IBM/U1 Topic 1 International Business- Introduction,

Concept, Definition
THESTREAK3 MONTHS AGO 1 COMMENT
With the globalization of the world economy, there has been a concomitant rise in the number
of companies that operate globally. Though international business as a concept has been around
since the time of the East India Company and continued into the early decades of the 20th
century, there was a lull in the international expansion of companies because of the Two World
Wars. After that, there was a hesitant move towards internationalizing the operations of
multinational companies.

What really provided a fillip to the global expansion of companies was the Chicago School of
Economic Thought propelled by the legendary economist, Milton Friedman, which
championed neoliberal globalization. This ideology, which started in the early 1970s gradually,
became a major force to reckon with in the 1980s and became the norm in the 1990s. The result
of all this was the frenzied expansion of global companies across the world.

Thus, international businesses grew in scope and size to the point where at the moment;
the global economy is dominated by multinationals from all countries in the world. What
was primarily a phenomenon of western corporations has now expanded to include companies
from the East (from countries like India and China). This module examines the phenomenon
of international businesses from different aspects like the characteristics of international
business, their effect on the local, target economies, and the ways and means with which they
would have to operate and succeed in the global competition for ideas and profits.

Above all, international businesses have to ensure that they blend the global outlook and the
local adaptation resulting in a “Glocal” phenomenon wherein they would have to think global
and act local. Further, international businesses need to ensure that they do not fall afoul of
local laws and at the same time repatriate profits back to their home countries. Apart from
this, the questions of employability and employment conditions that dictate the operations of
global businesses have to be taken into consideration as well.

Considering the fact that many third world countries are liberalizing and opening up their
economies, there can be no better time than now for international businesses. This is balanced
by the countervailing force of the ongoing economic crisis that has dealt a severe blow to the
global economy. The third force that determines international businesses are that not only is
the third world countries eager to welcome foreign investment, they seek to emulate the
international businesses and become like them. Hence, these aspects would be discussed in
detail in the subsequent articles.

Finally, international businesses have to ensure that they have a set of operating procedures
and norms that are sensitive to the local culture and customs and at the same time, they stick to
their brand that has been developed for global markets. This is the challenge that we discussed
earlier as “Glocal” orientation.

Any business that involves operations in more than one country can be called an international
business. International business is related to the trade and investment operations done by
entities across national borders.
 Firms may assemble, acquire, produce, market, and perform other value-addition-operations
on international scale and scope. Business organizations may also engage in collaborations
with business partners from different countries.

Apart from individual firms, governments and international agencies may also get involved in
international business transactions. Companies and countries may exchange different types of
physical and intellectual assets. These assets can be products, services, capital, technology,
knowledge, or labor.

Internationalization of Business

Let’s try to explore the reasons why a business would like to go global. It is important to note
that there are many challenges in the path of internationalization, but we’ll focus on the positive
attributes of the process for the time-being.

There are five major reasons why a business may want to go global −

 First-mover Advantage− It refers to getting into a new market and enjoy the advantages of
being first. It is easy to quickly start doing business and get early adopters by being first.
 Opportunity for Growth− Potential for growth is a very common reason of
internationalization. Your market may saturate in your home country and therefore you may
set out on exploring new markets.
 Small Local Markets− Start-ups in Finland and Nordics have always looked at
internationalization as a major strategy from the very beginning because their local market is
small.
 Increase of Customers− If customers are in short supply, it may hit a company’s potential for
growth. In such a case, companies may look for internationalization.
 Discourage Local Competitors− Acquiring a new market may mean discouraging other
players from getting into the same business-space as one company is in.

Advantages of Internationalization

There are multiple advantages of going international. However, the most striking and impactful
ones are the following four.

Product Flexibility

International businesses having products that don’t really sell well enough in their local or
regional market may find a much better customer base in international markets. Hence, a
business house having global presence need not dump the unsold stock of products at deep
discounts in the local market. It can search for some new markets where the products sell at a
higher price.

A business having international operations may also find new products to sell internationally
which they don’t offer in the local markets. International businesses have a wider audience and
thus they can sell a larger range of products or services.

Less Competition
 Competition can be a local phenomenon. International markets can have less competition
where the businesses can capture a market share quickly. This factor is particularly
advantageous when high-quality and superior products are available. Local companies may
have the same quality products, but the international businesses may have little competition in
a market where an inferior product is available.

Protection from National Trends and Events

Marketing in several countries reduces the vulnerability to events of one country. For example,
the political, social, geographical and religious factors that negatively affect a country may be
offset by marketing the same product in a different country. Moreover, risks that can disrupt
business can be minimized by marketing internationally.

Learning New Methods

Doing business in more than one country offers great insights to learn new ways of
accomplishing things. This new knowledge and experience can pave ways to success in other
markets as well.

Globalization

Although globalization and internationalization are used in the same context, there are some
major differences.

 Globalization is a much larger process and often includes the assimilation of the markets as a
whole. Moreover, when we talk about globalization, we take up the cultural context as well.
 Globalization is an intensified process of internationalizing a business. In general terms, global
companies are larger and more widespread than the low-lying international business
organizations.
 Globalization means the intensification of cross-country political, cultural, social, economic,
and technological interactions that result in the formation of transnational business
organization. It also refers to the assimilation of economic, political, and social initiatives on a
global scale.
 Globalization also refers to the costless cross-border transition of goods and services, capital,
knowledge, and labor.

Factors Causing Globalization of Businesses

There are many factors related to the change of technology, international policies, and cultural
assimilation that initiated the process of globalization. The following are the most important
factors that helped globalization take shape and spread it drastically.

The Reduction and Removal of Trade Barriers

After World War II, the General Agreement on Tariffs and Trade (GATT) and the WTO have
reduced tariffs and various non-tariff barriers to trade. It enabled more countries to explore
their comparative advantage. It has a direct impact on globalization.
Trade Negotiations

The Uruguay Round of negotiations (1986–94) can be considered as the real boon for
globalization. It is considerably a large set of measures which was agreed upon exclusively for
liberalized trade. As a result, the world trade volume increased by 50% in the following 6 years
of the Uruguay Round, paving the way for businesses to span their offerings at an international
level.

Transport Costs

Over the last 25 years, sea transport costs have plunged 70%, and the airfreight costs have
nosedived 3–4% annually. The result is a boost in international and multi-continental trade
flows that led to Globalization.

Growth of the Internet

Expansion of e-commerce due to the growth of the Internet has enabled businesses to compete
globally. Essentially, due to the availability of the Internet, consumers are interested to buy
products online at a low price after reviewing best deals from multiple vendors. At the same
time, online suppliers are saving a lot of marketing costs.

Growth of Multinational Corporations

Multinational Corporations (MNCs) have characterized the global interdependence. They

encompass a number of countries. Their sales, profits, and the flow of production is reliant on
several countries at once.

The Development of Trading Blocs

The ‘regional trade agreement’ (RTA) abolished internal barriers to trade and replaced them
with a common external tariff against non-members. Trading blocs actually promote
globalization and interdependence of economies via trade creation.

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IBM/U1 Topic 2 International Business: Scope, Trends,

Challenges and Opportunities
THESTREAK3 MONTHS AGO 1 COMMENT
Scope
International business is much broader than international trade. It includes not only
international trade (i.e., export and import of goods and services), but also a wide variety of
other ways in which the firms operate internationally. International Management professionals
are familiar with the language, culture, economic and political environment, and business
practices of countries in which multinational firms actively trade and invest.
Major forms of business operations that constitute international business are as follows.

(i) Merchandise exports and imports: Merchandise means goods that are tangible, i.e., those
that can be seen and touched. When viewed from this perceptive, it is clear that while
merchandise exports means sending tangible goods abroad, merchandise imports means
bringing tangible goods from a foreign country to one’s own country.

(ii) Service exports and imports: Service exports and imports involve trade in intangibles. It
is because of the intangible aspect of services that trade in services is also known as invisible
trade.

(iii) Licensing and franchising: Permitting another party in a foreign country to produce and
sell goods under your trademarks, patents or copy rights in lieu of some fee is another way of
entering into international business. It is under the licensing system that Pepsi and CocaCola
are produced and sold all over the world by local bottlers in foreign countries.

(iv) Foreign investments: Foreign investment is another important form of international

business. Foreign investment involves investments of funds abroad in exchange for financial
return. Foreign investment can be of two types: direct and portfolio investments.

Trends
As the economy grows slowly at home, your business may have to look at selling
internationally to remain profitable. Before examining foreign markets, you have to be aware
of the major trends in international business so you can take advantage of those that might
favor your company. International markets are evolving rapidly, and you can take advantage
of the changing environment to create a niche for your company.

Growing Emerging Markets

Developing countries will see the highest economic growth as they come closer to the standards
of living of the developed world. If you want your business to grow rapidly, consider selling
into one of these emerging markets. Language, financial stability, economic system and local
cultural factors can influence which markets you should favor.

Demographic Shifts
The population of the industrialized world is aging while many developing countries still have
very youthful populations. Businesses catering to well-off pensioners can profit from a focus
on developed countries, while those targeting young families, mothers and children can look
in Latin America, Africa and the Far East for growth.

Speed of Innovation
The pace of innovation is increasing as many new companies develop new products and
improved versions of traditional items. Western companies no longer can expect to be
automatically at the forefront of technical development, and this trend will intensify as more
businesses in developing countries acquire the expertise to innovate successfully.
More Informed Buyers
More intense and more rapid communications allow customers everywhere to purchase
products made anywhere around the globe and to access information about what to buy. As
pricing and quality information become available across all markets, businesses will lose
pricing power, especially the power to set different prices in different markets.

Increased Competition
As more businesses enter international markets, Western companies will see increased
competition. Because companies based in developing markets often have lower labor costs, the
challenge for Western firms is to keep ahead with faster and more effective innovation as well
as a high degree of automation.

Slower Growth
The motor of rapid growth has been the Western economies and the largest of the emerging
markets, such as China and Brazil. Western economies are stagnating, and emerging market
growth has slowed, so economic growth over the next several years will be slower.
International businesses must plan for profitability in the face of more slowly growing demand.

Clean Technology
Environmental factors are already a major influence in the West and will become more so
worldwide. Businesses must take into account the environmental impact of their normal
operations. They can try to market environmentally friendly technologies internationally. The
advantage of this market is that it is expected to grow more rapidly than the overall economy.

Challenges and Opportunities

Inevitably such challenges and opportunities vary between companies and sectors but some
frequently cited opportunities and challenges include:

Opportunities Challenges

New competition for existing customers in

Access to customers in new countries
domestic markets

Learning about customers in new Adjusting products to local tastes and cultural
markets peculiarities

Access to new, cheaper sources of

Global financial contagion
finance
 Costs of meeting a multitude of local/national
Government incentives to relocate
laws and regulations

Access to regional trading

Exchange rate fluctuations
agreements/avoidance of trade barriers

Economies of scale Managing long supply chains

Access to new resources (e.g. cheap of New competition for local resources (e.g. more
skilled labour, natural resources) demand for labour pushing up local wage costs)

Cross-cultural communication e.g. language

barriers, differing body language and etiquette

Corporate social responsibility issues

Capricious political environments/political risk

/bias in favour of domestic companies

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IBM/U1 Topic 3 Meaning and Importance of International

Competitive Advantage
THESTREAK3 MONTHS AGO 1 COMMENT

Participation in international business allows countries to take advantage of their comparative

advantage.

The concept of comparative advantage means that a nation has an advantage over other nations
in terms of access to affordable land, resources, labor, and capital. In other words, a country
will export those products or services that utilize abundant factors of production. Further,
companies with sufficient capital may seek another country that is abundant in land or labor,
or companies may seek to invest internationally when their home market becomes saturated.

Participation in international business allows countries to take advantage of specialized

expertise and abundant factors of production to deliver goods and services into the international
marketplace. This has the benefit of increasing the variety of goods and services available in
the marketplace.
 International business also increases competition in domestic markets and introduces new
opportunities to foreign markets. Global competition encourages companies to become more
innovative and efficient in their use of resources.

For consumers, international business introduces them to a variety of goods and services. For
many, it enhances their standard of living and increases their exposure to new ideas, devices,
products, services, and technologies.

The Growth of International Business

The prevalence of international business has increased significantly during the last part of the
twentieth century, thanks to the liberalization of trade and investment and the development of
technology. Some of the significant elements that have advanced international business
include:

 The formation of the World Trade Organization (WTO) in 1995

 The inception of electronic funds transfers
 The introduction of the euro to the European Union
 Technological innovation that facilitates global communication and transportation
 The dissolution of a number of communist markets, thus opening up many economies to private
business

Today, global competition affects nearly every company—regardless of size. Many source
suppliers from foreign countries and still more compete against products or services that
originate abroad. International business remains a broad concept that encompasses the smallest
companies that may only export or import with one other country, as well as the largest global
firms with integrated operations and strategic alliances around the globe.

The Challenges and Considerations of International Business

Because nation-states have unique government systems, laws and regulations, taxes, duties,
currencies, cultures, practices, etc. international business is decidedly more complex that
business that operates exclusively in domestic markets.

The major task of international business involves understanding the sheer size of the global
marketplace. There are currently more than 200 national markets in the world, presenting a
seemingly endless supply of international business opportunities. However, the diversity
between nations presents unique considerations and a plethora of hurdles, such as:

 National wealth disparities: Wealth disparities among nations remain vast.

 Regional diversity according to wealth and population: North America is home to just 5 percent of
the world’s population, yet it controls almost one-third of the world’s gross domestic product.
 Cultural/linguistic diversity: There are more than 10,000 linguistic/cultural groups in the world.
 Country size and population diversity: There were about 60 countries at the start of the twentieth
century; by 2000, this number grew to more than 200.

Some of the challenges considered by companies and professionals involved in international

business include:
Economic Environment

The economic environment may be very different from one country to the next. The economy
of countries may be industrialized (developed), emerging (newly industrializing), or less
developed (third world). Further, within each of these economies are a vast array of variations,
which have a major effect on everything from education and infrastructure to technology and
healthcare.

A nation’s economic structure as a free market, centrally planned market, or mixed market also
plays a distinct role in the ease at which international business efforts can take place. For
example, free market economies allow international business activities to take place with little
interference. On the opposite end of the spectrum, centrally planned economies are
government-controlled. Although most countries now function as free-market economies,
China—the world’s most populous country—remains a centrally planned economy.

Political Environment

The political environment of international business refers to the relationship between

government and business, as well as the political risk of a nation. Therefore, companies
involved in international business must expect to deal with different types of governments,
such as multi-party democracies, one-party states, dictatorships, and constitutional monarchies.

Some governments may view foreign businesses as positive, while other governments may
view them as exploitative. Because international companies rely on the goodwill of the
government, international business must take the political structure of the foreign government
into consideration.

International firms must also consider the degree of political risk in a foreign location; in other
words, the likelihood of major governmental changes taking place. Just a few of the issues of
unstable governments that international companies must consider include riots, revolutions,
war, and terrorism.

Cultural Environment

The cultural environment of a foreign nation remains a critical component of the international
business environment, yet it is one of the most difficult to understand. The cultural environment
of a foreign nation involves commonly shared beliefs and values, formed by factors such as
language, religion, geographic location, government, history, and education.

It is common for many international firms to conduct a cultural analysis of a foreign nation as
to better understand these factors and how they affect international business efforts.

Competitive Environment

The competitive environment is constantly changing according to the economic, political, and
cultural environments. Competition may exist from a variety of sources, and the nature of
competition may change from place to place. It may be encouraged or discouraged in favor of
cooperation, and the relationship between buyers and sellers may be friendly or hostile. The
level of technological innovation is also an important aspect of the competitive environment as
firms compete for access to the newest technology.

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GCSA/U1 Topic 1 Framework for Assessing

Competitiveness – Various Approaches
THEINTACTFRONT09/01/2019 2 COMMENTS
Global competitiveness is a multidimensional concept and has various definitions.

Thus, according to Rapkin, et al. competitiveness is “…a political and economic concept that
affect military, political and scientific potential of the country and is an integral factor in the
relative position of the country in the international political economy.”

Krugman defines competitiveness as a concept equivalent of productivity. On the other hand,

he claims that competitiveness is “wrong and dangerous definition” if to apply for the
international level.

According to Porter, this concept deals with the policy and institutions in the state that promotes
long-term growth. “National competitiveness” corresponds to the economic structures and
institutions of the state for economic growth within the structure of global economy.

Another outstanding definition states, that competitiveness “… refers to a country’s ability to

create, produce, distribute, and/or service products in international trade while earning rising
returns on its resources”.

Kulikov claims that there are real and nominal competitiveness. Real competitiveness requires
openness and fairness of markets, the quality and innovation of products and services in the
country of origin and the continued growth of life standard of its citizens. Therefore, the actual
degree of competitiveness is a possibility of national industries to have a free and fair market
of goods and services that meet the requirements of both domestic and foreign markets, and
simultaneous growth of real income. Since the nominal competitiveness can be achieved by a
particular government policy, creating a macroeconomic environment for domestic producers
through direct state subsidies and wage restraint. Thus, the real competitiveness is possible
only if national companies are able to effectively design, produce goods and sell them at prices
and quality that meets both external and internal customers’ requirements – without direct
subsidies, control of wages and unemployment.

Thus, it can be inferred, that competitiveness reflects the favourable position of the national
economy in the global space. This position can be reflected in many areas, mainly in the field
of international trade as the country’s ability to strengthen this position.

The competitiveness of the national economy is its concentrated expression of economic,

scientific, technological, organizational, managerial, marketing and other capabilities. This
concept embodies an ability of a state to achieve high rates of economic growth, ensure a steady
increase in real wages, promotion of domestic firms on the world market.
In this regard, economies that are more competitive tend to be able to produce higher levels of
income for their citizens, thus achieve a higher level of the quality of life. In other words,
competitiveness can be described as the ability of an economy to produce, promote and sell
goods and services in the global economy.

It can be inferred, that a more competitive economy is the one that is likely to grow faster over
the medium to long run.

The term itself came into use in the USA, in 1985. Than it became famous worldwide.
Nowadays the principle of competitiveness is one of the most important components of
qualitative analysis, trying to assess a country’s attractiveness and its engagement in global
processes.

Given this importance of maintaining competitiveness, governments of different countries

targeted their policies towards becoming more competitive and gaining their niche in this
globalized world. Thus, national governments’ principal goal is to establish an environment
that fosters wellbeing for its citizens by addressing health, safety, environmental issues and
laws. Undoubtedly, this goal can be achieved through effective management and allocation of
resources, and active political interventions. Therefore, it becomes imperative for governments
to coordinate a comprehensive approach towards trade and investment that incorporates a
competition orientation6. However, governmental bodies and decision makers must be
cognizant of the fact that their nation’s competitiveness depends upon their ability to sustain
trade and attract foreign investment.

Competitiveness is, perhaps, one of the widely discussed, criticized phenomena of international
economics. This fact explains existing of many theories discussing features of competitiveness.

Global competitiveness owes its origin to the theory of comparative advantage, which
historically was an antithesis to the perspective of the mercantilists. They believed in exports
and recommended strict government control of all economic activity with economic
nationalistic ideas. Mercantilists’ approach became a cornerstone to the many other theories
that came into use later. Among them are Ricardo’s theory of comparative advantage and
Heckscher-Ohlin’s factor abundance theory (according to this theory, countries will produce
and export those goods and services in which they have a comparative advantage in price or
factor cost). Initially Heckscher-Ohlin’s theory takes two factors as basic indicators
determining competitive advantages. Later some studies went beyond the two-factor analysis.

Another theory is ascribed to the Bank of England. According to this theory, competitiveness
should be measured in terms of relative indicators (i.e. relative export prices, relative export
productivity, relative unit labor cost, etc.).

Using a slightly different approach, the Economics and Statistics Department of Organization
for Economic Cooperation and Development (OECD) measures competitiveness as a sum of
export and import competitiveness.

One of the most well-known theories of national competitiveness is Michael Porter’s ‘National
Diamond’7, which represents a useful grouping of the concepts appropriate to analysis of
competitiveness and trade, thus is usually viewed in the context of case studies used to assess
 the prospects of an industry, product or economic activity. According to prof. Porter, there are
four driving factors, cornerstones in the competitiveness, entitled as “diamond”;

Many international, national, non-governmental organizations assess the level of

competitiveness of various countries.

Historically the first attempt made by the IMD World Competitiveness Center9, which
publishes its “World competitiveness yearbook” since 1989. One of the most outstanding
characteristics of the WCY is that it is the first comprehensive annual report and a worldwide
reference pointing on the competitiveness of countries. The yearbook provides benchmarks and
trends, statistics and survey data based on extensive research. According to the WCY a
country’s competitiveness is assessed and ranked according to how they manage their
competencies to achieve long-term value creation. According to the methodology report
published by the IMD World Competitiveness Center, an economy’s GDP and productivity
cannot be assesses as the only important indicators for its competitiveness, political, social and
cultural dimensions also play a vital role in the process of formatting competitive advantages10.
Thus, governments need to provide an environment for business enterprises. This environment
is to be characterised by efficient infrastructures, institutions and policies that encourage
sustainable value creation by these enterprises.

According to the WCY, observed countries’ ranking is calculated as the composite index. The
latter is based on nearly 340 indicators that measure competitiveness. Comparative data on the
abovementioned indicators are collected through various international, national, regional
sources, statistic databases, as well as from surveys conducted within business communities,
government agencies. The above-mentioned indicators are grouped in four major sets described
as follows.

1. A country’s economic Performance (assessed through 78 macroeconomic indicators);

2. Government Efficiency (government policy supports national competitiveness or not). These
set includes 70 indicators;
3. Business Efficiency – 67 indicators;
4. Infrastructure (do they fulfil business requirements or not) – 114 indicators.

The above-mentioned indicators are described in detail in the Table 1.

Economic Government’s
Business efficiency Infrastructure
performance efficiency

Extent to which
Extent to which Extent to which basic,
Macroeconomic enterprises are
government technological,
evaluation of the performing in an
policies are scientific and human
domestic innovative,
conductive to resources meet the
economy (5 sub- profitable and
competitiveness (5 needs of business (5
factors) responsible manner
sub-factors) sub-factors)
(5 sub-factors)
 Domestic,
Public finance Productivity Basic infrastructure
economy,

International Technological
Fiscal policy Labour market
trade infrastructure

International Institutional Scientific

Finance
investment framework infrastructure

Business Management Health and

Employment
legislation practices environment

Prices (78 Societal framework Attitudes and values Educations (96

criteria) (70 criteria) (67 criteria) criteria)

Table 1: Indicators are grouped in four major sets.

Each of these four sets is, in turn, divided into 5 sub-sectors. Thus, the ranking is based on 20
sub-factors. When describing the methodology of the WCY, it should also be noted that the
methodology has changed since 1989. These changes have been applied in accordance with the
challenges and changes of the global economy. It is notable, that WCY methodology relies on
four dimensions shaping a country’s competitiveness and determining countries’ development
strategies and participation in international division of labour. These four dimensions are listed
as follows;

1. Attractiveness vs. aggressiveness;

2. Proximity vs. globalism;
3. Assets vs. processes;
4. Individual risk taking vs. social cohesiveness.

To sum up, the WCY methodology emphasizes the multifaceted nature of the competitiveness
concept. One of the outstanding characteristics of this methodology is that it aggregates a set
of indicators, which determine the overall competitiveness index and rankings of the countries
included in the WCY database.

Another well-known and broadly used approach in assessment of the competitiveness is The
Global Competitiveness Report (Index) published (measured) by the World economic forum
international organization11. The Report was first published in 1979, when the world was facing
the worst and longest lasting financial and economic crisis of the last 80 years – in order to get
the pre-crisis situation. The Global Competitiveness Report ranks countries based on the Global
Competitiveness Index (calculated since 2004), taking into account the country’s ability to
ensure welfare for their citizens, which depends on the effectiveness of using all resources of
a given country.
 The Global Competitiveness index is a comprehensive tool, that measures the competitiveness
of 148 countries, contains 3 sub-indexes: basic requirements, efficiency enhancers, innovation
and sophistication factors that are based on 12 pillars (institutions, infrastructure,
macroeconomic environment, health and primary education, higher education and training,
etc.) including 119 indicators 12 pillars of competitiveness are:

1. Institutions;
2. Infrastructure;
3. Macroeconomic environment;
4. Health and primary education;
5. Higher education and training;
6. Goods market efficiency;
7. Labour market efficiency;
8. Financial market development;
9. Technological readiness;
10. Market size;
11. Business sophistication;
12. Innovation.

The 12 pillars are grouped in 3 sub-indexes described below in Table 2.

Innovation and
Basic requirements Efficiency enhancers
sophistication

Higher education and

Institutions Business sophistication
training

Infrastructure Goods market efficiency Innovation

Macroeconomic
Labor market development
environment

Health and primary Financial Market

education development

Technological readiness

Market size

Table 2: 12 pillars are grouped in 3 sub-indexes.

 The GCI is calculated as a weighted average of its components. The Harvard Institute proposes
one of well-known methodologies in assessment of competitiveness for International
Development (HIID). This methodology assesses competitiveness as the ability of a national
economy to achieve sustained high rates of economic growth, mainly focusing on the
competitiveness possibilities of economies in transition. The HIID mainly follows the
theoretical and methodological approaches of GCR and is based on the WEF’s competitiveness
definition presented in the Global Competitiveness Report. The main feature of this
methodology is that it puts emphasis on the initial conditions of transition and the ability of the
countries to improve the competitive positions of their economies. Thus, the HIID
differentiates three main types or initial conditions in transition, presented in the Table 3.

Fixed Hard Soft

These conditions are Refer to government

These conditions can be changed but not
invariant and cannot policy and can be
quickly
be changed changed easily

(Tax code,
(Geography, (The quality of institutions, industrial
international
topography, natural structure, ownership, public attitudes,
relations and
resource endowment, composition of economic output, level
agreements, laws,
culture, history, and quality of human and physical
regulating
climate, etc.) capital stocks, etc.)
frameworks, etc.)

Table 3: Three main types or initial conditions in transition.

The HIID calculates the overall competitiveness index basing on scores of its indices or factors,
collecting statistical data of international and national organizations and of survey data.

The HIID overall competitiveness index is composed of the following components;

 Openness of the economy,

 Government’s efficiency,
 Infrastructure,
 Technology,
 Financial sector,
 Efficiency of institutions,
 Management and labour.

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IFM/U1 Topic 2 International Monetary System

THEINTACTFRONT17/07/2018 4 COMMENTS
Paper Currency Standard & Purchasing Power Parity

With the breakdown of the gold standard during the period of the First World War, gold
parities and free movements of gold ceased, therefore the mint par of exchange lost
significance in the exchange markets.

Exchange rates fluctuated far beyond the traditional gold points and there was complete
confusion. Hence, to explain this phenomenon and the problem of determination of the
equilibrium exchange between inconvertible currencies, the theory of purchasing power parity
was enunciated.

The basic idea underlying the purchasing power parity theory is that the foreign
currencies are demanded by the nationals of a country because it has power to command
goods in its own country.

When domestic currency of a nation is exchanged for foreign currency, what is in fact done is
that domestic purchasing power is exchanged for foreign purchasing power. It follows that the
main factor determining the exchange rate is the relative purchasing power of the two
currencies.

For, when two currencies are exchanged, what is exchanged, in fact, is the internal
purchasing power of the two currencies.

Thus, the equilibrium rate of exchange should be such that the exchange of currencies would
involve the exchange of the equal amounts of purchasing power. It is the parity of the
purchasing power that determines the exchange rate. Thus, the purchasing power theory states
that exchange rate tends to rest at the point at which there is equality between the respective
purchasing power of the currencies. In other words, rate of exchange between two inconvertible
paper currencies tends to close to their purchasing power ratio. Hence,

The Purchasing Power Theory

(PPT) seeks to explain that under the system of autonomous paper standard the external
value of a currency depends ultimately and essentially on the domestic purchasing power
of that currency relative to that of another currency.

The PPT has been presented in two versions, namely

(1) Absolute Version of Purchasing Power Parity and

(2) Relative Version of Purchasing Power Parity.

Absolute Purchasing Power Parity

The absolute version of the purchasing power parity theory stresses that the exchange
rates should normally reflect the relation between the internal purchasing power of the
various national currency units.
The price of a tradable commodity in one country should theoretically be equal to the price of
the same commodity in another country, after adjusting for the foreign exchange rate. The
theory is known as the international law of one price. When the international law one price
applied to the representative good or basket of goods, it is called the absolute purchasing power
parity condition.

To illustrate the point, let us assume that a representative collection of goods costs Rs.9,625/-
in India and US$ 195 in USA. As per the Absolute PPP theory, the exchange rate between US$
and Indian Rupee is the ratio of two price indices.

Spot price (In Indian Rupee) = Price Index of India/ Price Index of USA

Spot Rate = PRupee / PUSA

As per the example mentioned above, the exchange rate would be;

Spot (in Rupee) = 9625/195 = Rs.47.5128

The theoretical argument behind the Absolute PPP condition is that a country’s goods are
relatively cheap internationally; goods market arbitrage would create pressure on both foreign
prices and goods prices to correct, and thereby conform to uniform international prices.

Relative Purchasing Power Parity

Purchasing Power for two currencies can be different not because of differences in their internal
purchasing power, but some other factors also.

Relative purchasing power parity relates the change in two countries’ expected inflation rates
to the change in their exchange rates. Inflation reduces the real purchasing power of a nation’s
currency.

If a country has an annual inflation rate of 5%, that country’s currency will be able to purchase
5% less real goods at the end of one year. Relative purchasing power parity examines the
relative changes in price levels between two countries and maintains the exchange rates, which
will compensate for inflation differentials between the two countries.

The relationship can be expressed as follows, using indirect quotes:

St / S0 = (1 + iy) ÷ (1 + ix) t

Where,

S0 is the spot exchange rate at the beginning of the time period (measured as the “y” country
price of one unit of currency x)

St is the spot exchange rate at the end of the time period.

iy is the expected annualized inflation rate for country y, which is considered to be the foreign
country.

Ix is the expected annualized inflation rate for country x, which is considered to be the
domestic country.

Example

The annual inflation rate is expected to be 8% in the India and that for the US is 3%. The
current exchange rate is Rs.46.5500/- per US $. What would the expected spot exchange rate
be in six months for Indian Rupee relative to US$.

Answer:

So the relevant equation is:

St / S0 = (1 + iy) ÷ (1 + ix)

= S6month ÷ Rs.46.5500 = (1.08 ÷ 1.03)0.5

Which implies S6month = (1.023984) × Rs.46.550 = Rs.47.6665.

So the expected spot exchange rate at the end of six months would be Rs.47.6665 per US$.

Inflation, taxes, quality of products, and other circumstances that change the market also
have bearing on the price or internal purchasing power. All these factors need to be
adjusted while estimating the exchange rate under in-convertible paper currency
standard. PPP theory may not reflect the true exchange rate in the short-run however; it
actually indicates the fundamental equilibrium exchange rate in the long-run.

International Monetary System – The Bretton Woods System

Attempts were initiated to revive the Gold Standard after the World War I, but it collapsed
entirely during the Great Depression of the 1930s.

It was felt that adherence to the Gold Standard prevented countries from expanding the
money supply significantly so as to revive economic activity.

However, after the Second World War, representatives of most of the world’s leading nations
met at Bretton Woods, New Hampshire, in 1944 to create a new international monetary system.

United States of America, at that time, was accounted for over half of the world’s
manufacturing capacity and held most of the world’s gold, the leaders decided to tie world
currencies to the US dollar, which, in turn, they agreed should be convertible into gold at
$35 per ounce. Under the Bretton Woods system, Central Banks of participating
countries were given the task of maintaining fixed exchange rates between their
currencies and the US-dollar.
They did this by intervening in foreign exchange markets. If a country’s currency was too high
relative to the US-dollar, its central bank would sell its currency in exchange for US-dollars,
driving down the value of its currency. Conversely, if the value of a country’s money was too
low, the country would buy its own currency, thereby driving up the price. The purpose of the
Bretton Woods meeting was to set up new system of rules, regulations, and procedures for the
major economies of the world.

The principal goal of the agreement was economic stability for the major economic powers of
the world. The system was designed to address systemic imbalances without upsetting the
system as a whole.

The Bretton Woods System continued until 1971. By that time, high inflation and trade
deficit in the USA were undermining the value of the dollar. Americans urged Germany
and Japan, both of which had favorable payments balances, to appreciate their
currencies.

But those nations were reluctant to take that step, since raising the value of their currencies
would increase prices for their goods and hurt their exports. Finally, the USA abandoned the
fixed value of the US-dollar and allowed it to “float” against other currencies, which led to
collapse of the Bretton Woods System.

The Bretton Woods system established the US Dollar as the reserve currency of the world. It
also required world currencies to be pegged to the US-dollar rather than gold. The demise of

Bretton woods started in 1971 when Richard Nixon took the US off of the Gold Standard to
stem the outflow of gold. By 1976 the principles of Bretton Woods were abandoned all together
and the world currencies were once again free floating.

World leaders tried to revive the system with the so-called “Smithsonian Agreement” in

1971, but the effort could not yield. Economists call the resulting system a “managed float
regime,” meaning that even though exchange rates most currencies float, central Banks
till intervene to prevent sharp changes.

As in 1971, countries with large trade surpluses often sell their own currencies in an effort to
prevent them from appreciating. Similarly, countries with large trade deficits buy their own
currencies in order to prevent depreciation, which raises domestic prices. But there are limits
to what can be accomplished through intervention, especially for countries with large trade
deficits. Eventually, a country that intervenes to support its currency may deplete its
international reserves, making it unable to continue support the currency and potentially
leaving it unable to meet its international obligations.

At present almost all countries having their own paper currencies standard which is
neither linked to gold or US-dollar or any other foreign currencies and they have adopted
the currency system which is “managed floating” in nature.
The Mint Par Parity Theory

This theory is associated with the working of the international gold standard. Under this system,
the currency in use was made of gold or was convertible into gold at a fixed rate. The value of
the currency unit was defined in terms of certain weight of gold, that is, so many grains of gold
to the rupee, the dollar, the pound, etc. The central bank of the country was always ready to
buy and sell gold at the specified price.

The rate at which the standard money of the country was convertible into gold was called
the mint price of gold.

If the official British price of gold was £6 per ounce and of the US price of gold $12 per ounce,
they were the mint prices of gold in the respective countries. The exchange rate between dollar
and pound would be fixed at $12/£6 =2, which in other words, one pound is equal to two dollar.

This rate is called mint parity rate or mint par of exchange because it was based on the mint
price of gold. However, the actual exchange rate between these currencies would vary above
or below the mint parity rate by the cost of shipping gold between two countries. To illustrate
this, suppose the US has a deficit in its balance of payments with Britain. The difference
between the value of imports and exports will have to be paid in gold by the US importers
because the demand for pounds exceeds the supply of pounds. But the transshipment of gold
involves cost. Suppose the shipping cost of gold from the US to Britain is 5 cents. So the US
importers would have to pay $2.05 per £1. This is exchange rate, which is equivalent to US
gold

Because currencies were convertible in gold, then nations could ship gold among themselves
to adjust their “balance of payments.”

In theory, all nations should have an optimal balance of payments of zero, i.e. they should
not have either a trade deficit or trade surplus.

For example, in a bilateral trade relationship between Australia and Brazil, if Brazil had a trade
deficit with Australia, then Brazil could pay Australia gold. Now that Australia had more gold,
it could issue more paper money since it now had a greater supply of gold to support new bills.

With an increase of paper bills in the Australian economy, inflation, i.e. a rise in prices due to
an overabundance of money, would occur. The rise in prices would subsequently lead to a drop
in exports, because Brazil would not want to buy the more expensive Australian goods.

Subsequently, Australia would then return to a zero balance of payments because its trade
surplus would disappear.

Likewise, when gold leaves Brazil, the price of its goods should decline, making them more
attractive for Australia. As a result, Brazil would experience an increase in exports until its
balance of payments reached zero. Therefore, the gold standard would ideally create a natural
balancing effect to stabilize the money supply of participating nations.
The Gold Standard in Operation

However, the operation of the gold standard in reality caused many problems. When gold left
a nation, the ideal balancing effect would not occur immediately. Instead, recessions and
unemployment would often occur. This was because nations with a balance of payments deficit
often neglected to take appropriate measures to stimulate economic growth. Instead of altering
tax rates or increasing expenditures – measures which should stimulate growth – governments
opted to not interfere with their nations’ economies. Thus, trade deficits would persist, resulting
in chronic recessions and unemployment.

With the outbreak of the First World War in 1914, the international trading system broke down
and nations valued their currencies by fiat instead, i.e. governments took their currencies off
the gold standard and simply dictated the value of their money. Following the war, some
nations attempted to reinstate the gold standard at pre-war rates, but drastic changes in the
global economy made such attempts futile. Britain, which had previously been the world’s
financial leader, reinstated the pound at its pre-war gold value, but because its economy was
much weaker, the pound was overvalued by approximately 10%. Consequently, gold swept out
of Britain, and the public was left with valueless notes, creating a surge in unemployment. By
the time of the Second World War, the inherent problems of the gold standard became apparent
to governments and economists alike.

Following the second world war, the International Monetary Fund replaced the gold
standard as a means for nations to address balance of payments problems with what
became a “gold-exchange” standard.

Currencies would be exchangeable not in gold but in the predominant post-war currencies of
the allied nations: British sterling, or more importantly, the U.S. dollar. Under the new
International Monetary Fund approach, governments had a more pronounced role in managing
their economies. Ideally, governments would hold dollars in “reserve.” If an economy needed
an influx of money because of a balance of payments deficit, the government could exchange
its reserve dollars for its own currency, and then inject this money into its economy. The dollar
would ideally remain stable since the U.S. government agreed to exchange dollars for gold at
a price of $35 an ounce. Thus, world currencies were officially off the gold standard. However,
they were exchangeable for dollars. Because dollars were still exchangeable for gold,
the “gold-exchange” standard became the prevailing monetary exchange system for many
years.

The effect of the gold-exchange system was to make the United States the center for
international currency exchange. However, due to the inflationary effects of the Vietnam War
and the resurgence of other economies, the United States could no longer comply with its
obligation to exchange dollars for gold. Its own gold supply was rapidly declining. In 1971,

President Richard Nixon removed the dollar from gold, ending the predominance of gold in
the international monetary system.

In retrospect, the gold standard had many weaknesses. Its foremost problem was that its
theoretical balancing effect rarely worked in reality. A much more efficient means to resolve
balance of payments problems is through government intervention in their economies and the
exchange of reserve currencies. Today, very few commentators propose a return to the gold
standard

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