Summary for the course International Economics and Business for the E&BE program at the University of Groningen. The summary contains the following chapters: Chapter 2, 6, 8, 9, 10, 11.
Chapter 2
2.2 Trade and multinational activity
Note: This paragraph is made clear with the help of Figure 2.1 in the book.
Firms go abroad and cross their national border to generate value added. In this context, the first
question to be asked is whether a firm wishes to serve foreign clients or source from abroad.
The most important reason for firms starting to engage in international business activities is their
wish to sell their goods in a new market in order to make a profit. Serving this new market can be
done in two ways (horizontal multinational):
Produce at home > export
Produce in the host country > directly sell
Sourcing from abroad can be done in two ways (vertical multinational):
Importing
Owning and controlling activities abroad
Horizontal multinational = market seeking, a firm starts producing and selling products or
services to clients in a host country (the value chain moves horizontally to a different location)
Vertical multinational = efficiency seeking, a specific part of the production process can be done
more efficiently in another country, so only a part of the value chain is moved to another country
> See Figure 2.2
2.3 Trade data and the current account
The decision tree in Figure 2.1 of the book told us that if a firm decides to internationalize by
producing at home and selling abroad, an export flow is created from home > host.
Export flows need to be accounted for at micro- and macro level. In both cases, the bookkeeping is
based at double entry bookkeeping = The process of identifying, measuring and communicating
economic information about an organization or other entity, in order to permit judgements by users
of the information.
For firms engaging in exports (international trade), micro level accounting is very complicated,
because:
1. An internationally operating firm must decide how to account for foreign-currency transactions.
Sales generated abroad are recorded in another currency than the costs made in the home country. In
the case of flexible exchange rates, this means that the exporting firm runs an exchange rate risk.
2. The exporting firm is confronted with diverging country-specific accounting regulations.
At the country level, all firm-level exports are recorded on the current account on the balance of
payments, which consists of two main parts: the current account and the capital and financial
account, each with subdivisions.
, The current account = Income-related transactions originating from produced goods and
services, incomes from investments and unilateral transfers (amounts of money sent or
received as gifts). Exports are recorded as credit items (+, as it is earned) and imports as debit
items (-, as it is spent) > Trade balance = Exports – imports
2.4 FDI data and the capital account
When firms decide to internationalize (either horizontal or vertical multinational activity), and they
have subsidiaries in other countries, this triggers all kinds of capital flows between home and host
country. Each firm with a production subsidiary in a foreign country needs to incorporate the
financial performance and figures of its foreign subsidiaries in the overall annual report of the
whole firm. This creates difficulties, but also opportunities:
Firms can turn exchange risks into benefits via different hedging strategies
Firms can shift profits to low tax level locations
Multinational activity:
Greenfield investments = Starting a brand new investment by building a new factory
Acquisitions = Buying an already existing firm abroad
Joint venture = Starting a cooperation with a firm in another country
In order to allow for a proper comparison of these capital flows between countries, FDI (Foreign
Direct Investment) became the universal definition and measurement of multinational activity data.
Keep in mind the difference between Foreign Direct Investment and Foreign Portfolio Investment.
FDI is about acquisitions for the purpose of control, whereas FPI refers to passive holdings of
securities and other financial assets.
FDI flows = Cross-border flows of financial capital that usually measure the difference between the
funds that multinational parents provided to their foreign subsidiaries and the funds that foreign
subsidiaries provided to their parents in a given year.
Three components:
Equity capital transactions = Purchases and sales by parents of the shares of enterprises
registered in foreign countries
Reinvested earnings = The parents' part of its foreign affiliates’ earnings that are neither
distributed as dividends by affiliates nor remitted to their parent, but instead are retained and
reinvested
Intra-company debt transactions = Short- and long-term borrowing and lending of funds
between parents and affiliates
FDI stock = Accumulated FDI flows, measure the value of a subsidiary’s shares and reserves
attributable to the parent, plus the net indebtedness of the affiliate to the parent.
This year's net capital flows, as reported on the balance of payments, only gives the change in a
,country's financial assets and liabilities. Using the analogy with a firm's financial accounting
system, the net capital flows are the net income of a country and the net capital stock of a country is
quivalent to a firm's net worth. The difference between the various components of the net capital
stock and the net capital flows is considerable. Higher stocks indicate that the flows were
substantially higher in previous years.
FDI flows are also recorded on a country’s balance of payments, on the capital account. An increase
in claims on foreigners is a capital outflow, a debit. An increase in claims by foreigners is a capital
inflow, a credit. If the claim is longer than a year, it’s called long-term capital. Shorter than a year of
course is short term capital.
The balance of payments is zero, such that:
Current account balance + Capital and financial account balance = 0
Suppose there is a surplus on the current account. This implies, roughly speaking, that the value of
the exports (credit) is higher than the value of the imports (debit). That is, the current account
represents a net credit item. By the rules of double-entry accounting this must be matched by a net
debit item on the capital account, and thus a net capital outflow, that is:
Surplus current account <=> Net capital and financial outflow
Though the net export proceeds do not have to be spent on foreign financial assets, exporting firms
may also put their money on deposit with their bank. This will lead to an increase by that amount in
the reserve asset position of this country, and therefore the result will be the same as with the
asquisition of foreign shares or bonds. This because the exporting firms have to be paid in local
currency, which means foreigners who have bought the goods will first have to go to the bank to
exchange their currency for that of the exporting firms, leading to an increase in the foreign
exchange reserves of the exporting country. A similar line of reasoning helps to explain why a net
capital inflow is booked as a credit.
2.5 Sales and value added
In the previous sections we discussed data that are used to measure exports and multinational
activity. But to understand firm activity abroad, it is in general better to use output indicators instead
of the foreign capital input that is measured by FDI data. The decoupling between financial and
operational activity means that it is increasingly difficult to use financial flows as a measure for
operational flows. Two of those operational output indicators are sales generated abroad, and the
value added generated abroad. There is a difference in outcome when comparing FDI, sales and
value added. Not all capital that is used to fund activities abroad is included in the FDI data, and not
all funds included in FDI data are really used to finance real economic activities abroad:
For example because of tax havens, those countries have a significant FDI inflow. But most
of this capital is not used for real value-adding multinational activity, as these countries do
not show up in the sales or value added ranking.
At the same time, locally raised external funds are not included in FDI stock and flow data,
yet the extent to which multinationals finance their foreign subsidiaries with locally raised
external equity and debt is substantial and varies across host countries.
And a third problem is that when, for example, a US parent finances a new subsidiary in
France with funds from its German subsidiary, this results in an FDI flow from Germany to
, France, suggesting that German multinational activity in France has increased, while in fact
it is US multinational activity in France that has increased.
One key problem with FDI data is that it thus only captures part of the funds that multinational
firms use to finance their activities. For this reason, international economists prefer to use output
indicators such as sales, and ideally value added. Although analyses on value added data are
insightful, the problem is that such data are not (yet) widely available, whereas FDI data are
available for a large number of countries. That is why most of the analyses are still based on FDI
data.
The number of firms that are internationally active has increased, and the country of origin of the
500 largest multinational firms has changed over time. This has tempted some observers to
conclude that all firms are becoming global. Using sales data of the largest 500 compannies
worldwide, Rugman and Verbeke provida an antithesis to this unidirectional globalization argument.
Their claim is that we are not su much witnessing globalization, as almost none of the firms in their
analysis can be considered truly global (sell at least 20 percent of their sales in all three regions of
the triad, but less than 50 percent in their home region), but a phenomenon they call regionalization.
Most of these firms have the vast majority of their sales in their home region. It is not so much
globalization, but a concentration of sales in certain regions, called a triad.
The coordination and organization costs of managing such truly global firms are immense, and a
trade-off exists between the degree of multinationality and the costs of doing business abroad.
2.6 The right type of data
The sum of micro is not always macro. Three examples may illustrate this observation:
Much of what is called an investment at the firm level is no investment at all at the macro-
level of a country. In the system of macro-level accounting, a firm-level investment is
counted only once, depending upon the money's origin and destination (otherwise it there
would be a double count, and that would contaminate the statistics).
Companies 'invest' a lot in buying other companies, or parts of other companies. In the
annual report this will then account for 'goodwill'. These types of firm-level 'investments' are
neutral from a macro perspective, however. It simply implies that money is shifted from one
firm or shareholder to another in order to restructure ownership, but without any productive
investment taking place. FDI flows are also often the result of internal financial engineering.
Many multinationals list much larger than many countries. In such rankings, the size
measure used for countries is GDP and for firms is sales. Such comparisons are problematic
for two main reasons. First, sales are the result of the number of products sold and the price
paid for these products. Value added (sum is GDP) is a part of the total sales. But also value
added is not perfect, since profit levels of firms fluctuate more over time (and sometimes
dissapear, a country's GDP obviously fluctuates less than the value added of a single firm.
Nevertheless, it is clear that some multinationals are larger than some countries, making
these multinationals powerful economic actors. Large multinationals can influence policy-
making in countries, enticing governments to provide interesting packages when a
multinational locates in their country.
Since whatever is earned must also be spent, we get:
C + M + S = I + X + C or S – I = X – M
The national savings surplus S – I must therefore necessarily be equal to the current account surplus
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