These offices are designed to promote the home country’s exports and introduce businesses to potential partners in the host nation. Government trade promotion agencies typically do a great deal of advertising in other countries to promote the nation’s exports. For example, Chile’s Trade Commission, ProChile, has commercial offices in 40 countries and a Web site (www.chileinfo.com).

Governments not only promote trade by encouraging exports but also can encourage imports that the nation does not or cannot produce. For example, the Japan External Trade Organization (JETRO) (www.jetro.go.jp) is a trade promotion agency of the Japanese government. The agency coaches small and medium-sized overseas businesses on the protocols of Japanese deal making, arranges meetings with suitable Japanese distributors and partners, and even assists in finding temporary office space.

For all companies, and particularly small ones with fewer resources, learning the government regulations in other countries is a daunting task. A company must know whether its product is subject to a tariff or quota, for instance. Fortunately, it is now possible to get answers to many such questions through the Internet. For some informative Web sites, see the Global Manager’s Briefcase titled, “Surfing the Regulatory Seas.”

GLOBAL MANAGER’S BRIEFCASE Surfing the Regulatory Seas

U.S. Department of Commerce

■ The International Trade Administration (ITA) Web site (www.trade.gov) offers trade data by country, region, and industry sector. It also has information on export assistance centers around the United States, a national export directory, and detailed background information on each trading partner of the United States.

■ The FedWorld Web site (www.fedworld.gov) is a comprehensive central access point for locating and acquiring information on U.S. government activities and trade regulations.

■ The Stat-USA Web site (www.stat-usa.gov) lists databases on trade regulations and documentation requirements on a country-by-country basis.

U.S. Chamber of Commerce

Dun & Bradstreet’s (www.dnb.com) 2,000-page Exporter’s Encyclopedia has been called the “bible of exporting,” and it’s now available online on the U.S. Chamber of Commerce’s International Business Exchange Web site (www.uschamber.org/international). Access to the encyclopedia is offered as part of a chamber membership package, which also includes information on a variety of international trade topics.

U.S. Trade Representative

The Office of the United States Trade Representative Web site (www.ustr.gov) has a wealth of free information on trade policy issues. Up-to-date reports on the site list important barriers that affect U.S. exports to other countries. It is also a source for information on trade negotiations, including a wide range of documents on all subjects relating to trade talk agendas, as well as a helpful section on acronyms to help you get through the entries.

U.S. Export Portal

This is the U.S. government’s online point of entry (www.export.gov) for U.S. exporters. The site organizes exportrelated programs, services, and market research information across 19 federal agencies. The site can be used to search for official trade shows, seminars, missions, and other related activities around the world.

Quick Study

1. How do governments use subsidies to promote trade? Identify the drawbacks of subsidies.

2. How does export financing promote trade? Explain its importance to small and medium-sized firms.

3. Define the term
foreign trade zone
. How can it be used to promote trade?

4. How can special government agencies help promote trade?

Methods of Restricting Trade

Earlier in this chapter we read about the political, economic, and cultural reasons for governmental intervention in trade. In this section we discuss the methods governments can use to restrict unwanted trade. There are two general categories of trade barrier available to governments. A

tariff

is a government tax levied on a product as it enters or leaves a country. A tariff increases the price of an imported product directly and, therefore, reduces its appeal to buyers. A nontariff barrier limits the availability of an imported product, which increases its price indirectly and, therefore, reduces its appeal to buyers. Let’s take a closer look at tariffs and the various types of nontariff barriers.

tariff

Government tax levied on a product as it enters or leaves a country.

Tariffs

We can classify a tariff into one of three categories. An export tariff is levied by the government of a country that is exporting a product. Countries can use export tariffs when they believe an export’s price is lower than it should be. Developing nations whose exports consist mostly of low-priced natural resources often levy export tariffs. A transit tariff is levied by the government of a country that a product is passing through on its way to its final destination. Transit tariffs have been almost entirely eliminated worldwide through international trade agreements. An import tariff is levied by the government of a country that is importing a product. The import tariff is by far the most common tariff used by governments today.

We can further break down the import tariff into three subcategories based on the manner in which it is calculated. An

ad valorem tariff

is levied as a percentage of the stated price of an imported product. A

specific tariff

is levied as a specific fee for each unit (measured by number, weight, etc.) of an imported product. A

compound tariff

is levied on an imported product and calculated partly as a percentage of its stated price and partly as a specific fee for each unit. Let’s now discuss the two main reasons why countries levy tariffs.

ad valorem tariff

Tariff levied as a percentage of the stated price of an imported product.

specific tariff

Tariff levied as a specific fee for each unit (measured by number, weight, etc.) of an imported product.

compound tariff

Tariff levied on an imported product and calculated partly as a percentage of its stated price and partly as a specific fee for each unit.

Protect Domestic Producers

Nations can use tariffs to protect domestic producers. For example, an import tariff raises the cost of an imported good and increases the appeal of domestically produced goods. In this way, domestic producers gain a protective barrier against imports. Although producers that receive tariff protection can gain a price advantage, in the long run protection can keep them from increasing efficiency. A protected industry can be devastated if protection encourages complacency and inefficiency and it is later thrown into the lion’s den of international competition. Mexico began reducing tariff protection in the mid-1980s as a prelude to NAFTA negotiations, and many Mexican producers went bankrupt despite attempts to grow more efficient.

Generate Revenue

Tariffs are also a source of government revenue, but mostly among developing nations. The main reason is that less-developed nations tend to have less formal domestic economies that lack the capability to record domestic transactions accurately. The lack of accurate record keeping makes collection of sales taxes within the country extremely difficult. Nations solve the problem by simply raising their needed revenue through import and export tariffs. As countries develop, however, they tend to generate a greater portion of their revenues from taxes on income, capital gains, and other economic activity.

The discussion so far leads us to question: “Who benefits from tariffs?” We’ve already learned the two principal reasons for tariff barriers—protecting domestic producers and raising government revenue. On the surface it appears that governments and domestic producers benefit. We also saw that tariffs raise the price of a product because importers typically charge a higher price to recover the cost of this additional tax. Thus it appears on the surface that consumers do not benefit. As we also mentioned earlier, there is the danger that tariffs will create inefficient domestic producers that may go out of business once protective import tariffs are removed. Analysis of the total cost to a country is far more complicated and goes beyond the scope of our discussion. Suffice it to say that tariffs tend to exact a cost on countries as a whole because they lessen the gains that a nation’s people obtain from trade.

Quotas

A restriction on the amount (measured in units or weight) of a good that can enter or leave a country during a certain period of time is called a

quota

. After tariffs, quotas are the second most common type of trade barrier. Governments typically administer their quota systems by granting quota licenses to the companies or governments of other nations (in the case of import quotas) and domestic producers (in the case of export quotas). Governments normally grant such licenses on a year-by-year basis.

quota

Restriction on the amount (measured in units or weight) of a good that can enter or leave a country during a certain period of time.

Reason for Import Quotas

A government may impose an import quota to protect its domestic producers by placing a limit on the amount of goods allowed to enter the country. This helps domestic producers maintain their market shares and prices because competitive forces are restrained. In this case, domestic producers win because their market is protected. Consumers lose because of higher prices and limited selection attributable to lower competition. Other losers include domestic producers whose own production requires the import subjected to a quota. Companies relying on the importation of so-called intermediate goods will find the final cost of their own products increase.

Workers sew at a garment factory in Gazipur near the Bangladeshi capital Dhaka. Across Bangladesh, hundreds of small clothing factories have thrived following removal of worldwide import quotas allowed under the Multi-Fibre Agreement. Under the MFA, wealthy nations guaranteed imports of textiles and garments from poor countries under a quota system. Under what conditions do you think nations should be allowed to impose import quotas?

Source: Rafiqur Rahman/Reuters/CORBIS-NY.

Historically, countries placed import quotas on the textile and apparel products of other countries under the Multi-Fibre Arrangement. This arrangement at one time affected countries accounting for over 80 percent of world trade in textiles and clothing. When that arrangement expired in 2005, many textile producers in poor nations feared the loss of jobs to China. But some countries, such as Bangladesh, are benefiting from cheap labor and the reluctance among purchasers to rely exclusively on China for all its inputs.11

Reasons for Export Quotas

There are at least two reasons why a country imposes export quotas on its domestic producers. First, it may wish to maintain adequate supplies of a product in the home market. This motive is most common among countries that export natural resources that are essential to domestic business or the long-term survival of a nation.

Second, a country may limit the export of a good to restrict its supply on world markets, thereby increasing the international price of the good. This is the motive behind the formation and activities of the Organization of Petroleum Exporting Countries (OPEC) (www.opec.org). This group of nations from the Middle East and Latin America attempts to restrict the world’s supply of crude oil to earn greater profits.

VOLUNTARY EXPORT RESTRAINTS

A unique version of the export quota is called a

voluntary export restraint (VER)

—a quota that a nation imposes on its own exports, usually at the request of another nation. Countries normally self-impose a voluntary export restraint in response to the threat of an import quota or total ban on the product by an importing nation. The classic example of the use of a voluntary export restraint is from the 1980s when Japanese carmakers were making significant market share gains in the United States. The closing of U.S. carmakers’ production facilities in the United States was creating a volatile anti-Japan sentiment among the population and the U.S. Congress. Fearing punitive legislation if Japan did not limit its automobile exports to the United States, the Japanese government and its carmakers self-imposed a voluntary export restraint on cars headed for the United States.

voluntary export restraint (VER)

Unique version of export quota that a nation imposes on its exports, usually at the request of an importing nation.

Consumers in the country that imposes an export quota benefit from lower-priced products (due to their greater supply) as long as domestic producers do not curtail production. Producers in an importing country benefit because the goods of producers from the exporting country are restrained, which may allow them to increase prices. Export quotas hurt consumers in the importing nation because of reduced selection and perhaps higher prices. Yet export quotas might allow these same consumers to retain their jobs if imports were threatening to put domestic producers out of business. Again, detailed economic studies are needed to determine the winners and losers in any particular export quota case.

Tariff-Quotas

A hybrid form of trade restriction is called a

tariff-quota

—a lower tariff rate for a certain quantity of imports and a higher rate for quantities that exceed the quota. Figure 6.1 shows how a tariff-quota actually works. Imports entering a nation under a quota limit of, say, 1,000 tons are charged a 10 percent tariff. But subsequent imports that do not make it under the quota limit of 1,000 tons are charged a tariff of 80 percent. Tariff-quotas are used extensively in the trade of agricultural products. Many countries implemented tariff-quotas in 1995 after their use was permitted by the World Trade Organization, the agency that regulates trade among nations.

tariff-quota

Lower tariff rate for a certain quantity of imports and a higher rate for quantities that exceed the quota.

Embargoes

A complete ban on trade (imports and exports) in one or more products with a particular country is called an

embargo

. An embargo may be placed on one or a few goods, or it may completely ban trade in all goods. It is the most restrictive nontariff trade barrier available, and it is typically applied to accomplish political goals. Embargoes can be decreed by individual nations or by supranational organizations such as the United Nations. Because they can be very difficult to enforce, embargoes are used less today than they have been in the past. One example of a total ban on trade with another country is the U.S. embargo on trade with Cuba. In fact, U.S. tourists are not legally able to vacation in Cuba.

embargo

Complete ban on trade (imports and exports) in one or more products with a particular country.

After a military coup ousted elected President Aristide of Haiti in the early 1990s, restraints were applied to force the military junta either to reinstate Aristide or to hold new elections. One restraint was an embargo by the Organization of American States. Because of difficulties in actually enforcing the embargo and after two years of fruitless United Nations diplomacy, the embargo failed. The United Nations then stepped in with a ban on trade in oil and weapons. Despite some smuggling through the Dominican Republic, which shares the island of Hispaniola with Haiti, the embargo was generally effective, and Aristide was eventually reinstated.

Local Content Requirements

Recall from Chapter 3 that
local content requirements
are laws stipulating that producers in the domestic market must supply a specified amount of a good or service. These requirements can state that a certain portion of the end product consists of domestically produced goods or that a certain portion of the final cost of a product has domestic sources.

The purpose of local content requirements is to force companies from other nations to use local resources in their production processes—particularly labor. Similar to other restraints on imports, such requirements help protect domestic producers from the price advantage of companies based in other, low-wage countries. Today, many developing countries use local content requirements as a strategy to boost industrialization. Companies often respond to local content requirements by locating production facilities inside the nation that stipulates such restrictions.

FIGURE 6.1 How a Tariff-Quota Works

Source: Based on World Trade Organization Web site (www.wto.org).

Although many people consider music the universal language, not all cultures are equally open to the world’s diverse musical influences. To prevent Anglo-Saxon music from invading French culture, French law requires radio programs to include at least 40 percent French content. Such local content requirements are intended to protect both the French cultural identity and the jobs of French artists against other nations’ pop culture that may wash up on French shores.

Administrative Delays

Regulatory controls or bureaucratic rules designed to impair the flow of imports into a country are called

administrative delays

. This nontariff barrier includes a wide range of government actions, such as requiring international air carriers to land at inconvenient airports, requiring product inspections that damage the product itself, purposely understaffing customs offices to cause unusual time delays, and requiring special licenses that take a long time to obtain. The objective of all such administrative delays for a country is to discriminate against imported products—it is, in a word, protectionism.

administrative delays

Regulatory controls or bureaucratic rules designed to impair the flow of imports into a country.

Currency Controls

Restrictions on the convertibility of a currency into other currencies are called

currency controls

. A company that wishes to import goods generally must pay for those goods in a common, internationally acceptable currency such as the U.S. dollar, European Union euro, or Japanese yen. Generally, it must also obtain the currency from its nation’s domestic banking system. Governments can require companies that desire such a currency to apply for a license to obtain it. Thus a country’s government can discourage imports by restricting who is allowed to convert the nation’s currency into the internationally acceptable currency.

currency controls

Restrictions on the convertibility of a currency into other currencies.

Another way governments apply currency controls to reduce imports is by stipulating an exchange rate that is unfavorable to potential importers. Because the unfavorable exchange rate can force the cost of imported goods to an impractical level, many potential importers simply give up on the idea. Meanwhile, the country will often allow exporters to exchange the home currency for an international currency at favorable rates to encourage exports.

Quick Study

1. How do
tariffs
and
quotas
differ from one another? Identify the different forms each can take.

2. Describe how a
voluntary export restraint
works and how it differs from a quota.

3. What is an
embargo
? Explain why it is seldom used today.

4. Explain how
local content requirements, administrative delays, and
currency controls
restrict trade.

Global Trading System

The global trading system certainly has seen its ups and downs. World trade volume reached a peak in the late 1800s, only to be devastated when the United States passed the Smoot–Hawley Act in 1930. The act represented a major shift in U.S. trade policy from one of free trade to one of protectionism. The act set off round after round of competitive tariff increases among the major trading nations. Other nations felt that if the United States was going to restrict its imports, they were not going to give exports from the United States free access to their domestic markets. The Smoot–Hawley Act, and the global trade wars that it helped to usher in, crippled the economies of the industrialized nations and helped spark the Great Depression. Living standards around the world were devastated throughout most of the 1930s.

We begin this section by looking at early attempts to develop a global trading system, the
General Agreement on Tariffs and Trade
, and then examine its successor, the
World Trade Organization
.

General Agreement on Tariffs and Trade (GATT)

Attitudes toward free trade changed markedly in the late 1940s. For the previous 50 years, extreme economic competition among nations and national quests to increase their resources for production helped create two world wars and the worst global economic recession ever. As a result, economists and policy makers proposed that the world band together and agree on a trading system that would help to avoid similar calamities in the future. A system of multilateral agreements was developed that became known as the
General Agreement on Tariffs and Trade (GATT)
—a treaty designed to promote free trade by reducing both tariff and nontariff barriers to international trade. The GATT was formed in

1947

by

23

nations—12 developed and 11 developing economies—and came into force in January 1948.12

The GATT was highly successful throughout its early years. Between 1947 and 1988, it helped to reduce average tariffs from 40 percent to 5 percent and multiply the volume of international trade by 20 times. But by the middle to late 1980s, rising nationalism worldwide and trade conflicts led to a nearly 50 percent increase in nontariff barriers to trade. Also, services (not covered by the original GATT) had become increasingly important and had grown to account for a much greater share of total world trade. It was clear that a revision of the treaty was necessary and in 1986 a new round of trade talks began.

Uruguay Round of Negotiations

The ground rules of the GATT resulted from periodic “rounds” of negotiations among its members. Though relatively short and straightforward in the early years, negotiations later became protracted as issues grew more complex. Table 6.2 shows the eight completed negotiating rounds that occurred under the auspices of the GATT. Note that whereas tariffs were the only topic of the first five rounds of negotiations, other topics were added in subsequent rounds.

TABLE 6.2 The Rounds of GATT

Year

Site

Number of Countries Involved

Topics Covered

1947

Geneva

, Switzerland

23
Tariffs

1949

Annecy, France

13

Tariffs

1951

Torquay, England

38
Tariffs

1956

Geneva

26

Tariffs

1960–1961

Geneva (Dillon Round)

26
Tariffs

1964–1967

Geneva (Kennedy Round)

62

Tariffs, antidumping measures

1973–1979

Geneva (Tokyo Round)

102

Tariffs, nontariff measures, “framework agreements”

1986–1994

Geneva (Uruguay Round)

123

Tariffs, nontariff measures, rules, services, intellectual property, dispute settlement, investment measures, agriculture, textiles and clothing, natural resources, creation of the WTO

Source: Based on “About the WTO,” World Trade Organization Web site (www.wto.org).

The Uruguay Round of GATT negotiations, begun in 1986 in Punta del Este, Uruguay (hence its name), was the largest trade negotiation in history. It was the eighth round of GATT talks within a span of 40 years and took more than seven years to complete. The Uruguay Round made significant progress in reducing trade barriers by revising and updating the 1947 GATT. In addition to developing plans to further reduce barriers to merchandise trade, the negotiations modified the original GATT treaty in several important ways.

AGREEMENT ON SERVICES

Because of the ever-increasing importance of services to the total volume of world trade, nations wanted to include GATT provisions for trade in services. The General Agreement on Trade in Services (GATS) extended the principle of nondiscrimination to cover international trade in all services, although talks regarding some sectors were more successful than were others. The problem is that, although trade in goods is a straightforward concept—goods are exported from one country and imported to another—it can be difficult to define exactly what a service is. Nevertheless, the GATS created during the Uruguay Round identifies four different forms that international trade in services can take:

1.
Cross-border supply
Services supplied from one country to another (for example, international telephone calls).

2.
Consumption abroad
Consumers or companies using a service while in another country (for example, tourism).

3.
Commercial presence
A company establishing a subsidiary in another country to provide a service (for example, banking operations).

4.
Presence of natural persons
Individuals traveling to another country to supply a service (for example, business consultants).

AGREEMENT ON INTELLECTUAL PROPERTY

Like services, products consisting entirely or largely of intellectual property account for an increasing portion of international trade. Recall from Chapter 3 that
intellectual property
refers to property resulting from people’s intellectual talent and abilities. Products classified as intellectual property are supposed to be legally protected by copyrights, patents, and trademarks.

Although international piracy continues, the Uruguay Round took an important step toward getting it under control. It created the Agreement on Trade-Related Aspects of Intellectual Property (TRIPS) to help standardize intellectual property rules around the world. The TRIPS Agreement agrees that protection of intellectual property rights benefits society because it encourages the development of new technologies and other creations. It supports the articles of both the Paris Convention and the Berne Convention (see Chapter 3) and in certain instances takes a stronger stand on intellectual property protection.

AGREEMENT ON AGRICULTURAL SUBSIDIES

Trade in agricultural products has long been a bone of contention for most of the world’s trading partners at one time or another. Some of the more popular barriers that countries use to protect their agricultural sectors include import quotas and subsidies paid directly to farmers. The Uruguay Round addressed the main issues of agricultural tariffs and nontariff barriers in its Agreement on Agriculture. The result is increased exposure of national agricultural sectors to market forces and increased predictability in international agricultural trade. The agreement forces countries to convert all nontariff barriers to tariffs—a process called “tariffication.” It then calls on developed and developing nations to cut agricultural tariffs significantly, but places no requirements on the least-developed economies.

World Trade Organization (WTO)

Perhaps the greatest achievement of the Uruguay Round was the creation of the
World Trade Organization (WTO)
—the international organization that regulates trade between nations. The three main goals of the WTO (www.wto.org) are to help the free flow of trade, to help negotiate further opening of markets, and to settle trade disputes between its members. One key component of the WTO that was carried over from GATT is the principle of nondiscrimination called
normal trade relations
(formerly called “most favored nation status”)—a requirement that WTO members extend the same favorable terms of trade to all members that they extend to any single member. For example, if Japan were to reduce its import tariff on German automobiles to 5 percent, it must reduce the tariff it levies against auto imports from all other WTO nations to 5 percent.

normal trade relations (formerly “most favored nation status”)

Requirement that WTO members extend the same favorable terms of trade to all members that they extend to any single member.

The WTO replaced the institution of GATT but absorbed the GATT agreements (such as on services, intellectual property, and agriculture) into its own agreements. Thus the GATT institution no longer officially exists. The WTO recognizes 153 members and 30 observers.

Dispute Settlement in the WTO

The power of the WTO to settle trade disputes is what really sets it apart from the GATT. Under the GATT, nations could file a complaint against another member and a committee would investigate the matter. If appropriate, the GATT would identify the unfair trade practices, and member countries would pressure the offender to change its ways. But in reality, GATT rulings (usually given only after very long investigative phases that sometimes lasted years) were likely to be ignored.

By contrast, the various WTO agreements are essentially contracts between member nations that commit them to maintaining fair and open trade policies. When one WTO member files a complaint against another, the Dispute Settlement Body of the WTO moves into action swiftly. Decisions are to be rendered in less than one year—although within nine months if the case is urgent and 15 months if the case is appealed. The WTO dispute settlement system is not only faster and automatic, but its rulings cannot be ignored or blocked by members. Offenders must realign their trade policies according to WTO guidelines or suffer financial penalties and perhaps trade sanctions. Because of its ability to penalize offending member nations, the WTO’s dispute settlement system is the spine of the global trading system.

Dumping and the WTO

The WTO also gets involved in settling disputes that involve “dumping” and the granting of subsidies. When a company exports a product at a price that is either lower than the price normally charged in its domestic market or lower than the cost of production, it is said to be

dumping

. Charges of dumping are made (fairly or otherwise) against companies from almost every nation at one time or another and can occur in any type of industry. For example, western European plastic producers considered retaliating against Asian competitors whose prices were substantially lower in European markets than at home. More recently, U.S. steel producers and their powerful union charged that steelmakers in Brazil, Japan, and Russia were dumping steel on the U.S. market at low prices. The problem arose as those nations tried to improve their economies through increased exporting of all products, including steel.

dumping

Exporting a product at a price either lower than the price that the product normally commands in its domestic market or lower than the cost of production.

The WTO cannot punish the country in which the company accused of dumping is based because dumping is an act by a company, not a country. The WTO can respond only to the actions of a country that retaliates against a company that is dumping. The WTO allows a nation to retaliate against dumping if it can show that dumping is actually occurring, can calculate the damage to its own companies, and can show that the damage is significant. The normal way a country retaliates is to charge an

antidumping duty

—an additional tariff placed on an imported product that a nation believes is being dumped on its market. But such measures must expire within five years of the time they are initiated unless a country can show that circumstances warrant their continuation. A large number of antidumping cases have been brought before the WTO in recent years.

antidumping duty

Additional tariff placed on an imported product that a nation believes is being dumped on its market.

Subsidies and the WTO

Governments often retaliate when the competitiveness of their companies is threatened by a subsidy that another country pays its own domestic producers. Like antidumping measures, nations can retaliate against product(s) that receive an unfair subsidy by charging a

countervailing duty

—an additional tariff placed on an imported product that a nation believes is receiving an unfair subsidy. Unlike dumping, because payment of a subsidy is an action by a country, the WTO regulates the actions of the government that reacts to the subsidy as well as those of the government that originally paid the subsidy.

countervailing duty

Additional tariff placed on an imported product that a nation believes is receiving an unfair subsidy.

Doha Round of Negotiations

The WTO launched a new round of negotiations in Doha, Qatar, in late 2001. The renewed negotiations were designed to lower trade barriers further and help poor nations in particular. Agricultural subsidies that rich countries pay to their own farmers are worth $1 billion per day—more than six times the value of their combined aid budgets to poor nations. Because 70 percent of the exports of poor nations are agricultural products and textiles, wealthy nations had intended to open these and other labor-intensive industries further. Poor nations were encouraged to reduce tariffs among themselves and were to receive help from rich nations in integrating themselves into the global trading system. Although the Doha round was to conclude by the end of 2004, negotiations are ongoing.13

WTO and the Environment

Steady gains in global trade and rapid industrialization in many developing and emerging economies have generated environmental concerns among both governments and special interest groups. Of concern to many people are levels of carbon dioxide emissions—the principal greenhouse gas believed to contribute to global warming. Most carbon dioxide emissions are created from the burning of fossil fuels and the manufacture of cement.

The World Trade Organization has no separate agreement that deals with environmental issues. The WTO explicitly states that it is not to become a global environmental agency responsible for setting environmental standards. It leaves such tasks to national governments and the many intergovernmental organizations that already exist for such purposes. The WTO works alongside existing international agreements on the environment, including the Montreal Protocol for protection of the ozone layer, the Basel Convention on international trade or transport of hazardous waste, and the Convention on International Trade in Endangered Species.

Nevertheless, the preamble to the agreement that established the WTO does mention the objectives of environmental protection and sustainable development. The WTO also has an internal committee called the Committee on Trade and Environment. The committee’s responsibility is to study the relationship between trade and the environment and to recommend possible changes in the WTO trade agreements.

In addition, the WTO does take explicit positions on some environmental issues related to trade. Although the WTO supports national efforts at labeling “environmentally friendly” products as such, it states that labeling requirements or policies cannot discriminate against the products of other WTO members. Also, the WTO supports policies of the least developed countries that require full disclosure of potentially hazardous products entering their markets for reasons of public health and environmental damage.

Quick Study

1. What was the
General Agreement on Tariffs and Trade (GATT)
? List its main accomplishments.

2. What is the
World Trade Organization (WTO)
? Describe how the WTO settles trade disputes.

3. Explain the difference between an
antidumping duty
and a
countervailing duty
.

4. What efforts have been made to protect the environment from trade and rapid industrialization?

Bottom Line FOR BUSINESS

Despite the theoretical benefits of free trade, nations do not simply throw open their doors to trade and force their domestic businesses to sink or swim. This chapter presented why governments protect their industries and how they go about it. The World Trade Organization tries to strike a balance between national desires for protection and international desires for free trade.

Implications of Trade Protection

Protection of free trade allows firms to move production to locations that maximize efficiency. Yet government interference in the free flow of trade has implications for production efficiency and firm strategy. Subsidies often encourage complacency on the part of companies receiving them because they discourage competition. Subsidies can be thought of as a redistribution of wealth in society whereby international firms not receiving subsidies are at a disadvantage. Unsubsidized firms must either cut production and distribution costs, or differentiate in some way to justify a higher selling price.

Import tariffs raise the cost of an imported good and make domestically produced goods more attractive to consumers. But because a tariff can create inefficient domestic producers, deteriorating competitiveness may offset the benefits of import tariffs. Companies trying to enter markets having high import tariffs often produce within that market. Import quotas help domestic producers maintain market share and prices by restraining competitive forces. Domestic producers protected by the quota win because the market is protected. Yet other producers that require the import subjected to a quota lose. These companies will need to pay more for their intermediate products or locate production outside the market imposing the quota.

Local content requirements
protect domestic producers from producers based in low-cost countries. A firm trying to sell to a market imposing local content requirements may have no alternative but to produce locally. The objective of
administrative delays
is to discriminate against imported products, but it can discourage efficiency.
Currency controls
can require firms to apply for a license to obtain an internationally accepted currency. The nation thus discourages imports by restricting who is allowed to obtain such a currency to pay for imports. A government may also block imports by stipulating an exchange rate that is unfavorable to potential importers. The unfavorable exchange rate forces the cost of imported goods to an impractical level. The same country then often stipulates an exchange rate that is favorable for exporters.

Government subsidies are typically paid for by levying taxes across the economy. Whether subsidies help a nation’s people long term is questionable, and they may actually harm a nation. Import tariffs also hurt consumers because they raise the price of imports and protect domestic firms that may raise prices. Import quotas hurt consumers because they lessen competition, boost prices, and decrease selection. Protection tends to lessen the long-term gains a people can obtain from free trade.

Implications of the Global Trading System

Development of the global trading system benefits international companies by promoting free trade through the reduction of both tariffs and nontariff barriers to international trade. The GATT treaty was successful in its early years, and its revision significantly improved the climate for trade. Average tariffs on merchandise trade were reduced and subsidies for agricultural products were lowered. Firms also benefited from an agreement that extended the principle of nondiscrimination to cover trade in services. The revision of GATT also clearly defined intellectual property rights—giving protection to copyrights, trademarks and service marks, and patents. This encourages firms to develop new products and processes because they know their rights to the property will be protected.

Creation of the WTO is also good for international firms because the various WTO agreements commit member nations to maintaining fair and open trade policies. Both domestic and international firms based in relatively poor nations should benefit most from future rounds of trade negotiations. Because poor nations tend to export agricultural products and textiles, their firms in these industries will benefit from wealthy nations reducing barriers to imports in these sectors. Companies based in poor countries should also benefit from better cooperation among poor countries and their further integration into the global trading system.

Chapter Summary

1. Describe the political, economic, and cultural motives behind governmental intervention in trade.

■ Political motives behind government intervention in trade include: (a) protecting jobs, (b) preserving national security, (c) responding to other nations’ unfair trade practices, and (d) gaining influence over other nations.

■ Economic reasons for government intervention in trade are: (a) protection of infant industries and (b) promotion of a strategic trade policy.

■ The infant industry argument says that a country’s emerging industries need protection from international competition during their development until they become sufficiently competitive, but this may reduce competitiveness and inflate prices.

■ Strategic trade policy argues for government intervention to help companies take advantage of economies of scale and be first movers in their industries; but this may cause inefficiency, higher costs, and trade wars.

■ The most common cultural motive for trade intervention is protection of national identity.

2. List and explain the methods governments use to promote international trade.

■ A
subsidy
is financial assistance to domestic producers in the form of cash payments, low interest loans, tax breaks, product price supports, or other form.

■ Although subsidies are intended to help domestic companies fend off international competitors, critics say that they amount to corporate welfare and are detrimental in the long term.

■ Export financing includes loans at below-market interest rates, loans that would otherwise be unavailable, and loan guarantees that a government will repay a loan if the company defaults.

■ A
foreign trade zone (FTZ)
is a designated geographic region in which merchandise is allowed to pass through with lower customs duties (taxes) and/or fewer customs procedures.

■ Special government agencies organize trips abroad for trade officials and businesspeople and open offices abroad to promote home country exports.

3. List and explain the methods governments use to restrict international trade.

■ A
tariff
is a government tax levied on a product as it enters or leaves a country; its three types are the export tariff, transit tariff, and import tariff.

■ An import tariff can be an
ad valorem tariff, specific tariff
, or
compound tariff
.

■ A restriction on the amount of a good that can enter or leave a country during a certain period of time is called a
quota
.

■ Import quotas protect domestic producers, whereas export quotas maintain adequate supplies domestically or increase the world price of a product.

■ A complete ban on trade with a particular country is an
embargo
.

■
Local content requirements
are laws stipulating that a specified amount of a good or service be supplied by producers in the domestic market.

■ Imports can also be discouraged using
administrative delays
(regulatory controls or bureaucratic rules) or
currency controls
(restrictions on currency convertibility).

4. Discuss the importance of the World Trade Organization in promoting free trade.

■ The
General Agreement on Tariffs and Trade (GATT)
was a treaty designed to promote free trade by reducing tariff and nontariff barriers to trade.

■ The Uruguay Round of GATT negotiations: (a) for the first time included trade in services, (b) defined intellectual property rights, (c) reduced trade barriers in agriculture, and (d) created the
World Trade Organization (WTO)
.

■ The three goals of the WTO are to help the free flow of trade, to help negotiate further opening of markets, and to settle trade disputes between its members.

■ A key component of the WTO is the principle of nondiscrimination called
normal trade relations
, which requires WTO members to treat all members equally.

■
Dumping
is said to occur when a company exports a product at a price either lower than the price it normally charges in its domestic market or lower than the cost of production.

Talk It Over

1. Imagine that people in your country believe international trade is harmful to their wages and jobs and your task is to change their minds. What kinds of programs would you implement to educate your people about the benefits of trade? Describe how each would help change people’s attitudes.

2. Most countries create a list of “hostile” countries that require special permission before an exporter will be allowed to proceed. Which countries and products would you place on such a list for your nation, and why?

3. Two students are discussing efforts within the global trading system to reduce trade’s negative effects on the environment. One student says, “Sure, there may be pollution effects, but they’re a small price to pay for a higher standard of living.” The other student agrees, saying, “Yeah, those ‘tree-huggers’ are always exaggerating those effects anyway. Who cares if some little toad in the Amazon goes extinct? I sure don’t.” What counterarguments can you offer to these students?

Teaming Up

1. Research Project. As a group, select a company in your city or town that is involved in importing and/or exporting, and interview the owner or a top manager. Your goal is to understand how government involvement in international trade has helped or harmed the company’s business activities. Prepare for your appointment by researching the topic of government trade intervention in a business periodical (in print or online), and follow-up the interview with additional research. Ask for past examples and specific potential impacts of government intervention on the business.

2. Market Entry Strategy Project. This exercise corresponds to the MESP online simulation. For the country your team is researching, to what extent does its government intervene in trade? What are its political, economic, or cultural motives for intervention? What methods, if any, does the government use to: (a) promote exports and (b) restrict imports? Does the nation maintain a free trade zone within its borders? Has the country filed a complaint with the WTO against another member nation? Has it been reported by another nation for unfair trade practices? Integrate your findings into your completed MESP report.

Key Terms

ad valorem tariff (p. 179)

administrative delays (p. 182)

antidumping duty (p. 185)

compound tariff (p. 179)

countervailing duty (p. 185)

currency controls (p. 182)

dumping (p. 185)

embargo (p. 181)

foreign trade zone (FTZ) (p. 177)

free trade (p. 170)

normal trade relations (p. 185)

quota (p. 179)

specific tariff (p. 179)

subsidy (p. 175)

tariff (p. 178)

tariff-quota (p. 181)

voluntary export restraint (VER) (p. 180)

Take It to the Web

1. Video Report. Visit this book’s channel on YouTube (You Tube.com/MyIBvideos). Click on “Playlists” near the top of the page and click on the set of videos labeled “Ch 06: Business–Government Trade Relations.” Watch one video from the list and summarize it in a half page report. Reflecting on the contents of this chapter, which aspects of governmental trade intervention can you identify in the video? How might a company engaged in international business act on the information contained in the video?

2. Web Site Report. The WTO recently ordered the United States to repeal $4 billion of tax breaks for U.S. exporters who operate through offshore subsidiaries or face possible sanctions. Although the case was brought by the European Union, many European companies were ambivalent about the tax breaks because they have U.S. subsidiaries that benefit from them.

Visit the Web site of the WTO (www.wto.org) and the Web sites of business periodicals on the Internet. Identify a case on which the WTO has recently ruled. What countries are involved? List as many cultural, political, or economic reasons you can think of that motivated the country to bring the case. Do you think it was a fair charge and do you think the ruling was correct? Explain your answer.

Do you think the WTO should have the power to dictate the trade policies of individual nations and punish them if they do not comply? Why or why not? Do you think countries experiencing economic difficulties should be allowed to erect temporary tariff and nontariff barriers? Why or why not? What effect do you think such an allowance would have on the future of the global trading system?

Ethical Challenges

1. You are an executive for a U.S. oil firm interested in forming a partnership with an Iranian oil producer. This will be a challenge because of the poor relations between the United States and Iran over the years. Since the early 1980s the United States has drawn fire from the business community for imposing economic sanctions (similar to an embargo) against Iran for primarily political reasons. Those sanctions disallow international trade and investment between U.S. and Iranian businesspeople. Business leaders in the United States would like the sanctions removed so they can be included in lucrative Iranian oil and gas deals in which firms from other countries are engaging. Other sanction opponents wonder if a policy of offering “all stick and no carrot” is undermining social and political change in Iran because the offending regime goes largely unpunished while ordinary citizens suffer. What arguments would you present to the U.S. government for removing sanctions on Iran? Do you think that one country, acting alone, can bring about reforms through the use of economic sanctions or embargoes?

2. You are the president of a sugar company based in southern Florida. Your firm is struggling lately to meet demand because of poor harvests in the Caribbean Islands, where your firm sources much of its raw product. Because of the Helms–Burton Act and the U.S. embargo on Cuba, your firm is not allowed to trade with Cuba. If the embargo were dropped, your firm would have an excellent source of cheap sugar, and profits would improve significantly. A U.S. senator from your state of Florida serves on an influential committee in Washington, D.C., that is reviewing the status of the embargo on Cuba. What arguments would you provide your senator that could help eliminate this trade barrier?

3. You are a consultant advising the World Trade Organization (WTO) on the U.S. Supreme Court decision regarding the state of Massachusetts and the country of Myanmar. A nonprofit trade and industry group, the National Foreign Trade Council (NFTC), based in Washington, D.C., won a court battle recently against the state of Massachusetts. In a unanimous decision, the U.S. Supreme Court sided with the NFTC and struck down a Massachusetts law that was designed to deny state contracts to any company doing business in Myanmar. The Court ruled that the Massachusetts law intruded on the federal government’s authority and was preempted by federal law regarding Myanmar. In fact, the U.S. Constitution states that “foreign policy is exclusively reserved for the federal government.” The NFTC says that it shares concern over human rights abuses occurring in Myanmar, but believes that a coordinated, multinational effort would be most effective at instilling change in the nation.

Do you think companies should be penalized in their domestic business dealings because of where they do business abroad? Should the World Trade Organization get involved in these types of political matters? Why or why not? How might domestic firms be affected if each state were allowed to punish firms based on its individual foreign policy ideals?

PRACTICING INTERNATIONAL MANAGEMENT CASE: Down with Dumping

“Canada Launches WTO Challenge to U.S. . . . Mexico Widens Anti-dumping Measure . . . China to Begin Probe of Synthetic Rubber Imports . . . Rough Road Ahead for U.S.-China Trade . . . It Must Be Stopped,” are just a sampling of headlines from around the world.

International trade theories argue that nations should open their doors to trade. Conventional free-trade wisdom says that by trading with others, a country can offer its citizens a greater quantity and selection of goods at cheaper prices than it could in the absence of trade. Nevertheless, truly free trade still does not exist because national governments intervene. Despite the efforts of the World Trade Organization (WTO) and smaller groups of nations, governments still cry foul in the trade game. On average, 234 antidumping cases are initiated each year.

In the past, the world’s richest nations would typically charge a developing nation with dumping. But today, emerging markets, too, are jumping into the fray. China recently launched an inquiry to determine whether synthetic rubber imports (used in auto tires and footwear) from Japan, South Korea, and Russia are being dumped in the country. Mexico expanded coverage of its Automatic Import Advice System. The system requires importers (from a select list of countries) to notify Mexican officials of the amount and price of a shipment 10 days prior to its expected arrival in Mexico. The 10-day notice gives domestic producers advanced warning of low-priced products so they can report dumping before the products clear customs and enter the marketplace. India set up a new government agency to handle antidumping cases. Even Argentina, Indonesia, South Africa, South Korea, and Thailand are using this recently popular tool of protectionism.

Why is dumping so popular? Oddly enough, the WTO allows it. The WTO has made major inroads on the use of tariffs, slashing them across almost every product category in recent years. But it does not have authority to punish companies, only governments. Thus the WTO cannot make judgments against individual companies that are dumping products in other markets. It can only pass rulings against the government of the country that imposes an antidumping duty. But the WTO allows countries to retaliate against nations whose producers are suspected of dumping when it can be shown that: (1) alleged offenders are significantly hurting domestic producers and (2) the export price is lower than the cost of production or lower than the home market price.

Alternatives to bringing antidumping cases before the WTO do exist. U.S. President George W. Bush relied on a Section 201 or “global safeguard” investigation under U.S. trade law to slap tariffs of up to 30 percent on steel imports. The U.S. steel industry had been suffering under an onslaught of steel imports from Brazil, the European Union, Japan, and South Korea. Yet nations still brought complaints about the action before the WTO. Similarly, in 2004 the U.S. government slapped around 100 percent tariffs on shrimp imported from China and Vietnam, charging those nations with dumping their crustaceans on U.S. shores.

Supporters of antidumping tariffs claim that they prevent dumpers from undercutting the prices charged by producers in a target market, driving them out of business. Another claim in support of antidumping is that it is an excellent way of retaining some protection against the potential dangers of totally free trade. Detractors of antidumping tariffs charge that once such tariffs are imposed they are rarely removed. They also claim that it costs companies and governments a great deal of time and money to file and argue their cases. It is also argued that the fear of being charged with dumping causes international competitors to keep their prices higher in a target market than would otherwise be the case. This would allow domestic companies to charge higher prices and not lose market share—forcing consumers to pay more for their goods.

Thinking Globally

1. “You can’t tell consumers that the low price they are paying for that fax machine or automobile is somehow unfair. They’re not concerned with the profits of some company. To them, it’s just a great bargain, and they want it to continue.” Do you agree with this statement? Do you think that people from different cultures would respond differently to this statement? Explain your answers.

2. As we have seen, currently the WTO cannot get involved in punishing individual companies—its actions can only be directed toward governments of countries. Do you think this is a wise policy? Why or why not? Why do you think the WTO was not given authority to charge individual companies with dumping? Explain.

3. Identify a recent antidumping case that was brought before the WTO. Locate as many articles in the press as you can that discuss the case. Identify the nations, product(s), and potential punitive measures involved. If you were part of the WTO dispute settlement body, would you vote in favor of the measures taken by the retaliating nation? Why or why not?

Source: World Trade Organization Annual Report 2007 (Geneva: World Trade Organization, July 2007) (www.wto.org), Table II.4; Frederik Balfour, “Rough Road Ahead for U.S.-China Trade,” Business Week (www.businessweek.com), April 4, 2007; “Shrimp Wars,” The Economist (www.economist.com), July 8, 2004; “China to Begin Probe of Synthetic Rubber Imports,” Wall Street Journal (www.wsj.com), March 19, 2002.

(Wild 168)

Wild, John J., Kenneth L. Wild & Jerry C.Y. Han. International Business: The Challenges of Globalization, 5th Edition. Pearson Learning Solutions. .

7 Foreign Direct Investment

Learning Objectives

After studying this chapter, you should be able to

1 Describe worldwide patterns of foreign direct investment (FDI) and reasons for these patterns.

2 Describe each of the theories that attempt to explain why foreign direct investment occurs.

3

Discuss the important management issues in the foreign direct investment decision.

4 Explain why governments intervene in the free flow of foreign direct investment.

5 Discuss the policy instruments that governments use to promote and restrict foreign direct investment.

A LOOK BACK

Chapter 6 explained business–government relations in the context of world trade in goods and services. We explored the motives and methods of government intervention. We also examined the global trading system and how it promotes free trade.

A LOOK AT THIS CHAPTER

This chapter examines another significant form of international business: foreign direct investment (FDI). Again, we are concerned with the patterns of FDI and the theories on which it is based. We also explore why and how governments intervene in FDI activity.

A LOOK AHEAD

Chapter 8 explores the trend toward greater regional integration of national economies. We explore the benefits of closer economic cooperation and examine prominent regional trading blocs that exist around the world.

Auf Wiedersein to VW Law

Frankfurt, Germany — The Volkswagen Group (www.vw.com) owns eight of the most prestigious and best-known automotive brands in the world, including Audi, Bentley, Bugatti, Lamborghini, Seat, Skoda, and Volkswagen. From its 48 production facilities worldwide, the company produces and sells around 6 million cars annually. The VW Group sells cars in more than

150

countries and holds a 10 percent share of the world car market. Pictured at right, workers train at the Volkswagen plant in Puebla, Mexico.

Volkswagen, like companies everywhere, received plenty of help in getting where it is today. Since the 1

9

60

s, Volkswagen received special protection from its own legislation known as the “VW Law.” The law gave the German state of Lower Saxony, which owns 20.1 percent of Volkswagen, the power to block any takeover attempt that threatened local jobs and the economy. Germany’s former Chancellor Gerhard Schröder once told a cheering crowd of autoworkers in Germany, “Any efforts by the [European Union] commission in Brussels to smash the VW culture will meet the resistance of the federal government as long as we are in power.”

Source: Keith Dannemiller/CORBIS-NY.

The European Court finally struck down the VW Law in late 2007, although Lower Saxony’s government did not give up the fight. Legislators introduced multiple reincarnations of the VW Law to help it avoid the wrath of European regulators, but it is unlikely to be resurrected.

Volkswagen’s special treatment lies in its importance to the German economy and close ties between government and management in Germany. Volkswagen employs tens of thousands of people at home and symbolizes the resurgence of the German economy over the past 60 years. As you read this chapter, consider all the issues that can arise between companies and governments in global business.1

Many early trade theories were created at a time when most production factors (such as labor, financial capital, capital equipment, and land or natural resources) either could not be moved or could not be moved easily across national borders. But today, all of the above except land are internationally mobile and flow across borders to wherever they are needed. Financial capital is readily available from international financial institutions to finance corporate expansion, and whole factories can be picked up and moved to another country. Even labor is more mobile than in years past, although many barriers restrict the complete mobility of labor.

International flows of capital are at the core of
foreign direct investment (FDI)
—the purchase of physical assets or a significant amount of the ownership (stock) of a company in another country to gain a measure of management control. But there is wide disagreement on what exactly constitutes foreign direct investment. Nations set different thresholds at which they classify an international capital flow as FDI. The U.S. Commerce Department sets the threshold at 10 percent of stock ownership in a company abroad, but most other governments set it at anywhere from 10 to 25 percent. By contrast, an investment that does not involve obtaining a degree of control in a company is called a

portfolio investment

.

foreign direct investment

Purchase of physical assets or a significant amount of the ownership (stock) of a company in another country to gain a measure of management control.

portfolio investment

Investment that does not involve obtaining a degree of control in a company.

In this chapter, we examine the importance of foreign direct investment to the operations of international companies. We begin by exploring the growth of FDI in recent years and investigating its sources and destinations. We then take a look at several theories that attempt to explain foreign direct investment flows. Next, we turn our attention to several important management issues that arise in most decisions about whether a company should undertake FDI. This chapter closes by discussing the reasons why governments encourage or restrict foreign direct investment and the methods they use to accomplish these goals.

Patterns of Foreign Direct Investment

Just as international trade displays distinct patterns (see Chapter 5), so too does foreign direct investment. In this section, we first take a look at the factors that have propelled growth in FDI over the past decade. We then turn our attention to the destinations and sources of foreign direct investment.

Ups and Downs of Foreign Direct Investment

After growing around 20 percent per year in the first half of the 1990s, FDI inflows grew by about 40 percent per year in the second half of the decade. In

2000

, FDI inflows peaked at around $1.4 trillion. Slower FDI for

2001

,

2002

, and

2003

reduced FDI inflows to nearly half its earlier peak. Strong economic performance and high corporate profits in many countries lifted FDI inflows to around $648 billion in

2004

, $946 billion in

2005

, and $1.3 trillion in

2006

. Figure 7.1 illustrates this pattern and shows that changes in FDI flows are far more erratic than changes in global GDP.2

The main causes of decreased FDI around the year 2000 were slower global economic growth, tumbling stock market valuations, and relatively fewer privatizations of state-owned firms. Yet FDI inflows show a recovery since then. Despite the ebb and flow of FDI that we see in Figure 7.1, the long-term trend points toward greater FDI inflows worldwide. Among the driving forces behind renewed activity in FDI is an emphasis on the “offshoring” of business activities. The two main drivers of FDI flows are
globalization
and international mergers and acquisitions.

Globalization

Recall from Chapter 6 that years ago barriers to trade were not being reduced, and new, creative barriers seemed to be popping up in many nations. This presented a problem for companies that were trying to export their products to markets around the world. This resulted in a wave of FDI as many companies entered promising markets to get around growing trade barriers. But then the Uruguay Round of GATT negotiations created renewed determination to further reduce barriers to trade. As countries lowered their trade barriers, companies realized that they could now produce in the most efficient and productive locations and simply export to their markets worldwide. This set off another wave of FDI flows into low-cost, newly industrialized nations and emerging markets. Forces causing globalization to occur are, therefore, part of the reason for long-term growth in foreign direct investment.

FIGURE 7.1 Growth Rate of FDI versus GDP

Source: World Investment Report 2007 (Geneva, Switzerland: UNCTAD, September 2007), Chapter 1, Table I.4, p. 9; World Economic Outlook Database, April 2008.

Increasing globalization is also causing a growing number of international companies from emerging markets to undertake FDI. For example, companies from Taiwan began investing heavily in other nations two decades ago. Acer (www.acer.com), headquartered in Singapore but founded in Taiwan, manufactures personal computers and computer components. Just 20 years after it opened for business, Acer had spawned 10 subsidiaries worldwide and became the dominant industry player in many emerging markets.

Mergers and Acquisitions

The number of mergers and acquisitions (M&As) and their exploding values also underlie long-term growth in foreign direct investment. In fact, cross-border M&As are the main vehicle through which companies undertake foreign direct investment. Throughout the past two decades the value of all M&A activity as a share of GDP rose from 0.3 percent to 8 percent. The value of cross-border M&As peaked in 2000 at around $1.15 trillion. This figure accounted for about 3.7 percent of the market capitalization of all stock exchanges worldwide. Reasons previously mentioned for the dip and later rise in FDI inflows also caused the pattern we see in cross-border M&A deals (see Figure 7.2). By 2006, the value of cross-border M&As had climbed back to around $880 billion.3

Many cross-border M&A deals are driven by the desire of companies to:

■ Get a foothold in a new geographic market

■ Increase a firm’s global competitiveness

■ Fill gaps in companies’ product lines in a global industry

■ Reduce costs of R&D, production, distribution, and so forth

FIGURE 7.2 Value of Cross-Border M&As

Source: Based on World Investment Report 2007 (Geneva, Switzerland: UNCTAD, 2007), Chapter 1, Figure I.3, p. 6.

Entrepreneurs and small businesses also play a role in the expansion of FDI inflows. There is no data on the portion of FDI contributed by small businesses, but we know from anecdotal evidence that these companies are engaged in FDI. Unhindered by many of the constraints of a large company, entrepreneurs investing in other markets often demonstrate an inspiring can-do spirit mixed with ingenuity and bravado. For a day-in-the-life look at a young entrepreneur who is realizing his dreams in China, see the Entrepreneur’s Toolkit titled, “The Cowboy of Manchuria.”

Worldwide Flows of FDI

Driving FDI growth are more than

70

,000 multinational companies with over 690,000 affiliates abroad, nearly half of which are now in developing countries.4 Developed countries remain the prime destination for FDI because cross-border M&As are concentrated in developed nations. Developed countries account for around

65

percent ($857 billion) of global FDI inflows, which were a little over $1.3 trillion in 2006. By comparison, FDI inflows to developing countries were valued at $

37

9 billion—about 29 percent of world FDI inflows and down from a peak of a little more than 40 percent a decade earlier.

Among developed countries, European Union (EU) nations, the United States, and Japan account for the vast majority of world inflows. The EU remains the world’s largest FDI recipient, garnering $531 billion in 2006 (over 40 percent of the world’s total). Behind the large FDI figure for the EU is increased consolidation in Europe among large national competitors and further efforts at EU regional integration.

Developing nations had varying experiences in 2006. FDI inflows to developing nations in Asia were nearly $259 billion in 2006, with China attracting over $69 billion of that total. India, the largest recipient on the Asian subcontinent, had inflows of nearly $17 billion. FDI flowing from developing nations in Asia is also on the rise, coinciding with the rise of these nations’ own global competitors.

ENTREPRENEUR’S TOOLKIT: The Cowboy of Manchuria

Tom Kirkwood, at just 28 years of age, turned his dream of introducing his grandfather’s taffy to China into a fast growing business. Kirkwood’s story—his hassles and hustling—provides some lessons on the purest form of global investing. The basics that small investors in China can follow are as basic as they get. Find a product that’s easy to make, widely popular, and cheap to sell and then choose the least expensive, investor-friendliest place to make it.

Kirkwood, whose family runs the Shawnee Inn, a ski and golf resort in Shawnee-on-Delaware, Pennsylvania, decided to make candy in Manchuria—China’s gritty, heavily populated, industrial northeast. Chinese people often give individually wrapped candies as a gift, and Kirkwood reckoned that China’s rising, increasingly prosperous urbanites would have a lucrative sweet tooth. “You can’t be M&Ms, but you don’t have to be penny candy, either,” Kirkwood says. “You find your niche because a niche in China is an awful lot of people.”

Kirkwood decided early on that he wanted to do business in China. In the mid-1980s after prep school, he spent a year in Taiwan and China learning Chinese and working in a Shanghai engineering company. The experience gave him a taste for adventure capitalism on the frontier of China’s economic development. Using $400,000 of Kirkwood’s family money, Kirkwood and his friend Peter Moustakerski bought equipment and rented a factory in Shenyang, a city of six million people in the heart of Manchuria. Roads and rail transport were convenient, and wages were low. The local government seemed amenable to a 100 percent foreign-owned factory, and the Shenyang Shawnee Cowboy Food Company was born.

Although it’s a small operation, it now has 89 employees and is growing. Kirkwood is determined to succeed selling his candies with names such as Longhorn Bars. As he boarded a flight to Beijing for a meeting with a distributor recently, Kirkwood realized he had a bag full of candy. He offered one to a flight attendant. When lunch is over, he vowed, “Everybody on this plane will know Cowboy Candy.”

Source: Adapted from Roy Rowan “Mao to Now,” Fortune (www.fortune.com), October 11,

1999

; Marcus W. Brauchli, “Sweet Dreams,” Wall Street Journal, June 27, 1996, R, 10:1.

Elsewhere, all of Africa drew in slightly more than $35 billion of FDI in 2006, or about 2.7 percent of the world’s total. FDI flows into Latin America and the Caribbean declined rapidly in the early 2000s but then surged to $84 billion in 2006. Finally, FDI inflows to southeast Europe and the Commonwealth of Independent States reached an all-time high of $69 billion in 2006.

Quick Study

1. What is the difference between
foreign direct investment
and
portfolio investment
?

2. What factors influence global flows of foreign direct investment?

3. Identify the main destinations of foreign direct investment. Is the pattern shifting?

Explanations for Foreign Direct Investment

So far we have examined the flows of foreign direct investment, but we have not investigated explanations for why FDI occurs. Let’s now investigate the four main theories that attempt to explain why companies engage in foreign direct investment.

International Product Life Cycle

Although we introduced the international product life cycle in Chapter 5 in the context of international trade, it is also used to explain foreign direct investment.5 The

international product life cycle

theory states that a company will begin by exporting its product and later undertake foreign direct investment as a product moves through its life cycle. In the new product stage, a good is produced in the home country because of uncertain domestic demand and to keep production close to the research department that developed the product. In the maturing product stage, the company directly invests in production facilities in countries where demand is great enough to warrant its own production facilities. In the final standardized product stage, increased competition creates pressures to reduce production costs. In response, a company builds production capacity in low-cost developing nations to serve its markets around the world.

international product life cycle

Theory stating that a company will begin by exporting its product and later undertake foreign direct investment as the product moves through its life cycle.

Despite its conceptual appeal, the international product life cycle theory is limited in its power to explain why companies choose FDI over other forms of market entry. A local firm in the target market could pay for (license) the right to use the special assets needed to manufacture a particular product. In this way, a company could avoid the additional risks associated with direct investments in the market. The theory also fails to explain why firms choose FDI over exporting activities. It might be less expensive to serve a market abroad by increasing output at the home country factory rather than by building additional capacity within the target market.

The theory explains why the FDI of some firms follows the international product life cycle of their products. But it does not explain why other market entry modes are inferior or less advantageous options.

Market Imperfections (Internalization)

A market that is said to operate at peak efficiency (prices are as low as they can possibly be) and where goods are readily and easily available is said to be a perfect market. But perfect markets are rarely, if ever, seen in business because of factors that cause a breakdown in the efficient operation of an industry—called

market imperfections

.
Market imperfections
theory states that when an imperfection in the market makes a transaction less efficient than it could be, a company will undertake foreign direct investment to internalize the transaction and thereby remove the imperfection. There are two market imperfections that are relevant to this discussion—trade barriers and specialized knowledge.

market imperfections

Theory stating that when an imperfection in the market makes a transaction less efficient than it could be, a company will undertake foreign direct investment to internalize the transaction and thereby remove the imperfection.

Employees from quality control check plasma screens on the production line at a newly opened television assembly plant in Nymburk near Prague, Czech Republic. The plant is a foreign direct investment by a company called Chinese Changhong Europe Electric TV. The plant is Changhong’s biggest foreign direct investment in recent times and produces LCD, plasma, and classic televisions. What advantages do you think the Chinese company gained by investing in the Czech Republic?

Source: Radim Beznoska/CORBIS-NY.

Trade Barriers

One common market imperfection in international business is trade barriers, such as tariffs. For example, the North American Free Trade Agreement stipulates that a sufficient portion of a product’s content must originate within Canada, Mexico, or the United States for the product to avoid tariff charges when it is imported to any of these three markets. That is why a large number of Korean manufacturers invested in production facilities in Tijuana, Mexico, just south of Mexico’s border with California. By investing in production facilities in Mexico, the Korean companies were able to skirt the North American tariffs that would have been levied if they were to export goods from Korean factories. The presence of a market imperfection (tariffs) caused those companies to undertake foreign direct investment.

Specialized Knowledge

The unique competitive advantage of a company sometimes consists of specialized knowledge. This knowledge could be the technical expertise of engineers or the special marketing abilities of managers. When the knowledge is technical expertise, companies can charge a fee to companies in other countries for use of the knowledge in producing the same or a similar product. But when a company’s specialized knowledge is embodied in its employees, the only way to exploit a market opportunity in another nation may be to undertake FDI.

The possibility that a company will create a future competitor by charging another company for access to its knowledge is another market imperfection that can encourage FDI. Rather than trade a short-term gain (the fee charged another company) for a long-term loss (lost competitiveness), a company will prefer to undertake investment. For example, as Japan rebuilt its industries following the Second World War, many Japanese companies paid Western firms for access to the special technical knowledge embodied in their products. Those Japanese companies became adept at revising and improving many of these technologies and became leaders in their industries, including electronics and automobiles.

Eclectic Theory

The

eclectic theory

states that firms undertake foreign direct investment when the features of a particular location combine with ownership and internalization advantages to make a location appealing for investment.6 A location advantage is the advantage of locating a particular economic activity in a specific location because of the characteristics (natural or acquired) of that location.7 These advantages have historically been natural resources such as oil in the Middle East, timber in Canada, or copper in Chile. But the advantage can also be an acquired one such as a productive workforce. An ownership advantage refers to company ownership of some special asset, such as brand recognition, technical knowledge, or management ability. An internalization advantage is one that arises from internalizing a business activity rather than leaving it to a relatively inefficient market. The eclectic theory states that when all of these advantages are present, a company will undertake FDI.

eclectic theory

Theory stating that firms undertake foreign direct investment when the features of a particular location combine with ownership and internalization advantages to make a location appealing for investment.

Market Power

Firms often seek the greatest amount of power possible in their industries relative to rivals. The

market power

theory states that a firm tries to establish a dominant market presence in an industry by undertaking foreign direct investment. The benefit of market power is greater profit because the firm is far better able to dictate the cost of its inputs and/or the price of its output.

market power

Theory stating that a firm tries to establish a dominant market presence in an industry by undertaking foreign direct investment.

One way a company can achieve market power (or dominance) is through

vertical integration

—the extension of company activities into stages of production that provide a firm’s inputs (
backward integration
) or absorb its output (
forward integration
). Sometimes a company can effectively control the world supply of an input needed by its industry if it has the resources or ability to integrate backward into supplying that input. Companies may also be able to achieve a great deal of market power if they can integrate forward to increase control over output. For example, they could perhaps make investments in distribution to leapfrog channels of distribution that are tightly controlled by competitors.

vertical integration

Extension of company activities into stages of production that provide a firm’s inputs (backward integration) or absorb its output (forward integration).

Quick Study

1. Explain the international
product life cycle theory
of foreign direct investment (FDI).

2. How does the theory of
market imperfections
(internalization) explain FDI?

3. Explain the
eclectic theory
, and identify the three advantages necessary for FDI to occur.

4. How does the theory of
market power
explain the occurrence of FDI?

Management Issues in the FDI Decision

Decisions about whether to engage in foreign direct investment involve several important issues regarding management of the company and its market. Some of these issues are grounded in the inner workings of firms that undertake FDI, such as the control desired over operations abroad or the firm’s cost of production. Others are related to the market and industry in which a firm competes, such as the preferences of customers or the actions of rivals. Let’s examine each of these important issues.

Control

Many companies investing abroad are greatly concerned with controlling the activities that occur in the local market. Perhaps the company wants to be certain that its product is being marketed in the same way in the local market as it is at home. Or maybe it wants to ensure that the selling price remains the same in both markets. Some companies try to maintain ownership of a large portion of the local operation, say, even up to 100 percent, in the belief that greater ownership gives them greater control.

Yet for a variety of reasons, even complete ownership does not guarantee control. For example, the local government might intervene and require a company to hire some local managers rather than bring them all in from the home office. Companies may need to prove a scarcity of skilled local managerial talent before the government will let them bring managers in from the home country. Governments might also require that all goods produced in the local facility be exported so they do not compete with products of the country’s domestic firms.

Partnership Requirements

Many companies have strict policies regarding how much ownership they take in firms abroad because of the importance of maintaining control. In the past, IBM (www.ibm.com) strictly required that the home office own 100 percent of all international subsidiaries. But companies must sometimes abandon such policies if a country demands shared ownership in return for market access.

Some governments saw shared ownership requirements as a way to shield their workers from exploitation and their industries from domination by large international firms. Companies would sometimes sacrifice control to pursue a market opportunity, but frequently they did not. Most countries today do not take such a hard-line stance and have opened their doors to investment by multinational companies. Mexico used to make decisions on investment by multinationals on a case-by-case basis. IBM was negotiating with the Mexican government for 100 percent ownership of a facility in Guadalajara and got the go-ahead only after the company made numerous concessions in other areas.

Benefits of Cooperation

Many nations have grown more cooperative toward international companies in recent years. Governments of developing and emerging markets realize the benefits of investment by multinationals, including decreased unemployment, increased tax revenues, training to create a more highly skilled workforce, and the transfer of technology. A country known for overly restricting the operations of multinational enterprises can see its inward investment flow dry up. Indeed, restrictive policies of India’s government hampered foreign direct investment inflows for many years.

Cooperation also frequently opens important communication channels that help firms to maintain positive relationships in the host country. Both parties tend to walk a fine line—cooperating most of the time, but holding fast on occasions when the stakes are especially high.

Cooperation with a local partner and respect for national pride in Central Europe contributed to the successful acquisition of Hungary’s Borsodi brewery (formerly a state-owned enterprise) by Belgium’s Interbrew (www.interbrew.com). From the start, Interbrew wisely insisted it would move ahead with its purchase only if local management would be in charge. Interbrew then assisted local management with technical, marketing, sales, distribution, and general management training. Borsodi eventually became one of Interbrew’s key subsidiaries and is now run entirely by Hungarian managers.

At one time, Boeing aircraft were made entirely in the United States. But today Boeing can source its landing gear doors from Northern Ireland, outboard wing flaps from Italy, wing tip assemblies from Korea, rudders from Australia, and fuselages from Japan. Boeing sometimes undertakes foreign direct investment by buying a large portion of its suppliers’ assets or traded stock in another country. Why do you think a company may want to control its suppliers through taking an ownership stake?

Source: Larry W. Smith/Getty Images.

Purchase-or-Build Decision

Another important matter for managers is whether to purchase an existing business or to build a subsidiary abroad from the ground up—called a greenfield investment. An acquisition generally provides the investor with an existing plant, equipment, and personnel. The acquiring firm may also benefit from the goodwill the existing company has built up over the years and, perhaps, brand recognition of the existing firm. The purchase of an existing business may also allow for alternative methods of financing the purchase, such as an exchange of stock ownership between the companies. Factors that can reduce the appeal of purchasing existing facilities include obsolete equipment, poor relations with workers, and an unsuitable location.

Mexico’s Cemex, S.A. (www.cemex.com), is a multinational company that made a fortune by buying struggling, inefficient plants around the world and reengineering them. Chairman Lorenzo Zambrano has long figured the overriding principle was “Buy big globally, or be bought.” The success of Cemex in using FDI has confounded, even rankled, its competitors in developed nations. For example, Cemex shocked global markets when it carried out a $1.8 billion purchase of Spain’s two largest cement companies, Valenciana and Sanson.

But adequate facilities in the local market are sometimes unavailable and a company must go ahead with a greenfield investment. Because Poland is a source of skilled and inexpensive labor, it is an appealing location for car manufacturers. But the country had little in the way of advanced car-production facilities when General Motors (www.gm.com) considered investing there. So GM built a $320 million facility in Poland’s Silesian region. The factory has the potential to produce 200,000 units annually—some of which are destined for export to profitable markets in Western Europe. However, greenfield investments can have their share of headaches. Obtaining the necessary permits, financing, and hiring local personnel can be a real problem in some markets.

Production Costs

Many factors contribute to production costs in every national market. Labor regulations can add significantly to the overall cost of production. Companies may be required to provide benefits packages for their employees that are over and above hourly wages. More time than was planned for might be required to train workers adequately to bring productivity up to an acceptable standard. Although the cost of land and the tax rate on profits can be lower in the local market (or purposely lowered to attract multinationals), it cannot be assumed that they will remain constant. Companies from around the world using China as a production base have witnessed rising wages erode their profits as the economy continues to industrialize. Some companies are therefore finding that Vietnam is their low-cost location of choice.

Rationalized Production

One approach companies use to contain production costs is called

rationalized production

—a system of production in which each of a product’s components is produced where the cost of producing that component is lowest. All the components are then brought together at one central location for assembly into the final product. Consider the typical stuffed animal made in China whose components are all imported to China (with the exception of the polycore thread with which it’s sewn). The stuffed animal’s eyes are molded in Japan. Its outfit is imported from France. The polyester-fiber stuffing comes from either Germany or the United States, and the pile-fabric fur is produced in Korea. Only final assembly of these components occurs in China.

rationalized production

System of production in which each of a product’s components is produced where the cost of producing that component is lowest.

Although this production model is highly efficient, a potential problem is that a work stoppage in one country can bring the entire production process to a standstill. For example, the production of automobiles is highly rationalized, with parts coming in from a multitude of countries for assembly. When the United Auto Workers (www.uaw.com) union held a strike for weeks against General Motors (www.gm.com), many of GM’s international assembly plants were threatened. The UAW strategically launched their strike at GM’s plant that supplied brake pads to virtually all of its assembly plants throughout North America.

Mexico’s Maquiladora

Stretching 2,000 miles from the Pacific Ocean to the Gulf of Mexico, the

130

-mile-wide strip along the U.S.–Mexican border may well be North America’s fastest-growing region. With 11 million people and $150 billion in output, the region’s economy is larger than that of Israel’s. The combination of a low-wage economy nestled next to a prosperous giant is now becoming a model for other regions that are split by wage or technology gaps. Some analysts compare the U.S.–Mexican border region to that between Hong Kong and its manufacturing realm, China’s Guangdong province. Officials from cities along the border between Germany and Poland studied the U.S.–Mexican experience to see what lessons could be applied to their unique situation.

Cost of Research and Development

As technology becomes an increasingly powerful competitive factor, the soaring cost of developing subsequent stages of technology has led multinationals to engage in cross-border alliances and acquisitions. For instance, huge multinational pharmaceutical companies are intensely interested in the pioneering biotechnology work done by smaller, entrepreneurial startups. Cadus Pharmaceutical Corporation of New York determined the function of 400 genes related to so-called receptor molecules. Many disorders are associated with the improper functioning of these receptors—making them good targets for drug development. Britain’s SmithKline Beecham (www.gsk.com) then invested around $68 million with Cadus in order to access Cadus’s research knowledge.

One indicator of technology’s significance in foreign direct investment is the amount of R&D conducted by companies’ affiliates in other countries. The globalization of innovation and the phenomenon of foreign direct investment in R&D are not necessarily motivated by demand factors such as the size of local markets. They instead appear to be encouraged by supply factors, including gaining access to high-quality scientific and technical human capital.

Customer Knowledge

The behavior of buyers is frequently an important issue in the decision of whether to undertake foreign direct investment. A local presence can help companies gain valuable knowledge about customers that could not be obtained from the home market. For example, when customer preferences for a product differ a great deal from country to country, a local presence might help companies to better understand such preferences and tailor their products accordingly.

Some countries have quality reputations in certain product categories. German automotive engineering, Italian shoes, French perfume, and Swiss watches impress customers as being of superior quality. Because of these perceptions, it can be profitable for a firm to produce its product in the country with the quality reputation, even if the company is based in another country. For example, a cologne or perfume producer might want to bottle its fragrance in France and give it a French name. This type of image appeal can be strong enough to encourage foreign direct investment.

Following Clients

Firms commonly engage in foreign direct investment when the firms they supply have already invested abroad. This practice of “following clients” is common in industries in which producers source component parts from suppliers with whom they have close working relationships. The practice tends to result in companies clustering within close geographic proximity to each other because they supply each other’s inputs (see Chapter 5). When Mercedes (www.mercedes.com) opened its first international car plant in Tuscaloosa County, Alabama, auto-parts suppliers also moved to the area from Germany—bringing with them additional investment in the millions of dollars.

Following Rivals

FDI decisions frequently resemble a “follow the leader” scenario in industries having a limited number of large firms. In other words, many of these firms believe that choosing not to make a move parallel to that of the “first mover” might result in being shut out of a potentially lucrative market. When firms based in industrial countries moved back into South Africa after the end of apartheid, their competitors followed. Of course, each market can sustain only a certain number of rivals. Firms that cannot compete choose the “least damaging option.” This seems to have been the case for Pepsi (www.pepsi.com), which went back into South Africa in 1994, but withdrew in

1997

after being crushed there by Coke (www.cocacola.com).

GLOBAL MANAGER’S BRIEFCASE: Surprises of Investing Abroad

The decision of whether to build facilities in a market abroad or to purchase existing operations in the local market can be a difficult one. Managers can minimize risk by preparing their companies for a number of surprises they might face.

■ Human Resource Policies. Home country policies cannot be simply imported and they seldom address local laws and customs. Countries have differing requirements for plant operations and their own regulations regarding business operations.

■ Labor Costs. France has a minimum wage of about $

12

an hour, whereas Mexico has a minimum wage of nearly $5 a day. But Mexico’s real minimum wage is nearly double that due to government-mandated benefits and employment practices.

■ Mandated Benefits. These include company-supplied clothing and meals, required profit sharing, guaranteed employment contracts, and generous dismissal policies. These costs can exceed an employee’s wages and are typically nonnegotiable.

■ Labor Unions. In some countries organized labor is found at almost every company. Rather than dealing with a single union at plants in Scandinavin countries, managers may need to negotiate with five or six different unions, each of which represents a distinct skill or profession.

■ Economic-Development Incentives. These incentives can be substantial and change constantly. The European Union is trying to standardize incentives based on unemployment levels, but some nations continually stretch the rules and exceed guidelines.

■ Information. Sometimes there simply is no reliable data on factors such as labor availability, cost of energy, and national inflation rates. These data are generally high quality in developed countries and suspect in developing ones.

■ Personal and Political Contacts. These contacts can be extremely important in developing and emerging markets and the only way to establish operations. But complying with locally accepted practices can cause ethical dilemmas for managers.

Source: Conrad de Aenlle, “China’s Cloudy Investment Picture,” International Herald Tribune (www.iht.com), June 13, 2008; “Mexico Raises Minimum Wages by 4 Percent, to around $4.85 a Day,” International Herald Tribune (www.iht.com), December 22, 2007; U.S. Department of Labor Web site (www.dol.gov), select reports.

In this section we have presented several key issues managers consider when investing abroad. We will have more to say on this topic in Chapter 15, when we learn how companies take on such an ambitious goal. Meanwhile, you can read more about what managers should consider when going global in the Global Manager’s Briefcase titled, “Surprises of Investing Abroad.”

Quick Study

1. Why is control important to companies considering the FDI decision?

2. What is the role of production costs in the FDI decision? Define
rationalized production
.

3. Explain the need for customer knowledge, following clients, and following rivals in the FDI decision.

Government Intervention in Foreign Direct Investment

Nations often intervene in the flow of FDI to protect their cultural heritages, domestic companies, and jobs. They can enact laws, create regulations, or construct administrative hurdles that companies from other nations must overcome if they want to invest in the nation. Yet rising competitive pressure is forcing nations to compete against each other to attract multinational companies. The increased national competition for investment is causing governments to enact regulatory changes that encourage investment. As Table 7.1 demonstrates, the number of regulatory changes that governments introduced in recent years has climbed, the vast majority of which are more favorable to FDI.

In a general sense, a bias toward protectionism or openness is rooted in a nation’s culture, history, and politics. Values, attitudes, and beliefs form the basis for much of a government’s position regarding foreign direct investment. For example, South American nations with strong cultural ties to a European heritage (such as Argentina) are generally enthusiastic about investment received from European nations. South American nations with stronger indigenous influences (such as Ecuador) are generally less enthusiastic.

Opinions vary widely on the appropriate amount of foreign direct investment a country should encourage. At one extreme are those who favor complete economic self-sufficiency and oppose any form of FDI. At the other extreme are those who favor no governmental intervention and booming FDI inflows. Between these two extremes lie most countries, which believe a certain amount of FDI is desirable to raise national output and enhance the standard of living for their people.

Besides philosophical ideals, countries intervene in FDI for a host of very practical reasons. But to fully appreciate those reasons, we must first understand what is meant by a country’s

balance of payments

.

Balance of Payments

A country’s
balance of payments
is a national accounting system that records all payments to entities in other countries and all receipts coming into the nation. International transactions that result in payments (outflows) to entities in other nations are reductions in the balance of payments accounts, and are therefore recorded with a minus sign. International transactions that result in receipts (inflows) from other nations are additions to the balance of payments accounts, and thus are recorded with a plus sign.

balance of payments

National accounting system that records all payments to entities in other countries and all receipts coming into the nation.

For example, when a U.S. company buys 40 percent of the publicly traded stock of a Mexican company on Mexico’s stock market, the U.S. balance of payments records the transaction as an outflow of capital and it is recorded with a minus sign. Table 7.2 shows the recent balance of payments accounts for the United States. As shown in the table, any nation’s balance of payments consists of two major components—the

current account

and

capital account

. Let’s describe each of these accounts and discuss how to read Table 7.2.

TABLE 7.1 National Regulations and FDI

1997

1998

1999
2000
2001
2002
2003
2004
2005
2006

Number of countries that introduced changes

76

60
65
70

71

72

82

103

93

93

Number of changes

150

14

5

139

150

207

24

6

242

270

205

184

    More favorable to FDI

134

1

36

130

147

193

234

218

234

16

4

147

    Less favorable to FDI

16
9
9
3
14
12
24
36

41

37

Source: Based on World Investment Report 2007 (Geneva, Switzerland: UNCTAD, September 2007), Overview, Table I.8, p. 14.

TABLE 7.2 U.S. Balance of Payments Accounts (U.S. $ millions)

Current Account

Exports of goods and services and income receipts

1,418,568

  Merchandise

772,210

  Services

293,492

  Income receipts on U.S. assets abroad

352,866

Imports of goods and services and income payments

–1,809,099

  Merchandise
 

–1,224,417

  Services
 

–217,024

  Income payments on foreign assets in United States

–367,658

Unilateral transfers

–54,136

Current account balance

–444,667

Capital Account

Increase in U.S. assets abroad (capital outflow)

–580,952

  U.S. official reserve assets

–290

  Other U.S. government assets

–944

  U.S. private assets

–579,718

Foreign assets in the United States (capital inflow)

1,024,218

  Foreign official assets

37,619

  Other foreign assets

986,599

Capital account balance

443,266

Statistical discrepancy

55,537

Source: Survey of Current Business, July 2001, (Washington, D.C.: U.S. Department of Commerce, 2001), p. 47.

Current Account

The
current account
is a national account that records transactions involving the import and export of goods and services, income receipts on assets abroad, and income payments on foreign assets inside the country. The merchandise account in Table 7.2 includes exports and imports of tangible goods such as computer software, electronic components, and apparel. The services account includes exports and imports of services such as tourism, business consulting, and banking services. Suppose a company in the United States receives payment for consulting services provided to a company in another country. The receipt is recorded as an “export of services” and assigned a plus sign in the services account in the balance of payments.

current account

National account that records transactions involving the import and export of goods and services, income receipts on assets abroad, and income payments on foreign assets inside the country.

The income receipts account includes income earned on U.S. assets held abroad. When a U.S. company’s subsidiary in another country remits profits back to the parent in the United States, the receipt is recorded in the income receipts account and given a plus sign. The income payments account includes income paid to entities in other nations that is earned on assets they hold in the United States. For example, when a French company’s U.S. subsidiary sends profits earned in the United States back to the parent company in France, the transaction is recorded in the income payments account as an outflow, and it is given a minus sign.

A

current account surplus

occurs when a country exports more goods and services and receives more income from abroad than it imports and pays abroad. Conversely, a

current account deficit

occurs when a country imports more goods and services and pays more abroad than it exports and receives from abroad. Table 7.2 shows that the United States had a current account deficit in the year shown.

current account surplus

When a country exports more goods and services and receives more income from abroad than it imports and pays abroad.

current account deficit

When a country imports more goods and services and pays more abroad than it exports and receives from abroad.

Capital Account

The
capital account
is a national account that records transactions involving the purchase or sale of assets. Suppose a U.S. citizen buys shares of stock in a Mexican company on Mexico’s stock market. The transaction would show up on the capital accounts of both the United States and Mexico—as an outflow of assets from the United States and an inflow of assets to Mexico. Conversely, suppose a Mexican investor buys real estate in the United States. That transaction also shows up on the capital accounts of both nations—as an inflow of assets to the United States and as an outflow of assets from Mexico. Although the balances of the current and capital accounts should be the same, there commonly is error caused by recording methods. This figure is recorded in Table 7.2 as a statistical discrepancy.

capital account

National account that records transactions involving the purchase or sale of assets.

Reasons for Intervention by the Host Country

A number of reasons underlie a government’s decisions regarding foreign direct investment by international companies. Let’s now look at the two main reasons countries intervene in FDI flows—to control the
balance of payments
and to obtain resources and benefits.

Control Balance of Payments

Many governments see intervention as the only way to keep their balance of payments under control. First, because foreign direct investment inflows are recorded as additions to the balance of payments, a nation gets a balance-of-payments boost from an initial FDI inflow. Second, countries can impose local content requirements on investors from other nations coming in for the purpose of local production. This gives local companies the chance to become suppliers to the production operation, which can help reduce the nation’s imports and thereby improve its balance of payments. Third, exports (if any) generated by the new production operation can have a favorable impact on the host country’s balance of payments.

But when companies repatriate profits back to their home countries, they deplete the foreign exchange reserves of their host countries. These capital outflows decrease the balance of payments of the host country. To shore up its balance of payments, the host nation may prohibit or restrict the nondomestic company from removing profits to its home country.

Alternatively, host countries conserve their foreign exchange reserves when international companies reinvest their earnings. Reinvesting in local manufacturing facilities can also improve the competitiveness of local producers and boost a host nation’s exports—thus improving its balance-of-payments position.

Obtain Resources and Benefits

Beyond balance-of-payments reasons, governments might intervene in FDI flows to acquire resources and benefits such as technology and management skills and employment.

A worker is shown looking up at a skyscraper being built in Beijing, China. The country’s liberal economic policies have caused foreign direct investment in China to surge. The investments of multinationals brings badly needed jobs to China’s 130 million migrant workers, who travel from one city and job site to another doing day labor on construction sites. How might such investments affect China’s balance of payments?

Source: Michael Reynolds/CORBIS-NY.

ACCESS TO TECHNOLOGY

Investment in technology, whether in products or processes, tends to increase the productivity and the competitiveness of a nation. That is why host nations have a strong incentive to encourage the importation of technology. For years, developing countries in Asia were introduced to expertise in industrial processes as multinationals set up factories within their borders. But today some of them are trying to acquire and develop their own technological expertise. When German industrial giant Siemens (www.siemens.com) chose Singapore as the site for an Asia-Pacific microelectronics design center, Singapore gained access to valuable technology. Singapore also accessed valuable semiconductor technology by joining with U.S.-based Texas Instruments (www.ti.com) and others to set up the country’s first semiconductor production facility.

MANAGEMENT SKILLS AND EMPLOYMENT

As we saw in Chapter 4, many formerly communist nations suffer from a lack of management skills needed to succeed in the global economy. By encouraging FDI, these nations can attract talented managers to come in and train locals and thereby improve the international competitiveness of their domestic companies. Furthermore, locals who are trained in modern management techniques may eventually start their own local businesses—further expanding employment opportunities. Yet detractors argue that, although FDI may create jobs, it may also destroy jobs because less competitive local firms may be forced out of business.

Reasons for Intervention by the Home Country

Home nations (those from which international companies launch their investments) may also seek to encourage or discourage outflows of FDI for a variety of reasons. But home nations tend to have fewer concerns because they are often prosperous, industrialized nations. For these countries, an outward investment seldom has a national impact—unlike the impact on developing or emerging nations that receive the FDI. Nevertheless, among the most common reasons for discouraging outward FDI are the following:

■
Investing in other nations sends resources out of the home country.
As a result, fewer resources are used for development and economic growth at home. On the other hand, profits on assets abroad that are returned home increase both a home country’s balance of payments and its available resources.

■
Outgoing FDI may ultimately damage a nation’s balance of payments by taking the place of its exports.
This can occur when a company creates a production facility in a market abroad, the output of which replaces exports that used to be sent there from the home country. For example, if a Volkswagen (www.vw.com) plant in the United States fills a demand that U.S. buyers would otherwise satisfy with purchases of German-made autos, Germany’s balance of payments is correspondingly decreased. Still, Germany’s balance of payments would be positively affected when companies repatriate U.S. profits, which helps negate the investment’s initial negative balance-of-payments effect. Thus an international investment might make a positive contribution to the balance-of-payments position of the country in the long term and offset an initial negative impact.

■
Jobs resulting from outgoing investments may replace jobs at home.
This is often the most contentious issue for home countries. The relocation of production to a low-wage nation can have a strong impact on a locale or region. However, the impact is rarely national, and its effects are often muted by other job opportunities in the economy. In addition, there may be an offsetting improvement in home country employment if additional exports are needed to support the activity represented by the outgoing FDI. For example, if Hyundai (www.hyundai-motor.com) of South Korea builds an automobile manufacturing plant in Brazil, Korean employment may increase in order to supply the Brazilian plant with parts.

But foreign direct investment is not always a negative influence on home nations. In fact, under certain circumstances governments might encourage it. Countries promote outgoing FDI for the following reasons:

■
Outward FDI can increase long-term competitiveness.
Businesses today frequently compete on a global scale. The most competitive firms tend to be those that conduct business in the most favorable location anywhere in the world, continuously improve their performance relative to competitors, and derive technological advantages from alliances formed with other companies. Japanese companies have become masterful at benefiting from FDI and cooperative arrangements with companies from other nations. The key to their success is that Japanese companies see every cooperative venture as a learning opportunity.

■
Nations may encourage FDI in industries identified as “sunset” industries.
Sunset industries are those that use outdated and obsolete technologies or employ low-wage workers with few skills. These jobs are not greatly appealing to countries having industries that pay skilled workers high wages. By allowing some of these jobs to go abroad and retraining workers in higher-paying skilled work, they can upgrade their economies toward “sunrise” industries. This represents a trade-off for governments between a short-term loss of jobs and the long-term benefit of developing workers’ skills.

Quick Study

1. What is a country’s
balance of payments
? Briefly explain its usefulness.

2. Explain the difference between the
current account
and the
capital account
.

3. For what reasons do host countries intervene in FDI?

4. For what reasons do home countries intervene in FDI?

Government Policy Instruments and FDI

Over time, both host and home nations have developed a range of methods to either promote or restrict FDI (see Table 7.3). Governments use these tools for many reasons, including improving balance-of-payments positions; acquiring resources; and, in the case of outward investment, keeping jobs at home. Let’s take a look at these methods.

Host Countries

: Promotion

Host countries offer a variety of incentives to encourage FDI inflows. These take two general forms—financial incentives and infrastructure improvements.

Financial Incentives

Host governments of all nations grant companies financial incentives if they will invest within their borders. One method includes tax incentives, such as lower tax rates or offers to waive taxes on local profits for a period of time—extending as far out as five years or more. A country may also offer low interest loans to investors.

The downside of these types of incentives is they can allow multinationals to create bidding wars between locations that are vying for the investment. In such cases, the company typically invests in the most appealing region after the locations endure rounds of escalating incentives. Companies have even been accused of engaging other governments in negotiations to force concessions from locations already selected for investment. The cost to taxpayers of attracting FDI can be several times what the actual jobs themselves pay—especially when nations try to one-up each other to win investment.

TABLE 7.3 Methods of Promoting and Restricting FDI

FDI Promotion

FDI Restriction

Host Countries

Tax incentives

Ownership restrictions

Low-interest loans

Performance demands

Infrastructure improvements

Home Countries

Insurance

Differential tax rates

Loans

Sanctions

Tax breaks

Political pressure

Infrastructure Improvements

Because of the problems associated with financial incentives, some governments are taking an alternative route to luring investment. Lasting benefits for communities surrounding the investment location can result from making local infrastructure improvements—better seaports suitable for containerized shipping, improved roads, and increased telecommunications systems. For instance, Malaysia is carving an enormous Multimedia Super Corridor (MSC) into a region’s forested surroundings. The MSC promises a paperless government, an intelligent city called Cyberjaya, two telesuburbs, a technology park, a multimedia university, and an intellectual-property-protection park. The MSC is dedicated to creating the most advanced technologies in telecommunications, medicine, distance learning, and remote manufacturing.

Host Countries: Restriction

Host countries also have a variety of methods to restrict incoming FDI. Again, these take two general forms—ownership restrictions and performance demands.

Ownership Restrictions

Governments can impose ownership restrictions that prohibit nondomestic companies from investing in certain industries or from owning certain types of businesses. Such prohibitions typically apply to businesses in cultural industries and companies vital to national security. For example, as some Islamic countries in the Middle East try to protect traditional values, accepting investment by Western companies is a controversial issue between purists and moderates. Also, most nations do not allow FDI in their domestic weapons or national defense firms. Another ownership restriction is a requirement that nondomestic investors hold less than a 50 percent stake in local firms when they undertake foreign direct investment.

But nations are eliminating such restrictions because companies today often can choose another location that has no such restriction in place. When General Motors was deciding whether to invest in an aging automobile plant in Jakarta, Indonesia, the Indonesian government scrapped its ownership restriction of an eventual forced sale to Indonesians because China and Vietnam were also courting GM for the same financial investment.

Performance Demands

More common than ownership requirements are performance demands that influence how international companies operate in the host nation. Although typically viewed as intrusive, most international companies allow for them in the same way they allow for home country regulations. Performance demands include ensuring that a portion of the product’s content originates locally, stipulating the portion of output that must be exported, or requiring that certain technologies be transferred to local businesses.

Home Countries: Promotion

To encourage outbound FDI, home country governments can do any of the following:

■ Offer insurance to cover the risks of investments abroad, including, among others, insurance against expropriation of assets and losses from armed conflict, kidnappings, and terrorist attacks.

■ Grant loans to firms wishing to increase their investments abroad. A home country government may also guarantee the loans that a company takes from financial institutions.

■ Offer tax breaks on profits earned abroad or negotiate special tax treaties. For example, several multinational agreements reduce or eliminate the practice of double taxation—profits earned abroad being taxed both in the home and host countries.

■ Apply political pressure on other nations to get them to relax their restrictions on inbound investments. Non-Japanese companies often find it very difficult to invest inside Japan. The United States, for one, repeatedly pressures the Japanese government to open its market further to FDI. But because such pressure has achieved little success, many U.S. companies cooperate with local Japanese businesses.

Home Countries: Restriction

On the other hand, to limit the effects of outbound FDI on the national economy, home governments may exercise either of the following two options:

■ Impose differential tax rates that charge income from earnings abroad at a higher rate than domestic earnings.

■ Impose outright sanctions that prohibit domestic firms from making investments in certain nations.

Quick Study

1. Identify the main methods host countries use to promote and restrict FDI.

2. What methods do home countries use to promote and restrict FDI?

Bottom Line FOR BUSINESS

Companies ranging from massive global corporations to adventurous entrepreneurs all contribute to FDI flows, and the long-term trend in FDI is upward. Here we briefly discuss the influence of national governments on FDI flows and flows of FDI in Asia and Europe.

National Governments and FDI

The actions of national governments have important implications for business. Companies can either be thwarted in their efforts or be encouraged to invest in a nation, depending on the philosophies of home and host governments. The balance-of-payments positions of both home and host countries are also important because FDI flows affect the economic health of nations. To attract investment, a nation must provide a climate conducive to business operations, including pro-growth economic policies, a stable regulatory environment, and a sound infrastructure, to name just a few.

Increased competition for investment by multinationals has caused nations to make regulatory changes more favorable to FDI. Moreover, just as nations around the world are creating free trade agreements (covered in Chapter 8), they are also embracing bilateral investment treaties. These bilateral investment treaties are becoming prominent tools used to attract investment. Investment provisions within free trade agreements are also receiving greater attention than in the past. These efforts to attract investment have direct implications for the strategies of multinational companies, particularly when it comes to deciding where to locate production, logistics, and backoffice service activities.

Foreign Direct Investment in Europe

Developing nations in Africa, Latin America, and much of Southeast Asia were hit especially hard by the lower FDI flows in the early 2000s, but are rebounding. FDI inflows into the developing (transition) nations of Southeast Europe and the Commonwealth of Independent States hit an all-time high in 2006. Countries that recently entered the European Union did particularly well. They saw less investment in areas supporting low-wage, unskilled occupations, and greater investment in higher value-added activities that take advantage of a well-educated workforce.

Yet the main reason for the fast pace at which foreign direct investment is occurring in Western Europe is regional economic integration (see Chapter 8). Some of the foreign investment reported by the European Union certainly went to the relatively less developed markets of the new central and eastern European members. But much of the activity occurring among western European companies is industry consolidation brought on by the opening of markets and the tearing down of barriers to free trade and investment. Change in the economic landscape across Europe is creating a more competitive business climate there.

Foreign Direct Investment in Asia

China attracts the majority of Asia’s FDI, luring companies with a low-wage workforce and access to an enormous domestic market. Many companies already active in China are upping their investment further, and companies not yet there are developing strategies for how to include China in their future plans. The “off-shoring” of services will likely propel continued FDI in the coming years, of which India is the primary destination. India’s attraction is its well-educated, low-cost, and English-speaking workforce.

An aspect of national business environments that has implications for future business activity is the natural environment. By their actions, businesses lay the foundation for people’s attitudes in developing nations toward FDI by multinationals. For example, greater decentralization in China’s politics has placed local Communist Party bosses and bureaucrats at the center of many FDI deals there. These individuals are often more motivated by their personal financial gain than they are worried about pollution. But China’s government is increasing spending on the environment, and multinationals are helping in cleaning up the environment.

Chapter Summary

1. Describe worldwide patterns of foreign direct investment (FDI) and reasons for these patterns.

■ FDI inflows peaked in 2000 at $1.4 trillion, but then contracted through 2003. They then rebounded to around $648 billion in 2004, $946 billion in 2005, and $1.3 trillion in 2006.

■ Developed countries account for around 65 percent of global FDI inflows, and developing countries account for about 29 percent.

■ Among developed countries, the European Union (EU), the United States, and Japan account for the majority of FDI inflows. The EU garnered $531 billion of FDI in 2006 (40 percent of the world total).

■ FDI inflows to developing Asian nations were just over $259 billion in 2006, with China attracting over $69 billion and India attracting nearly $17 billion.

■ FDI inflows to all of Africa accounted for about 2.7 percent of total world FDI inflows in 2006.

■
Globalization
and a growing number of mergers and acquisitions account for the rising tide of FDI flows.

2. Describe each of the theories that attempt to explain why foreign direct investment occurs.

■ The
international product life cycle theory
says that a company begins by exporting its product and later undertakes foreign direct investment as the product moves through its life cycle of three stages: new product, maturing product, and standardized product.

■
Market imperfections theory
says that when an imperfection in the market makes a transaction less efficient than it could be, a company will undertake foreign direct investment to internalize the transaction and thereby remove the imperfection.

■ The
eclectic theory
says that firms undertake foreign direct investment when the features of a particular location combine with ownership and internalization advantages to make a location appealing for investment.

■ The
market power theory
states that a firm tries to establish a dominant market presence in an industry by undertaking foreign direct investment.

3. Discuss the important management issues in the foreign direct investment decision.

■ Although companies investing abroad often wish to control activities in the local market, they may be forced to hire local managers or to export all goods produced locally.

■ Acquisition of an existing business is preferred when the existing business entails updated equipment, good relations with workers, and a suitable location.

■ When adequate facilities are unavailable, a company might need to pursue a greenfield investment.

■ A local market presence can give a company valuable knowledge of local buyer behavior.

■ Firms commonly engage in FDI when it locates them close to client firms and rival firms.

4. Explain why governments intervene in the free flow of foreign direct investment.

■ Host nations receive a balance-of-payments boost from initial FDI and from any exports the FDI generates, but they see a decrease in balance of payments when a company sends profits to the home country.

■ FDI in technology brings in people with management skills who can train locals and increase a nation’s productivity and competitiveness.

■ Home countries intervene in FDI outflows because they can lower the balance of payments, but profits sent home that are earned on assets abroad increase the balance of payments.

■ FDI outflows may replace jobs at home that were based on exports to the host country and may damage the home nation’s balance of payments if they reduce prior exports.

5. Discuss the policy instruments that governments use to promote and restrict foreign direct investment.

■ Host countries can promote FDI inflows by offering companies tax incentives (such as lower tax rates or waived taxes), extending low interest loans, and making local infrastructure improvements.

■ Host countries can restrict FDI inflows by imposing ownership restrictions (prohibitions from certain industries) and by creating performance demands that influence how a company can operate.

■ Home countries can promote FDI outflows by offering insurance to cover investment risks abroad, granting loans to firms investing abroad, guaranteeing company loans from financial institutions, offering tax breaks on profits earned abroad, negotiating special tax treaties, and applying political pressure to get other nations to accept FDI.

■ Home countries can restrict FDI outflows by imposing differential tax rates that charge income from earnings abroad at a higher rate than domestic earnings and by imposing sanctions that prohibit domestic firms from making investments in certain nations.

Talk It Over

1. You overhear your superior tell another manager in the company: “I’m fed up with our nation’s companies sending manufacturing jobs abroad and offshoring service work to lower-wage nations. Don’t any of them have any national pride?” The other manager responds, “I disagree. It is every company’s duty to make as much profit as possible for its owners. If that means going abroad to reduce costs, so be it.” Do you agree with either of these managers? Why or why not? Now step into the conversation and explain where you stand on this issue.

2. The global carmaker you work for is investing in an automobile assembly facility in Costa Rica with a local partner. Explain the potential reasons for this investment. Will your company want to exercise a great deal of control over this operation? Why or why not? In what areas might your company want to exercise control and in what areas might it cede control to the partner?

3. This chapter presented several theories that attempt to explain why firms undertake foreign direct investment. Which of these theories seems most appealing to you? Why is it appealing? Can you think of one or more companies that seem to fit the pattern described by the theory? In your opinion, what faults do the alternative theories have?

Teaming Up

1. Research Project. In a small group, locate an article in the business press that discusses a cross-border merger or acquisition within the past year. Gather additional information on the deal from any sources available. What reasons did each company give for the merger or acquisition? Was it a marriage of equals or did a larger partner absorb a far smaller one? Do the articles identify any internal issues managers had to deal with following the merger or acquisition? What is the current performance of the new company? Write a two- to three-page report of your group’s findings.

2. Market Entry Strategy Project. This exercise corresponds to the MESP online simulation. For the country your team is researching, does it attract large amounts of FDI? Is it a major source of FDI for other nations? What is the nation’s balance-of-payments position? What is its current account balance? List some possible causes for its surplus or deficit. How is this surplus or deficit affecting the nation’s economic performance? What is its capital account balance? How does the government encourage or restrict trade with other nations? Integrate your findings into your completed MESP report.

Key Terms

balance of payments (p. 204)

capital account (p. 205)

current account (p. 205)

current account deficit (p. 205)

current account surplus (p. 205)

eclectic theory (p. 198)

foreign direct investment (FDI) (p. 194)

international product life cycle (p. 197)

market imperfections (p. 197)

market power (p. 199)

portfolio investment (p. 194)

rationalized production (p. 201)

vertical integration (p. 199)

Take It to the Web

1. Video Report. Visit this book’s channel on YouTube (YouTube.com/MyIBvideos). Click on “Playlists” near the top of the page and click on the set of videos labeled “Ch 07: Foreign Direct Investment.” Watch one video from the list and summarize it in a half-page report. Reflecting on the contents of this chapter, which aspects of foreign direct investment can you identify in the video? How might a company engaged in international business act on the information contained in the video?

2. Web Site Report. This chapter presented many reasons why companies directly invest in other nations and factors in the decision of whether and where to invest abroad.

Research the economy of the Philippines and its neighbors. In what economic sectors is each country strong? Do the strengths of each country really complement one another, or do they compete directly with one another? If you were considering investing in the Philippines, what management issues would concern you? Be specific in your answer. (Hint: A good place to begin your research is the CIA’s World Factbook (www.odci.gov/cia/publications/factbook).

In this era of intense national competition to attract jobs, Southeast Asian governments fear losing ground to China in the race for investment. What do you think those governments could do to increase the attractiveness of their homelands for multinationals?

Find an article on the Internet that describes a company’s decision to relocate some or all of its business operations (goods or services). What reasons are stated for the relocation? Was any consideration given to the plight of employees being put out of work?

Ethical Challenges

1. You are a sales manager working in international sales for a major U.S. beef distributor. Your firm is attempting to sell a large quantity of beef to a developing market in northern Africa where U.S. beef is a rarity. The vice president for new business development has instructed you to sell the beef well below market price quickly. Standing at the coffee machine, you overhear two quality assurance managers discussing “the potentially tainted beef heading for Africa.” You are aware that in the past your firm has come across small traces of typhoid in some of its products. What do you do? Do you go through with the northern Africa deal? Do you first contact someone inside or outside the company? If additional information would be helpful to you, what would it be?

2. You are the U.S. senator deciding whether to vote up or down on a new piece of legislation. The potential new law places restrictions on the practice of outsourcing work to low-wage countries and is designed to protect U.S. workers’ jobs. These days it is increasingly common for companies to promise manufacturing contracts to overseas suppliers in exchange for entry into that country’s market. Labor union representatives argue that these kinds of deals are made at the expense of jobs at home. After all, if a company can have parts made in China at lower wages, why keep factories going at home? They also are concerned that the transfer of technology will breed strong competitors in other nations and thereby threaten even more domestic jobs in the future. But others argue that increased sales abroad actually helps create more jobs at home. Discuss the ethics of companies contracting out production to factories abroad in exchange for sales contracts. How would you vote on the pending legislation? What other issues must you consider?

3. You are the U.S. ambassador to Malaysia. In order to become a major export platform for the semiconductor industry, Malaysia’s government not only offered tax breaks but also guaranteed that electronics workers would be prohibited from organizing independent labor unions. The government decreed that the goal of national development required a “union-free” environment for the “pioneers” of semiconductors. Under pressure from U.S. labor unions, the Malaysian government offered a weak alternative to industry unions—company-by-company “in-house” unions. Yet as soon as workers organized one at a Harris Electronics plant, the 21 union leaders were fired, and the new union was disbanded. In another instance, when French-owned Thomson Electronics inherited a Malaysian factory with a union of 3,000, it closed the plant and moved the work to Vietnam. Newly industrialized nations such as Malaysia feel that their futures depend on investment by multinationals. Yet their governments are acutely aware that in the absence of incentives such as a “union-free” workforce, international companies can easily take their investment money elsewhere. Discuss the problems that these governments face in balancing the needs of their citizens with the long-term quest for economic development. As the ambassador, what advice do you give Malaysian business and government leaders? Can you think of examples from other nations that can help you make the case for local unions?

PRACTICING INTERNATIONAL MANAGEMENT CASE: World Class in Dixieland

“A loof.” “Serious.” “Not youthful.” Definitely “not fun.” These were the unfortunate epithets applied to Mercedes-Benz by a market research firm that assesses product personalities. Research among dealers in the United States also revealed that consumers felt so intimidated by Mercedes that they wouldn’t sit in the cars at the showroom.

To boost sales and broaden the market to a more youthful and value-conscious consumer, Mercedes-Benz U.S. International (www.mbusi.com) came up with a series of inventive, free-spirited ads featuring stampeding rhinos and bobbing aliens. Although the new ads boosted sales, the company needed more than a new marketing message to ensure its future growth. What it needed was an all-new Mercedes. Enter the Mercedes M-Class, a sports utility vehicle (SUV). With a base price of $35,000 and a luxury lineage, Mercedes placed its M-Class to compete squarely against the Ford Explorer and Jeep Grand Cherokee.

Not only was the M-Class Mercedes’ first SUV, it was also the first car that Mercedes had manufactured outside Germany—in the heart of Dixie, no less. The rough-hewn town of Vance, Alabama (population 400), in Tuscaloosa County is where people hang out at the local barbecue joint. And it is the last place you’d expect to find button-down engineers from Stuttgart, Germany. But this small town appealed to Mercedes for several reasons. Labor costs in the U.S. Deep South are 50 percent lower than in Germany. Also, Alabama offered an attractive $250 million in tax refunds and other incentives to win the much-needed Mercedes jobs. Mercedes also wanted to be closer to the crucial U.S. market and to create a plant from the ground up, one that would be a model for its future international operations.

When Japanese carmakers entered the U.S. market, they reproduced their car-building philosophies, cultures, production practices, and management styles. By contrast, Mercedes started with the proverbial blank sheet of paper at Tuscaloosa. To appeal to U.S. workers, Mercedes knew it had to abandon the rigid hierarchy of its typical production line and create a more egalitarian shop floor. Administrative offices in the gleaming, E-shaped Mercedes plant run through the middle of the manufacturing area, and administrators are accessible to team members on the shop floor. Also, the plant’s design lets workers unilaterally stop the assembly line to correct manufacturing problems.

So far, the system has been a catalyst to communication among the Tuscaloosa plant’s U.S. workers, German trainers, and a diverse management team that includes executives from Detroit and Japan. Even so, an enormous amount of time and effort was invested in training the U.S. workforce. Explains Sven Schoolman, a 31-year-old trainer from Sindelfingen, “In Germany, we don’t say we build a car. We say we build a Mercedes. We had to teach that.” The innovative production system is a combination of German, Japanese, and U.S. automotive best practices within a young corporate culture. The Tuscaloosa plant uses a “just-in-time” manufacturing method that requires only about two hours of inventory on line and about three hours of inventory in the body shop. As of 2008, Mercedes’ experience is so successful that Honda, Toyota, and Hyundai followed it to Alabama, and Volkswagen may soon as well.

Mercedes later expanded its Tuscaloosa operations to nearly triple the size of its original factory. The plant now uses flexible manufacturing technology to accommodate the M-Class, R-Class, and GL-Class. Production volume in 2006 was 173,600 vehicles for all three classes. Around 65 percent of vehicle content comes from Canada, Mexico, and the United States, whereas engines and transmissions are imported from Germany. Every vehicle built at the Tuscaloosa plant is for an order from one of Mercedes’ 135 markets worldwide.

The company is gaining valuable experience in how to set up and operate a plant in another country. “It was once sacrosanct to talk about our cars being ‘Made in Germany’,” said Jurgen E. Schrempp, then CEO of Mercedes’ parent company. “We have to change that to ‘Made by Mercedes’, and never mind where they are assembled.”

Thinking Globally

1. What do you think were the chief factors involved in Mercedes’ decision to undertake FDI in the United States rather than build the M-Class in Germany?

2. Why do you think Mercedes decided to build the plant from the ground up in Alabama rather than buy an existing plant in, say, Detroit? List as many reasons as you can, and explain your answer.

3. Do you think Mercedes risks diluting its “Made in Germany” reputation for engineering quality by building its M-class outside Germany? Why or why not?

4. What do you see as the pros and cons of Mercedes’ approach to managing FDI—abandoning the culture and some of its home country practices?

Source: “Love Me, Love Me Not,” The Economist (www.economist.com), July 10, 2008; Gail Edmondson, David Welch, and David Kiley, “Daimler Shakeup: Realignment in the Auto Industry,” Business Week (www.businessweek.com), January 25, 2006; Mercedes-Benz U.S. International, Inc., Web site (www.www.mbusi.com), select reports.

(Wild 192)

Wild, John J., Kenneth L. Wild & Jerry C.Y. Han. International Business: The Challenges of Globalization, 5th Edition. Pearson Learning Solutions. .

8 Regional Economic Integration

Learning Objectives

After studying this chapter, you should be able to

1 Define regional economic integration and identify its five levels.

2 Discuss the benefits and drawbacks of regional economic integration.

3 Describe regional integration in Europe and its pattern of enlargement.

4 Discuss regional integration in the Americas and analyze its future prospects.

5 Characterize regional integration in Asia and how it differs from integration elsewhere.

6 Describe integration in the Middle East and Africa and explain the slow progress.

A LOOK BACK

Chapter 7 examined recent patterns of foreign direct investment. We explored the theories that try to explain why it occurs and saw how governments influence investment flows.

A LOOK AT THIS CHAPTER

This chapter explores the trend toward greater integration of national economies. We first examine the reasons why nations are making significant efforts at regional integration. We then study the most prominent regional trading blocs in place around the world today.

A LOOK AHEAD

Chapter 9 begins our inquiry into the international financial system. We describe the structure of the international capital market and explain how the foreign exchange market operates.

Nestlé’s Global Recipe

Vevey, Switzerland — Although based in small Switzerland, Nestlé (www.nestle.com) sells its products in nearly every country on the planet. Nestlé is the world’s largest food company. It operates across cultural borders 24 hours a day and earns just 2 percent of its sales at home.

Nestlé is known for its ability to turn humdrum products like bottled water and pet food into well-known global brands. The company also takes regional products to the global market when the opportunity arises. For example, Nestlé first launched a cereal bar for diabetics in Asia under the brand name Nutren Balance and is now taking it to other markets worldwide.

Nestlé must navigate cultural and political traditions in other countries because food is an integral part of the social fabric everywhere. Nestlé learned from its past and does all it can to ensure mothers use pure water to mix its baby milk formulas. Today, the company makes every effort to be sensitive to the traditional ways in which babies are fed. Nestlé must also watch for changes in attitudes due to greater cross-cultural contact caused by regional integration. Pictured above, a pharmacist in Rome, Italy, reaches for a package of Mio brand baby milk made by Nestlé.

Source: Alessia Pierdomenico/CORBIS-NY.

The laws of regional trading blocs also affect the business activities of Nestlé. When Nestlé and Coca-Cola announced a joint venture to develop coffee and tea drinks, they first had to show the European Union (EU) Commission that they would not stifle competition across the region. Firms operating within the EU also have to abide by EU environmental protection laws. Nestlé works with governments to minimize the packaging waste that results from the use of its products by developing and managing waste-recovery programs. As you read this chapter, think of all the ways business activities are affected when groups of nations band together in regional trading blocs.1

Regional trade agreements are changing the landscape of the global marketplace. Companies like Nestlé of Switzerland are finding that these agreements lower trade barriers and open new markets for goods and services. Markets otherwise off-limits because tariffs made imported products too expensive can become quite attractive once tariffs are lifted. But trade agreements can be double-edged swords for many companies. Not only do they allow domestic companies to seek new markets abroad, but they also let competitors from other nations enter the domestic market. Such mobility increases competition in every market that takes part in an agreement.

Trade agreements can allow companies to alter their strategies, sometimes radically. As we will see in this chapter, for example, nations in the Americas want to create a free trade area that runs from the northern tip of Alaska to the southern tip of South America. Companies that do business throughout this region could save millions of dollars annually from the removal of import tariffs under an eventual agreement. Multinationals could also save money by supplying entire regions from just a few regional factories, rather than have a factory in each nation.

We began Part Three of this book by discussing the gains resulting from specialization and trade. We now close this part of the book by showing how groups of countries are cooperating to dismantle barriers that threaten these potential gains. In this chapter, we focus on regional efforts to encourage freer trade and investment. We begin by defining regional economic integration and describing its five different levels. We then examine the benefits and drawbacks of regional trade agreements. Finally, we explore several long-established trade agreements and several agreements in the early stages of development.

What Is Regional Economic Integration?

The process whereby countries in a geographic region cooperate to reduce or eliminate barriers to the international flow of products, people, or capital is called regional economic integration (regionalism). A group of nations in a geographic region undergoing economic integration is called a regional trading blocs.

regional economic integration (regionalism)

Process whereby countries in a geographic region cooperate to reduce or eliminate barriers to the international flow of products, people, or capital.

The goal of nations undergoing economic integration is not only to increase cross-border trade and investment but also to raise living standards for their people. We saw in Chapter 5, for example, how specialization and trade create real gains in terms of greater choice, lower prices, and increased productivity. Regional trade agreements are designed to help nations accomplish these objectives. Regional economic integration sometimes has additional goals, such as protection of intellectual property rights or the environment, or even eventual political union.

Levels of Regional Integration

Since the development of theories demonstrating the potential gains available through international trade, nations have tried to reap these benefits in a variety of ways. Figure 8.1 shows five potential levels (or degrees) of economic and political integration for regional trading blocs. A free trade area is the lowest extent of national integration, political union is the greatest. Each level of integration incorporates the properties of those levels that precede it.

Free Trade Area

Economic integration whereby countries seek to remove all barriers to trade between themselves, but each country determines its own barriers against nonmembers, is called a free trade area. A free trade area is the lowest level of economic integration that is possible between two or more countries. Countries belonging to the free trade area strive to remove all tariffs and nontariff barriers, such as quotas and subsidies, on international trade in goods and services. However, each country is able to maintain whatever policy it sees fit against nonmember countries. These policies can differ widely from country to country. Countries belonging to a free trade area also typically establish a process by which trade disputes can be resolved.

free trade area

Economic integration whereby countries seek to remove all barriers to trade between themselves, but each country determines its own barriers against nonmembers.

FIGURE 8.1 Levels of Regional Integration

Customs Union

Economic integration whereby countries remove all barriers to trade among themselves, but erect a common trade policy against nonmembers, is called a customs union. Thus the main difference between a free trade area and a customs union is that the members of a customs union agree to treat trade with all nonmember nations in a similar manner. Countries belonging to a customs union might also negotiate as a single entity with other supranational organizations, such as the World Trade Organization.

customs union

Economic integration whereby countries remove all barriers to trade between themselves but erect a common trade policy against nonmembers.

Common Market

Economic integration whereby countries remove all barriers to trade and the movement of labor and capital between themselves, but erect a common trade policy against nonmembers, is called a common market. Thus a common market integrates the elements of free trade areas and customs unions and adds the free movement of important factors of production—people and cross-border investment. This level of integration is very difficult to attain because it requires members to cooperate to at least some extent on economic and labor policies. Furthermore, the benefits to individual countries can be uneven because skilled labor may move to countries where wages are higher, and investment capital may flow to where returns are greater.

common market

Economic integration whereby countries remove all barriers to trade and the movement of labor and capital between themselves but erect a common trade policy against nonmembers.

Economic Union

Economic integration whereby countries remove barriers to trade and the movement of labor and capital, erect a common trade policy against nonmembers, and coordinate their economic policies is called an economic union. An economic union goes beyond the demands of a common market by requiring member nations to harmonize their tax, monetary, and fiscal policies and to create a common currency. Economic union requires that member countries concede a certain amount of their national autonomy (or sovereignty) to the supranational union of which they are a part.

economic union

Economic integration whereby countries remove barriers to trade and the movement of labor and capital, erect a common trade policy against nonmembers, and coordinate their economic policies.

Political Union

Economic and political integration whereby countries coordinate aspects of their economic and political systems is called a political union. A political union requires member nations to accept a common stance on economic and political matters regarding nonmember nations. However, nations are allowed a degree of freedom in setting certain political and economic policies within their territories. Individually, Canada and the United States provide early examples of political unions. In both these nations, smaller states and provinces combined to form larger entities. A group of nations currently taking steps in this direction is the European Union—discussed later in this chapter.

political union

Economic and political integration whereby countries coordinate aspects of their economic and political systems.

Table 8.1 identifies each country involved in the European Union and the members of every regional trading bloc presented in this chapter. As you work through this chapter, refer back to this table for a quick summary of each bloc’s members.

TABLE 8.1 The World’s Main Regional Trading Blocs

EU

European Union

Austria, Belgium, Britain, Bulgaria, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greec e, Greek Cyprus (southern portion), Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden

EFTA

European Free Trade Association

Iceland, Liechtenstein, Norway, Switzerland

NAFTA

North American Free Trade Agreement

Canada, Mexico, United States

CAFTA-DR

Central American Free Trade Agreement

Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua

, Dominican

Republic, United States

Andean

Andean Community (CAN)

Bolivia, Colombia, Ecuador, and Peru

ALADI

Latin American Integration Association

Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, Paraguay, Peru, Uruguay, Venezuela

MERCOSUR

Southern Common Market

Argentina, Brazil, Paraguay, Uruguay, Venezuela (Bolivia, Chile, Colombia, Ecuador, and Peru are associate members)

CARICOM

Caribbean Community and Common Market

Antigua and Barbuda, Bahamas, Barbados, Belize, Dominica, Grenada, Guyana, Haiti, Jamaica, Montserrat, St. Kitts and Nevis, St. Lucia, St. Vincent

and the Grenadines, Suriname, Trinidad and Tobago

CACM

Central American Common Market

 
Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua

FTAA

Free Trade Area of the Americas

34 nations from Central, North, and South America and the Caribbean

ASEAN

Association of Southeast Asian Nations

Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand, Vietnam

APEC

Asia Pacific Economic Cooperation

Australia, Brunei, Canada, Chile, China, Hong Kong, Indonesia, Japan, South Korea, Malaysia, Mexico, New Zealand, Papu New Guinea, Peru, Philippines, Russia, Singapore, Taiwan, Thailand, United States, Vietnam

CER

Closer Economic Relations Agreement

Australia, New Zealand

GCC

Gulf Cooperation Council

Bhrain, Kuwait, Oman, Qatar, Saudi Arabia, United Arab Emirates

ECOWAS

Economic Community of West African States

Benin, Burkina Faso, Cape Verde, Gambia, Ghana, Guinea, Guinea-Bissau, Ivory Coast, Liberia, Mali, Niger, Nigeria, Senegal, Sierra Leone, Togo

AU

African Union

Total of 53 nations on the continent of Africa

Effects of Regional Economic Integration

Few topics in international business are as hotly contested and involve as many groups as the effects of regional trade agreements on people, jobs, companies, cultures, and living standards. The topic often spurs debate over the merits and demerits of such agreements. On one side of the debate are people who see the bad that regional trade agreements cause; on the other, those who see the good. Each party to the debate cites data on trade and jobs that bolster their position. They point to companies that have picked up and moved to another country where wages are lower after a new agreement was signed, or to companies that have stayed at home and kept jobs there. The only thing made clear as a result of such debates is that both sides are right some of the time.

There is also the cultural aspect of such agreements. Some people argue that they will lose their unique cultural identity if their nation cooperates too much with other nations. As we saw in this chapter’s opening company profile, Nestlé tries to be sensitive to cultural differences across markets. But such large global companies are often lightning rods for those warning of cultural homogenization. Let’s take a closer look at the main benefits and drawbacks of regional integration.

Benefits of Regional Integration

Recall from Chapter 5 that nations engage in specialization and trade because of the potential for gains in output and consumption. Higher levels of trade between nations should result in greater specialization, increased efficiency, greater consumption, and higher standards of living.

Trade Creation

Economic integration removes barriers to trade and/or investment for nations belonging to a trading bloc. The increase in the level of trade between nations that results from regional economic integration is called trade creation. One result of trade creation is that consumers and industrial buyers in member nations are faced with a wider selection of goods and services not available before.2 For example, the United States has many popular brands of bottled water, including Coke’s Dasani (www.dasani.com) and Pepsi’s Aquafina (www.pepsi.com). But grocery and convenience stores inside the United States stock a wide variety of lesser-known imported brands of bottled water, such as Stonepoint from Canada. Certainly, the free trade agreement between Canada, Mexico, and the United States (discussed later in this chapter) created export opportunities for other Canadian brands.

trade creation

Increase in the level of trade between nations that results from regional economic integration.

Another result of trade creation is that buyers can acquire goods and services at lower cost after removal of trade barriers such as tariffs. Furthermore, lower-priced products tend to drive higher demand for goods and services because they increase purchasing power.

Greater Consensus

In Chapter 6 we saw how the World Trade Organization (WTO) works to lower barriers on a global scale. Efforts at regional economic integration differ in that they comprise smaller groups of nations—ranging from several countries to as many as 30 or more. The benefit of trying to eliminate trade barriers in smaller groups of countries is that it can be easier to gain consensus from fewer members as opposed to, say, the 153 countries that comprise the WTO.

Political Cooperation

There can also be political benefits from efforts toward regional economic integration. A group of nations can have significantly greater political weight than each nation has individually. Thus the group, as a whole, can have more say when negotiating with other countries in forums such as the WTO. Integration involving political cooperation can also reduce the potential for military conflict between member nations. In fact, peace was at the center of early efforts at integration in Europe in the 1950s. The devastation of two world wars in the first half of the twentieth century caused Europe to see integration as one way of preventing further armed conflicts.

Employment Opportunities

Regional integration can expand employment opportunities by enabling people to move from one country to another to find work or, simply, to earn a higher wage. Regional integration has opened doors for young people in Europe. Forward-looking young people have abandoned extreme nationalism and have taken on what can only be described as a “European” attitude that embraces a shared history. Those with language skills and a willingness to pick up and move to another EU country get to explore a new culture’s way of life while earning a living. As companies seek their future leaders in Europe, they will hire people who can think across borders and across cultures.

Drawbacks of Regional Integration

Although regional integration tends to benefit countries, it can also have substantial negative effects. Let’s examine each of these potential consequences.

Trade Diversion

The flip side of trade creation is trade diversion—the diversion of trade away from nations not belonging to a trading bloc and toward member nations. Trade diversion can occur after the formation of a trading bloc because of the lower tariffs charged between member nations. It can actually result in increased trade with a less-efficient producer within the trading bloc and reduced trade with a more efficient, non-member producer. In this sense, economic integration can unintentionally reward a less efficient producer within the trading bloc. Unless there is other internal competition for the producer’s good or service, buyers will likely pay more after trade diversion because of the inefficient production methods of the producer.

trade diversion

Diversion of trade away from nations not belonging to a trading bloc and toward member nations.

A World Bank report caused a stir over the results of the free trade bloc between Latin America’s largest countries, MERCOSUR (discussed later in this chapter). The report suggested that the bloc’s formation only encouraged free trade in the lowest-value products of local origin, while deterring competition for more sophisticated goods manufactured outside the market. Closer analysis showed that while imports from one member state to another tripled during the period studied, imports from the rest of the world also tripled. Thus the net effect of the agreement was trade creation, not trade diversion as critics had charged. Also, the Australian Department of Foreign Affairs and Trade released results of a study that examined the impact of the North American Free Trade Agreement (NAFTA) on Australia’s trade with and investment in North America. The study found no evidence of trade diversion following the agreement’s formation.3

Shifts in Employment

Perhaps the most controversial aspect of regional economic integration is its effect on people’s jobs. The formation of a trading bloc promotes efficiency by significantly reducing or eliminating barriers to trade among its members. The surviving producer of a particular good or service, then, is likely to be the bloc’s most efficient producer. Industries requiring mostly unskilled labor, for example, tend to respond to the formation of a trading bloc by shifting production to a low-wage nation within the bloc.

Yet figures on jobs lost or gained as a result of trading bloc formation vary depending on the source. The U.S. government contends that rising U.S. exports to Mexico and Canada have created a minimum of 900,000 jobs.4 But the AFL-CIO (www.aflcio.org), the federation of U.S. unions, disputes these figures and claims a loss of jobs due to NAFTA. Trade agreements do cause dislocations in labor markets; some jobs are lost while others are gained.

It is likely that once trade and investment barriers are removed, countries protecting low-wage domestic industries from competition will see these jobs move to the country where wages are lower. This can be an opportunity for workers who lose their jobs to upgrade their skills and gain more advanced job training. This can help nations increase their competitiveness because a more educated and skilled workforce attracts higher-paying jobs than does a less skilled workforce.5

Loss of National Sovereignty

Successive levels of integration require that nations surrender more of their national sovereignty. The least amount of sovereignty that must be surrendered to the trading bloc occurs in a free trade area. By contrast, a political union requires nations to give up a high degree of sovereignty in foreign policy. This is why political union is so hard to achieve. Long histories of cooperation or animosity between nations do not become irrelevant when a group of countries forms a union. Because one member nation may have very delicate ties with a nonmember nation with which another member may have very strong ties, the setting of a common foreign policy can be extremely tricky.

Economic integration is taking place throughout the world because of the benefits and despite the drawbacks of regional trade agreements. Europe, the Americas, Asia, the Middle East, and Africa are all undergoing integration to varying degrees (see Map 8.1). Let’s now begin our coverage of economic integration by exploring Europe, which has the longest history and highest level of integration to date.

Quick Study

1. What is the ultimate goal of regional economic integration?

2. What are the five levels, or degrees, of regional integration? Briefly describe each one.

3. Identify several potential benefits and several potential drawbacks of regional integration.

4. What is meant by the terms trade creation and trade diversion? Why are these concepts important?

Integration in Europe

The most sophisticated and advanced example of regional integration that we can point to today is occurring in Europe. European efforts at integration began shortly after the Second World War as a cooperative endeavor among a small group of countries and involved a few select industries. Regional integration now encompasses practically all of Western Europe and all industries.

European Union

In the middle of the twentieth century, many would have scoffed at the idea that European nations, which had spent so many years at war with one another, could present a relatively unified whole 50 years later. Let’s investigate how Europe came so far in such a relatively short time.

Early Years

A war-torn Europe emerged from the Second World War in 1945 facing two challenges: (1) it needed to rebuild itself and avoid further armed conflict and (2) it needed to increase its industrial strength to stay competitive with an increasingly powerful United States. Cooperation seemed to be the only way of facing these challenges. Belgium, France, West Germany, Italy, Luxembourg, and the Netherlands signed the Treaty of Paris in 1951, creating the European Coal and Steel Community. These nations were determined to remove barriers to trade in coal, iron, steel, and scrap metal so as to coordinate coal and steel production among themselves, thereby controlling the postwar arms industry.

The members of the European Coal and Steel Community signed the Treaty of Rome in 1957, creating the European Economic Community. The Treaty of Rome outlined a future common market for these nations. It also aimed at establishing common transportation and agricultural policies among members. In 1967 the community’s scope was broadened to include additional industries, notably atomic energy, and changed its name to the European Community. As the goals of integration continued to expand, so too did the bloc’s membership. Waves of enlargement occurred in 1973, 1981, 1986, 1995, 2004, and 2007. In 1994 the bloc once again changed its name to the European Union (EU). Today the 27-member European Union (www.europa.eu) has a population of about 495 million people and a GDP of around $18 trillion (see Map 8.2).

MAP 8.1 Most Active Economic Blocs

MAP 8.2 Economic Integration in Europe

Over the past two decades two important milestones contributed to the continued progress of the EU: the Single European Act and the Maastricht Treaty.

SINGLE EUROPEAN ACT

By the mid-1980s, EU member nations were frustrated by remaining trade barriers and a lack of harmony on several important matters, including taxation, law, and regulations. The important objective of harmonizing laws and policies was beginning to appear unachievable. A commission that was formed to analyze the potential for a common market by the end of 1992 put forth several proposals. The goal was to remove remaining barriers, increase harmonization, and thereby enhance the competitiveness of European companies. The proposals became the Single European Act (SEA) and went into effect in 1987.

As companies positioned themselves to take advantage of the opportunities that the SEA offered, a wave of mergers and acquisitions swept across Europe. Large firms combined their special understanding of European needs, capabilities, and cultures with their advantage of economies of scale. Small and medium-sized companies were encouraged through EU institutions to network with one another to offset any negative consequences resulting from, for example, changing product standards.

MAASTRICHT TREATY

Some members of the EU wanted to take European integration further still. A 1991 summit meeting of EU member nations took place in Maastricht, the Netherlands. The meeting resulted in the Maastricht Treaty, which went into effect in 1993.

The Maastricht Treaty had three aims. First, it called for banking in a single, common currency after January 1, 1999, and circulation of coins and paper currency on January 1, 2002. Second, the treaty set up monetary and fiscal targets for countries that wished to take part in monetary union. Third, the treaty called for political union of the member nations—including development of a common foreign and defense policy and common citizenship. Member countries will hold off further political integration until they gauge the success of the final stages of economic and monetary union. Let’s take a closer look at monetary union in Europe.

European Monetary Union

As stated previously, EU leaders were determined to create a single, common currency. European monetary union is the European Union plan that established its own central bank and currency in January 1999. The Maastricht Treaty stated the economic criteria with which member nations must comply to partake in the single currency, the euro. First, consumer price inflation must be below 3.2 percent and must not exceed that of the three best-performing countries by more than 1.5 percent. Second, the debt of government must be 60 percent of GDP or lower. An exception is made if the ratio is diminishing and approaching the 60 percent mark.

European monetary union

European Union plan that established its own central bank and currency.

Third, the general government deficit must be at or below 3.0 percent of GDP. An exception is made if the deficit is close to 3.0 percent or if the deviation is temporary and unusual. Fourth, interest rates on long-term government securities must not exceed, by more than 2.0 percent, those of the three countries with the lowest inflation rates. Meeting these criteria better aligned countries’ economies and paved the way for smoother policy making under a single European Central Bank. The 16 EU member nations that have adopted the single currency are Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain.

MANAGEMENT IMPLICATIONS OF THE EURO

The move to a single currency influences the activities of companies within the European Union. First, the euro removes financial obstacles created by the use of multiple currencies. It completely eliminates exchange-rate risk for business deals between member nations using the euro. The euro also reduces transaction costs by eliminating the cost of converting from one currency to another. In fact, the EU leadership estimates the financial gains to Europe could eventually be 0.5 percent of GDP. The efficiency of trade between participating members resembles that of interstate trade in the United States because only a single currency is involved.

Second, the euro makes prices between markets more transparent, making it difficult to charge different prices in adjoining markets. As a result, shoppers feel less of a need to travel to other countries to save money on high-ticket items. For example, shortly before monetary union a Mercedes-Benz S320 (www.mercedes.com) cost $72,614 in Germany but only $66,920 in Italy. A Renault Twingo (www.renault.com) that sold for $13,265 in France cost $11,120 in Spain. Car brokers and shopping agencies even sprang up specifically to help European consumers reap such savings. The euro has greatly reduced or eliminated this type of situation.

Enlargement of the European Union

One of the most historic events across Europe in recent memory was EU enlargement from 15 to 27 members. Croatia, Turkey, and the former Yugoslav Republic of Macedonia remain candidates for EU membership and are to become members after they meet certain demands laid down by the EU. These so-called Copenhagen Criteria require each country to demonstrate that it:

■ Has stable institutions, which guarantee democracy, the rule of law, human rights, and respect for and protection of minorities.

■ Has a functioning market economy, capable of coping with competitive pressures and market forces within the European Union.

■ Is able to assume the obligations of membership, including adherence to the aims of economic, monetary, and political union.

■ Has the ability to adopt the rules and regulations of the community, the rulings of the European Court of Justice, and the treaties.

Although it has applied for membership, negotiations for Turkey are expected to be difficult. One reason for Turkey’s lack of support in the EU is charges (fair or not) of human rights abuses with regard to its Kurdish minority. Another reason is intense opposition by Greece, Turkey’s longtime foe. Turkey does have a customs union with the EU, however, and trade between them is growing. Despite disappointment among some EU-hopefuls and despite intermittent setbacks in the enlargement process, integration is progressing. To learn a bit more about how entrepreneurs can do business in one EU country, see the Entrepreneur’s Toolkit titled, “Czech List.”

Structure of the European Union

Five EU institutions play particularly important roles in monitoring and enforcing economic and political integration (see Figure 8.2). Two other EU institutions (Ombudsman and Data Protection Supervisor) fulfill secondary and support roles and are not discussed here.

ENTREPRENEUR’S TOOLKIT Czech List

The countries of Central and Eastern Europe that belong to the EU represent a land of opportunity. But like doing business anywhere, opportunity must be balanced against the challenges of a particular location. Entrepreneurs who have succeeded in the Czech Republic offer this advice.

■ Formalities. Czech society is rather formal, and it is best to tend toward the more formal unless you know your colleague well. This includes using titles like “doctor” and “mister.” It’s rarely appropriate to use first names unless you’re close friends.

■ Business Relationships. Making money is obviously important and the ultimate goal for any business. Still, building personal relationships, establishing good references, and doing favors for others can smooth the way for newcomers.

■ Czech Partners. Being communist for 40 years before it became a capitalist democracy has left its mark on the Czech people and their culture. Finding a local partner who can handle the inevitable cultural difficulties that arise is crucial.

■ Local Professionals. It is a good idea to hire a Czech accountant or someone familiar with Czech laws, taxes (including a VAT tax of 19 percent), and red tape. An attorney who is bilingual can also interpret differences between Czech and U.S. laws.

■ Who’s in Charge. Companies need a “responsible person” (or jednatel in Czech) who is in charge of all aspects of the business. Some Czechs still feel more comfortable working with this jednatel rather than unfamiliar company reps.

Source: “Online Business Guide to the Czech Republic,” Price-waterhouseCoopers Web site (www.pwc.com/cz/eng/ins-sol/spec-int/taxguide), select reports; Czech Republic Web site (www.czech.cz), select reports; Moira Allen, “Czech List: Doing Business with Eastern Europe,” Entrepreneur Magazine (www.entrepreneur.com), July 2000.

FIGURE 8.2 Institutions of the European Union

EUROPEAN PARLIAMENT

The European Parliament consists of nearly 800 members elected by popular vote within each member nation every five years. As such, they are expected to voice their particular political views on EU matters. The European Parliament fulfills its role of adopting EU law by debating and amending legislation proposed by the European Commission. It exercises political supervision over all EU institutions—giving it the power to supervise commissioner appointments and to censure the commission. It also has veto power over some laws (including the annual budget of the EU). There is a call for increased democratization within the EU, and some believe this could be achieved by strengthening the powers of the Parliament. The Parliament conducts its activities in Belgium (in the city Brussels), France (in the city Strasbourg), and Luxembourg.

COUNCIL OF THE EUROPEAN UNION

The council is the legislative body of the EU. When it meets it brings together representatives of member states at the ministerial level. The makeup of the council changes depending on the topic under discussion. For example, when the topic is agriculture, the council is composed of the ministers of agriculture from each member nation. No proposed legislation becomes EU law unless the council votes it into law. Although passage into law for sensitive issues such as immigration and taxation still requires a unanimous vote, some legislation today requires only a simple majority to win approval. The council also concludes, on behalf of the EU, international agreements with other nations or international organizations. The council is headquartered in Brussels, Belgium.

EUROPEAN COMMISSION

The commission is the executive body of the EU. It comprises commissioners appointed by each member country—larger nations get two commissioners, smaller countries get one. Member nations appoint the president and commissioners after being approved by the European Parliament. It has the right to draft legislation, is responsible for managing and implementing policy, and monitors member nations’ implementation of, and compliance with, EU law. Each commissioner is assigned a specific policy area, such as competitive policy or agricultural policy. Although commissioners are appointed by their national governments, they are expected to behave in the best interest of the EU as a whole, not in the interest of their own country. The European Commission is headquartered in Brussels, Belgium.

COURT OF JUSTICE

The Court of Justice is the court of appeals of the EU and is composed of 27 judges (one from each member nation) and eight advocates general who hold renewable six-year terms. One type of case that the Court of Justice hears is one in which a member nation is accused of not meeting its treaty obligations. Another type is one in which the commission or council is charged with failing to live up to their responsibilities under the terms of a treaty. Like the commissioners, justices are required to act in the interest of the EU as a whole, not in the interest of their own countries. The Court of Justice is located in Luxembourg.

Romania’s president (left) and prime minister point to their country on a map of Europe during a welcoming ceremony for Bulgaria and Romania to the European Union. The EU grew from a grouping of just six nations to include 27 members today. To balance divergent national interests, the EU created a unique system of government and designed the role of each EU institution to reflect this balancing act.

Source: Nicolas Bouvy/CORBIS-NY.

COURT OF AUDITORS

The Court of Auditors comprises 27 members (one from each member nation) appointed for renewable six-year terms. The court is assigned the duty of auditing the EU accounts and implementing its budget. It also aims to improve financial management in the EU and report to member nations’ citizens on the use of public funds. As such, it issues annual reports and statements on implementation of the EU budget. The court has roughly 800 auditors and additional staff to assist it in carrying out its functions. The Court of Auditors is based in Luxembourg.

European Free Trade Association (EFTA)

Certain nations in Europe were reluctant to join in the ambitious goals of the EU, fearing destructive rivalries and a loss of national sovereignty. Some of these nations did not want to be part of a common market but instead wanted the benefits of a free trade area. So in 1960 several countries banded together and formed the European Free Trade Association (EFTA) to focus on trade in industrial, not consumer, goods. Because some of the original members joined the EU and some new members joined EFTA (www.efta.int), today the group consists of only Iceland, Liechtenstein, Norway, and Switzerland (see Map 8.2).

The population of EFTA is around 12.5 million, and it has a combined GDP of around $707 billion. Despite its relatively small size, members remain committed to free trade principles and raising standards of living for their people. The EFTA and EU created the European Economic Area (EEA) to cooperate on matters such as the free movement of goods, persons, services, and capital among member nations. The two groups also cooperate in other areas, including the environment, social policy, and education.

Quick Study

1. Why did Europe initially desire to form a regional trading bloc?

2. Describe the evolution of the European Union. What are its five primary institutions?

3. What is European monetary union? Explain its importance to business in Europe.

4. Briefly describe the European Free Trade Association.

Integration in the Americas

Europe’s success at economic integration caused other nations to consider the benefits of forming their own regional trading blocs. Latin American countries began forming regional trading arrangements in the early 1960s, but they made substantial progress only in the 1980s and 1990s. North America was about three decades behind Europe in taking major steps toward economic integration. Let’s now explore the major efforts toward economic integration in North, South, and Central America, beginning with North America.

North American Free Trade Agreement (NAFTA)

There has always been a good deal of trade between Canada and the United States. Canada and the United States had in the past established trade agreements in several industrial sectors of their economies, including automotive products. In January 1989 the U.S.–Canada Free Trade Agreement went into effect. The goal was to eliminate all tariffs on bilateral trade between Canada and the United States by 1998.

Accelerating integration in Europe caused new urgency in the task of creating a North American trading bloc that included Mexico. Mexico joined what is now the World Trade Organization in 1987 and began privatizing state-owned enterprises in 1988. Talks among Canada, Mexico, and the United States in 1991 eventually resulted in the formation of the North American Free Trade Agreement (NAFTA). NAFTA (www.nafta-sec-alena.org) became effective in January 1994 and superseded the U.S.–Canada Free Trade Agreement. Today NAFTA comprises a market with 445 million consumers and a GDP of around $16 trillion (see Map 8.1).

As a free trade agreement, NAFTA seeks to eliminate all tariffs and nontariff trade barriers on goods originating from within North America. The agreement also calls for liberalized rules regarding government procurement practices, the granting of subsidies, and the imposition of countervailing duties (see Chapter 6). Other provisions deal with issues such as trade in services, intellectual property rights, and standards of health, safety, and the environment.

Local Content Requirements and Rules of Origin

While NAFTA encourages free trade among Canada, Mexico, and the United States, manufacturers and distributors must abide by local content requirements and rules of origin. Although producers and distributors rarely know the precise origin of every part or component in a piece of industrial equipment, they are responsible for determining whether a product has sufficient North American content to qualify for tariff-free status. The producer or distributor must also provide a NAFTA “certificate of origin” to an importer to claim an exemption from tariffs. Four criteria determine whether a good meets NAFTA rules of origin:

■ Goods wholly produced or obtained in the NAFTA region

■ Goods containing non-originating inputs but meeting Annex 401 origin rules (which covers regional input)

■ Goods produced in the NAFTA region wholly from originating materials

■ Unassembled goods and goods classified in the same harmonized system category as their parts that do not meet Annex 401 rules but have sufficient North American regional value content

Effects of NAFTA

Since NAFTA went into effect, trade among the three nations has increased markedly, with the greatest gains occurring between Mexico and the United States. Today the United States exports more to Mexico than it does to Britain, France, Germany, and Italy combined. In fact, in 1997 Mexico became the second largest export market for the United States for the first time ever. Since then, however, China has taken over second place and bumped Mexico to third place in terms of exports to the United States.

Overall, NAFTA helped trade among the three countries to grow from $297 billion in 1993 to nearly $930 billion in 2007.6 Since the start of NAFTA, Mexico’s exports to the United States jumped an astonishing 275 percent, to around $150 billion, and U.S. exports to Mexico grew 170 percent, to more than $111 billion.7 As these numbers suggest, the United States has developed a trade deficit with Mexico.8 Over the same period, Canada’s exports to the United States more than doubled to nearly $300 billion, while U.S. exports to Canada grew 76 percent, to $176 billion. Canada exported very little to Mexico before NAFTA, but afterward exports grew more than threefold, to nearly $2.7 billion.9

The agreement’s effect on employment and wages is not as easy to determine. The U.S. Trade Representative Office claims that exports to Mexico and Canada support 2.9 million U.S. jobs (900,000 more than in 1993), which pay 13 to 18 percent more than national averages for production workers.10 But the AFL-CIO group of unions dispute this claim; they argue that since its formation, NAFTA has cost the United States over one million jobs and job opportunities.11

In addition to claims of job losses, opponents claim that NAFTA has damaged the environment, particularly along the United States–Mexico border. Although the agreement included provisions for environmental protection, Mexico is finding it difficult to deal with the environmental impact of greater economic activity. But Mexico’s Instituto Nacional de Ecologia (www.ine.gob.mx) has developed an industrial-waste-management program, including an incentive system to encourage waste reduction and recycling. The U.S. and Mexican federal governments have invested several billion dollars in environmental protection efforts since the creation of NAFTA.12

Expansion of NAFTA

Continued ambivalence among union leaders and environmental watchdogs regarding the long-term effects of NAFTA is delaying its expansion. The pace at which NAFTA expands will depend to a large extent on whether the U.S. Congress grants successive U.S. presidents trade-promotion (“fast track”) authority. Trade-promotion authority allows a U.S. administration to engage in all necessary talks surrounding a trade deal without the official involvement of Congress. After details of the deal are decided, Congress then simply votes yes or no on the deal and cannot revise the treaty’s provisions.

But there is little doubt that integration will expand some day in the Americas. In fact, it is even possible that the North American economies will one day adopt a single currency. As trade among Canada, Mexico, and the United States strengthens, a single currency (most likely the U.S. dollar) would benefit companies in these countries with reduced exposure to changes in exchange rates. Although this would be difficult for Canada and Mexico to accept politically, in the long run we could see one currency for all of North America. Ecuador, in fact, has already “dollarized” its economy.

Central American Free Trade Agreement (CAFTA-DR)

The potential benefits from freer trade induced another trading bloc between the United States and six far smaller economies. The Central American Free Trade Agreement (CAFTA-DR) was established in 2006 between the United States and Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, and later the Dominican Republic.

Prior to its creation, CAFTA-DR nations had already traded a great deal. The Central American nations and the Dominican Republic are already the second-largest U.S. export market in Latin America behind Mexico. The CAFTA-DR nations represent a U.S. export market larger than India, Indonesia, and Russia combined. Likewise, nearly 80 percent of exports from the Central American nations and the Dominican Republic already enter the United States tariff-free. And Central American nations have already cut average tariffs from 45 percent in 1985 to around 7 percent today. The combined value of goods traded between the United States and the six other CAFTA-DR countries is around $32 billion.13

The agreement benefits the United States in several ways. CAFTA-DR aims to reduce tariff and nontariff barriers against U.S. exports to the region. It also ensures that U.S. companies are not disadvantaged by Central American nations’ trade agreements with Mexico, Canada, and other countries. The agreement also requires the Central American nations and the Dominican Republic to reform their legal and business environments to encourage competition and investment, protect intellectual property rights, and promote transparency and the rule of law. CAFTA-DR is also designed to support U.S. national security interests by advancing regional integration, peace, and stability.

A tractor pulls several trailers of picked pineapples on a farm in La Virgen, Costa Rica. Like any free trade agreement, CAFTADR has supporters and detractors. Supporters say that the agreement will encourage trade efficiency and promote investment that will bring good-paying jobs to the region. Yet others fear the agreement will benefit large U.S. companies and badly damage small businesses and farmers across Central America.

Source: John Coletti/JAI/CORBISNY.

Quick Study

1. What was the impetus for the formation of the North American Free Trade Agreement?

2. What effect has NAFTA had on trade among its member nations?

3. List the main benefits the United States obtains from the Central American Free Trade Agreement.

Andean Community (CAN)

Attempts at integration among Latin American countries had a rocky beginning. The first try, the Latin American Free Trade Association (LAFTA), was formed in 1961. The agreement first called for the creation of a free trade area by 1971 but then extended that date to 1980. Yet because of a crippling debt crisis in South America and a reluctance of member nations to do away with protectionism, the agreement was doomed to an early demise. Disappointment with LAFTA led to the creation of two other regional trading blocs—the Andean Community and the Latin American Integration Association.

Formed in 1969, the Andean Community (in Spanish Comunidad Andina de Naciones, or CAN) includes four South American countries located in the Andes mountain range—Bolivia, Colombia, Ecuador, and Peru (see Map 8.1). Today the Andean Community (www.comunidadandina.org) comprises a market of around 97 million consumers and a combined GDP of about $220 billion. The main objectives of the group include tariff reduction for trade among member nations, a common external tariff, and common policies in both transportation and certain industries. The Andean Community had the ambitious goal of establishing a common market by 1995, but delays mean that it remains a somewhat incomplete customs union.

Several factors hamper progress. Political ideology among member nations is somewhat hostile to the concept of free markets and favors a good deal of government involvement in business affairs. Also, inherent distrust among members makes lower tariffs and more open trade hard to achieve. The common market will be difficult to implement within the framework of the Andean Community. One reason is that each country has been given significant exceptions in the tariff structure that they have in place for trade with nonmember nations. Another reason is that countries continue to sign agreements with just one or two countries outside the Andean Community framework. Independent actions impair progress internally and hurt the credibility of the Andean Community with the rest of the world.

Latin American Integration Association (ALADI)

The Latin American Integration Association (ALADI) was formed in 1980 and consists of 11 countries today. Because of the failure of the first attempt at integration (LAFTA), the objectives of ALADI were scaled back significantly. The ALADI agreement calls for preferential tariff agreements (bilateral agreements) to be made between pairs of member nations that reflect the economic development of each nation. Although the agreement resulted in roughly 24 bilateral agreements and five subregional pacts, it did not accomplish a great deal of cross-border trade. Dissatisfaction with progress once again caused certain nations to form a trading bloc of their own—the Southern Common Market.

Southern Common Market (MERCOSUR)

The Southern Common Market ((in Spanish El Mercado Comun del Sur, or MERCOSUR) was established in 1988 between Argentina and Brazil, but expanded to include Paraguay and Uruguay in 1991 and Venezuela in 2006. Associate members of MERCOSUR (www.mercosur.int) include Bolivia, Chile, Colombia, Ecuador, and Peru (see Map 8.1). Mexico has been granted observer status in the bloc.

Today, MERCOSUR acts as a customs union and boasts a market of more than 266 million consumers (nearly half of Latin America’s total population) and a GDP of around $2.8 trillion. Its first years of existence were very successful, with trade among members growing nearly fourfold. MERCOSUR is progressing on trade and investment liberalization and is emerging as the most powerful trading bloc in all of Latin America. Latin America’s large consumer base and its potential as a low-cost production platform for worldwide export appeal to both the European Union and the United States.

Central America and the Caribbean

Attempts at economic integration in Central American countries and throughout the Caribbean basin have been much more modest than efforts elsewhere in the Americas. Nevertheless, let’s look at two efforts at integration in these two regions—CARICOM and CACM.

Caribbean Community and Common Market (CARICOM)

The Caribbean Community and Common Market (CARICOM) trading bloc was formed in 1973. There are 15 full members, 5 associate members, and 7 observers active in CARICOM (www.caricom.org). Although the Bahamas is a member of the Community, it does not belong to the Common Market. As a whole, CARICOM has a combined GDP of nearly $30 billion and a market of almost six million people.

In early 2000, CARICOM members signed an agreement calling for the establishment of the CARICOM Single Market, which calls for the free movement of factors of production including goods, services, capital, and labor. The main difficulty CARICOM will continue to face is that most members trade more with nonmembers than they do with one another simply because members do not have the imports each other needs.

Central American Common Market (CACM)

The Central American Common Market (CACM) was formed in 1961 to create a common market among Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua. Together, the members of CACM (www.sieca.org.gt) comprise a market of 33 million consumers and have a combined GDP of about $120 billion. The common market was never realized, however, because of a long war between El Salvador and Honduras and guerrilla conflicts in several countries. Yet renewed peace is creating more business confidence and optimism, which is driving double-digit growth in trade between members.

Furthermore, the group has not yet created a customs union. External tariffs among members range between 4 and 12 percent. The tentative nature of cooperation was obvious in 2000 when Honduras and Nicaragua slapped punitive tariffs on each other’s goods during a dispute. But officials remain positive, saying that their ultimate goal is European-style integration, closer political ties, and adoption of a single currency—probably the dollar. In fact, El Salvador adopted the U.S. dollar as its official currency in 2000, and Guatemala already uses the dollar alongside its own currency, the quetzal.

Free Trade Area of the Americas (FTAA)

A truly daunting trading bloc would be the creation of a Free Trade Area of the Americas (FTAA). The objective of the FTAA (www.alca-ftaa.org) is to create the largest free trade area on the planet, stretching from the northern tip of Alaska to the southern tip of Tierra del Fuego, in South America. The FTAA would comprise 34 nations and 830 million consumers, with Cuba being the only Western Hemisphere nation excluded from participating. The FTAA would work alongside existing trading blocs throughout the region.

The first official meeting, the 1994 Summit of the Americas, created the broad blueprint for the agreement. Nations reaffirmed their commitment to the FTAA at the Second Summit of the Americas in April 1998 and negotiations began in September 1998. The Third Summit of the Americas was held in April 2001 and met with fierce protests. The ambitious plan of the FTAA means that it will likely be many years before such an agreement would be realized.

Quick Study

1. What is the Andean Community? Identify why its progress is behind schedule.

2. Identify the members of the Southern Common Market (MERCOSUR). How has it performed?

3. Characterize economic integration efforts throughout Central America and the Caribbean.

4. What is the objective of the Free Trade Area of the Americas? What are its current prospects for success?

Integration in Asia

Efforts outside Europe and the Americas at economic and political integration have tended to be looser arrangements. Let’s take a look at important coalitions in Asia and among Pacific Rim nations—the Association of Southeast Asian Nations, the organization for Asia Pacific Economic Cooperation, and the Australian and New Zealand Closer Economic Relations Agreement.

Association of Southeast Asian Nations (ASEAN)

Indonesia, Malaysia, the Philippines, Singapore, and Thailand formed the Association of Southeast Asian Nations (ASEAN) in 1967. Brunei joined in 1984, Vietnam in 1995, Laos and Myanmar in 1997, and Cambodia in 1998 (see Map 8.1). Together, the 10 ASEAN (www.aseansec.org) countries comprise a market of about 560 million consumers and a GDP of nearly $1.1 trillion. The three main objectives of the alliance are to: (1) promote economic, cultural, and social development in the region; (2) safeguard the region’s economic and political stability; and (3) serve as a forum in which differences can be resolved fairly and peacefully.

The decision to admit Cambodia, Laos, and Myanmar was criticized by some Western nations. The concern regarding Laos and Cambodia being admitted stems from their roles in supporting the communists during the Vietnam War. The quarrel with Myanmar centers on evidence cited by the West of its continued human rights violations. Nevertheless, ASEAN felt that by adding these countries to the coalition, it could counter China’s rising strength and its resources of cheap labor and abundant raw materials.

Companies involved in Asia’s developing economies are likely to be doing business with an ASEAN member. This is even a more likely prospect as China, Japan, and South Korea accelerate their efforts to join ASEAN. China’s admission would allow the club to bridge the gap between less advanced and more advanced economies. Some key facts about ASEAN that companies should consider are contained in the Global Manager’s Briefcase titled, “The Ins and Outs of ASEAN.”

Asia Pacific Economic Cooperation (APEC)

The organization for Asia Pacific Economic Cooperation (APEC) was formed in 1989. Begun as an informal forum among 12 trading partners, APEC (www.apecsec.org.sg) now has 21 members (see Map 8.1). Together, the APEC nations account for more than 40 percent of world trade and a combined GDP of more than $19 trillion.

The stated aim of APEC is not to build another trading bloc. Instead, it desires to strengthen the multilateral trading system and expand the global economy by simplifying and liberalizing trade and investment procedures among member nations. In the long term, APEC hopes to have completely free trade and investment throughout the region by 2020.

The Record of APEC

APEC has succeeded in halving members’ tariff rates from an average of 15 percent to 7.5 percent. The early years saw the greatest progress, but liberalization received a setback when the Asian financial crisis struck in the late 1990s. APEC is at least as much a political body as it is a movement toward freer trade. After all, APEC certainly does not have the focus or the record of accomplishments of NAFTA or the EU. Nonetheless, open dialogue and attempts at cooperation should continue to encourage progress, however slow.

GLOBAL MANAGER’S BRIEFCASE: The Ins and Outs of ASEAN

Businesses unfamiliar with operating in ASEAN countries should exercise caution in their dealings. Some inescapable facts about ASEAN that warrant consideration are the following.

■ Diverse Cultures and Politics. The Philippines is a representative democracy, Brunei is an oil-rich sultanate, and Vietnam is a state-controlled communist country. Business policies and protocol must be adapted to each country.

■ Economic Competition. Many ASEAN nations are feeling the effects of China’s power to attract investment from multinationals worldwide. Whereas ASEAN members used to attract around 30 percent of foreign direct investment into Asia’s developing economies, it now attracts about half that amount.

■ Corruption and Black Markets. Bribery and black markets are common in many ASEAN countries, including Indonesia, Myanmar, the Philippines, and Vietnam. Corruption studies typically place these countries at or very near the bottom of nations surveyed.

■ Political Change and Turmoil. Several nations in the region recently elected new leaders. Indonesia in particular has gone through presidents at a fast clip recently. Companies must remain alert to shifting political winds and laws regarding trade and investment.

■ Border Disputes. Parts of Thailand’s borders with Cambodia and Laos are tested frequently. Hostilities break out sporadically between Thailand and Myanmar over border alignment and ethnic Shan rebels operating along the border.

■ Lack of Common Tariffs and Standards. Doing business in ASEAN nations can be costly. Harmonized tariffs, quality and safety standards, customs regulations, and investment rules would cut transaction costs significantly.

Further progress may create some positive benefits for people doing business in APEC nations. APEC is changing the granting of business visas so businesspeople can travel throughout the region without obtaining multiple visas. It is recommending mutual recognition agreements on professional qualifications so that engineers, for example, could practice in any APEC country, regardless of nationality. And APEC is ready to simplify and harmonize customs procedures. Eventually, businesses could use the same customs forms and manifests for all APEC economies.

Closer Economic Relations Agreement (CER)

Australia and New Zealand created a free trade agreement in 1966 that slashed tariffs and quotas 80 percent by 1980. The agreement’s success encouraged the pair to form the Closer Economic Relations (CER) Agreement in 1983 to advance free trade and further integrate their two economies (see Map 8.1).

The CER was an enormous success in that it totally eliminated tariffs and quotas between Australia and New Zealand in 1990, five years ahead of schedule. Each nation allows goods (and most services) to be sold within its borders that can be legally sold in the other country. Each nation also recognizes most professionals who are registered to practice their occupation in the other country.

Integration in the Middle East and Africa

Economic integration has not left out the Middle East and Africa, although progress there is more limited than in any other geographic region. Its limited success is due mostly to the small size of the countries involved and their relatively low level of development. The largest of these coalitions are the Gulf Cooperation Council and the Economic Community of West African States.

Gulf Cooperation Council (GCC)

Several Middle Eastern nations formed the Gulf Cooperation Council (GCC) in 1980. Members of the GCC are Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates. The primary purpose of the GCC at its formation was to cooperate with the increasingly powerful trading blocs in Europe at the time—the EU and EFTA. The GCC has evolved, however, to become as much a political entity as an economic one. Its cooperative thrust allows citizens of member countries to travel freely in the GCC without visas. It also permits citizens of one member nation to own land, property, and businesses in any other member nation without the need for local sponsors or partners.

Economic Community of West African States (ECOWAS)

The Economic Community of West African States (ECOWAS) was formed in 1975 but restarted efforts at economic integration in 1992 because of a lack of early progress. One of the most important goals of ECOWAS (www.ecowas.int) is the formation of a customs union, an eventual common market, and a monetary union. Together, the ECOWAS nations comprise a large portion of the economic activity in sub-Saharan Africa.

Progress on market integration is almost nonexistent. In fact, the value of trade occurring among ECOWAS nations is just 11 percent of the value that the trade members undertake with third parties. But ECOWAS has made progress in the free movement of people, construction of international roads, and development of international telecommunication links. Some of its main problems are due to political instability, poor governance, weak national economies, poor infrastructure, and poor economic policies.

Gwari women carry firewood on their backs in the village of Gwagwalada, which is about 20 miles from Abuja in the middle of Nigeria. A growing number of Nigerians from rural areas are beginning to cut down more trees for domestic firewood as an alternative energy following the increase of kerosene prices. Nigeria participates in the regional trading bloc known as ECOWAS to improve the lives of ordinary people, such as the women pictured here.

Source: Ceorge Esiri/Reuters/CORBIS-NY.

African Union (AU)

A group of 53 nations on the African continent joined forces in 2002 to create the African Union (AU). Heads of state of nations belonging to the Organization of African Unity paved the way for the AU (www.africa-union.org) when they signed the Sirte Declaration in 1999.

The AU is based on the vision of a united and strong Africa and on the need to build a partnership between governments and all segments of civil society to strengthen cohesion among the peoples of Africa. Its ambitious goals are to promote peace, security, and stability across Africa and to accelerate economic and political integration while addressing problems compounded by globalization. Specifically, the stated aims of the AU are to: (1) rid the continent of the remaining vestiges of colonialism and apartheid, (2) promote unity and solidarity among African states, (3) coordinate and intensify cooperation for development; (4) safeguard the sovereignty and territorial integrity of members, and (5) promote international cooperation within the framework of the United Nations.

It is too early to judge the success of the AU, but there is no shortage of opportunities on the continent for it to demonstrate its capabilities. Ethnic violence in the Darfur region of Sudan continues despite heavy involvement by the AU in solving the problem. The people of Africa have much to gain from an effective and successful African Union.

Quick Study

1. Identify the three main objectives of the Association of Southeast Asian Nations.

2. How do the goals of the Asia Pacific Economic Cooperation forum differ from those of other regional blocs?

3. What is the Gulf Cooperation Council? Identify its members.

4. List the aims of both the Economic Community of West African States and the African Union.

Bottom Line FOR BUSINESS

Regional economic integration can expand buyer selection, lower prices, increase productivity, and boost national competitiveness. Yet integration has its drawbacks and governments and independent organizations work to counter these negative effects. Let’s examine the issue of regional integration as it relates to business operations and employment.

Integration and Business Operations

Regional trade agreements are changing the landscape of the global marketplace. They are lowering trade barriers and opening up new markets for goods and services. Markets otherwise off limits because tariffs made imported products too expensive can become attractive after tariffs are lifted. But trade agreements can also be double-edged swords for companies. Not only do they allow domestic companies to seek new markets abroad, they also let competitors from other nations enter the domestic market. Such mobility increases competition in every market that participates in such an agreement.

Despite increased competition that often accompanies regional integration, there can be economic benefits, such as those provided by a single currency. Companies in the European Union clearly benefit from its common currency, the euro. First, charges for converting from one member nation’s currency to that of another can be avoided. Second, business owners need not worry about potential losses due to shifting exchange rates on cross-border deals. Not having to cover such costs and risks frees up capital for greater investment. Third, the euro makes prices between markets more transparent, making it more difficult to charge different prices in different markets. This helps companies compare prices among suppliers of a raw material, intermediate product, or service.

Another benefit for companies is lower or no tariffs. This allows a multinational to reduce its number of factories that supply a region and thereby reap economies of scale benefits. This is possible because a company can produce in one location, then ship products throughout the low-tariff region at little additional cost. This lowers costs and increases productivity.

One potential drawback of regional integration is that lower tariffs between members of a trading bloc can result in trade diversion. This can increase trade with less efficient producers within the trading bloc and reduce trade with more efficient nonmember producers. Unless there is other internal competition for the producer’s good or service, buyers will likely pay more after trade diversion.

Integration and Employment

Perhaps most controversial is the impact of regional integration on jobs. Companies can affect the job environment by contributing to dislocations in labor markets. The nation that supplies a particular good or service within a trading bloc is likely to be the most efficient producer. When that product is labor intensive, the cost of labor in that market is likely to be quite low. Competitors in other nations may shift production to that relatively lower-wage nation within the trading bloc to remain competitive. This can mean lost jobs in the relatively higher-wage nation.

Yet job dislocation can be an opportunity for workers to upgrade their skills and gain more advanced training. This can help nations increase their competitiveness because a more educated and skilled workforce attracts higher-paying jobs. An opportunity for a nation to improve its competitiveness, however, is little consolation to people finding themselves suddenly out of work.

Although there are drawbacks to integration, there are potential gains from increased trade such as raising living standards. Regional economic integration efforts are likely to continue rolling back barriers to international trade and investment because of their potential benefits.

Chapter Summary

1. Define regional economic integration and identify its five levels.

■ The process whereby countries in a geographic region cooperate with one another to reduce or eliminate barriers to the international flow of products, people, or capital is called regional economic integration.

■ Free trade area: countries seek to remove all barriers to trade among themselves, but each country determines its own barriers against non-members.

■ Customs union: countries remove all barriers to trade among themselves but erect a common trade policy against nonmembers.

■ Common market: countries remove all barriers to trade and the movement of labor and capital among themselves but erect a common trade policy against nonmembers.

■ Economic union: countries remove barriers to trade and the movement of labor and capital, erect a common trade policy against nonmembers, and coordinate their economic policies.

■ Political union: countries coordinate aspects of their economic and political systems.

2. Discuss the benefits and drawbacks of regional economic integration.

■ Trade creation is the increase in trade that results from regional economic integration, which can expand buyer selection, lower prices, increase productivity, and boost national competitiveness.

■ Smaller, regional groups of nations can find it easier to reduce trade barriers than can larger groups.

■ Nations can have more say when negotiating with other countries or organizations, reduce the potential for military conflict, and expand employment opportunities.

■ Trade diversion is the diversion of trade away from nations not belonging to a trading bloc and toward member nations; it can result in increased trade with a less-efficient producer within the trading bloc.

3. Describe regional integration in Europe and its pattern of enlargement.

■ The European Coal and Steel Community was formed in 1951 to remove trade barriers for coal, iron, steel, and scrap metal among the member nations.

■ Following several waves of expansion, broadenings of its scope, and name changes, the community is now known as the European Union (EU) and has 27 members.

■ Five main institutions of the EU are the European Parliament, European Commission, Council of the European Union, Court of Justice, and Court of Auditors.

■ The EU single currency has been adopted by 16 member nations, which benefit from elimination of exchange-rate risk and currency conversion costs within the euro zone.

■ The European Free Trade Association (EFTA) has four members and was created to focus on trade in industrial goods.

4. Discuss regional integration in the Americas and analyze its future prospects.

■ The North American Free Trade Agreement (NAFTA) began in 1994 among Canada, Mexico, and the United States; it seeks to eliminate all tariffs and nontariff trade barriers on goods originating from within North America.

■ The Central American Free Trade Agreement (CAFTA-DR) was established in 2006 between the United States and six Central American nations to boost the efficiency of trade.

■ The Andean Community was formed in 1969 and calls for tariff reduction for trade among member nations, a common external tariff, and common policies in transportation and certain industries.

■ The Latin American Integration Association (ALADI) formed in 1980 between Mexico and 10 South American nations has had little impact on cross-border trade.

■ The Southern Common Market (MERCOSUR) established in 1988 acts as a customs union.

■ The Caribbean Community and Common Market (CARICOM) trading bloc was formed in 1973 and the Central American Common Market (CACM) was formed in 1961.

5. Characterize regional integration in Asia and how it differs from integration elsewhere.

■ The Association of Southeast Asian Nations (ASEAN) formed in 1967 and seeks to: (1) promote economic, cultural, and social development; (2) safeguard economic and political stability; and (3) serve as a forum to resolve differences peacefully.

■ The organization for Asia Pacific Economic Cooperation (APEC) was formed in 1989 and strives to strengthen the multilateral trading system and expand the global economy by simplifying and liberalizing trade and investment procedures.

■ The Closer Economic Relations (CER) agreement in 1983 between Australia and New Zealand totally eliminated tariffs and quotas between the two economies.

6. Describe regional integration in the Middle East and Africa and explain the slow progress.

■ Several Middle Eastern nations in 1980 formed the Gulf Cooperation Council (GCC), which allows citizens of member countries to travel freely without visas and to own properties in other member nations without the need for local sponsors or partners.

■ The Economic Community of West African States (ECOWAS) formed in 1975, with a major goal being formation of a customs union and an eventual common market.

■ The African Union (AU) was started in 2002 among 53 nations to promote peace, security, and stability and to accelerate economic and political integration across Africa.

Talk It Over

1. Proliferation and growth of regional trading blocs will likely continue into the foreseeable future. At what point do you think the integration process will stop (if ever)? Explain your answer.

2. Some people believe that the rise of regional trading blocs threatens free trade progress made by the World Trade Organization (WTO). Do you agree? Why or why not?

3. Certain groups of countries, particularly in Africa, are far less economically developed than other regions, such as Europe and North America. What sort of integration arrangement do you think developed countries could create with less developed nations to improve living standards? Be as specific as you can.

Teaming Up

1. Debate Project. In this project, two groups of four students each will debate the merits of extending NAFTA to more advanced levels of economic (and even political) integration. After the first student from each side has spoken, the second student will question the opposing side’s arguments, looking for holes and inconsistencies. The third student will attempt to answer these arguments. The fourth student will present a summary of each side’s arguments. Finally, the class will vote to determine which team has offered the more compelling argument.

2. Market Entry Strategy Project. This exercise corresponds to the MESP online simulation. For the country your team is researching, identify any regional integration efforts in which the nation may be participating. What other nations are members? What economic, political, and social objectives drive integration? So far, what have been the positive and negative results of integration? How are international companies (domestic and nondomestic) coping? Explain why companies’ coping strategies are, or are not, succeeding. Integrate your findings into your completed MESP report.

Key Terms

common market (p. 219)

customs union (p. 219)

economic union (p. 219)

European monetary union (p. 227)

free-trade area (p. 218)

political union (p. 219)

regional economic integration (regionalism) (p. 218)

trade creation (p. 221)

trade diversion (p. 222)

Take It to the Web

1. Video Report. Visit this book’s channel on YouTube (YouTube.com/MyIBvideos). Click on “Playlists” near the top of the page and click on the set of videos labeled “Ch 08: Regional Economic Integration.” Watch one video from the list and summarize it in a half-page report. Reflecting on the contents of this chapter, which aspects of regional integration can you identify in the video? How might a company engaged in international business act on the information contained in the video?

2. Web Site Report. Visit the official Web site of the FTAA (www.alca-ftaa.org). What are the stated reasons why governments across the Americas are pushing for the free trade area? Why do some groups protest implementation of the FTAA? Do you think the FTAA would help lift living standards in small countries (such as Ecuador or Nicaragua) or be a boon only for the largest nations such as Canada and the United States?

Small companies typically have difficulty competing against large multinationals when their governments take part in regional trading blocs. What could governments do to help their small companies compete in such blocs? Do you think subregional trading blocs can help small nations strengthen their negotiating positions against large nations? Do you think that very small nations should even participate in regional trade agreements with very large nations? Why or why not?

Do you think subregional or regional trade agreements cause instability on a subregional, regional, or global scale, or do you believe they foster cooperation? After all you’ve read in this chapter about regional trade agreements, what is your assessment of their value? Should their progress continue or be rolled back?

Ethical Challenges

1. You are a member of the U.S. Congress from the state of Florida. Many constituents in your district have complained that NAFTA is unfair to the economies of the Caribbean islands where they have family. Some experts argue that the term free trade agreement in describing NAFTA or the European Union is misleading. They say these agreements are really “preferential trade agreements” that offer free trade only to members and relative protection against nonmembers. You worry that this is the case for Caribbean nations excluded from NAFTA. Some argue that from apparel factories in Jamaica to sugar cane fields in Trinidad, NAFTA has cost jobs, market share, and income for the vulnerable island nations of the region as jobs have migrated to Mexico. Given the impact on nonmember nations, do you think such trade agreements are ethical? Why do you think islands in the Caribbean basin were not invited to be part of NAFTA? As a member of the U.S. Congress, what arguments do you make for including the Caribbean in the expansion of NAFTA?

2. You are a world-renowned economist hired by Ecuador’s government to advise it on its current involvement with the Andean Community. The Andean Community is a customs union that consists of four nations in South America: Bolivia, Colombia, Ecuador, and Peru. Member nations are permitted free access to one another’s markets, with nonmember nations required to negotiate tariffs with community members. Because Ecuador recently adopted the U.S. dollar as its currency, some believe that the other Andean members are perhaps holding Ecuador back from more rapid development. As the consultant, what pros and cons do you present to the Ecuadorean government for breaking free from the Andean Community?

3. You are the economic adviser to the president of Mexico. Labor unions and environmentalists in the United States aren’t the only ones speaking out against NAFTA. There continues to be opposition in Mexico by those complaining of a loss of national sovereignty and who feel that the income gap between the two countries will never be narrowed. Average hourly wages on the U.S. side of the border can be six times that on the Mexican side. Mexican critics fear that their entire country will be subsumed by companies from the United States, which do not contribute to Mexico’s higher standard of living, but who instead use Mexico as a low-cost assembly site while keeping high-paying, high-skilled jobs at home. Do you think that there is a way for trade agreements to help close the economic gap between poor and wealthy partners? Or will the interests of poorer nations always be subordinate to wealthier countries within regional trading blocs? As economic adviser, how do you suggest the president protect Mexico’s workforce?

PRACTICING INTERNATIONAL MANAGEMENT CASE: Global Trade Deficit in Food Safety

Today, U.S. citizens trudging through a freezing Minnesota winter can indulge their cravings for summer-fresh raspberries. Europeans who are thousands of miles away from North America can put Mexican mangoes in their breakfast cereal. Japanese shoppers can buy radishes that were grown from seeds cultivated in Oregon. Globalization of the food industry, falling trade barriers, and the formation of regional trading blocs make it possible for people to choose from produce grown all over the world. Unfortunately, these forces have also made it more likely that consumers will contract illnesses from food-borne pathogens.

In recent years several outbreaks linked to the burgeoning global trade in produce have made headlines. One serious case occurred when 2,300 people were victims of a parasite called cyclospora that had hitched a ride on raspberries grown in Guatemala. Outbreaks of hepatitis A and salmonella from tainted strawberries and alfalfa sprouts, respectively, have also sickened consumers. The outbreak of severe acute respiratory syndrome (SARS) killed hundreds and sickened hundreds more, mainly in China, Singapore, and Canada. Some scientists believe a fair amount of those cases might actually have been cases of H5N1, also called Avian (bird) flu. Avian flu is particularly virulent and can cross barriers between species. It is most likely transmitted through the handling of poultry and poor sanitation.

Although health officials say that there is no evidence that imports are inherently more dangerous, they do cite several reasons for concern. For one thing, produce is often imported from less advanced countries where food hygiene and sanitation are lacking in important ways. Also, some microbes that cause no damage in their home country can be deadly when introduced in other countries. Finally, the longer the journey from farm to table, the greater is the chance of contamination. Just consider the journey taken by the salmonella-ridden alfalfa sprouts: The seeds for the sprouts were bought from Uganda and Pakistan, among other nations, shipped through the Netherlands, flown into New York, trucked to retailers all across the United States, and then purchased by consumers.

Incidences of food contamination show no signs of abating. Since the passage of NAFTA, cross-border trade in food among Canada, Mexico, and the United States has skyrocketed. Meanwhile, federal inspections of U.S. imports by the Food and Drug Administration have declined. Increasing imports has strained the U.S. food-safety system, which was built 100 years ago for a country contained within its own borders.

Although it isn’t feasible for the United States to plant FDA inspectors in every country, options are available. The U.S. Congress could further tighten the ban on importing fruit and vegetables from countries that fail to meet expanded U.S. food-safety standards. Better inspections could be performed of farming methods and government safety systems in other countries. Countries that blocked the new inspections could be forbidden to sell fruit and vegetables in the United States. The World Health Organization (WHO) also proposes new policies for food safety, such as introducing food irradiation and other technologies. The WHO believes the most critical intervention in preventing food-borne diseases is by promoting good manufacturing practices and educating retailers and consumers on appropriate food-handling.

Thinking Globally

1. How do you think countries with a high volume of exports to the United States, such as Mexico, would respond to stricter food-safety rules? Do you think such measures are a good way to stem the tide of food-related illnesses? Why or why not?

2. Sue Doneth of Marshall, Michigan, is a mother of one of the schoolchildren who was exposed to the hepatitis A virus after eating tainted frozen strawberry desserts. Speaking before Congress she said, “We are forcing consumers to trade the health and safety of their families for free trade. That is not fair trade. NAFTA is not a trade issue: it is a safety issue.” Do you think food-safety regulations should be built into an extension of NAFTA? Why or why not? What are the benefits and drawbacks of putting food-safety regulations into international trade pacts?

3. The lack of harmonized food-safety practices and standards is just one of the challenges faced by the food industry as it becomes more global. What other challenges face the food industry in an era of economic integration and opening markets?

Source: “A Game of Chicken,” The Economist (www.economist.com), June 26, 2008; “Food Safety and Foodborne Illness,” World Health Organization Fact Sheet No. 237, March 2007; “Preparing for a Pandemic,” Harvard Business Review Special Report, May 2006, pp. 20–40; “The Aves, and Ave Nots,” The Economist (www.economist.com), February 23, 2006.

(Wild 216)

Wild, John J., Kenneth L. Wild & Jerry C.Y. Han. International Business: The Challenges of Globalization, 5th Edition. Pearson Learning Solutions. .

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GOGGLE IN CHINA

“It’s an imperfect world, we had to make an imperfect choice.”

Elliot Schrage, Google vice president for global communications and public affairs.

INTRODUCTION

Using servers located in the United States, Google began offering a Chinese-language version of

Google.com

in

2

000. The site, however, was frequently unavailable or slow because of censoring by the Chinese government. Google obtained a significant share of searches in China but lagged behind market leader

Baidu.com

. To achieve commercial success, Google concluded that it was imperative to host a website from within China. Given its motto, “Don’t Be Evil,” Google had to decide whether to operate from within China or to continue to rely on Google.com. If it decided to establish operations in China, the company had to decide how to deal with the censorship imposed by the Chinese government.

As a result of an extensive debate within the company, cofounder Serge Brin explained their decision: “We gradually came to the realization that we were hurting not just ourselves but the Chinese people.”1 Google decided to establish the site Google.cn, but without features that allowed users to provide content. To avoid putting individuals in jeopardy of being arrested, Google offered neither e-mail nor the ability to create blogs, since user-generated material could be seized by the Chinese government. This allowed Google to avoid putting individuals in jeopardy of being arrested. Because it would be required by Chinese law to censor search results associated with sensitive issues, Google decided to place a brief notice at the bottom of a search page when material had been censored, as it did in other countries such as France and Germany which banned the sale of Nazi items. Google planned to exercise self-censorship and developed a list of sensitive items by consulting with third parties and by studying the results of the Chinese government’s Internet filtering. Senior policy counsel Andrew McLaughlin stated, “Google is mindful that governments around the world impose restriction on access to information. In order to operate from China, we have removed some content from the search results available on Google.cn, in response to local law, regulation or policy. While removing search results is

1 San Jose Mercury News, March

3

, 2006.

Professor David P. Baron prepared this case from public sources as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation.

Copyright © 2006 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. To order copies or request permission to reproduce materials, e-mail the Case Writing Office at: cwo@gsb.stanfordedu or write: Case Writing Office, Stanford Graduate School of Business, 51

8

Memorial Way, Stanford University, Stanford, CA 94305-5015. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means — electronic, mechanical, photocopying, recording, or otherwise — without the permission of the Stanford Graduate School of Business.

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Google in China P-54
p. 2inconsistent with Google’s mission, providing no information (or a heavily degraded user experience that amounts to no information) is more inconsistent with our mission.”2

Within a month of offering Google.cn, Google came under criticism from two government-run newspapers in China. The Beijing News criticized the company for not doing enough to block “harmful information.” Referring to Google’s practice of informing users when search results had been censored, the China Business Times wrote in an editorial, “Is it necessary for an enterprise that is operating within the borders of China to constantly tell your customers you are following domestic law?” Both publications claimed that Google was operating as an Internet content provider without a proper license.3

Reporters Without Borders, a Paris-based organization campaigning for freedom of expression, called the establishment of Google.cn “a black day for freedom of expression in China.” It stated:

The firm defends the rights of U.S. Internet users before the U.S. government, but fails to defend its Chinese users against theirs. United States companies are now bending to the same censorship rules as their Chinese competitors, but they continue to justify themselves by saying their presence has a long-term benefit. Yet the Internet in China is becoming more and more isolated from the outside world.4

Other activists demanded that Google publish its censorship blacklist in the United States. Internet Censorship in China

According to the U.S. State Department, companies offering Internet services were “pressured to sign the Chinese government’s ‘Public Pledge on Self-Discipline for the Chinese Internet Industry.” Under the agreement, they promised not to disseminate information that “breaks laws or spreads superstition or obscenity” or that “may jeopardize state security and disrupt social stability.”5 Providing Internet services required a license which in turn required not circulating information that “damages the honor or interests of the state” or “disturbs the public order or destroys public stability. ,,6

Censorship in China involved self-regulation by Internet companies as well as government actions. The government did not provide a list of objectionable subjects—instead companies inferred which topics were out of bounds by observing what the government censors removed. The State Council Information Office also convened weekly meetings with Internet service providers. An American executive explained, “It’s known informally as the ‘wind-blowing meeting’—in other words, which way is the wind blowing. They say: ‘There’s this party

2 The New York Times, January 25, 2006.

3 Washington Post, February 22,2006. Google shared a license with a Chinese company

Ganji.com

. This practice was common among foreign Internet firms.

4 The New York Times, January 25, 2006, op. cit.

5 BusinessWeek, January 23, 2006.

6 Clive Thompson, “Google’s China Problem (And China’s Google Problem),” The New York Times Magazine, April 23,2006.

2
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Google in China P-54 p.3

conference going on this week. There are some foreign dignitaries here on this trip.'”

7

Xin Ye, a founder of

Sohu.com

, a Chinese value-added Internet services firm, was asked how hard it was to navigate the censorship system. He said, “I’ll tell you this, it’s not more hard than dealing with Sarbanes and Oxley.”8

Zhao Jing, a political blogger in China, “explained that he knew where the government drew the line. ‘If you talk every day online and criticize the government, they don’t care. Because it’s

just talk. But if you organize even if it’s just three or four people—that’s what they crack
down on. It’s not speech; it’s organizing.'”9 In December 2005 Zhao called for a boycott of a newspaper because it had fired an editor. In response, the Chinese government asked Microsoft’s MSN to close Zhao’s blog and Microsoft complied.10 Brooke Richardson of MSN said, “We only remove content if the order comes from the appropriate regulatory authority.”11

Yahoo and MSN, as well as other sites, complied with Chinese law as well as exercising self-censorship.12 Robin Li, chairman of the Chinese search company Baidu.com, said, “We are trying to provide as much information as possible. But we need to obey Chinese law.”13 Baidu had reached an agreement that allowed the Chinese government to oversee its website and in exchange it avoided the disruptions of service and strict operating rules that plagued foreign Internet companies.14

In 2004 Yahoo provided information to the Chinese government that led to the arrest of the journalist Shi Tao. Shi was subsequently sentenced to 10 years in prison for releasing state secrets on a foreign website. Shi had provided information by e-mail about a Communist party decision. Yahoo general counsel Michael Callahan said the company regretted that action but had no alternative since its Chinese employees could have been arrested on criminal charges for not providing the information to the government. Callahan also said that Chinese law prohibited disclosing how many times the company had provided information on users to the government.15

The agencies that regulated the Internet employed 30,000 people who monitored e-mail, websites, blogs, and chat rooms. Internet cafes were required to use software that stored data on all users. Anyone establishing a blog was required to register with the government. Telephone companies were required to incorporate software that censored text messaging.

A key part of the censorship system was the control by the government of all gateways into China. This allowed the censors to block undesired content on websites and restrict Internet search results. Referred to as the Great Firewall of China, routers at China’s nine Internet

7 Clive Thompson, “Google’s China Problem (and China’s Google Problem),” The New York Times Magazine, April 23, 2006.

8 ibid.

9 Ibid.

113 Microsoft’s blogging servers are located in the United States. Clive Thompson, “Google’s China Problem (and China’s Google Problem),” The New York Times Magazine, April 23, 2006.

11

Business Week, January 23, 2006, op. cit.

12 Yahoo lagged behind other Internet companies in China and in 2005 invested $1 billion for a 40 percent interest in the Chinese company

Alibaba.com

. Yahoo then turned operating control of Yahoo China over to Alibaba.com.

13 Business Week, January 23, 2006, op. cit. Baidu had a 46.5 percent share of Internet searches in China; Google was second with 26.9 percent. Google had a small stake in Baidu but sold it in June 2006.

14 The New York Times, September 17, 2006.

15 San Jose Mercury News, February 20,2006.

3
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Googde
in China P-54
p. 4gateways examined messages and search requests and were programmed to block or censor information. It was this firewall that made accessing Google.com slow or at times unavailable from China.

China also blocked certain news sites including the BBC News, Voice of America, Amnesty International, Human Rights in China, and Wikipedia, in addition to any information on the spiritual movement Falun Gong which was banned in China. Search results on terms such as Tiananmen Massacre, Tibet, and Dalai Lama were also suppressed.

Censorship was also practiced elsewhere, including at universities. University computer systems and bulletin boards banned certain subjects such as politics, and student monitors directed chatroom conversations away from sensitive subjects to those that helped build a “harmonious society.” Student monitor Hu Yingying said, “We don’t control things, but we don’t want bad or wrong things to appear on the websites. According to our social and educational systems, we should judge what is right and wrong. And as I’m a student cadre, I need to play a pioneering role among other students, to express my opinion, to make stronger my belief in Communism.” Another student, Tang Guochao, said, “A bulletin board is like a family, and in a family, I want my room to be clean and well-lighted, without dirty or dangerous things in it.”16

The censorship system was in a technology race with those attempting to evade it. Bill Xia, who arrived in the United States as a student in the 1990s and subsequently founded Dynamic Internet Technology (DIT), developed software called FreeGate that masks the websites that users visit.17 Companies such as DIT and UltraReach also used software to create new websites to elude the Chinese censors.1g For Voice of America, for example, DIT established uncensored proxy sites that directed users to the real site. DIT and UltraReach sent millions of e-mails a day alerting users to the uncensored sites. The Chinese censors worked to shut down the proxy sites and were often able to close the sites within a few days. The companies then would develop new software to evade the censors.

The Chinese government sought to justify its practices. Liu Zhengrong, deputy director of the State Council Information Office’s Internet Affairs Bureau, argued that China’s efforts to keep out “harmful” and “illegal” information were similar to those in Western countries. He said, “If you study the main international practices in this regard you will find that China is basically in compliance. The main purposes and methods of implementing our laws are basically the same.”19 He observed that the New York Times and Washington Post websites deleted content that was illegal or in bad taste. He added, “Our practices are completely consistent with international ~ractices.” He continued, “Many of our practices we got from studying the U.S. experience.”2 He noted, “It is clear that any country’s legal authorities closely monitor the spread of illegal information. We have noted that the U.S. is doing a good job on this front.”21

16 The New York Times, May 9, 2006.

17 Human Rights in China and Radio Free Asia were also DIT clients.

1s Both DIT and UltraReach were said to be connected to the Falun Gong movement. San Jose Mercury News, July 2, 2006.

19 The New York Times, February, 15, 2006.

20 Wall Street Journal, February 15, 2006.

21 The New York Times, February, 15, 2006, op. cit.

4
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Google in China P-54 p. 5

Liu commented, “No one in China has been arrested simply because he or she said something on the Internet.”22 Reporters Without Borders claimed that 62 Chinese were in prison for “Posting on the Internet articles and criticism of the authorities.”23

Despite the international criticism of Internet censorship in China, it was not clear that the Chinese people were concerned. Kai-Fu Lee, who headed operations for Google in China said, “People are actually quite free to talk about [democracy and human rights in China]. I don’t think they care that much. I think people would say: `Hey, U.S. democracy, that’s a good form of government. Chinese government, good and stable, that’s a good form of government. Whatever, as long as I get to go to my favorite website, see my friends, live happily.'”2a

Ji Xiaoyin, a junior at Shanghai Normal University, commented, “I don’t think anybody can possibly control any information in the Internet. If you’re not allowed to talk here you just go to another place to talk, and there are countless places for your opinions. It’s easy to bypass the firewalls, and anybody who spends a little time researching it can figure it out.”25

Google’s Perspective

In response to criticism that Google should lobby the Chinese government to change its censorship system, CEO Eric E. Schmidt said during a visit to China, “I think it’s arrogant for us to walk into a country where we are just beginning operations and tell that country how to run itself.” He also explained, “We had a choice to enter the country and follow the law. Or we had a choice not to enter the country.” Earlier he had said, “We believe the decision that we made to follow the law in China was absolutely the right one.”26

Speaking at an ethics conference on Internet search at Santa Clara University, Peter Norvig, director of research at Google, commented on the decision not to offer services such as e-mail and blogging in China. “We didn’t want to be in a position to hand over users’ information. … We thought that was just too dangerous….We thought it was very important to keep our users out of jail.”27

Norvig justified Google’s policies in China. “Yes, it’s important to get information about democracy and Falun Gong. They also want to know about outbreaks of bird flu. We thought it was more im~ortant to give them this information that they can use even if we have to compromise.” s

Google continued to debate internally whether and how it should operate in China. It also hoped for guidance from the U.S. government and the industry. Norvig said, “We feel that the U.S. government can stand up and make stronger laws, and we feel that corporate America can get together and have stronger principles. We’re supporting efforts on both those fronts. We feel we can’t do it alone.”29

22 San Jose Mercury News, February 20, 2006, op. cit.

23 San Jose Mercury News, July 2, 2006. 2~ Clive Thompson, op. cit.

25 The New York Times, May 9, 2006, op. cit.

26 The New York Times, April 13, 2006.

27 San Jose Mercury News, March 1, 2006, and March 3, 2006, op. cit.

2s San Jose Mercury News, March 1, 2006, op. cit. 29 San Jose Mercury News, March 1, 2006, op. cit.

5
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Google in China P-54
p. 6Norvig disclosed that Google was not keeping search logs in China. “They don’t have personally identifiable information but they do have IP addresses that are potentially identifiable with an individual.”30 That information was kept in the United States, and China could request that information through the U.S. State Department.

Political Pressure in the United States

In advance of congressional hearings on China and censorship, the State Department announced the creation of a Global Internet Task Force to decrease censorship and encourage change in other countries. Paula Dobriansky, undersecretary of state for democracy, human rights, and labor, said, “The Internet, especially, can be a liberating force. Topics once politically taboo can become freely discussed, and people can communicate anonymously. We must ensure it does not become a tool of repression.”31

Representative Chris Smith (R-NJ), chairman of the House Subcommittee on Africa, Global Human Rights, and International Operations, introduced the Global Internet Freedom Act that would impose restrictions on U.S. companies operating in China. It included a code of conduct, requiring that e-mail servers be located outside the country, and licensing requirements for the export of technologies that could be used for censorship. Smith held a hearing in which Cisco Systems, Google, Microsoft, and Yahoo testified and were grilled by subcommittee members. Commenting on China’s sophisticated censorship system, Smith said, “It’s an active partnership with both the disinformation campaign and …, and the secret police in China are among the most brutal on the planet. I don’t know if these companies understand that or they’re naive about it, whether they’re witting or unwitting. But it’s been a tragic collaboration. There are people in China being tortured courtesy of these corporations.”32 The bill was passed by the subcommittee and was sent to full committee for consideration.

Representative Tom Lantos (D-CA), leader of the Congressional Human Rights Caucus and a survivor of the Holocaust, said, “These captains of industry should have been developing new technologies to bypass the sickening censorship of government and repugnant barriers to the Internet. Instead, they enthusiastically volunteered for the censorship brigade.”33

In congressional testimony Elliot Schrage, vice president of global communications and public affairs at Google, explained that China was an important market for the company. He said, “It would be disingenuous to say that we don’t care about that because, of course, we do. We are a business with stockholders, and we want to prosper and grow in a highly competitive world. At the same time, acting ethically is a core value for our company, and an integral part of our business culture.”3a

30 San Jose Mercury News, March 3, 2006, op. cit.

31 San Jose Mercury News, February 15, 2006, op. cit.

32 Ibid.

33 San Jose Mercury News, February 19, 2006. 3a Wall Street Journal, March 10, 2006.

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Google in China P-54 p. ~

Earlier in 2006 Google had refused to comply with a request from the U.S. government to provide information on Internet search requests.35 The government had asked Google for a random sample of 1 million web addresses and a week’s search requests with any information that could identify the user removed. The information was to be used for a study to show that Internet filters were not sufficient to prevent children from accessing pornographic websites. The Department of Justice sought the information to help revive the 1998 Child Online Protection Act that had been blocked by the Supreme Court and sent to the Court of Appeals for reconsideration. Google strongly objected to the request on privacy grounds and refused to provide the information. The Department of Justice then took Google to court to force it to provide the information. In the court hearing the government substantially scaled back its request, and the judge ordered Google to provide 50,000 random web addresses. The judge also ruled that providing the requested 5,000 random search queries could harm Google through a loss of goodwill among its users.36

In June Brin commented on the criticism Google had received. He said, “We felt that perhaps we could compromise our principles but provide ultimately more information for the Chinese and be a more effective service and perhaps make more of a difference. … Perhaps now the principled approach makes more sense.”37

In July Amnesty International launched a campaign against Internet oppression, mentioning Sun Microsystems, Nortel, Cisco, Yahoo, Google, and Microsoft. Amnesty stated, “Internet companies often claim to be ethically responsible—these pledges will highlight how their cooperation in repression risks making them complicit in human rights abuses and damages their credibility.”38

35 The government also sought similar data from AOL, Microsoft’s MSN, and Yahoo, all of which complied with the request.

36 The judge also stated that the search queries could be within the scope of a subpoena. San Francisco Chronicle, March 18, 2006.

37 San Jose Mercury News, June 7, 2006.

38 Amnesty International, press release, July 20, 2006,

www.amnesty.org

.

7
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Google in China P-54
p. 8Preparation questions:

1. What principles are relevant for Google’s decision to enter China? Is censorship consistent with Google’s core values? Should compromises be made?

2. Why does the Chinese government censor information so aggressively?

3. Should Google have entered China?

4. Given that Google decided to enter China, should it have offered e-mail and hosted blogs? Should it have restricted its offerings more than it actually did?

5. Are Google’s practices sufficient? What else should it do?

6. Should Google lobby the Chinese government to change its censorship policies?

7. Should Google lobby the U.S. government to develop a policy to guide U.S. Internet companies in China?

8
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