different country. It also includes the value of l patents and trademarks that are trans- ferred across country borders. The sale of patent rights by a U.S. firm to a Canadian firm reflects a credit to the U.S. balance-of-payments account, and a U.S. purchase of patent rights from a Canadian firm reflects a debit to the U.S. balance-of-payments account. The capital account items are relatively minor (in terms of dollar amounts) when compared with the financial account items.
2-1c Financial Account
The key components of the financial account are payments for (1) direct foreign invest- ment, (2) portfolio investment, and (3) other capital investment.
Direct Foreign Investment Direct foreign investment represents the investment in fixed assets in foreign countries that can be used to conduct business operations.
Examples of direct foreign investment include a firm’s acquisition of a foreign company, its construction of a new manufacturing plant, or its expansion of an existing plant in a foreign country.
Portfolio Investment Portfolio investment refers to transactions between countries involving long-term financial assets (such as stocks and bonds) that do not affect the transfer of control. Thus, a purchase of Heineken (Netherlands) stock by a U.S. investor is classified as portfolio investment because it represents a purchase of foreign financial assets without changing control of the company. If a U.S. firm purchased all of Heineken’s stock in an acquisition, this transaction would result in a transfer of control and therefore would be classified as direct foreign investment instead of portfolio investment.
Other Capital Investment A third component of the financial account consists of other capital investment, which represents transactions involving short-term financial assets (such as money market securities) between countries. In general, direct foreign investment measures the expansion of firms’foreign operations whereas portfolio invest- ment and other capital investment measure the net flow of funds due to financial asset transactions between individual or institutional investors.
Errors and Omissions and Reserves If a country has a negative current account balance then it should have a positive capital and financial account balance. This implies that, although it sends more money out of the country than it receives from other coun- tries for trade and factor income, it receives more money from other countries than it spends for capital and financial account components such as investments. In fact, the negative balance on the current account should be offset by a positive balance on the capital and financial account. However, the offsetting effect is seldom perfect because measurement errors can occur when attempting to measure the value of funds trans- ferred into or out of a country. For this reason, the balance-of-payments account includes a category of errors and omissions.
2-2a Events That Increased Trade Volume
International trade has increased substantially over time, which has strongly affected multi- national corporations. First, it has enabled some MNCs to obtain materials at lower prices.
Second, it has allowed many MNCs to increase their sales and expand their operations.
The development of international trade is the result of numerous efforts by govern- ments to remove cross-border restrictions. Some of the more important historical events that increased trade activity are discussed next.
Fall of the Berlin Wall In 1989, the Berlin Wall separating East Germany from West Germany was torn down. This symbolic event led to improved relations between Eastern Europe and Western Europe and also encouraged free enterprise in all Eastern European countries and the privatization of businesses that were owned by the govern- ment. Finally, the Berlin Wall’s removal led to major reductions in trade barriers in Eastern Europe. Many MNCs began to export products there, and others capitalized on the cheap labor costs by importing supplies from that region.
Single European Act In the late 1980s, industrialized countries in Europe agreed to make regulations more uniform and to remove many taxes on goods traded among themselves. This agreement, which was formalized by the Single European Act of 1987, was followed by a series of negotiations among the countries to achieve uniform policies by 1992. The act allows firms in a given European country greater access to supplies from firms in other European countries.
Many firms, including European subsidiaries of U.S.-based MNCs, have capitalized on this agreement by attempting to penetrate markets in border countries. By producing more of the same product and distributing it across European countries, firms are now better able to achieve economies of scale. Best Foods (now part of Unilever) was one of many MNCs that increased efficiency by streamlining manufacturing operations in response to reduced trade barriers.
NAFTA As a result of the North American Free Trade Agreement (NAFTA) of 1993, trade barriers between the United States and Mexico were eliminated. Some U.S. firms attempted to capitalize on this by exporting goods that had previously been restricted by barriers to Mexico. Other firms established subsidiaries in Mexico to produce their goods at a lower cost than was possible in the United States before selling them in the United States. The removal of trade barriers essentially allowed U.S. firms to penetrate product and labor markets that were previously inaccessible.
The removal of trade barriers between the United States and Mexico allows Mexican firms to export some products to the United States that were previously restricted. Thus, U.S. firms that produce these goods are now subject to competition from Mexican expor- ters. Given the low cost of labor in Mexico, some U.S. firms have lost some of their market share. These effects are most pronounced in labor-intensive industries, such as clothing.
GATT Within a month of the NAFTA accord, the momentum for free trade contin- ued with a General Agreement on Tariffs and Trade (GATT) accord. This particular agreement was the conclusion of the so-called Uruguay round of trade negotiations that had begun seven years earlier. It called for the reduction or elimination of trade restric- tions on specified imported goods over a ten-year period across 117 countries. This accord has generated more international business for firms that had been unable to pen- etrate foreign markets because of trade restrictions.
Inception of the Euro In 1999, several European countries adopted the euro as their currency for business transactions among these countries. The euro was phased in as a currency for other transactions during 2001 and completely replaced the currencies WEB
www.census.gov/
foreign-trade Click on U.S.
International Trade in Goods and Services.
There are several links here to additional details about the U.S.
balance of trade.
WEB
www.ecb.int/euro/
coins/html/index.en.
html
Information about the euro.
of participating countries on January 1, 2002. Hence only the euro is used for transac- tions in these countries, and firms (including European subsidiaries of U.S.-based MNCs) no longer face the costs and risks associated with converting one currency to another. This single-currency system, which applies in most of Western Europe, has led to more trade among European countries.
Expansion of the European Union In 2004, the European Union (EU) was expanded to include Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia; these countries were followed by Bulgaria and Romania in 2007. Slovenia adopted the euro as its currency in 2007, Cyprus and Malta adopted it as their currency in 2008, and Estonia adopted it in 2011. The other new members of the European Union continue to use their own currencies, yet they could adopt the euro in the future after meeting specified guidelines (with regard to budget deficits) and other financial conditions. Nevertheless, their admission into the EU is rel- evant because restrictions on their trade with Western Europe are thus reduced. Because wages in these countries are substantially lower than in Western European countries, many MNCs have established manufacturing plants there to produce goods for export to Western Europe.
Other Trade Agreements In June 2003, the United States and Chile signed a free trade agreement to remove tariffs on products traded between the two countries.
In 2006, the Central American Trade Agreement (CAFTA) was implemented; this pact allowed for lower tariffs and regulations among the United States, the Dominican Republic, and four Central American countries. In addition, there is an pending ini- tiative for Caribbean nations to create a single market featuring free flow of trade, capital, and workers across countries. The United States has also established trade agreements with many other countries, including Singapore (2004), Morocco (2006), Oman (2006), Peru (2007), and Bahrain (2010). Yet because of the weak global econ- omy in the period 2008–2011, momentum for trade agreements subsided as some gov- ernments became more concerned about protecting their own country’s companies and local jobs.
2-2b Impact of Outsourcing on Trade
The term outsourcing refers to the process of subcontracting to a third party. In the context of multinational financial management, outsourcing consists of subcontracting to a third party in another country to provide supplies or services that were previously produced internally. Under this definition, outsourcing increases international trade activity because it means that MNCs now purchase products or services from another country. For example, technical support for computer systems used in the United States is commonly outsourced to India or other countries.
Outsourcing allows MNCs to conduct operations at a lower cost. The reason is that the expenses incurred from paying a third party are less than those incurred if the MNC itself produces the product or service. Many MNCs argue that they cannot compete globally without outsourcing some of their production or services. Outsourcing by MNCs has created many jobs in countries where wages are low. However, outsourcing by U.S.-based MNCs is sometimes criticized because it may reduce jobs in the United States. These MNCs might counter that, if they had not outsourced, they would have shut down some labor-intensive operations because labor expenses are too high in the United States to compete on a global basis.
There are many opinions about outsourcing but no simple solutions. Often people have opinions about outsourcing that are inconsistent with their own behavior.
EXAMPLE As a U.S. citizen, Rick says he is embarrassed by U.S. firms that outsource their labor services to other countries as a means of increasing their value because this practice eliminates jobs in the United States. Rick is president of Atlantic Co. and says the company will never outsource its services. Atlantic Co. imports most of its materials from a foreign company. It also owns a factory in Mexico, and the materials produced there are exported to the United States.
Rick recognizes that outsourcing may replace jobs in the United States, but he does not realize that importing materials or operating a factory in Mexico may also replace U.S. jobs. When questioned about his use of foreign labor markets for materials and production, he explains that the high manufacturing wages in the United States force him to rely on lower-cost labor in foreign countries. However, the same argument could be used by other U.S. firms that outsource services.
Rick owns a Toyota, a Nokia cell phone, a Toshiba computer, and Adidas clothing. He argues that these non-U.S. products are a better value for the money than their U.S. counterparts. His friend Nicole suggests that Rick’s consumption choices are inconsistent with his“create U.S. jobs”philoso- phy. She explains that she only purchases U.S. products. She owns a Ford automobile (produced in Mexico), an Apple iPod and iPhone (produced in China), a Compaq computer (produced in China), and Nike clothing (produced in Indonesia).l
Managerial Decisions about Outsourcing Managers of a U.S.-based MNC may argue that they produce their products in the United States to create jobs for U.S. workers.
However, when the same products can be easily duplicated in foreign markets for one-fifth of the cost, shareholders may pressure the managers to establish a foreign subsidiary or to engage in outsourcing. Shareholders could argue that the managers are failing to maximize the MNC’s value as a result of their commitment to creating U.S. jobs. The MNC’s board of directors, which governs all major managerial decisions, could pressure the managers to move some of the production outside the United States. The board should consider the potential savings that could occur from this strategy, but it must also consider the possible adverse effects due to bad publicity or to bad morale among its remaining U.S. workers. If production cost could be substantially reduced outside the United States without a loss in quality, then a possible compromise is to restrict foreign production to accommodating any growth in the firm’s business. That way, the outsourcing strategy would not adversely affect the employees already involved in production.
2-2c Trade Volume among Countries
Some countries rely more heavily on international trade than do others. The annual interna- tional trade volume of the United States is typically between 10 and 20 percent of its annual gross domestic product (GDP). Based on this ratio, the United States is less reliant on trade than many other developed countries. Canada, France, Germany, and other European coun- tries rely more heavily on trade than does the United States. For instance, Canada’s volume of exports and imports per year is valued at more than 50 percent of its annual GDP. The annual international trade volume of European countries is typically between 30 and 40 per- cent of their respective GDPs. The annual trade volume of Japan is typically between 10 and 20 percent of its GDP, much as in the United States.
Trade Volume between the United States and Other Countries The dollar value of U.S. exports to various countries during 2010 is shown in Exhibit 2.3, where amounts are rounded to the nearest billion. For example, exports to Canada were valued at $251 billion.
The proportion of total U.S. exports to various countries is shown in the upper por- tion of Exhibit 2.4. About 20 percent of all U.S. exports are to Canada and 13 percent are to Mexico.
The proportion of total U.S. imports from various countries is shown in the lower part of Exhibit 2.4. Canada, China, Mexico, and Japan are the key exporters to the United States; together, they account for more than half of the value of all U.S. imports.
WEB
http://trade.gov The international trade conditions outlook for each of several industries.
Exhibit 2.3 Distribution of U.S. Exports by Country (2010, billions of $)
Australia 22
Canada 251 Mexico 162 Argentina 8
Colombia 11
Venezuela 11 Peru 7
Brazil 35 Chile 11
Dominican Republic 7
Bahamas 3 Costa Rica 5
India 20 Pakistan 3China 90
Russia 6 Thailand 9 Malaysia 14Singapore 29
Philippines 7 Taiwan 26
Hong Kong 26 Indonesia 7
Japan 65 New Zealand 3
South Korea 39 Ecuador 5
Jamaica 2
Finland 2Sweden 5 Austria 3Spain 9
Norway 3 Germany 54 France 25
Switzerland 21 Portugal 1Belgium 25
Netherlands 35
Denmark 2 Ireland 7 Hungary 1 Italy 14
United Kingdom 48
Source:U.S. Census Bureau, 2010.
2-2d Trend in U.S. Balance of Trade
The quarterly trend in the U.S. balance of trade is shown in Exhibit 2.5. The U.S. balance- of-trade deficit increased substantially from 1997 until 2008. During 2008–2009, U.S. eco- nomic conditions worsened considerably and so the U.S. demand for foreign products and services decreased. As a result, the balance-of-trade deficit also decreased. Much of the U.S. trade deficit is due to a trade imbalance with just two countries: China and Japan. In recent years, the U.S. annual balance-of-trade deficit with China has exceeded $200 billion.
Any country’s balance of trade can change substantially over time. Shortly after World War II, the United States experienced a large balance-of-trade surplus because Europe relied on U.S. exports as it was rebuilt. During the last decade, the United States has experienced balance-of-trade deficits owing to strong U.S. demand for imported
Exhibit 2.4 Distribution of U.S. Exports and Imports by Country (2008)
Mexico 13%
Germany 4%
Canada 20%
China 7%
China 20%
Japan 5%
Japan 6%
Other 42%
Other 37%
Canada 14%
Mexico 11%
France 2%
France 2%
South Korea 3%
South Korea 3%
Germany 4%
United Kingdom
3%
United Kingdom
4%
Distribution of Exports
Distribution of Imports
Source:Bureau of Economic Analysis, 2010.
WEB
www.ita.doc.gov Access to a variety of trade-related country and sector statistics.
WEB
www.census.gov Latest economic, financial,
socioeconomic, and political surveys and statistics.
products that are produced at a lower cost than similar products can be produced in the United States.