Lecture 9: Globalisation
EC100 Economics for Business
2010/2011
EC100 Economics for Business
Lecture 9: Globalisation
Lecture Outline: -
Globalisation, Multinational firms and foreign direct investments; Introduction to open economy macro: nominal and real exchange rates;
Essential reading: Sloman, Hinde and Garratt: Ch. 23 and Ch. 27. Globalisation We have seen that international trade can be mutually beneficial for the countries involved in it. Moreover we have seen that by increasing the barriers to trade a country can be worse-off (the consumers in that country will surely be worse-off). This may explain why in recent decades most of the countries in the world have lowered their barriers to trade and international trade has increased. This increase in international trade in the world has been named Globalisation. This term was coined in the 80s but we will see that is not a new concept after all. Globalisation can be defined as an increase in worldwide trade and exchanges in an increasingly open, integrated, and borderless international economy. There has been remarkable growth in such trade and exchanges, not only in traditional international trade in goods and services, but also in exchanges of currencies, in capital movements, in technology transfer, in people moving through international travel and migration, and in international flows of information and ideas. A broader definition of globalisation may include also cultural, political and military integration. However here we will focus only on the economics behind globalisation. First of all: is globalisation something new? Did international trade increase only in the last few decades? The answer is no. Globalisation as an increase in international trade is not a new concept. Indeed we have seen two waves of globalisation in our history. The first wave went from 1870 until the beginning of the first world ward, while the second
1
wave is the one we are experiencing now that started around the 1960s/ beginning of 70s. To see this in the following table we report for different countries the current account value (current account = export – imports + net factor payment from abroad) as a percentage of their GDP. The current account provides a measure of international trade of a country. It measures the trade in goods and services of that country with other countries. If for an economy the share of the current account on the GDP is high it means that the economy is very open to international trade.
From the table you can see that between 1870 and 1914 many economies were even more open to trade than they are in recent years. For example, in 1870-1889 the current account (so international trade between UK and other countries) counted for 4.6% of the UK GDP in that period. Between 1989 and 1996 international trade counted for 2.6% of the UK GDP in that period. So in terms of openness to trade, many economies were even more open between 1870 and 1914 than they are now. Globalisation then is not something really new. However there are differences between the first wave of globalisation and the second one. A very important difference is played by the role of multinational firms that we will discuss later.
What causes globalisation? There are many reasons why trade among countries increased over time. The main drivers of globalisation are: a) Market drivers: markets all over the world are becoming similar. For example, per capita income is converging among industrialised nations. This means that
2
developed countries are becoming more similar in terms of their wealth. There is also a convergence of lifestyles and tastes among those countries. Companies then have an incentive to become more global since they can have a bigger market for their products. b) Cost drivers: the decrease in transportation costs due to the increase in transport technology creates an advantage for the movement of goods around the world. Better information technology also helps in reducing costs for international transactions. Many firms try to lower their costs and possible ways of doing that are through production and service outsourcing. In many cases this outsourcing can be international (UK companies outsourcing their call centre services to Indian companies). c) Government drivers: this is a very important aspect. This is related to the reduction of tariff and non tariff barriers that many countries have achieved through international negotiations (for example through the World Trade Organization). In the following graphs we see how during the last 140 years the tariff imposed by France, UK and US have changed. Between 1870 and 1914 tariff barriers decreased in all three countries. This reduction in the barriers to trade was associated with the first wave of globalisation.
In that period many things helped the increase in international trade. Important technological advances were made in transportation. Steam power and refrigeration reduced the costs of ocean transportation of goods. The internal transportation also
3
improved thanks to the development of railroads. Also communication technology improved through the invention of the development of the telegraph. Between the two world wars, tariff barriers were increased:
Finally, tariff barriers started to decrease again after 1960s and beginning of the 70s and the second wave of globalisation started.
Those pictures are also true for many other countries, meaning that the tendency outlined here is quite general.
4
Costs and benefits of Globalisation We know that international trade can be beneficial and so globalisation should be beneficial too. However, there are also costs associated with an increase in international trade. What matters is to see if benefits are larger than costs. a) Potential benefits of globalisation: globalisation has led to growing competition on a global basis. While some fear competition, there are many beneficial effects of competition that can increase production or efficiency. More competition means firms can become more specialised in production and so more efficient, otherwise they will be pushed out of the market. This increases the amount produced by firms. Now this increase in production exists not just in a nation but also on a worldwide basis. The usual benefits from international trade apply here. Globalisation can also result in the increase in the spread of technology due to the competitive pressures for continual innovation on a worldwide basis.
b) Potential costs of globalisation: a possible cost is related by the distribution of the benefits discussed above. There can be substantial equity problems in the distribution of the gains among individuals, organizations, nations, and regions. Many of the gains have been going to the rich nations or individuals, creating greater inequalities and leading to potential conflicts nationally and internationally. For example the least developed nations of Africa, Asia, and South and Central America have been growing at a slower rate than the rich nations. This means that the poorest countries are the ones that gain less (this des not mean they do not gain, they just gain less). Another cost is that more interconnected economies may face more instability. The example of the recent credit crunch is particularly illuminating. Since many development economies are connected globally, a crisis happening in US can easily spread in other economies. Another possible cost is that the control of national economies is seen by some (especially the proponents of the anti-global movement) as possibly shifting from sovereign governments to other entities, including the most powerful nation states, multinational or global firms, and international organizations. Thus, globalization could lead to a belief among national leaders that they are helplessly in the grip of global forces. The result could be extreme nationalism along with calls for protectionism and the growth of extremist or fundamentalist political movements, ultimately leading to potential conflicts.
5
Multinational Firms One of the main elements related to globalisation is the increase in the number of big firms that become global, what we call multinational firms. This is also one of the most controversial elements in the globalisation debate. A multinational firm is a company that owns and controls foreign subsidiaries in more than one country. For example, Toyota is a big company with headquarter in Japan and with various branches in many other countries in the world. In general multinational companies tend to be very big. Many of those companies are so big that their revenues are bigger than the GDP of various countries. For example, in 2000 the revenues of Wal-Mart Stores were 67.7 billion dollars, while the GDP of New Zealand was 50 billion. General Motors had revenues for 46.2 while the GDP in Nigeria was 41.1.
Why firms become multinationals? There are three necessary conditions for a firm to be willing to become a multinationals, meaning that the firm is willing to invest in other countries to create subsidiaries and branches. These three conditions have been pointed out by John Dunning and are known as the Eclectic Paradigm: a) Ownership Advantage: the firm must have a product or a production process such that the firm enjoys some market power advantage in foreign markets. Those advantages can be derived from a superior technology. IBM had a better technology in creating computers for example. By creating branches on other countries IBM could penetrate new markets and enjoy a competitive advantage compared to national companies. Another ownership advantage can be derived from product differentiation. Firms that become multinationals can normally invest heavily in advertising and so they can make their product successful also in foreign markets. For example Kellogg’s cornflakes are probably not very different from other cornflake brands, however they have become widely successful more than their competitors. b) Location Advantage: the firm must have a reason to want to locate production abroad rather than concentrate it in the home country (like Japan for Toyota, or US for Kellogg’s). For example a firm may believe that by locating part of its production abroad it can lower its costs, or it can improve the quality of its
6
product or it can have bigger sales for its product in that particular country or area. The main location advantages are: i)
the relative costs of inputs: in some countries labour is cheaper than in others. By locating production in countries where labour cost is low a firm can decrease its production costs. This may enhance profits. For example Nike that creates branches in Bangladesh and Indonesia to exploit the low wages in those countries.
ii)
The quality of inputs: in some countries workers are more skilled than in others. More skilled workers are normally more expensive (they receive higher wages) but are also more productive. Firm that need highly skilled workers may find profitable to locate production where those workers are abundant. For example UK governments have tried to attract multinational investments by lowering labour costs and more flexible employment conditions than other European countries, while still having a relatively high skilled labour force compared to those in other European countries.
iii)
Avoiding transport costs: a firm may locate production in another country simply because it may be cheaper than producing at home and export the goods in that country. By doing that a firm can avoid the transportation cost. For example Nissan has created branches in European countries, like in UK. Instead of producing cars in Japan and shipping them to Europe, they can produce cars in Europe and sell them in Europe.
c) Internalization Advantage: the firm must have a reason to want to exploit its ownership advantage internally, rather than license or sell its product/process to a foreign firm. For example a firm mat find cheaper to create its own branch in another country than arranging a contract with an external party, for example an import dealer. This is the case when transaction costs are too high. For example it may too costly to reach an agreement with an import dealer and so creating a new branch may be a better choice. Transaction costs are not just monetary costs, but also finding the right partner may be costly especially when we move to a different country. Moreover, even if you find the right
7
partner there are costs of monitoring that partner, etc. etc. By creating its own branch a firm can reduce all those transaction costs.
Foreign Direct Investments (FDI) A firm becomes multinational by creating subsidiaries in different countries. When a firm from one country owns a company in another country we call it a Foreign Direct Investment (FDI). When do we have a FDI? Using the definition of the Department of Commerce in US we have: If a foreign firm acquires 10% or more of a US firm, then this is counted an inflow FDI into the US. If a US firm acquires 10% or more of a foreign firm then this wll be counted as an outflow FDI the US. Sometimes FDI are distinguished in the following way: a) Greenfield FDI: when a company builds a productive plant or branch in a foreign country. For example Nissan that build a factory in UK in order to produce its own cars; b) Acquisition FDI: when a firm buys an existing foreign plant. This includes also international mergers and acquisitions. For example Volkswagen acquired the existing factories own by Skoda in Czech Republic;
Foreign direct investments are the tools by which a firm becomes a multinationals. This represents an important aspect of the current wave of globalisation. Indeed, the amount of FDI has increased quite remarkably in recent years, confirming that the role of multinationals is particularly important in the current wave of globalisation. This is reported in the following graph where we plot how the value of FDI has changed between 1980 and 2005. We plot the world value, the value of inflow FDI in developed countries (that is the value of investments in developed countries made by multinationals) and the inflow FDI in developing countries.
8
You can notice that the massive increase in the level of FDI that we have seen after 1995 is due to investment that went to developed countries. The FDI going to developing countries is also increasing over time, but the large majority of the multinationals’ investments go to developed countries.
Empirical Evidence on Multinationals As we said the role of multinationals is controversial. The anti-global movement sees multinationals and their expansion as bad thing. Multinationals are becoming so big that some fear they can become too influential and so affecting the decisions of governments. Moreover their expansion in less developed countries to take advantage of cheap labour is considered to increase income inequality. Multinationals are becoming richer while workers in less developed countries are exploited being paid very little. Moreover by relocating production from the home country to cheaper countries, job losses may arise in the home country. However, what is the empirical evidence on the role of multinationals? Do we see what the opponents to globalisation claim? The answer is not really. The empirical evidence we have on multinationals tells us that: a) Multinationals are associated with high ratios of Research and Development (R&D) relative to sales. This means that multinationals do perform large
9
investments in research and development. We now that R&D is an important source of technological progress and technological progress is very important in creating economic growth. b) Multinationals are associated with new and/or technically complex products. This is related with the fact that multinationals invest heavily in R&D. c) The high-income developed countries are not only the major source of direct investment, they are also the major recipients. This means that cheaper labour cost in less developed countries is not an important determinant of FDI. d) Infrastructure, skill levels, and a minimum threshold level of per capita income seem to be very important determinants of direct investment. This is related to point c). e) In average multinational firms pay higher wages than national firms. This is true independently if we are in more developed or in a less developed country. Therefore the idea that some multinationals exploit cheap labour costs in less developed countries does not appear to be correct in average. f) There is little evidence that the expansion of multinationals had created higher income inequality. Evidence suggests that globalisation (so not only the increase in FDI) can explain between 7 and 11% of the income inequality among countries between 1995 and 2001.
Introduction to open economy macroeconomics We have introduced the idea of trade, now we introduce the idea of an open economy, that is an economy that can trade with other economies and we look at how an open economy behaves. In a closed economy the basic national accounting identity is given by:
Y = C + I +G In a open economy the national accounting identity is given by: Y = C + I +G + X −M
where: X > 0 is the level of Exports of goods and services; M > 0 is the level of Imports of goods and services;
When we talk about an open economy we normally distinguish between the Home Country and the Foreign Country (the foreign country can be the rest of the world, it does not need to be a specific country). This is because now the open economy can
10
export and import. So the home country can export goods to the Foreign country and the Home country can import goods from the Foreign country. We define the Trade Balance in our economy as the level of Net Exports (X–M):
NX = X − M a) If X > M , then NX > 0 and we say that we have a Trade Surplus. In this case our economy is spending less than it produces and so it LENDS to the rest of the world. b) If X < M , then NX < 0 and we have a Trade Deficit. Our economy is spending more than it produces and so it BORROWS from the rest of the world.
We can see this from the national accounting identity: NX = Y − (C + I + G )
If domestic spending is higher than what is produced domestically, we have (C + I + G ) > Y and so NX < 0 . This is case b) described above.
From Lecture 1) we also know that: S = I + CA where CA is the current account = NX + NFP (NFP= net factor payments from abroad). Assume that NFP is zero. The equation above tells you that when NX < 0 , then CA 0 , then S > I the economy can lend its extra saving to other countries (this is the case of China). The quantity S − I is equal to the current account. It is also called the Net Capital Outflow. The reason is that if S > I , some capital will flow from the home country to the foreign country (financial capital, not physical capital) while if S < I some capital must flow into the home country from the foreign country.
The Balance of Payments The balance of payments records all the transactions between a country and the rest of the world in a given period of time (for example a given year). The Balance of Payments is divided into two main parts: a) The Current Account: it records exports and imports of goods and services, receipts and payments of investment income and transfer payments. In practice the Current Account is given by Net Export (or Trade Balance)
11
plus Net Factor Payments from abroad. b) The Financial Account: it records purchases and sales of foreign assets by domestic residents and purchases and sales of domestic assets by foreign residents (for example, a British resident that buys a US bond for $100 will enter with a minus into the UK financial account (-$100 converted into pounds according to the exchange rate). A US resident that buys a UK government bond for £100 will enter with a plus into the UK financial account, and so on). The FDI discussed previously will enter here. An investment abroad by a UK company represents and outflow investment and so it enters as a minus in the UK financial account. Prior 1998, this was called capital account.
The Nominal Exchange Rate The nominal exchange rate is the price of one currency in terms of another currency (bilateral rate). There two ways to quote an exchange rate: a) The relative price of domestic currency in terms of foreign currency. For example, Euros per UK pound: €1.55 = £1. To buy one pound we must pay 1.55 euros. b) The relative price of foreign currency in terms of domestic currency. For example, UK pounds per Euros. In this case: £0.645 = €1. To buy one Euro we need to pay 0.645 pounds. It is clear that the definition in b) is the reciprocal of the definition in a). Define the exchange rate €1.55 = £1 as e€,£ = 1.55 , that is the price of a pound in
terms of Euros. Define the exchange rate £0.645 = €1 as e£,€ = 0.645 . Then, it is clear that: e€,£ =
1 . e£,€
In this note we will consider the nominal exchange rate defined as in a). The reason is: suppose that e€,£ increases, for example, from 1.55 to 2. This means that it is more expensive to buy British pounds using Euros. In this case we say that an increase in e€,£ means an APPRECIATION of the British pound against the Euro.
12
On the other hand if e€,£ decreases, then it is cheaper to buy the same amount of pounds using euros, and therefore the British pound is DEPRECIATING against the Euro. Therefore: 1) e€,£ increases: this corresponds to an “appreciation” of the country’s currency against the foreign currency (in this case Euros); 2) e€,£ decreases: this corresponds to an “depreciation” of the country’s currency against the foreign currency; In the following we will call the nominal exchange rate as e without specifying the currencies involved. This means that an increase in e will mean an appreciation of the home currency and a decrease in e will mean a depreciation in home currency. Note: using the definition of the exchange rate as in b) the previous reasoning must
be reversed. If e£,€ increases, for example from 0.645 to 1, then we have a Depreciation of the British pound against the Euro (the Euro is now more expensive
meaning that the pound is losing value). For example in the following graph you have the nominal exchange rate between sterling pound and the Euro in recent years.
13
In that graph the definition for the exchange rate is the one given in b). An increase in the exchange rate means a depreciation of the pound against the Euro. The Real Exchange Rate
The real exchange rate is defined as the relative price of domestic goods in terms of foreign goods (for example, the Big Mac in Japan compared to the Big Mac in US). Formally, the real exchange rate between the home country (for example UK) and the foreign country (for example US) can be written as:
ε=
eP P*
2)
where ε is the real exchange rate, e is the nominal exchange rate, P is the overall price level in the home country and P* is the overall price level in the foreign country. The real exchange rate measures the amount of purchasing power in the Foreign country that must be sacrificed for each unit of purchasing power in the Home country. Example: consider only one good, like the Big Mac. Assume that in UK the price of a Big Mac is £2, while in the US the price is $2. The nominal exchange rate is $2=£1, therefore, e = 2 . The real exchange rate is:
ε=
eP 2 × £2 $4 = = =2 P* $2 $2
A Big Mac in UK is equivalent to two Big Macs in US. Or another way to say, the Big Mac in UK is as twice as expensive as the Big Mac in US. We can think at the real exchange rate as measuring the relative price of a basket of domestic goods in terms of a basket of foreign goods. In all the macro models we have seen there is normally only one good, real output (= real GDP). So the real exchange rate can be interpreted as is the relative price of one country’s output in terms of the other country’s output. From equation 2) we have: a)
For a given nominal exchange rate, when prices increases in the domestic countries compared to the foreign country, meaning
P > 1 , the real P*
exchange rate increases, meaning that goods in the domestic country are becoming relatively more expensive compared to the goods in the foreign country. We call this case a real appreciation of domestic currency. b)
When prices in the foreign country increases compared to domestic prices we have
P < 1 , then ε ↓ , and we say that there is a real depreciation of P*
domestic currency.
14
2010/2011
EC100 Economics for Business
Lecture 9: Globalisation
Lecture Outline: -
Globalisation, Multinational firms and foreign direct investments; Introduction to open economy macro: nominal and real exchange rates;
Essential reading: Sloman, Hinde and Garratt: Ch. 23 and Ch. 27. Globalisation We have seen that international trade can be mutually beneficial for the countries involved in it. Moreover we have seen that by increasing the barriers to trade a country can be worse-off (the consumers in that country will surely be worse-off). This may explain why in recent decades most of the countries in the world have lowered their barriers to trade and international trade has increased. This increase in international trade in the world has been named Globalisation. This term was coined in the 80s but we will see that is not a new concept after all. Globalisation can be defined as an increase in worldwide trade and exchanges in an increasingly open, integrated, and borderless international economy. There has been remarkable growth in such trade and exchanges, not only in traditional international trade in goods and services, but also in exchanges of currencies, in capital movements, in technology transfer, in people moving through international travel and migration, and in international flows of information and ideas. A broader definition of globalisation may include also cultural, political and military integration. However here we will focus only on the economics behind globalisation. First of all: is globalisation something new? Did international trade increase only in the last few decades? The answer is no. Globalisation as an increase in international trade is not a new concept. Indeed we have seen two waves of globalisation in our history. The first wave went from 1870 until the beginning of the first world ward, while the second
1
wave is the one we are experiencing now that started around the 1960s/ beginning of 70s. To see this in the following table we report for different countries the current account value (current account = export – imports + net factor payment from abroad) as a percentage of their GDP. The current account provides a measure of international trade of a country. It measures the trade in goods and services of that country with other countries. If for an economy the share of the current account on the GDP is high it means that the economy is very open to international trade.
From the table you can see that between 1870 and 1914 many economies were even more open to trade than they are in recent years. For example, in 1870-1889 the current account (so international trade between UK and other countries) counted for 4.6% of the UK GDP in that period. Between 1989 and 1996 international trade counted for 2.6% of the UK GDP in that period. So in terms of openness to trade, many economies were even more open between 1870 and 1914 than they are now. Globalisation then is not something really new. However there are differences between the first wave of globalisation and the second one. A very important difference is played by the role of multinational firms that we will discuss later.
What causes globalisation? There are many reasons why trade among countries increased over time. The main drivers of globalisation are: a) Market drivers: markets all over the world are becoming similar. For example, per capita income is converging among industrialised nations. This means that
2
developed countries are becoming more similar in terms of their wealth. There is also a convergence of lifestyles and tastes among those countries. Companies then have an incentive to become more global since they can have a bigger market for their products. b) Cost drivers: the decrease in transportation costs due to the increase in transport technology creates an advantage for the movement of goods around the world. Better information technology also helps in reducing costs for international transactions. Many firms try to lower their costs and possible ways of doing that are through production and service outsourcing. In many cases this outsourcing can be international (UK companies outsourcing their call centre services to Indian companies). c) Government drivers: this is a very important aspect. This is related to the reduction of tariff and non tariff barriers that many countries have achieved through international negotiations (for example through the World Trade Organization). In the following graphs we see how during the last 140 years the tariff imposed by France, UK and US have changed. Between 1870 and 1914 tariff barriers decreased in all three countries. This reduction in the barriers to trade was associated with the first wave of globalisation.
In that period many things helped the increase in international trade. Important technological advances were made in transportation. Steam power and refrigeration reduced the costs of ocean transportation of goods. The internal transportation also
3
improved thanks to the development of railroads. Also communication technology improved through the invention of the development of the telegraph. Between the two world wars, tariff barriers were increased:
Finally, tariff barriers started to decrease again after 1960s and beginning of the 70s and the second wave of globalisation started.
Those pictures are also true for many other countries, meaning that the tendency outlined here is quite general.
4
Costs and benefits of Globalisation We know that international trade can be beneficial and so globalisation should be beneficial too. However, there are also costs associated with an increase in international trade. What matters is to see if benefits are larger than costs. a) Potential benefits of globalisation: globalisation has led to growing competition on a global basis. While some fear competition, there are many beneficial effects of competition that can increase production or efficiency. More competition means firms can become more specialised in production and so more efficient, otherwise they will be pushed out of the market. This increases the amount produced by firms. Now this increase in production exists not just in a nation but also on a worldwide basis. The usual benefits from international trade apply here. Globalisation can also result in the increase in the spread of technology due to the competitive pressures for continual innovation on a worldwide basis.
b) Potential costs of globalisation: a possible cost is related by the distribution of the benefits discussed above. There can be substantial equity problems in the distribution of the gains among individuals, organizations, nations, and regions. Many of the gains have been going to the rich nations or individuals, creating greater inequalities and leading to potential conflicts nationally and internationally. For example the least developed nations of Africa, Asia, and South and Central America have been growing at a slower rate than the rich nations. This means that the poorest countries are the ones that gain less (this des not mean they do not gain, they just gain less). Another cost is that more interconnected economies may face more instability. The example of the recent credit crunch is particularly illuminating. Since many development economies are connected globally, a crisis happening in US can easily spread in other economies. Another possible cost is that the control of national economies is seen by some (especially the proponents of the anti-global movement) as possibly shifting from sovereign governments to other entities, including the most powerful nation states, multinational or global firms, and international organizations. Thus, globalization could lead to a belief among national leaders that they are helplessly in the grip of global forces. The result could be extreme nationalism along with calls for protectionism and the growth of extremist or fundamentalist political movements, ultimately leading to potential conflicts.
5
Multinational Firms One of the main elements related to globalisation is the increase in the number of big firms that become global, what we call multinational firms. This is also one of the most controversial elements in the globalisation debate. A multinational firm is a company that owns and controls foreign subsidiaries in more than one country. For example, Toyota is a big company with headquarter in Japan and with various branches in many other countries in the world. In general multinational companies tend to be very big. Many of those companies are so big that their revenues are bigger than the GDP of various countries. For example, in 2000 the revenues of Wal-Mart Stores were 67.7 billion dollars, while the GDP of New Zealand was 50 billion. General Motors had revenues for 46.2 while the GDP in Nigeria was 41.1.
Why firms become multinationals? There are three necessary conditions for a firm to be willing to become a multinationals, meaning that the firm is willing to invest in other countries to create subsidiaries and branches. These three conditions have been pointed out by John Dunning and are known as the Eclectic Paradigm: a) Ownership Advantage: the firm must have a product or a production process such that the firm enjoys some market power advantage in foreign markets. Those advantages can be derived from a superior technology. IBM had a better technology in creating computers for example. By creating branches on other countries IBM could penetrate new markets and enjoy a competitive advantage compared to national companies. Another ownership advantage can be derived from product differentiation. Firms that become multinationals can normally invest heavily in advertising and so they can make their product successful also in foreign markets. For example Kellogg’s cornflakes are probably not very different from other cornflake brands, however they have become widely successful more than their competitors. b) Location Advantage: the firm must have a reason to want to locate production abroad rather than concentrate it in the home country (like Japan for Toyota, or US for Kellogg’s). For example a firm may believe that by locating part of its production abroad it can lower its costs, or it can improve the quality of its
6
product or it can have bigger sales for its product in that particular country or area. The main location advantages are: i)
the relative costs of inputs: in some countries labour is cheaper than in others. By locating production in countries where labour cost is low a firm can decrease its production costs. This may enhance profits. For example Nike that creates branches in Bangladesh and Indonesia to exploit the low wages in those countries.
ii)
The quality of inputs: in some countries workers are more skilled than in others. More skilled workers are normally more expensive (they receive higher wages) but are also more productive. Firm that need highly skilled workers may find profitable to locate production where those workers are abundant. For example UK governments have tried to attract multinational investments by lowering labour costs and more flexible employment conditions than other European countries, while still having a relatively high skilled labour force compared to those in other European countries.
iii)
Avoiding transport costs: a firm may locate production in another country simply because it may be cheaper than producing at home and export the goods in that country. By doing that a firm can avoid the transportation cost. For example Nissan has created branches in European countries, like in UK. Instead of producing cars in Japan and shipping them to Europe, they can produce cars in Europe and sell them in Europe.
c) Internalization Advantage: the firm must have a reason to want to exploit its ownership advantage internally, rather than license or sell its product/process to a foreign firm. For example a firm mat find cheaper to create its own branch in another country than arranging a contract with an external party, for example an import dealer. This is the case when transaction costs are too high. For example it may too costly to reach an agreement with an import dealer and so creating a new branch may be a better choice. Transaction costs are not just monetary costs, but also finding the right partner may be costly especially when we move to a different country. Moreover, even if you find the right
7
partner there are costs of monitoring that partner, etc. etc. By creating its own branch a firm can reduce all those transaction costs.
Foreign Direct Investments (FDI) A firm becomes multinational by creating subsidiaries in different countries. When a firm from one country owns a company in another country we call it a Foreign Direct Investment (FDI). When do we have a FDI? Using the definition of the Department of Commerce in US we have: If a foreign firm acquires 10% or more of a US firm, then this is counted an inflow FDI into the US. If a US firm acquires 10% or more of a foreign firm then this wll be counted as an outflow FDI the US. Sometimes FDI are distinguished in the following way: a) Greenfield FDI: when a company builds a productive plant or branch in a foreign country. For example Nissan that build a factory in UK in order to produce its own cars; b) Acquisition FDI: when a firm buys an existing foreign plant. This includes also international mergers and acquisitions. For example Volkswagen acquired the existing factories own by Skoda in Czech Republic;
Foreign direct investments are the tools by which a firm becomes a multinationals. This represents an important aspect of the current wave of globalisation. Indeed, the amount of FDI has increased quite remarkably in recent years, confirming that the role of multinationals is particularly important in the current wave of globalisation. This is reported in the following graph where we plot how the value of FDI has changed between 1980 and 2005. We plot the world value, the value of inflow FDI in developed countries (that is the value of investments in developed countries made by multinationals) and the inflow FDI in developing countries.
8
You can notice that the massive increase in the level of FDI that we have seen after 1995 is due to investment that went to developed countries. The FDI going to developing countries is also increasing over time, but the large majority of the multinationals’ investments go to developed countries.
Empirical Evidence on Multinationals As we said the role of multinationals is controversial. The anti-global movement sees multinationals and their expansion as bad thing. Multinationals are becoming so big that some fear they can become too influential and so affecting the decisions of governments. Moreover their expansion in less developed countries to take advantage of cheap labour is considered to increase income inequality. Multinationals are becoming richer while workers in less developed countries are exploited being paid very little. Moreover by relocating production from the home country to cheaper countries, job losses may arise in the home country. However, what is the empirical evidence on the role of multinationals? Do we see what the opponents to globalisation claim? The answer is not really. The empirical evidence we have on multinationals tells us that: a) Multinationals are associated with high ratios of Research and Development (R&D) relative to sales. This means that multinationals do perform large
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investments in research and development. We now that R&D is an important source of technological progress and technological progress is very important in creating economic growth. b) Multinationals are associated with new and/or technically complex products. This is related with the fact that multinationals invest heavily in R&D. c) The high-income developed countries are not only the major source of direct investment, they are also the major recipients. This means that cheaper labour cost in less developed countries is not an important determinant of FDI. d) Infrastructure, skill levels, and a minimum threshold level of per capita income seem to be very important determinants of direct investment. This is related to point c). e) In average multinational firms pay higher wages than national firms. This is true independently if we are in more developed or in a less developed country. Therefore the idea that some multinationals exploit cheap labour costs in less developed countries does not appear to be correct in average. f) There is little evidence that the expansion of multinationals had created higher income inequality. Evidence suggests that globalisation (so not only the increase in FDI) can explain between 7 and 11% of the income inequality among countries between 1995 and 2001.
Introduction to open economy macroeconomics We have introduced the idea of trade, now we introduce the idea of an open economy, that is an economy that can trade with other economies and we look at how an open economy behaves. In a closed economy the basic national accounting identity is given by:
Y = C + I +G In a open economy the national accounting identity is given by: Y = C + I +G + X −M
where: X > 0 is the level of Exports of goods and services; M > 0 is the level of Imports of goods and services;
When we talk about an open economy we normally distinguish between the Home Country and the Foreign Country (the foreign country can be the rest of the world, it does not need to be a specific country). This is because now the open economy can
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export and import. So the home country can export goods to the Foreign country and the Home country can import goods from the Foreign country. We define the Trade Balance in our economy as the level of Net Exports (X–M):
NX = X − M a) If X > M , then NX > 0 and we say that we have a Trade Surplus. In this case our economy is spending less than it produces and so it LENDS to the rest of the world. b) If X < M , then NX < 0 and we have a Trade Deficit. Our economy is spending more than it produces and so it BORROWS from the rest of the world.
We can see this from the national accounting identity: NX = Y − (C + I + G )
If domestic spending is higher than what is produced domestically, we have (C + I + G ) > Y and so NX < 0 . This is case b) described above.
From Lecture 1) we also know that: S = I + CA where CA is the current account = NX + NFP (NFP= net factor payments from abroad). Assume that NFP is zero. The equation above tells you that when NX < 0 , then CA 0 , then S > I the economy can lend its extra saving to other countries (this is the case of China). The quantity S − I is equal to the current account. It is also called the Net Capital Outflow. The reason is that if S > I , some capital will flow from the home country to the foreign country (financial capital, not physical capital) while if S < I some capital must flow into the home country from the foreign country.
The Balance of Payments The balance of payments records all the transactions between a country and the rest of the world in a given period of time (for example a given year). The Balance of Payments is divided into two main parts: a) The Current Account: it records exports and imports of goods and services, receipts and payments of investment income and transfer payments. In practice the Current Account is given by Net Export (or Trade Balance)
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plus Net Factor Payments from abroad. b) The Financial Account: it records purchases and sales of foreign assets by domestic residents and purchases and sales of domestic assets by foreign residents (for example, a British resident that buys a US bond for $100 will enter with a minus into the UK financial account (-$100 converted into pounds according to the exchange rate). A US resident that buys a UK government bond for £100 will enter with a plus into the UK financial account, and so on). The FDI discussed previously will enter here. An investment abroad by a UK company represents and outflow investment and so it enters as a minus in the UK financial account. Prior 1998, this was called capital account.
The Nominal Exchange Rate The nominal exchange rate is the price of one currency in terms of another currency (bilateral rate). There two ways to quote an exchange rate: a) The relative price of domestic currency in terms of foreign currency. For example, Euros per UK pound: €1.55 = £1. To buy one pound we must pay 1.55 euros. b) The relative price of foreign currency in terms of domestic currency. For example, UK pounds per Euros. In this case: £0.645 = €1. To buy one Euro we need to pay 0.645 pounds. It is clear that the definition in b) is the reciprocal of the definition in a). Define the exchange rate €1.55 = £1 as e€,£ = 1.55 , that is the price of a pound in
terms of Euros. Define the exchange rate £0.645 = €1 as e£,€ = 0.645 . Then, it is clear that: e€,£ =
1 . e£,€
In this note we will consider the nominal exchange rate defined as in a). The reason is: suppose that e€,£ increases, for example, from 1.55 to 2. This means that it is more expensive to buy British pounds using Euros. In this case we say that an increase in e€,£ means an APPRECIATION of the British pound against the Euro.
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On the other hand if e€,£ decreases, then it is cheaper to buy the same amount of pounds using euros, and therefore the British pound is DEPRECIATING against the Euro. Therefore: 1) e€,£ increases: this corresponds to an “appreciation” of the country’s currency against the foreign currency (in this case Euros); 2) e€,£ decreases: this corresponds to an “depreciation” of the country’s currency against the foreign currency; In the following we will call the nominal exchange rate as e without specifying the currencies involved. This means that an increase in e will mean an appreciation of the home currency and a decrease in e will mean a depreciation in home currency. Note: using the definition of the exchange rate as in b) the previous reasoning must
be reversed. If e£,€ increases, for example from 0.645 to 1, then we have a Depreciation of the British pound against the Euro (the Euro is now more expensive
meaning that the pound is losing value). For example in the following graph you have the nominal exchange rate between sterling pound and the Euro in recent years.
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In that graph the definition for the exchange rate is the one given in b). An increase in the exchange rate means a depreciation of the pound against the Euro. The Real Exchange Rate
The real exchange rate is defined as the relative price of domestic goods in terms of foreign goods (for example, the Big Mac in Japan compared to the Big Mac in US). Formally, the real exchange rate between the home country (for example UK) and the foreign country (for example US) can be written as:
ε=
eP P*
2)
where ε is the real exchange rate, e is the nominal exchange rate, P is the overall price level in the home country and P* is the overall price level in the foreign country. The real exchange rate measures the amount of purchasing power in the Foreign country that must be sacrificed for each unit of purchasing power in the Home country. Example: consider only one good, like the Big Mac. Assume that in UK the price of a Big Mac is £2, while in the US the price is $2. The nominal exchange rate is $2=£1, therefore, e = 2 . The real exchange rate is:
ε=
eP 2 × £2 $4 = = =2 P* $2 $2
A Big Mac in UK is equivalent to two Big Macs in US. Or another way to say, the Big Mac in UK is as twice as expensive as the Big Mac in US. We can think at the real exchange rate as measuring the relative price of a basket of domestic goods in terms of a basket of foreign goods. In all the macro models we have seen there is normally only one good, real output (= real GDP). So the real exchange rate can be interpreted as is the relative price of one country’s output in terms of the other country’s output. From equation 2) we have: a)
For a given nominal exchange rate, when prices increases in the domestic countries compared to the foreign country, meaning
P > 1 , the real P*
exchange rate increases, meaning that goods in the domestic country are becoming relatively more expensive compared to the goods in the foreign country. We call this case a real appreciation of domestic currency. b)
When prices in the foreign country increases compared to domestic prices we have
P < 1 , then ε ↓ , and we say that there is a real depreciation of P*
domestic currency.
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