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ECON 401The Changing Global Economy

Unit 3: Foreign Direct Investment

Unit Overview

Introduction

The growth of foreign direct investment (FDI) is a key aspect of todays global economy. World GDP increased by 45 percent between 1992 and 2006, but FDI increased by 700 percent.

The acceleration of economic development in many parts of the less developed world is tied to increases in FDI. FDI may provide more (and cheaper) capital, access to new technologies and business practices, and improved access to developed country markets.

FDI growth reflects the growing relative importance of multinational corporations (MNCs) in the global economy. While the investment activities of these giants often bring important economic benefits, critics are concerned that these MNCs may possess undue political influence and distort the pattern of economic development.

Note: The textbook refers to multinational corporations as multinational enterprises or MNEs. Either term is acceptable, but we use MNC throughout these course materials.

Web Links

These articles on the WTO Web site address specific issues related to foreign direct investment.

Foreign direct investment seen as primary motor of globalization, says WTO Director-GeneralTrade and foreign direct investmentNew Report by the WTO Does globalization cause a higher concentration of international trade and investment flows? (select ERAD-98-08 under the year 1998)

References

Statistics Canada. (2008). Canadas international investment position, 2007. Catalogue No. 67-202-X. Ottawa: Minister of Industry.

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Section 3.1: Foreign Direct Investment

Reading Assignment and Learning Objectives

In the textbook:Chapter 7 (pp. 240254; pp. 257262; pp. 265268)Closing Case: Cemex's Foreign Direct Investment (pp. 269270)

After completing Section 3.1, you should be able to

describe recent trends in the levels and directions of foreign direct investment (FDI) in 1.Canada and worldwide.define the following terms:2.

foreign portfolio investment foreign direct investment multinational enterpriselicensinginternalization theorygreen-field investmentslocation-specific advantages

explain the market imperfection theory of FDI.3.explain the strategic behavior theory of FDI.4.explain the main factors that will determine whether a firm will export, license, or engage 5.in FDI.discuss the main costs and benefits of FDI to host or receiving nations.6.discuss the main costs and benefits of FDI to sending nations.7. explain why the composition of foreign direct investment has shifted more toward services 8.over the past two decades.

Types of Foreign Investment

The integrated nature of economies and financial markets has increased the ease and flexibility with which foreign investors and corporations can seek out and take advantage of opportunities that yield higher rates of return, diversified portfolios, and reduced risk. This

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section describes some basic theories of foreign investment and reasons that firms undertake foreign direct investment rather than simply exporting products. We will also discuss recent patterns of foreign investment in Canada.

Foreign investment can take different forms. One is simply to lend money (in the form of bank loans or new bond purchases) or to buy relatively small blocks of stock in companies. The injection of funds into the host economy does not involve any control over the assets of that country. There is foreign funding but no foreign ownership or control; the transaction transfers funds and represents a portfolio investment. This type of investment is called foreign portfolio investment and involves very low transaction and transportation costs, as it is often just an electronic transfer of funds.

Foreign investment can also involve the outright purchase of a Canadian asset such as a factory. This type of investment is called foreign direct investment (FDI), and can take the form of purchasing enough stock in an existing firm to become a controlling shareholder, taking over a firm outright or building a new plant or enterprise from scratch. It may or may not result in additional investment in Canada, depending on the financing. If the foreign investor uses their own funds to create a new plant in Canada, Canadas capital stock has increased and, therefore, Canadas capacity to produce goods and services has increased. Even if the foreign investor buys an existing plant from Canadian owners, it may eventually lead to new capital formation (investment). In that case, the Canadian seller would have to use the money from the sale to create new capital in Canada. If the seller uses the money to buy assets in another country, spends it on high living, or uses it to retire somewhere warm, Canada does not benefit from increased capacity. Similarly, if the foreign investor uses Canadian funds for their venture into Canada, there is no gain. A substantial number of foreign takeovers are financed by loans from Canadian banks.

With FDI, a firm could have a significant ownership in a foreign operation and the potential to affect managerial decisions. By using FDI, multinational corporations are able to circumvent the effects of changing exchange rates, enabling them to secure and maintain market share.

A firm may choose to undertake FDI in a particular foreign market or region because of location-specific advantages, perhaps to gain access to specific natural resources (e.g., Albertas energy industry) or expertise (e.g., Silicon Valley in California or Ottawa), or to be located near customers, specific feedstocks, or suppliers with unique characteristics (e.g., Fort Saskatchewans petrochemical industry).

Recent FDI Trends in Canada

Table 3.1 highlights Canadas current international investment position, with information on direct and portfolio investment by Canadians abroad as well as foreign investment in Canada. The important trend to observe from this table is the significant gap between total Canadian investment abroad ($1,176,870,000) and total foreign investment in Canada ($1,309,392,000). The predominance of foreign investment in Canada has been a key feature in Canada for years; in 2007, direct investment abroad decreased due to the appreciation of the Canadian dollar against foreign currencies. Canadian direct investments abroad are denominated in foreign currencies. Consequently, the appreciation of the

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Canadian dollar lowered the value of the assets held abroad. Canadian investment abroad is split between direct and portfolio investment, as is foreign investment. There are significantly more holdings of Canadian stocks than bonds.

Table 3.1 Canadas International Investment Position, 2007

AssetsCanadian Direct Investment Abroad $ 514,540,000Portfolio Investment 346,765,000

(Foreign Bonds: $136,701,000)(Foreign Stocks: $210,064,000)

Other Investment 315,565,000(Loans: $76,122,000)(Allowances: $0)(Deposits: $156,890,000)(Official International Reserves: $40,593,000)(Other Assets: $41,960,000)

Total 1,176,870,000

LiabilitiesForeign Direct Investment in Canada $ 500,851,000Portfolio Investment 486,738,000

(Canadian Bonds: $382,080,000)(Canadian Stocks: $82,658,000)(Canadian Money Market Instruments: $21,999,000)

Other Investment 321,804,000(Loans: $52,971,000)(Deposits: $243,525,000)(Other Liabilities: $25,307,000)

Total 1,309,392,000

Net International Investment Position -132,522,000

Adapted from Statistics Canada. (2008). Canadas international investment position, Second Quarter 2008. Catalogue No. 67-202-X, Minister of Industry. Note. Discrepancies due to rounding.

Figure 3.1 and Figure 3.2, below, illustrate (by geographic area) the foreign direct investment flows in Canada from abroad and the direct investment abroad by Canadians. Note that other EU includes Belgium, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Austria, Finland, Sweden, Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, the Slovak Republic, and Slovenia.

Figure 3.1 FDI in Canada, 2007 (percent of total)

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Source: Statistics Canada. (2008). Canadas international investment position, Second Quarter 2008. Catalogue No. 67-202-X, Minister of Industry.

According to the figures above, the United States is, by far, the largest direct investor in Canada, followed by other EU countries (excluding the United Kingdom). The American share of total foreign direct investment has fallen steadily since its peak of 70 percent in 1999. This is despite the fact that the overall level of FDI in Canada has nearly doubled over this period. As we discussed in Unit 1, the relative share of US investment has fallen as the relative shares of other nations have risen, led by strong FDI from the United Kingdom and other EU nations. Direct investment in Canada by foreign companies has been expanding rapidly, and this has had a major impact on the Canadian economy. It has affected Canadian trade, employment prospects, industrial and business location, and regional economic growth prospects, and it has also led to the appreciation of the Canadian dollar.

Figure 3.2 Canadian FDI Abroad, 2007 (percent of total)


In 2007, US assets accounted for only 44 percent of total Canadian direct investment

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abroad, the lowest proportion on record. American investors accounted for 58 percent of FDI in Canada. Net direct investment with the United States has never been positive, meaning that American investors have always held more assets in Canada than Canadian investors have held in the United States.

Figure 3.3 below highlights the trends in Canadas direct investment abroad (outflows) and foreign direct investment in Canada (inflows). Since 1980, the average annual inflow of FDI totalled $204.4 billion and grew by an annual average rate of 7.9 percent. By comparison, the average annual outflow of direct investment totalled $207.9 billion and grew at an average annual rate of 11.3 percent.

Figure 3.3 Canadas International Investment Position (millions of dollars)


The influx of FDI into Canada was significant in the early 1980smore than twice that of Canadian direct investment abroad. Even during the Canadian recessions of the early 1980s and 1990s, FDI continued to expand. One of the attractions of the Canadian economy was the Canadian dollar, which was undervalued against the US dollar, making Canadian purchases cheaper for foreigners. Land and labour costs were significantly lower than in competing countries. As well, the Canadian dollar returns abroad rose, due to a dollar appreciation against other major currencies. Foreign investors were attracted to Canadas dynamic and stable economy and favourable political environment. The significance of NAFTA also created a new market for foreign investors. Governments at all levels in Canada provide a favourable investment climate for foreign companies. Not only does the federal government place few restrictions on foreign investors, but provincial and municipal governments compete vigorously for investments by offering tax and financial incentives.

Canadian direct investment abroad has become greater than foreign direct investment in Canada. This change occurred in 1997. This unprecedented trend reflects an economy in an expansionary phase of the business cycle, with strong natural resource prices. Firms earning strong corporate profits are able to invest abroad. In addition, Canadian investors holdings of foreign stocks have risen due to the higher foreign content limits for Registered Retirement Savings Plans. The rapid rise in inflows can also be interpreted by comparing this trend with Canadas production and trade patterns over the same period. Despite the

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general decline in trade barriers, growth in foreign direct investment since 1980 has exceeded growth in nominal GDP and exports.

Globally, FDI has taken off since the mid 1970s. In 1975, global FDI amounted to $25 billion. It increased to $1.2 trillion in 2000, and remained at this level until 2006. Rates of growth of world output, trade, and FDI provide a picture of the globalizing economy. Consider the following:

Between 1992 and 2006, world output increased by 45 percent.Between 1992 and 2006, world trade increased by 150 percent.Between 1992 and 2006, FDI increased by 700 percent.

Why has FDI increased so rapidly? There are a number of reasons:

FDI can help a firm overcome trade barriers.Deregulation and privatization has opened up economic space that had been closed off to private investment in the past.Trade and investment are complements, not substitutes, in many cases. A high proportion of trade consists of intra-firm trade between divisions of a single firm. Firms may invest in many different regions in order to best capture location economies. The new information and communication technologies have reduced the cost of managing at a distance.Russia and eastern Europe are no longer under communist rule.Government regulations that limited FDI in many countries have been replaced by a new receptiveness to FDI.Many multinational firms wanting to sell in multiple markets may believe they need a presence close to their consumers in order to serve them properly. In other words, they feel exporting is a poor substitute for direct investment.

It should not be surprising that most FDI comes from the developed world, but it may be surprising that most FDI goes to the developed world. As Figure 7.3 on page 244 of the textbook shows, although FDI flowing to the developed world has increased substantially over the 1990s and beyond, the proportion going to the developing world has increased marginally.

Theories of Foreign Direct Investment

Hill identifies five key factors that help to explain the relative attractiveness of FDI, exporting, and licensing:

transportation costsmarket imperfectionsstrategic behaviourproduct life cyclelocation-specific advantages

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If transportation costs are relatively high, then exporting may simply not be cost effective. Cement, for example, is not widely traded.

Many international firms have developed unique competitive advantages on the basis of their technology, marketing strategies, or management know-how and ability. If this collective know-how is employed across a wider market, profits will be greater. A firm will choose FDI over licensing if the costs of doing so are lower. Transportation costs, tariffs, and non-tariff barriers often raise the cost of exporting.

Licensing is the main method by which firms sell the rights to their know-how. Unfortunately, markets for such knowledge are likely to be incomplete. A licence generally gives the purchaser the right to use the production methods, technologies, and management and marketing practices of the seller. However, it is difficult to protect ownership once the information has been shared. Hill refers to the case of RCA, which licensed its technology to Sony and Matsushita. Soon after, the Japanese companies were able to take the US technology, make some minor adaptations to it that rendered US patents invalid, and produce in competition with RCA. Sony managed to capture much of RCAs market in the United States.

Pricing is also difficult with a licensing agreement. Skills, know-how, and procedures are extremely difficult to specify, let alone price efficiently, because the true value of the technology or the management practice cannot really be known until it has been employed in the field by the licensee. Only the seller has a good idea of how much these are worth (sometimes even the seller cannot value this properly), and the buyer has inadequate information. This alone precludes an efficient market solution.

The selling firm may also be concerned about the purchaser's devaluing the selling firms brand value. A restaurant chain may highly value its reputation for a clean eating environment, but by licensing its brand, it runs the risk of finding itself working with a partner that does not wish to pay the costs of keeping such a clean environment. The brand may become devalued or the selling firm may have to spend a lot of money monitoring and enforcing very detailed licensing agreements.

A licensee that is given a regional exclusive agreement may not expand as rapidly as the selling firm wishes. The selling firm relinquishes substantial control over production and expansion, and the selling firm may not wish to give up so much control.

Licensing is unlikely to be an efficient solution when one of the following three conditions applies:

The selling firm has valuable know-how that cannot be protected in a licensing contract.1.The selling firm wishes to have control over the business strategy of the licensee in 2.order to maximize global profits.The selling firms know-how is simply not amenable to licensing. (Hill, p. 251)3.

Hill (pp. 251252) summarizes two alternative explanations of FDI. Strategic Behaviour theory begins with the assumption that FDI is a strategic tool of oligopolistic competitors. Raymond Vernon's Product Life Cycle theory argues that a firm will pioneer a new product in its home market first, but as the market for the product grows in other regions, and as production methods become routine and standardized, it may be profitable to shift

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production to other locations with lower labour costs. Vernon argued that many firms FDI in developing countries fits this explanation.

Location-Specific Advantages

There are some resources or assets that may be more valuable in one location than in others. Obviously, this applies to resource-based industries and agriculture. It also applies to a number of technologically advanced industries. Silicon Valley in California has become one of the worlds leading centres of cutting-edge research and development for the computing and semiconductor industries. Local universities turn out large numbers of graduates who are well trained for these sectors. There are hundreds of small firms that are world leaders in niche markets. The knowledge that exists in Silicon Valley is difficult to reproduce elsewhere. Firms seeking to establish production and new product development in these sectors will seek to go where the best knowledge is and can be tapped into fairly easily. The existence of such pools of knowledge or talent (think of the fashion design houses in France and Italy) tends to attract new entrants and the expansion of existing firms. This knowledge pool constitutes an external benefit that is available only in this location.

This also explains why governments everywhere attempt to subsidize the development of centres of excellence for particular sectors or technology applications. They are attempting to catch up and overtake the first-mover advantage claimed by Silicon Valley and similar centres in other sectors.

See Figure 7.6 in the textbook (p. 266) for a useful decision framework that firms implicitly use when facing the decision to export, license, or engage in FDI.

Benefits and Costs of FDI

The major benefits of FDI are the following:

increased access to capitalaccess to superior technologyaccess to superior management methods (pp. 257260)

FDI will often mean an injection of new investment in the host country. This is one of the main benefits of FDI. Multinational firms can often access international capital at a lower price than is available to domestic firms. In addition, FDI is often attached to investment decisions that local firms are unprepared or unwilling to make, thus increasing the domestic rate of investment and economic growth.

New technologies are often not for sale or lease but become available only if the owners of those technologies decide to invest in the domestic market. Governments will often attempt to negotiate terms that include provisions for the transfer of technology to other sectors of the local economy. Multinational firms are usually unwilling to license or sell key technologies, but host economies can capture many of the benefits of these technologies through FDI.

These are the resource-transfer effects that host countries are most interested in capturing. FDI from global multinational firms often brings new technologies and management practices that are simply not available elsewhere. Local managers hired by multinational

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firms learn new managerial practices. Host governments often attempt to maximize the local benefit of the investment by ensuring that provisions are made for local training and hiring, local purchasing, technology transfers to local partners, and so on. Section 3.2, The Age of the Multinational, examines these issues in more depth.

Hill identifies three additional benefits:

employment effectsa.balance-of-payments effectsb.effects on competition and economic growth c.

FDI alone will not have an impact on the rate of unemployment in an economy at or near full employment, but in some less developed countries (LDCs), FDI will usually contribute to a relative expansion of the higher paid segment of the labour force. Multinational firms operate in sectors that typically pay wage rates that are between 50 percent and 100 percent higher than local wage rates for comparable skill levels. In countries where regulations keep labour markets from approaching full employment levels, FDI alone can cause the rate of unemployment to fall.

FDI normally involves flows of capital in both directions. Initially, capital flows in as a multinational firm acquires local assets or builds facilities. This produces an initial positive impact on the host countrys balance of payments through enhanced exports.

Study Questions

Provide complete answers for each of the following study questionsyou need to be able to explain how and why a factor or consideration is important or relevant. Students often lose marks on their assignments or examinations by providing answers that are too short and incomplete. Some questions have answers provided at the end of this section. The rest of the answers can be found in the assigned readings or the lesson notes. If you still have problems answering any question, contact the Call Centre.

What is the difference between a green-field investment and acquiring or merging with 1.an existing firm?Describe the trends and characteristics of FDI in the past 30 years.2.Consider why firms selling products with low value-to-weight ratios choose FDI over 3.exporting. AnswerWhat are location-specific advantages, and why might they be an important factor in 4.explaining FDI? AnswerUnder what circumstances might a firm prefer to engage in FDI rather than exporting or 5.licensing? AnswerWhat are the advantages and disadvantages of licensing as compared to FDI? Answer6.What are the main advantages of FDI for host (recipient) countries?7.What are the potential costs of FDI for host (recipient) countries?8.

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What are the possible costs and benefits of FDI for sending (home) countries?9. Which theoretical explanation (or explanations) of FDI best explain(s) Cemex's FDI? 10.Answer

Answers to Selected Study Questions

3. Products with low value-to-weight ratios, such as soft drinks or cement, are frequently produced in the market where they are consumed. When transportation costs are added to production costs, it becomes unprofitable to shift such products over a long distance. For firms that can produce low value-to-weight products at almost any location, the attractiveness of exporting decreases and FDI or licensing becomes more appealing. Back

4. Location-specific advantages are advantages that arise from using resource endowments or assets that are tied to a particular foreign location and that a firm finds valuable to combine with its own unique assets. Natural resources such as oil and minerals, for example, are specific to certain locations. Firms must undertake FDI to exploit such foreign resources. Back

5. A firm will favour foreign direct investment over exporting as an entry strategy when transportation costs or trade barriers make exporting unattractive. Furthermore, the firm will favour foreign direct investment over licensing (or franchising) when it wishes to maintain control over its technological know-how or its operations and business strategy or when the firm's capabilities are simply not amenable to licensing, as may often be the case. Back

6. Licensing occurs when a domestic firm (the licensor) licenses a foreign firm (the licensee) to produce the licensors product, to use its production processes, or to use its brand name or trademark. In return, the licensor collects royalty fees on every unit the licensee sells or on total revenues.

The advantage of this type of arrangement over FDI is that the licensor does not have to pay (in terms of cost, time, or risk) to open up a foreign market, as this has already been established by the licensee. There are several disadvantages to licensing as a strategy to exploit foreign market opportunities. Licensing may require that a firm relinquish valuable knowledge or technology to a potential foreign competitor. Licensing does not give the firm adequate control over the manufacturing, marketing, and strategy-making aspects of a business located in a foreign country. As well, the firm providing the licence may not feel that the licensee is adequately exploiting all of the profit potential inherent in the foreign market. Back

10. Cemex is a cement company. Consequently, exporting is difficult because of the weight of the product. If Cemex wants to expand into new markets, the company would either need to license a local company or make an investment in the market directly. Cemexs success is due in part to its top-notch customer service and its relationship with distributors. Because these advantages could be difficult to transfer,

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the company will probably choose to invest directly. Back

Section 3.2: The Age of the Multinational


In the Reading File:Age of the Multinational, by Robert Gilpin. The Challenge of Global Capitalism: The World Economy in the 21st Century, pp. 163192

In the textbook:Government Policy Instruments and FDI, pp. 262-265

In the DRR:Worldbeater, Inc. The Economist, November 22, 1997, pp. 9395


explain how MNCs have accelerated the integration of the global economy.1.describe how the national ownership of MNCs has changed over the past 40 years.2.describe the regional allocation of MNC investment.3.explain why countries are interested in attracting MNC investment.4.explain some potential costs and concerns related to MNC investment.5.explain the meaning of performance requirements.6.discuss why there is no set of international rules governing global investment that would be 7.similar to global trading rules.discuss what principles might be built into a new Multilateral Agreement on Investment 8.(MAI).

The Age of the Multinational Enterprise and FDI

In the assigned reading Age of the Multinational, Gilpin examines how MNCs have established an overwhelming and growing presence in the global economy. MNCs are behind much of the very rapid growth in FDI over the past 25 years. An MNC may be defined as a firm of a particular nationality with partially or wholly owned subsidiaries

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within two or more national economies (Gilpin, p. 164).

In earlier days, the purpose of much investment by MNCs was to gain access to raw materials or to establish a presence in a major market that was protected by tariffs. FDI was often seen as a way of jumping over tariff walls.

FDI by MNCs has now changed in dramatic ways. The globalization of production introduced in Unit 1 describes how MNCs have begun to unbundle the components and services that are used to produce a final product and reallocate the production site for each separate component or service to the most efficient location. Outsourcing is a part of this phenomenon.

We have seen that FDI has grown much faster than trade over the past quarter century, and FDI is the way in which MNCs expand into new territory. MNCs are key actors in the emergence of the global economy.

Technological change and a more open, market-friendly approach to FDI has facilitated MNC expansion. The new communications technologies have greatly reduced the cost of managing at a distance. Industrial and distribution systems can be effectively managed on a global scale now. This has greatly reduced the costs of such coordination, essentially permitting firms, for the first time, the opportunity to search the world for the best location for a specific activity. In the not too distant past, communication and coordination costs would simply rise too rapidly if an organization tried to globalize production the way many MNCs do today.

The globalization of production via FDI is integrating the world economy in a much more profound way than the globalization of markets ever could. As MNCs search the world for the best location for a new call centre, a new factory to produce tires, or a site to conduct research and development activities, national governments come to understand that their economic success will depend, in large part, on developing the ability to find a niche or a role to play in the global investment plans of MNCs. Corporate investment strategy is affected by many policies of potential host countries: tariff policies, tax policies, regulatory environment, and so on.

Although initially the United States dominated MNC FDI, the situation has changed dramatically since 1980. MNC FDI has grown rapidly in Europe, Japan, South Korea, Canada, and, to a lesser extent, a few Southeast Asian countries. At present, MNC FDI is concentrated in the high-income regions of the world. North American, European, and Japanese MNCs are largely investing in each others markets. MNC activity in less developed countries is still surprisingly small, although it is growing rapidly. As Figure 6.1 in Gilpin shows, MNC FDI in less developed countries rose from about US$22 billion in 1990 to over US$120 billion by 1997. MNC FDI in the less developed regions was very concentrated as wellChina alone received over 31 percent of the FDI going to less developed countries. Mexico, Brazil, Poland, Indonesia, and Malaysia also received significant amounts. Very little MNC FDI was recorded in Africa.

MNCs are crucial sources of capital, technology, management methods, and access to new markets for almost all countries, especially the less developed countries that, in the absence of MNCs, simply would not have access to these benefits. National policy makers have come to recognize that market-friendly regimes have simply outperformed market-unfriendly regimes in all regions of the globe. As a result, there has been a shift worldwide, from regulatory regimes that attempt to keep out MNCs toward regulatory regimes that attempt to attract MNC investment.

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Economic and Political Significance of the MNC

Gilpin comments that a bargaining relationship exists between MNCs and host governments. While it is true that attracting the investment of MNCs can accelerate economic development, the terms on which that investment is available are very important. Host nations will attempt to maximize the external benefits that may arise. For example, a government might

seek to ensure that locals are employed, trained, and taught how to use specific technologies seek to ensure that the MNC meets export targets and sources inputs from domestic producers attempt to force the MNC to work in partnership with a local firm and promote technology transfer to that firm.

These obligations are called performance requirements.

While host governments are interested in deriving maximum benefit from the MNC, the MNC will also attempt to bargain for maximum benefits for itself. This bargaining is not a one-time affair; it will continue as long as the MNC continues to operate in the host country. The MNC may seek a wide range of benefits, including

protection from import competitionlower tax ratessubsidized power and watertax holidaysdirect and indirect subsidiesresearch and development tax creditslow-interest loansa less burdensome regulatory environmentimproved public infrastructure.

Many nations also wish to protect certain sectors of the economy from foreign involvement. Canada, for example, limits the activities of foreign firms in banking, airlines, and all media or cultural industries such as film, television, radio, and publishing.

Governments that are home to a large number of MNCs worry from time to time about possible negative impacts of MNC investment in other countries. The question that is asked is, Wouldnt it be better for us if company X invested at home rather than in a foreign country?

It is important to remember the comparative advantage argument raised when we examined trade. Free trade allows each region to specialize in those activities for which it possesses a comparative, or relative, advantage. As resources are limited, it is best to focus on what we do best and not try to do all things. MNC investment abroad produces the same kind of advantages. It permits those agents with unique technologies or business practices to locate production facilities in the most efficient location.

For example, an American MNC might choose to operate its call centre out of India. If it was prohibited from doing so, then it would be at a competitive disadvantage compared to other international firms that were free to locate production and other facilities in the most desirable location. There is also no guarantee that this investment would take place by the firm in the United States. The firm might simply buy call centre services from an Indian firm operating in India.

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Nations that are home to many MNCs often object to the performance requirements imposed by other governments. These are often seen as detrimental to the home country. Boeing has recently signed an agreement with China to produce aircraft in China, but under the terms of the agreement, Boeing must form a joint partnership with a Chinese firm and produce the aircraft in China. The United States is concerned that China may gain access to valuable technology which might have military applications.

Gilpin (p. 181) notes that regionalization, as opposed to globalization, characterizes much MNC investment in recent years. American MNCs focus on Mexico and Latin America, European MNCs are focusing on eastern Europe, and Japanese MNCs are concentrated in the lower income areas of Asia. This may permit MNC networks to remain physically closer to their main markets, while taking advantage of lower wage costs in nearby regions.

In the assigned textbook reading (pp. 262265), Hill notes that many governments have policies that both promote and restrict outward and inward FDI. This may not be as contradictory as it sounds. Canada, for example, attempts to attract MNC investment in most sectors, but has regulations in place that limit foreign investment in banking, transportation, cultural industries, and other sectors. Over the past 20 years or so, there has been a growing recognition that MNC investment can, and usually does, accelerate economic growth, especially in the less developed regions of the world, and more countries have adopted MNC-friendly investment policies that are designed to attract, as opposed to repel, foreign investment. However, it is still a major political issue in most countries that attract substantial amounts of FDI; concern that local control or national sovereignty will be reduced due to the dominating position of these foreign entities is seldom far from the surface.

Rules for FDI and MNCs

World trade is governed via a host of global (e.g., WTO) and regional (e.g., NAFTA) trade agreements that set out the rules that all must follow. Free trade agreements usually require that signatories agree not to impose tariffs on goods from other parties to the agreement and spell out, often in great detail, the limits on the use of non-tariff barriers (rules on subsidies, anti-dumping, and so forth). Normally, a general objective is to ensure that foreign goods are treated in the same manner as domestically produced goods. This kind of trading regime provides the incentive structure that will permit firms to produce efficiently on a global basis.

It is somewhat odd that no similar agreements exist with respect to investment rules. No common set of rules exists, so each nation must establish its own rules. Economists generally favour an even-playing-field approach, one that would ensure that foreign firms are treated in the same way as domestic firms with respect to rules governing investments, but this is seldom the case.

It is fairly easy for MNCs to set up operations in the United States, and few performance requirements are needed. In Canada, it is easy for MNCs to set up operations in many sectors; indeed, foreign MNCs dominate many sectors of the Canadian economy. In other sectors, foreign ownership is severely limited. In Europe and much of the developing world, detailed performance requirements are the norm. Japan has shown little interest in permitting foreign MNCs access to the local marketplace and has used a variety of bureaucratic measures to keep them out. South Korea and many other LDCs have adopted

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aggressive industrial policies that aim to develop local industrial champions in major sectors of the economy. These governments provide subsidies and various types of protection to these firms, including a type of infant industry protection model in which the government picks out and protects firms it hopes will develop into leading world-class firms.

Gilpin argues that globally, efficiency could be enhanced if the world were able to develop a global investment regime based on universal and neutral principles analogous to the free trade principle (p. 191). This would have the same advantages as a global free-trade agreement, in that investment and output would tend to move according to the dictates of comparative advantage, not according to which government was offering the largest subsidies at the moment.

A global investment regime would likely have the following characteristics:

the right of establishmentthe right of national treatmentthe right of non-discrimination (Gilpin p. 183)

In 1995, the United States proposed a Multilateral Agreement on Investment (MAI) that attempted to establish such global principles. Massive opposition to this idea arose in many countries. It quickly became apparent that such an agreement would limit the ability of states to pursue independent industrial policies or policies to promote and subsidize approved firms. Such policies are firmly entrenched in many nations.

Gilpin sees little hope for such an international rules-based approach to global investment. There are a number of difficult technical questions, such as how to tax profits earned in a supply chain that includes more than one nation. However, the major challenges are political. The terms under which investment takes place are seen as critical by many national governments, and they are not willing to surrender their right to negotiate technology transfer, employment, export, and local content performance requirements.

Study Questions

Provide complete answers for each of the following study questionsyou need to be able to explain how and why a factor or consideration is important or relevant. Students often lose marks on their assignments or examinations by providing answers that are too short and incomplete. The answers can be found in the assigned readings or the lesson notes. If you still have problems answering any question, contact the Call Centre.

Why does Gilpin regard the post-1980 era as the era of the MNC?1.Describe how the pattern of ownership of MNCs has changed over the past 25 years.2.What are the possible advantages to a nation of attracting MNC investment?3.What are the major concerns that national governments may have with respect to 4.attracting MNC investment?What kinds of policies might national governments use to attract MNC investment?5.Define performance requirements and indicate when they might be used.6.

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What are the arguments in favour of developing a global set of rules governing MNC 7.investment?Why has it been so difficult for nations to agree on such a set of rules?8.

ECON 401The Changing Global Economy

Unit 4: The Global Monetary System

Unit Overview

Introduction

Unit 3 discussed the tremendous growth in capital flows over the past 30 years. The volume of foreign direct investment has grown much more rapidly than the volume of world trade in recent years. There are several potential benefits to this trend, including the ability of capital to move into regions where it is scarce and valuable. Foreign direct investment can make a positive contribution to a host economy by supplying capital, new technology, and management resources that would otherwise not be available. This is particularly the case for the less developed countries and poorer regions of the world.

Firms and governments around the world are increasingly able to access the global capital markets. Innovations in telecommunications systems have created instantaneous access to global financial markets, while the banking industry is being revolutionized to meet the needs of institutional changes required to remain competitive. These technological advances have created new opportunities to develop alternative banking instruments, and they provide greater access to financing. Capital can be moved around the globe at a keystroke, and at virtually no cost.

In Unit 4, we will look at the

specific functions of the foreign exchange market tools designed to deal with and manage the risk of adverse consequences of unpredictable changes in exchange and interest ratesdifferent types of exchange rate regimescurrent theories used to determine the future value of exchange rates growth of global capital markets.

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There are many debates surrounding the global financial market instability. While the International Monetary Fund (IMF) has pushed LDCs toward financial market liberalization, many economists have challenged this wisdom. These debates and the recent experience in Mexico, the Congo, and Russia are examined briefly in this unit, and the Asian crisis is examined more fully in Unit 5.

Web Links

The following Web links highlight some interesting issues related to the role of the IMF and the debate that surrounds that effectiveness of the IMFs macroeconomic stabilization policies (see Section 4.4).

The IMF at a Glance

International Capital Markets: Developments, Prospects, and Key Policy Issues

Finance and Development

The IMF and its Critics

The following Web links highlight some interesting issues related to global capital market (see Section 4.5) as presented by the IMF as well as some issues surrounding the use of capital controls.

IMF Global Financial Stability Report

Institute of Economic Affairs

IMF Policy Discussion Paper

References

World Bank. (2002). Globalization, growth, and poverty: Building an inclusive world economy . Washington, DC and New York: World Bank and Oxford University Press.

Section 4.1: Foreign Exchange Markets


In the textbook:Chapter 9 (pp. 322330 only)

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describe the major functions of the foreign exchange market.1.explain the factors that determine the demand and supply of foreign exchange.2.define spot exchange rates .3.define forward exchange rates .4.define foreign exchange risk .5.describe how firms might use forward exchange markets to manage foreign exchange risk.6.explain the meaning of the following terms:7.

exchange ratecurrency speculationcurrency swapsarbitrage.

Foreign Exchange Rates

You have probably bought an American dollar at one time or another. Before vacationing in the United States, you might go to your bank to buy American dollars and pay for them with Canadian dollars. Foreign exchange markets deal in American dollars, Canadian dollars, pounds sterling, and all other currencies. These markets are complex networks of institutions, banks, foreign exchange dealers, and government agencies through which the currency of one country may be exchanged for that of another. In many ways, these markets operate in the same way as the markets for apples or French wine. There is a supply of a foreign currency and a demand for it; in a free market, supply and demand interact to determine the price.

Your textbook defines an exchange rate as the rate at which one currency is converted into another (p. 324). There are two ways to report the exchange rate between Canadian and US currency: one way is to state that one Canadian dollar is now worth US$0.82, and the other is to report that one US dollar is worth Can$1.22.

In one sense, the price of a currency is unique. We can speak of the price of the Canadian dollar, for example, only by relating it to the value of another currency, often the US dollar. We could, however, correctly speak of the price of Canadian dollars measured in Turkish lire or British pounds. When we speak of the price of beef, chicken, or stereos, on the other hand, we measure price in terms of units of the domestic currency.

To convert US$1 into Canadian dollars, perform the following calculations:

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1current exchange rate= 1$0.82= Can$1.22

To convert Can$1 into US dollars, perform the following calculations:

1current exchange rate= 1$1.22= US$0.82

Under a flexible exchange rate system, the value of a currency is determined by the demand and supply for that currency. This is determined in the foreign exchange market.

The demand for US dollars comes mainly from non-US citizens or firms who wish to buy American goods and services, travel to the United States, or invest in the United States. International visitors to the United States must first go to their local bank to purchase US dollars (by selling local currency to their bank) in order to have US currency to spend while in the country.

If you live in Europe and want to purchase American-produced cars, CDs, or beer, you must arrange to acquire US dollars to buy the goods. These transactions show up in the Balance of Payments as exports from the United States. If Toyota, the Japanese car producer, wishes to build a car plant in the United States, it must exchange its Japanese yen for US dollars in order to make this investment in the United States. If an individual living in Malaysia wishes to buy shares in a firm listed on the New York Stock Exchange (NYSE), he will first have to sell some Malaysian currency in order to buy US dollars to make the purchase. Often the individual is not even aware that such an exchange takes place. The Malaysian investor will likely have an account with a Malaysian stockbroker and enter an order to purchase stocks on the NYSE. His Malaysian currency account is reduced by a certain amount, and the broker makes the purchase on his behalf.

The demand for US currency is determined largely by

exports of US goodsforeign direct investment into the United Statesthe purchase of US financial instruments by those living outside the United Statesforeign visitors to the United States.

These are the major determinants of demand, but there are a few other activities that produce a demand for US currency.

Factors that influence the value of currency include

political instabilityinvestor psychologyperception and rumourthe level of domestic and foreign economic activitythe level of domestic and foreign interest ratesbandwagon effects (which will be discussed in the next section).

As you know from your introductory economics course, demand is only one side of the equation. Where does the supply come from? It is helpful to remember that, in a foreign exchange market, those supplying one currency in the marketplace do so only to purchase

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another currency. If I sell US dollars in the foreign exchange market, I am doing so to purchase another currency. Who in the United States will want to sell US dollars in order to purchase Japanese yen, Canadian dollars or other currencies? The answer is, those in the United States who wish to

purchase goods produced abroadmake investments in other countriespurchase stocks, bonds, or other financial instruments issued in other countriestravel to other countries.

You will notice that this list is a mirror of the list above that explains the demand for US currency.

Not surprisingly, the demand curve for US dollars has the familiar downward slope. If the price of US currency (in terms of foreign currency) rises, the quantity demanded will fall. For example, if the cost of purchasing one US dollar rises (in terms of Canadian dollars), which is the same as stating that the value of the Canadian dollar falls, Canadians will buy fewer US goods; Canadian FDI into the United States will fall; purchases of US stocks, bonds, and other financial instruments by Canadian residents will fall; and Canadians will take fewer holidays in the United States. If the price of US dollars is relatively high, it will be more expensive in terms of local currency, and individuals and firms will reduce their purchases of US dollars.

The supply curve also looks like a normal supply curve, although in the case of foreign exchange, it is important to remember that the supply of US dollars in the marketplace really represents the demand for all currencies other than the US dollar.

Why does the supply of US dollars slope upward, as in Figure 4.1 below? If the price of the US dollar rises, then, by definition, the price of the currency it is being measured against has fallen, and the quantity of the non-US currency demanded will go up as its price has fallen. To US residents, a rise in the US dollar means that foreign travel becomes cheaper, foreign goods become cheaper, it becomes cheaper (in terms of US dollars) to buy foreign stocks and bonds, and so on.

Figure 4.1 The Demand and Supply of Foreign Exchange

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Looking for the moment at the demand curve, we can see that if the price of US dollars is high, at Can$1.50, only Q

0 units are demanded. If the price is lower, at Can$1.25, then Q

1

units are demanded.

Similarly, if the price of US dollars is high (meaning that the price of Canadian dollars is low), then the supply of US dollars in the foreign exchange market is high. When the price of US$1.00 is Can$1.36, Qd = Qs, and the market is in equilibrium.

Figure 4.2 Demand and Supply Shifts

The market for foreign exchange adjusts in the same way that other markets adjust to changes in the determinants of demand or supply. If, for example, more foreign tourists wish to visit the United States, the demand for US currency will rise, shifting D to the right to D

2. The new equilibrium exchange rate will be higher, at Can$1.45.

Other factors could have shifted the demand curve to the right. If foreigners wanted to buy more US goods, then US exports would rise, shifting the demand curve to the right. If foreigners wanted to buy more US stocks or bonds, the effect would be the same.

To understand what causes shifts in the supply curve, you need to remember that the desire to sell US dollars in the foreign exchange markets exists only because firms and individuals want to buy other currencies. If US citizens want to take more trips to France, the supply curve above will shift to the right. If US citizens want to buy more Canadian or British stocks, or make more investments in other countries, the supply curve will also shift to the right. If D

1 is the initial demand for US dollars (and the price is Can$1.36) and S

1 is

the initial supply curve, any of the above changes would cause the supply curve of US dollars to shift to the right, to S

2. This causes the equilibrium value of the price of the US

dollar to fall from Can$1.36 to Can$1.28.

Spot and Forward Exchange Markets

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Foreign exchange markets are like auction marketsdemand and supply interact constantly, and the price may rise or fall many times over the course of a day or even an hour. This is called the spot market for foreign exchange. When you check the newspaper to find out the current rate of exchange, you will most likely see the rate established at the end of trading on the previous day.

Forward exchange rates are rates established today for a specified date in the future. This may seem a bit odd, but there are good reasons for such markets to exist. Basically, they permit those who know they will need foreign exchange at a certain date in the future to buy that foreign exchange now at a given price. As every act of buying foreign exchange also entails an act of selling a different currency, it means there is both a demand crowd and a supply crowd willing and able to make such a market function.

Consider the Canadian farmer who plants wheat in the spring for fall harvest and sale. Assume that much of the harvest is sold in the United States and abroad. The farmer makes a business decision regarding what and how much to plant based on an understanding of expected costs and revenues. But the spot price of foreign exchange can move around quite a bit over a six-month period. The farmer faces a number of risks, many of which he can do little about. The weather may be good or bad, farm prices in the fall may be high or low, and so on. But if he plans on selling abroad, he also a faces a different risk: foreign exchange risk. This is the risk that he may get less when he exchanges his Canadian dollars for another currency six months into the future than he could get now. As a farmer and businessman, he may be willing to take on certain risks, but the forward exchange market allows him to lock in the price of foreign exchange. He buys a contract to sell Canadian dollars for US dollars at a price fixed today, to be executed when he sells his grain six months from today. In this way, the farmer can determine, today, the price of foreign exchange in the future.

In practice, many market participants prefer to lock in future prices of foreign exchange today, and as long as there are individuals prepared to buy and sell such contracts, these markets will exist.

Currency swap is also an important term to understand. A currency swap occurs when a firm or bank simultaneously buys and sells a certain amount of foreign exchange for two different valuation dates. A firm will engage in a currency swap to eliminate foreign exchange risk. Hill illustrates the merits of a currency swap by discussing Apple Computer, which buys parts from Japan, assembles computers in the United States, and then sells some computers to consumers in Japan. Reread this detailed example on page 328 of the textbook and ensure that you understand this concept.

Arbitrage

Fluctuating currencies are an opportunity to speculate on currencies and, it is hoped, gain a profit. Consider the following illustration. A Spanish professor, while a graduate student, lived in Mexico with a group of American and Canadian students who, like himself, had limited funds. When they had some free time, they made money by going to various currency exchange outlets, trading dollars for pesos or pesos for dollars. The exchange rates varied slightly from one exchange site to another. For example, the First Bank of Mexico City exchanged 255 pesos for Can$1, and the Mexican Bank of Commerce exchanged 252 pesos for Can$1. The students had Can$100 between them. At First Bank, they bought 25,500 pesos. They then walked to the Commerce Bank and used 25,200 of those pesos to buy $100. They now had a 300 peso profit. Returning to First Bank, they

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used their $100 to buy 25,500 pesos. Back at the Commerce, they bought $100 with 25,200 of their pesos, for another 300 peso profit and a total profit of 600 pesos. They continued the exercise until they had enough profit for each to buy a drink at a local hotel. It was hard work, but a sure profit. These students were engaged in what is called arbitrage. In todays world of computers, it is unlikely that you could earn much money this way, but arbitrage still exists and it is very important.

Arbitrage is defined as the simultaneous buying and selling of currencies or commodities for profit in two or more markets with inconsistent prices. Arbitrage can exist in any type of market. If wheat prices in London and Toronto vary by more than can be explained by shipping costs and other trade barriers, a profit can be made by buying in the lower-priced center and selling in the higher-priced centre. Our concern in this course is how arbitrage influences foreign exchange rates.

It is possible for a bank to make a profit from inconsistent prices, but it must work fast, because all of the big banks watch for such inconsistencies. An employee of a Canadian bank calls New York and sells Can$10,000,000 for US$7,519,000. At the same time, another employee calls Toronto and sells US$7,515,000 for Can$10,000,000. The profit is US$4,000, less the costs of the transactionnot bad for a couple of minutes work on the phone. In addition to the profit the Canadian bank made from the transaction, this buying and selling increased the demand for American money in New York (or it increased the supply of Canadian dollars). As a result, the bank brought down the price of Canadian money in New York. On the other hand, it increased the demand for Canadian money in Toronto and, as a result, increased the price of Canadian money in Toronto. The process of arbitrage continues until the price for Canadian money is the same in both markets. Arbitrage ensures that prices in all markets are the same.

Study Questions


What is the difference between a spot exchange rate and a forward exchange rate? 1.AnswerWhat are the main determinants of demand for a nations currency in the foreign 2.exchange market?What are the main determinants of supply of a nations currency in the foreign 3.exchange market? Answer What are the main uses of foreign exchange markets for international business? Answer4.Explain how each of the following will affect the price of the US dollar:5.

There is an increase in the number of foreign tourists heading to Disneyland in a.California.

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American consumers decide to buy more French wine.b.Japanese investors decide to purchase more US stocks and bonds.c.Prices in the United States begin to rise more rapidly than prices in the rest of the d.world.

Explain how a firm or an individual can use forward exchange rates to reduce or 6.eliminate foreign exchange risk.What is arbitrage?7.Explain how currency swaps work and why a firm may engage in a currency swap. 8.Answer


1. The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day. Spot exchange rates are reported daily in the financial section of the newspapers. Spot rates are continually changing, their value being determined by supply and demand for that currency relative to others. A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future. Exchange rates governing such transactions are referred to as forward rates. Most major currencies are quoted 30, 90, and 120 days into the future. Back

3. There are a number of factors that determine the supply of a domestic currency in the foreign exchange market. If we consider the case of the Canadian dollar, supply of the Canadian dollar is determined by the change in the amount of goods and services imported. For example, as an economys employment and output rises, there is greater demand for foreign-produced goods and services, which leads to a greater supply of Canadian dollars as Canadians convert their currency into the foreign currency. This is also the case if there is a greater amount of FDI made by Canadians to foreign markets or if more Canadians are visiting international locations such as the United States. If international interest rates are higher than those found in Canada, Canadians would purchase international financial instruments rather than Canadian instruments, causing the supply of Canadian dollars in the foreign exchange market to rise. Back

4. The foreign exchange market serves four primary functions for international companies:

The market is used to convert payments a company receives in foreign currencies into the currency of its home country. The market is used to convert the currency of a company's home country into another currency when the company must pay a foreign company for its products and services in the currency of the foreign company's country. International businesses may use foreign exchange markets when they have

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spare cash that they wish to invest for short terms in money markets (of another country). The market is used for currency speculation. Back

8. A currency swap is the simultaneous purchase and sale of a certain amount of foreign exchange for two different valuation dates. This activity is conducted in order to eliminate foreign exchange risk. Swaps can be conducted between banks, between a firm and a bank, or between governments where large amounts of currency are moved from one location to another. Back

Section 4.2: Theories of Exchange Rate Determination




explain the purchasing power parity (PPP) theory of exchange rate determination.1.calculate predicted exchange rates using PPP.2.explain why PPP may not work well in the short run.3.explain how a change in the rate of expected inflation will affect the exchange rate.4.explain what is meant by5.

law of one price the Fisher Effectthe International Fisher Effect (IFE)real and nominal interest ratesbandwagon effectscapital flightefficient and inefficient markets .

explain currency convertibility and why governments may attempt to limit it.6.

Purchasing Power Parity

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One of the most difficult economic indicators to forecast is the value of a domestic currency. An exchange rate is determined by the market forces of demand and supply. These forces can be influenced by factors such as political instability, perception and rumour, commodity price fluctuations, the level of domestic and foreign economic activity, and the level of domestic and foreign interest rates, all of which make it difficult to determine the value of a currency in the coming year with any degree of certainty.

One of the simplest theories of exchange rates is called purchasing power parity (PPP), which states that a unit of any given currency should be able to buy the same quantity of goods in all countries. For example, Can$5 should buy one Big Mac in Canada, while Can$5, when converted to US dollars, should buy the same Big Mac in the United States.

PPP theory predicts that exchange rates are determined by relative prices and that changes in relative prices will cause changes in exchange rates. Many economists believe that the theory of PPP determines the long-run value of a currency. The theory asserts that if a commodity has two different prices in two different locations, forces are set in motion to equalize the prices. If a Canadian dollar can buy more coffee in Canada than in the United States, international traders could profit from buying coffee in Canada and selling it in Japan (an example of arbitrage, which we discussed in the Section 4.1). The export of coffee to Japan from Canada will cause the price of Canadian coffee to rise and the price of Japanese coffee to fall. Eventually, the two prices equalize. This is called the law of one price, which states that a Canadian dollar should be able to buy the identical amounts of a certain good in two different markets. The textbook provides a good example of this law on the bottom of page 331.

There is an important conclusion to be drawn from PPP theory. PPP predicts that if prices in country A rise by more than prices in country B, then the value of the currency in A will fall by an amount that exactly offsets the price change difference, in order to maintain PPP. This is, in fact, a logical conclusion to be drawn if PPP holds.

Suppose Canada and the United States both have inflation rates of 5 percent and PPP holds. If inflation starts to accelerate in Canada, the value of the Canadian dollar will have to fall in order to maintain PPP. This is one reason the Bank of Canada has a significant preoccupation with keeping inflation under control in Canada. Canadas high inflation affects Canadas competitive position vis--vis its trading partners and puts downward pressure on the value of the dollar. This is true for all countries: other things being equal, an acceleration of the rate of inflation relative to major trading partners will cause the value of the domestic currency to fall.

Money Supply, Prices, and Exchange Rates

We have seen that PPP predicts that a change in relative inflation between two countries will lead to an equal and opposite change in the value of the exchange rate.

In your introductory economics course, you learned that inflation is a monetary phenomenon. Consider an economy with output growing at 3 percent per annum. We can say that the economy will need its money supply to grow at roughly 3 percent per annum to ensure that cash balances are adequate for households and firms to make their planned

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purchases. What happens, though, if the money supply grows at a higher rate, say at 5 percent, and the real supply of physical goods rises by only 3 percent? This means that demand for goods is rising by 5 percent per year, but since the supply of goods is rising by only 3 percent, the only possible outcome is that prices will have to rise.

The money supply, therefore, gives market actors a good idea of what is likely to happen to exchange rates. If the money supply in country A increases rapidly, we expect that prices will also rise rapidly in the not too distant future. If the money supply in country B is rising only modestly, we do not expect inflation to rise significantly. Given this information, we would expect that the currency in country A will fall relative to the value of the currency in country B.

Economists often use newspaper articles to issue stern warnings to governments that are bent on expanding the money supply to pay for an ambitious agenda. The warning is always the same: If you expand the money supply rapidly, prices will rise, and if prices rise more rapidly at home than they do for our trading partners, we can expect the value of our currency to fall.

Empirical Tests of PPP Theory

If markets were competitive, transportation costs were zero, there were no non-traded goods, and uncertainty was not an issue, we would expect exchange rates to be determined by PPP most of the time. While the theory of PPP is a simple model to determine exchange rates over the long run, it does have limitations:

It is not completely accurate, in that exchange rates do not always move to ensure that a Canadian dollar has the same purchasing power in all countries. It does not address differences in transportation costs and barriers to trade and investment, which could also influence prices.

It does not account for investor psychology or for the fact that perception can cause a herd mentality or the bandwagon effect. Capital flows may be guided, to a much greater extent, by investor perceptions of expected profits, and these may be linked only weakly to relative price inflation.

It may not hold if markets are dominated by several large MNCs that may have influence over market prices.

All of these factors will cause actual exchange rates to differ from those predicted by PPP. Also, the theory is less useful for predicting short-term exchange-rate movements between nations that have relatively small inflation-rate differentials. However, most economists argue that PPP is the exchange value that real exchange rates will tend toward in the long run, but in the short run, many variables can keep the PPP exchange rate from being realized.

Interest Rates and Exchange Rates

Investors and borrowers are primarily interested in the real interest rate, not the nominal

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interest rate, which is simply the rate of interest charged on a loan or attached to a financial instrument. A nominal rate of 10 percent is quite good if the rate of inflation is 1 percent; this means that the actual rate of return, after taking inflation into account, is 9 percent. If, on the other hand, inflation is running at 10 percent, that nominal rate of 10 percent implies that the investor will receive an after-inflation rate of return of zero (10 percent minus 10 percent). Investors are interested in real, inflation-adjusted rates of interest, not nominal rates of interest.

Thus, we can say that the nominal rate of interest, let's call it i, is equal to the real rate of interest, r, plus the expected rate of inflation, I. This relationship can be written as

i = r + I

When expressed in this form, it is referred to as the Fisher Effect, after Irvin Fisher, the economist who first formalized the relationship.

In a world where capital is free to move across borders, arbitrage is going to make sure that the real rate of interest, r , is the same in all countries, assuming that the level of risk is the same. If risk is higher in one country than in another, then the real rate of return required to induce investors to invest in the risky country will have to be higher. For the moment, let us assume that we are looking at only two countries and that there is no risk differential between the two.

In this case, we can see why the real rate of interest in the two countries will have to be the same. If, for example, risk-free government bonds offer a 5 percent rate of interest in the United States and a 5 percent rate of interest in Canada and expected inflation is equal to zero in both countries, then the real rate of return is 5 percent in both countries.

What if the real rate of return was higher in Canada? Let us assume, for the moment, that the US government decided that interest rates were too high in the United States and decided to expand the money supply to lower interest rates in order to stimulate economic activity. As the nominal interest rate fell in the United States, a gap would open up between the real interest rate in Canada and the real interest rate in the United States. Let us assume that nominal and, therefore, real rates of interest fall to 3 percent in the United States.

Is this likely to be a stable situation? Clearly, the answer is noreal interest rates are 5 percent in Canada, but only 3 percent in the United States. Will investors alter their behaviour now? Yes, they most certainly will. Investors will sell off US stocks, bonds, and other assets to buy Canadian stocks, bonds, and other financial assets that can earn a higher rate of return. This will also cause the value of the Canadian dollar to appreciate as foreign capital flows into Canada.

This is simply engaging in arbitrage. The demand for financial instruments (stocks, bonds, and so on) will rise in Canada, and the demand for financial instruments in the United States will fall. Through the simple interaction of demand and supply, real and nominal interest rates in Canada will rise, and real and nominal rates in the United States will fall. Equilibrium will be restored only when the real rates of interest are the same in both countries again.

If the real interest rate is the same worldwide (for the moment, we need to assume away differences in risk and government regulations limiting capital flows), then what will explain differences in nominal interest rates? It has to be the expected rate of inflation. If, for

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example, real interest rates are 5 percent in both Canada and the United States, but the nominal rate is 10 percent is Canada and 6 percent in the United States, it means that the expected rate of inflation in Canada is 5 percent (10 minus 5), and the expected rate of inflation in the United States is 1 percent (6 minus 5).

The International Fisher Effect summarizes the relationship between exchange rates, interest rates, and inflation. It states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries (pp. 337338).

This is simply the logical conclusion to what we have learned about the relationships between interest rates, inflation, and the exchange rate. If real interest rates are the same in two countries, then nominal interest rates will differ only because of differing rates of inflation. If the rate of inflation in one country is higher than it is in the other country, the value of the currency of the inflating country must fall.

Investor Psychology, Bandwagon Effects, and Short-run Exchange Rate Movements

PPP and the International Fisher Effect are based on sound economic principles, but in the short run, we often find that exchange rates are not based on these principles. It is often said that these principles will determine exchange rates in the long run, or that exchange rates are tending toward the exchange rates predicted by these principles, but that, in the short run, exchange rates can be well above or well below predicted values. There appears to be a lot of overshooting or undershooting when an exchange rate begins to move.

Why might this be the case? Hill suggests that investor information is often poor, especially concerning risks in emerging countries, and that investors will often tend to follow bursts of optimism (during which expectations of economic performance are very rosy) by bursts of pessimism (when expectations turn dramatically downward). This kind of boom/bust investor psychology will result in exchange rates that do not quickly settle down at predicted values.

Currency Convertibility

Freely convertible currencythe domestic government places no restrictions on residents or non-residents with respect to the buying and selling of currency.Externally convertible currencythe domestic government places no restrictions on non-residents with respect to the buying and selling of currency, although it may place some restrictions on residents.Non-convertible currencyneither residents nor non-residents are permitted to convert the domestic currency to a foreign currency.

Countries may limit convertibility in order to protect foreign exchange reserves. Not surprisingly, it is the weaker economic countries that most often limit convertibility. If a government of a particular country fears that market participants may wish to sell off that countrys currency, that government may take action to limit convertibility. This will usually occur if the government has done something that would likely lead to a fall in the value of

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its currency. If a government attempts to spend money that it does not possess by printing more money and increasing the money supply, a rise in the domestic inflation rate would normally result. If inflation in that country suddenly rises, we would expect the value of its exchange rate to fall, as market participants move to sell that currency and buy foreign exchange.

This great rush by residents and non-residents to convert their holdings of domestic currency to foreign currency is known as capital flight (Hill, p. 343). It is a danger that can occur when government policies are expected to lead to very high rates of inflation. Investors fear that, if the government stays on the path to high inflation, it will have to permit the currency to devalue in the near future.

Study Questions


Explain the theory of purchasing power parity (PPP). Use an example to show how PPP 1.can help explain exchange rates. AnswerIn a two-country, one-good model, Trinidad and Jamaica both produce only rum. The 2.domestic price of one bottle of rum in Jamaica is 10 Jamaican dollars. The domestic price of one bottle of rum in Trinidad is 15 Trinidadian dollars. What will the exchange rate between the two countries be, according to PPP?Why might PPP not be a good predictor of exchange rates in the short run? Answer3.What is the International Fisher Effect?4.What is the relationship between interest rates, the rate of inflation, and exchange 5.rates?Consider the following scenario. The rate of inflation in Malaysia is 10 percent; in 6.Singapore, it is 5 percent. The nominal rate of interest in Malaysia is 3 percent; in Singapore, it is also 3 percent. Is this a stable equilibrium position? If not, explain what will happen to capital flows, nominal interest rates, and the exchange rate between the two countries. Assume that both currencies are fully convertible. AnswerWhat is the most common approach to exchange rate forecasting?7.What is meant by currency convertibility ?8.What is meant by capital flight ?9.What is meant by non-convertibility ?10.

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1. PPP theory states that, given relatively efficient markets, the price of a basket of goods should be roughly equivalent in each country. So, if a basket of goods costs $200 in the United States and 20,000 in Japan, PPP predicts that the dollar/yen exchange should be $200/20,000 or US$.01 per Japanese yen. Back

3. There are a number of reasons why exchange rates may differ from the exchange rates predicted by the PPP theory.

The PPP theory assumes no transportation costs or barriers to trade, but we know that there are differences in transportation costs and trade barriers between countries. Government intervention in cross-border trade affects the efficient workings of the market, as prices of goods and services are influenced. Government intervention in the form of buying and selling currencies in the foreign exchange market further weakens the link between price changes and changes in exchange rates. The PPP theory tends to be less useful when applied to currencies of advanced industrialized nations that have small differences in inflation rates. The PPP theory also does not take into account the influence of the changes in investor psychology or perceptions that can lead to large changes in the exchange rates. Back

6. This is not a stable equilibrium situation because the real interest rates are higher in Malaysia than in Singapore. This situation will lead to investors looking to take advantage of the higher rate of return in Malaysia. Investors located in Singapore will sell off their stocks, bonds, and other assets and then convert them to the Malaysian currency. This creates an increase in the demand for the Malaysian currency in the foreign exchange market, which leads to an appreciation of the currency as capital flows into Malaysia. The demand for financial instruments will rise in Malaysia, and the demand for financial instruments in Singapore will fall. Conversely, as investors leave Singapore, there is a capital outflow and greater supply of Singapores currency in the foreign exchange market, which leads to a depreciation of the currency. An opposing influence to all of this is that arbitrage will soon equalize the differences in real interest rates. Because the real interest rate is lower in Singapore, investors will borrow money in Singapore and invest it in Malaysia, causing an increase in the demand for money in Singapore. This has the effect of raising the real interest rate, while the increase in the supply of money flowing into Malaysia will lower the real interest rate in Malaysia. Equilibrium will be restored only when the real rates of interest are the same in both countries.

Another issue to consider is the fact that the inflation rates are vastly different between Malaysia and Singapore. Inflation in Malaysia is double that of Singapore, which will put downward pressure on Malaysias currency. To slow this trend, nominal interest rates have to rise. Back

Section 4.3: The International Monetary System

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Sect o 3 e te at o a o eta y Syste




explain the meaning of the following terms:1.

floating exchange ratepegged exchange ratedirty floatIMF conditionalityfixed exchange ratecurrency board

explain how the gold standard worked and why it collapsed.2.explain the objectives and key components of the Bretton Woods system established in 3.1944.explain the factors that led to the collapse of the Bretton Woods system.4.compare the advantages and disadvantages of flexible and fixed exchange rates.5.discuss the role of the IMF in the post-war international monetary system.6.

Exchange Rate Models

Floating Exchange Rate

The model of exchange rate determination introduced in Section 4.1 is the model of a floating exchange rate. Simply put, a floating exchange rate system is said to exist when the forces of demand and supply in the marketplace are permitted to determine the value of the exchange rate.

This is not the only model in use, however. It probably wont surprise you to find out that governments intervene, in varying degrees, in an effort to control, manage, or affect the exchange rate. This is because the price of foreign exchange, especially in an economy that is relatively open to foreign trade and investment, is the most important price in the economy.

Why do you think this might be so? Remember that, as the exchange rate changes, so does the price of all imports and exports and so does the relative profitability of investing at

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home relative to investing in other countries. It is no wonder that governments pay so much attention to the value of the domestic currency.

There are three other important exchange rate models: pegged, fixed, and dirty float.

Pegged Exchange Rate

Under a pegged exchange rate regime, a government declares that it will not permit the value of its currency to deviate by more than a small margin from a chosen reference currency, usually a major one like the US dollar or the Japanese yen. For example, Trinidad may declare that it is pegging its dollar to the US dollar at a rate of, say, seven Trinidadian dollars to one US dollar.

But what does this mean and why would Trinidad do it? In practice, it means simply that the government of Trinidad promises to intervene in foreign exchange markets and buy or sell foreign exchange if necessary to keep the value of the Trinidadian dollar from changing from the pegged rate of 7 to 1. So, if there is a sell-off of Trinidadian dollars in the marketplace and the price of the currency is threatening to fall, the Trinidadian central bank will intervene by selling US dollars or other currency in the foreign exchange markets and buying up Trinidadian dollars.

A central issue is the credibility of the peg. Does the central bank have enough foreign exchange reserves to ensure that it can buy up enough Trinidadian dollars if there is a large sell-off? A problem arises if markets suspect that the government is engaging in policy changes that will cause the value of the currency to fall. If, for example, a government wants to engage in a public spending spree but does not have the tax revenues, it can simply increase the money supply (print more money) and ensure that new funds are lent to the government. This acceleration of the rate of growth of the money supply will lead to more inflation. Do you remember what happens to a floating exchange rate if the rate of inflation in country A begins to increase relative to the rate of inflation in country B? The value of country As currency must fall. country As prices rise, and it finds it more difficult to compete in foreign markets. Exports decline and the balance of trade moves toward a deficit position. Country A is not earning as much foreign exchange (from exports) as before.

If markets conclude that the pegged rate is too high (because the peg is sustaining a rate that, under a floating exchange rate, would be falling), then the pegged rate can be maintained only as long as the central bank has enough foreign exchange reserves to continue purchasing domestic currency. When foreign exchange reserves fall too low, markets will conclude that the central bank may not be able to sustain its peg at the established level. Speculators may make (or lose) fortunes by making large bets against the ability of central banks to maintain pegged exchange rates.

Dirty Float

It is possible to manage an exchange rate regime that is neither fully pegged nor completely floating. This is often called a dirty float. A dirty float is said to exist when a country has not formally adopted a pegged or fixed exchange rate regime, but its central bank will intervene from time to time to buy or sell foreign exchange in order to keep the value of the currency from rising or falling too much or too rapidly. Many central banks may engage in such smoothing currency sales or purchases because they do not like to see highly volatile exchange rates. Canada essentially operates under a dirty float exchange rate regime.

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Fixed Exchange Rate

A fixed exchange rate is similar to a pegged exchange rate, but in the case of a fixed exchange rate, two or more nations agree to fix their exchange rates against each other.

The Gold Standard

The gold standard was a special form of fixed exchange regime that existed in many countries between the 1870s and 1914. Countries that were on the gold standard fixed their domestic currency in terms of gold and promised to convert currency into gold. The British pound was fixed at 1 = 113 grains of gold, and the US dollar was fixed as being equivalent to 23.22 grains of gold. This effectively fixed the exchange rate between US dollars and

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