Economics Evaluate Explanations Offered Economics of Mnes,

Economics

Evaluate explanations offered

Economics of MNEs, China and Exchange Rates

Evaluate the various explanations that have been offered for the existence of the multinational enterprise.

China is a notoriously difficult place to do business. Explain what makes the business environment so challenging and explain the strategies a firm may use in order to overcome those challenges.

Explain how exchange rates are determined in a floating exchange rate system and identify the key causes of exchange rate movements.

Evaluate the various explanations that have been offered for the existence of the multinational enterprise.

A multinational enterprise is one which has a presence in terms of an office in more than one country, even if it does not employ itself in manufacturing in the country. As far as the explanations regarding the existence of MNEs are concerned, there are various that have been employed as the concept of multinational enterprises has evolved from what it was before.

One such theory is the trade theory that is generally the argument of the economists who insist that MNEs are a source of foreign direct investment and were a long-term capital investment that led to inflow of funds in the economy. These are seen as a form of capital inflow following when there was a difference in interest rates and yields of return which enabled an investment friendly climate.

However there are drawbacks with this theory and economists such as Steven Hymer have addressed the fact that real interests rates were not the reason behind the exponential growth of MNEs as there seemed to be no correlation between FDI growth and MNEs. Moreover interest rates are subject to fluctuations as are rates of returns which essentially do not explain the rationale behind investment in foreign countries. Again as banks are in a better position to predict these and invest, why would banks not invest their funds and manage their investment portfolios in a manner that would maximize these returns. Another factor to do with the trade theory is that interest rates can be easily maneuvered by countries, and in some cases can be increased artificially causing a sudden loss in value if they are decreased. Therefore this volatility inherent in basing long-term investment judgments purely on short-term interest rate returns defeats logical decision making by firms who are looking for a continuous business presence in a country. Lastly, interest rate differentials mainly induce short terms investments in capital stock, referred to as hot money. This money is generally fluid, and flows from one country to the other when there are interest rate fluctuations. (Hennart, 2000)

Steven Hymer, who was the critic of the trade theory, argued that MNEs were mainly a form for firms to reduce competition in the local markets and to seek revenue streams abroad where conditions were more conducive. He argued that in case of local markets where barriers to entry were high and typically created to sustain monopolies, competing firms looked for avenues elsewhere where they could locate. Moreover he postulated that firms were looking to internalize 'pecuniary externalities'. The term pecuniary externalities refer to the increase in prices of goods due to a rise in demand caused by external factors. Therefore where these externalities exist, firms move in to take advantage and that was the reason for the existence of MNEs.

It can be said that Hymer's arguments were correct, but were limited. Decreasing competition in the local market is not the only reason why firms would look to locate abroad. Other reasons include the fact that the companies might think that another market was more feasible for their venture or they might find a good window of opportunity in order to develop their markets.

Yet another theory that has been forwarded by different experts at different times is that of transaction costs theory. This proposes that markets are imperfect and that agents for firms work under a constraint of bounded rationality which indicates that they have imperfect information. Therefore in order to overcome this weakness they indulge into transactions with other companies which are known to have better knowledge in some issues. In order for this exchange of information to happen, there will be price charged by the companies who are experts. The application of this for MNEs is that firms might be looking to maximize efficiencies and for this might have to collaborate with partners located in a different part of the world. To negotiate a deal with them and to use their expertise for their benefit these firms will have to look at transactions which will have costs. In order to meet these costs and in order to turn them into revenue streams acquisitions of specialist companies or joint ventures and other forms of international transactions occur leading to the existence of MNEs.

The shortfall in this approach is that it only looks at the increasing efficiency motive in order to reduce costs. In fact some companies might be looking at diversification or market development for their line of products warranting expansion overseas.

Other theories and arguments include the fact that MNEs exist to allow for tax savings, or they might see a large potential market for something that has reached maturity or is declining in their home countries. Additionally they might be looking for new ways to elongate their product life cycle among other motives. Another reason, especially for MNEs belonging to developed countries is that as their populations are aging and labor in these countries is expensive, MNEs expand abroad in search for better factor prices as well as a large market with low rates of penetration. Here these MNEs can easily apply their learning from their experiences in more mature markets and compete extensively and easily with local firms.

As a closing comment on this aspect of MNEs: globalization and the widespread use of the internet have enabled companies to go worldwide even before they are locally known. Companies that want international presence can open a small office in the intended country and become multinational with the rest of the business processes in that country outsourced.

The formal model of a company catering to local, national, regional and then global demand seems to be aged now when companies that have online model seem to be doing that with a mere click of a button. Of course supply chain, logistics and other processes need to be in place, but with outsourcing being a new way of doing business, there are no boundaries for businesses anymore. Brick and click models are increasingly the vogue with purely brick and mortar business being rarely the case.

China is a notoriously difficult place to do business. Explain what makes the business environment so challenging and explain the strategies a firm may use in order to overcome those challenges.

China is one of the largest countries of the world - a vast land that houses an immense population, and yet in terms of diversity, the people there are largely homogenous in their cultures with 95% of the population being Han Chinese. After years of stagnation, after the Qing dynasty ended, the Chinese economy suffered at the behest of the opium wars and was the finally galvanized by implementing indigenous reforms, aimed to bring the Chinese economy back to its former glory.

But the scars of history took time to heal. The concessions given to the British at their conquest of the war were looked down upon as a humiliating defeat for the Chinese. For a culture that places emphasis on trust and ethics and on saving face, this defeat was felt deeply. The wounds have still been carried on, where the Chinese are still resisting external companies setting up in their lands, but today it is through modern means of regulation.

Had it been a country other than China, it would probably have been pressurized to yield to international free trade treaties and would have been coerced to lower tariffs. However, being the engine for the world economy and being a major supplier on which the U.S. economy depends, China has been able to carry on its legacy of regulations and barriers.

China's early ideologies were socialism, where all enterprises were state owned and farmers and workers sold to and were employed by the states. They were cared for in a similar fashion and there was concern with equitable distribution of income. However, modern concepts of progress are based on capitalist gains, which cannot be had without income disparity and one group being rich enough and having the resources enough to set up their own enterprise. As Deng Xiaoping came into power in the 1970's and initiated Mao's reforms in 1978, private enterprise was encouraged gradually. Another push factor was also that the Soviet Bloc had fallen and there were lessons to be learnt from its radical experiments with communism and then with a completely free market. (Watkins, n.d.)

Having laid the backdrop of China from a historic perspective, some of the modern reservations can be explained, and some light can be shed on why Chinese government is resistant to change and to external influences. (Gwartney, Stroup, Sobel, & MacPherson, 2008 )

One of the main reasons as to why China is a tough place to do business in is the fact that there are no set laws on counterfeiting and piracy is rampant in the absence of regulatory checks. This means that businesses looking to set up there will have to face the pressure from sub-standard fake products that can eat into its revenues as well as tarnish its image in the consumer's mind, a consumer who unknowingly buys these counterfeit versions.

Another factor is that Chinese government is oppressive in that any voices that rise to challenge the government are oppressed and are punished severely. Especially so in cases of media reporting where people looking to express themselves in the leftist factions are jailed. This impacts business in the sense that if it is wronged by the government in some way, it effectively has no way in which it can argue its case. One similar happening came to light recently when a company Cathay found its products being copied by another firm, in the presence of patents. When it sought to appeal, it found that the cheating company had been backed by a government enterprise. (Barboza, 2011)

"Cathay Industrial Biotech, a private company here, developed a way to ferment hydrocarbons in industrial vats and turn them into advanced nylon ingredients for use in lubricants, diabetes drugs and other 21st-century marvels.

The patents Cathay won prompted Dupont, a leading global producer of nylon, to become one of Cathay's biggest customers. And the $120 million that Goldman Sachs and other backers have pumped into Cathay in recent years primed investors in China and abroad to eagerly await a public stock offering that had been planned for earlier this year. They're still waiting. According to Cathay, a factory manager stole its secrets and started a rival company that has begun selling a suspiciously similar ingredient, undermining Cathay's profits. Instead of planning to go public, Cathay is now struggling to stay in business"

The case goes to indicate how cheating is sometimes blatantly carried out in the country and those who complain regarding the state are either indicted in some made up crimes or are put out of business.

Therefore it is of utmost importance that investors in china tread their ground carefully and look at all variables, particularly the feasibility of their project and conduct proper research and a cost benefit analysis to see how they can gain better of investing in the country.

Some of the obstacles that have been stated by U.S. firms include factors such as the regulatory framework which is deteriorating, with a report stating that:

"Bureaucratic licensing procedures, information restrictions and uneven enforcement standards all present daily operational challenges that can hinder growth," (Elaine Kurtenbach, 2011)

Moreover in accordance to Indian firms locating in China, some of the obstacles they faced were cultural in the sense that even t though India and China are neighbors there are vast differences in their cultures. Indian firms are more western in their approach, and having been established on a capitalist ideology cannot see eye-to-eye with the elaborate and long processes that typify a Chinese negotiation. (Agnihotri, 2011)

Another factor is also in finding the right people for the company given that Chinese is a difficult language to learn and use. Additionally as the impact of the one-child policy comes to light, it remains to be seen what sort of a workforce the new age will present, and the natural resource that China always had in terms of cheap labor will exist in the long-run.

Apart from these distinct country difficulties the fact is that China is a high-context society and is high on collectivism. (Geert Hofstede ™ Cultural Dimensions, n.d.) This goes to indicate that Chinese business men place a lot of importance on trust and relationships which are nurtured over time. A new company looking to establish its chain of operations in the country might find itself faced with hurdles in establishing contacts and setting up business. Distributors also look at relationships and might not be willing to carry the goods that are marketed by these new entrants.

Additionally establishing a relationship might take a long time so companies will have to look at a long-term horizon before they enter the country. Keeping these constraints in mind, there are several ways in which a new firm can enter the Chinese market. These include:

A joint venture partnership with an existing firm, preferable a non-Chinese firm or western company that has been operating in China for some time. This allows for two advantages. Firstly that the western firm will be easy to take on board as they are more open to new propositions from people who are efficient. Secondly, the firm with its established relationships will provide the new entrant with a window of opportunity which can be used to establish relationships with the Chinese.

Another novel way of entering can be via franchising where a local Chinese party can be approached to buy the franchise of the company. its success will signal whether the Chinese market is ready for it or not and will also enable company recognition by other local value chain partners leading to better perceptions of the company even before it enters the market on its own accord. (Phatak, Bhagat, & Kashlak, 2006)

Explain how exchange rates are determined in a floating exchange rate system and identify the key causes of exchange rate movements.

Exchange rates are subject to various factors and the movements of exchange rates in a floating exchange rate system are based on free market conditions with no government intervention as is the scenario in case of a pegged exchange rate where the government sets a band or a range beyond which it takes matters into its own hands.

There are various implications of a strong and a weak currency and each has its set of advantages and disadvantages. The advantages of a strong currency are that the imports become cheaper and people can easily buy more from other countries. On the other hand exports become more expensive and this means that the source of revenue is limited when prices of the exports become uncompetitive in the international market. For a weak currency, exports become cheaper and prices more competitive, where as imports become dearer, so that countries which depend upon imported raw materials find inflation making its way into the country.

Going back to the discussion on how exchange rates are determined, the main variable is interest rates in home and foreign countries, followed by prices of foreign currencies relative to the home currency. Other factors that impact exchange rates are money supply in home and foreign markets as well as the demand for currency backed by demand for certain goods that only the home country can supply.

Taking turns to explain each factor in detail. First consider interest rates, taking Country A to represent the home country and B. To represent the other country. For purpose of explanation, all other countries are taken as one country -- B.

If the government in A wants to encourage capital flows, and increases interests rate then international investors will want to invest in bonds that are yielding more returns and will buy these instruments to be able to earn more. This will exert upward pressure on the prices of currency in a leading to its rate being appreciated more than that of country B. where interest rates are lower.