Unit 1

QUESTION-1. Define and explain the concept of Business. What are the significant
characteristics of Business and Business Organizations?

Answer:

Business–Business is not a new or modern concept rather it is eras old. A Business is an

important institution in any society in any part of this world. Be it for the supply of goods or
services, creation of employment opportunities, offer of better quality life, or contribution to the
economic growth of a country, the role of business is crucial. So the first question arises in
anyone’s mind is what really a business is? The following definition is an attempt to provide
appropriate answer.

“A Business is nothing more than a person or group of persons properly organized to produce or
distribute goods or services. The study of business is the study of activities involved in the
production or distribution of goods and services-buying, selling, financing, personnel and the
like”. Practically the above said definition is true but in theoretical sense it is incorrect. Before
any activities can be considered in the business, there must exist both the goal of profit and the
risk of loss. Thus Business can be accurately defined by K. Ashwathapa as “Complex field of
commerce and industry in which goods and services are created and distributed in the hope of
profit within a framework of laws and regulations”.

The Concept of Business:

To understand any business the critical step is to explore all the factors related to business and
properly judging its impact on the business. There are many factors and forces which have
considerable impact on any business. All these forces come under one word called environment.
Hence understanding the business means understanding its environment. Environment refers to
all external forces which have a bearing on the functioning of business. From the micro point of
view, a business is an economic institution, as it is concerned with production and/or distribution
of goods and services, in order to earn profits and acquire wealth. Different kinds of
organizations (i.e., sole trader ship, partnership, Joint Stock Company and co-operative
organization) are engaged in business and are operating from small scale, as in case of grocery in
a start, to large scale, as in case of Tata Iron and Steel Co., Bajaj Auto, Maruti Udyog, and
Reliance Industries.

Characteristics of Business & Business Organizations

The characteristics of a business organization are very dynamic and versatile in nature. Whatever
may be the nature, magnitude and scale of operations of a business activity, a business
Organization must possess the following characteristics:

1. Dealings in Goods and Services:

The first basic characteristic of a business is that it deals in goods and services. Goods produced
or exchanged, may be consumers' goods, such as bread, rice, cloth, etc. or producers' goods such
as machines, tools, etc. The consumer goods are meant for direct consumption, either
immediately, or after undergoing some processes, whereas the producers' goods are meant for
being used for the purposes of Further production. Producers’ goods are also known as capital
goods. Services include supply of electricity, gas, water finance, insurance, transportation,
warehousing, etc.

2. Production and/or Exchange:

Every business is concerned with production and exchange of goods and services for value.
Thus, goods produced or purchased for personal consumption or for presenting to others as gifts
do not constitute business, because there is no sale or transfer for value. For example, if a person
cooks at home for personal consumption, it is not business activity. But, if he cooks for others in
his 'dhaba, or restaurant and receives payment from them, it becomes his business.

3. Creation of form, time and place utility:

All business activities create utilities for the society. Form utility is created, when raw materials
are converted into finished goods and services. Place utility is created, when goods are
transported from the place of production to the place of consumption. Storage of goods creates
time utility. This helps in preserving the goods, when not required and making them available,
when demanded by the consumers.

4. Regularity and Continuity in Dealings:

Regularity of economic transactions is the essence of business. There should be continuity or
regularity of exchange of goods and services for money. An isolated transaction cannot be called
a business. For example, if aperson sells his flat and earns some profits, it cannot be called a
business. But, if he purchases and sells flats regularly to earn his livelihood, it will be called his
business.

5. Profit Motive:

Another important feature of a business activity is its objective. The chief objective of a business
is to earn reasonable profits or 'surplus' as it is called in case of public enterprises. The survival
of a business depends upon its ability to earn profits. Every businessman wants to earn profits, to
get return on his capital and to reward himself for his services. Actually, profit is the spur that
helps in the continuation of the business. Profit is also essential for growth. Recreation clubs and
religious institutions cannot be called business enterprises, as they have nothing to do with the
profit motive.

Question-2. What is the meaning and concept of International Business? Why the business
organizations decide to go international? What are various types of International Business?

Answer: International Business

International business is a term used to collectively describe all commercial transactions (private
and governmental, sales, investments, logistics, and transportation)that take place between two
or more regions, countries and nations beyond their political boundary. Usually, private
companies undertake such transactions for profit; governments under take them for profit and for
political reasons. It refers to all those business activities which involves cross border transactions
of goods, services, resources between two or more nations. Transaction of economic resources
include capital, skills, people etc. for international production of physical goods and services
such as finance, banking, insurance, construction etc.

A multinational enterprise (MNE) is a company that has a worldwide approach to markets and
production or one with operations in more than a country. An MNE is often called Multinational
Corporation (MNC) or Transnational Company (TNC). Well known MNCs include fast food
companies such as McDonald's and Yum Brands, vehicle manufacturers such as General Motors,
Ford Motor Company and Toyota, consumer electronics companies like Samsung, LG and Sony,
and energy companies such as Exxon Mobil, Shell and BP. Most of the largest corporations
operate in multiple national markets. Areas of study within this topic include differences in legal
systems, political systems, economic policy, language, accounting standards, labor standards,
living standards, environmental standards, local culture, corporate culture, foreign exchange
market, tariffs, import and export regulations, trade agreements, climate, education and many
more topics. Each of these factors requires significant changes in how individual business units
operate from one country to the next. The conduct of international operations depends on
companies' objectives and the means with which they carry them out. The operations affect and
are affected by the physical and societal factors and the competitive environment

Why Business Organizations Go International?

The basic question of “why do the businesses organizations of a country go to the other
countries?” might have been in your minds. Therefore, we answer this question, before
proceeding further.

 To achieve higher rate of profits

 Expanding the production capacities beyond the demand of the domestic country
 Severe competition in the home country
 Limited home market
 Political stability vs. Political instability
 Availability of technology and managerial competence
 High cost of transportation
 Nearness to raw materials
 Availability of quality human resources at less cost
 Liberalization and Globalization
 To increase market share
 To avoid tariffs and import quotas

Types of International business

There are different ways through which we can invest in foreign countries. These modes
of International business are as follows:
1. Exporting-
Exporting is the simplest and widely used mode of entering foreign markets. There are three
forms of exporting includes: indirect exporting, direct exporting, and intra-corporate
transfers.
 Indirect exporting: Indirect exporting is exporting the products either in their original
form or in the modified form to a foreign country through another domestic company.
Various publishers in India including Himalaya Publishing House sell their products, i.e.,
books to UBS publishers of India, which in turn exports these books to various foreign
countries.
 Direct Exporting: Direct exporting is selling the products in a foreign country directly
through its distribution arrangements or through a host country’s company. Baskin
Robbins initially exported its ice-cream to Russia in 1990 and later opened 74 outlets
with Russian partners. Finally in 1995 it established its ice-cream plant in Moscow.

 Intra corporate transfers:

Intra corporate transfers are selling of products by a company to its affiliated company in
host country (another country). Selling of products by Hindustan Lever in India to
Unilever in USA. This transaction is treated as exports in India and imports in USA
2. Licensing-
In this mode of entry, the domestic manufacturer leases the right to use its intellectual
property, i.e., technology, work methods, patents, copy rights, brand names, trademarks
etc. to a manufacturer in a foreign country for a fee. Here the manufacturer in the
domestic country is called ‘licensor’ and the manufacturer in the foreign country is called
‘licensee.’ Licensing is a popular method of entering foreign markets. The cost of
entering foreign markets through this mode is less costly. The domestic company need
not invest any capital as it has already developed intellectual property. As such, the
domestic company earns revenue without additional investment. Hence, most of the
companies prefer this mode of foreign entry. The domestic company can choose any
international location and enjoy advantages without incurring any obligations and
 responsibilities of ownership, managerial, investment etc. Kirin Brewery-Japan’s largest
beer producer entered Canada by granting license to Molson and British market by
granting license to Charles Wells Brewery.
3. Franchising-
Franchising is a form of licensing. The franchisor can exercise more control over the
franchised compared to that in licensing to licensing. International franchising is growing
at a fast rate.
Under franchising, an independent organization called the franchisee operates the
business under the name of another company called franchisor. Under this agreement the
franchisee pays a fee to the franchisor. The franchisor provides the following services to
the franchisee:

 Trade marks
 Operating systems
 Product reputations
 Continuous support systems like advertising, employee training, reservation
services, and quality assurance programmes etc.

Basic Issues in Franchising

 The franchisor has been successful in his home country. McDonald was successful
in USA due to the popular menu and fast and efficient services.
 The factors for the success of the McDonald are later transferred to other countries.
 The franchiser may have the experience in franchising in the home country before
going for international franchising.
 Foreign investors should come forward for introducing the product on franchising
basis.

4. Contract Manufacturing: Some companies outsource their part of our entire production
and concentrate on marketing operations. This practice is called contract manufacturing or
outsourcing.
The advantages are as follows:

o International business can focus on the part of the value chain where it has distinctive
competence.
o It reduces the cost of production as the host country’s companies with their relative cost
advantage produce at low cost.
o Small and medium industrial units in the host country can also develop as most the
production activities take in these units.
o The international company gets the location advantages generated by the host
Country’s production.

The disadvantages are as follows:

 Host country’s companies may take up the marketing activities also, hindering the
interest of the international company.
 Host country’s companies may not strictly adhere to the production design, quality
standards etc. These factors result in quality problems, design problems and other surprises.
 The poor working countries in the host country’s companies affect the company’s image.
For example, Nike has suffered a string of blows to its public image because of reports of
unsafe and harsh working conditions in Vietnamese factories churning our Nike foot ware.

4. Management Contracts
The companies with low level technology and managerial may seek the assistance of a
foreign company. Then the foreign company may agree to provide technical assistance and
managerial expertise. This agreement between these two companies is called the management
contract. A management contract is an agreement between two companies, whereby one
company provides managerial assistance, technical expertise and specialized services to the
second company of the argument for a certain agreed period in return for monetary
compensation. Monetary compensation may be in the form of:

 A flat fee or
 Percentage over sales and
 Performance bonus based on profitability, sales growth, production or quality measures.
Management contracts are mostly due to governmental inventions. The Government of the
Kingdom of Saudi Arabia nationalized Armco and requested the former owners to manage the
company. Exxon and other former owner of Armco accepted the offer. Delta, Air France and
KLM often provide technical managerial assistance to the small airlines companies owned by
the Governments

Advantages

 Foreign company earns additional income without any additional investment, risks and
obligations.
 Hilton Hotels provided these services to other hotels without additional investment and
earned additional income.
 This arrangement and additional income allows the company to enhance its image in the
investors and mobilize the funds for expansion.
 Management contract helps the companies to enter other business areas in the host
country.
Disadvantages:
 Sometimes the companies allow the companies in the host country even to use their
trademarks and brand name. The host country’s companies spoil the brand name, if they do
not keep up the quality of product service.
 The host country’s companies may leak the secrets of technology.

6. Turnkey project
Indonesia government during 1974 invited global tenders for construction of a sugar factory
in the country. Indonesia Government received the tenders from the companies of USA, UK,
France, Germany and Japan. One of the Japanese Company quoted highest price compared to
all other companies.
Indonesia Government was very much satisfied with the total package and invited the
Japanese company to implement the project. The Japanese company and Indonesian
Government entered an agreement for implantation of this project by Japanese company for a
price. This project is called “Turnkey Project.”
 A turnkey project is a contract under which firm agrees to fully design, construct and equip a
manufacturing/business/service facility and turn the project over the purchaser when it is
ready for operation for a remuneration. The form of remuneration includes:

 A fixed price (firm plans to implement the project below this price)

 Payment on cost plus basis (i.e., total cost incurred plus profit)This form of pricing
allows the company to shift the risk of inflation/enhanced costs to the purchaser.
International turnkey projects include nuclear power plants, airports, oil refinery,national
highways, railway lines etc. Hence, they are large and multiyear projects.International
companies involve in such projects include: Bechtel, Brown and Root,Hyundai Group,
Kennengen, Friedrich Krupp Gmb H. etc
The Greenfield Strategy

The term Greenfield refers to starting with a virgin green site and then building on it.
Thus,Greenfield strategy is starting of the operations of a company from scratch in a foreign
market. The company conducts the market survey, selects the location, buys or leases land,
creates the new facilities, erects the machinery, remits or transfers the human resources and
starts the operations and marketing activities. This strategy is followed by Fuji inlocating its
manufacturing facilities in South Carolina, by Mercedes-Benz in locating automobile
assembly plant in Alabama and Nissan in locating its factory in Sunderland, England. Disney
management faced the problems in building Disneyland in Paris. These problems include:

 Problems in dealing with French construction contractors.

 Communication difficulties with painters.
 Local contractors demanded $150 million extra at the time of opening and threatened the
opening.
 Local employees resisted the firm’s attempt to impose its US work values.
Advantages:
 The company selects the best location from all view points.
  The company can avail the incentives, rebates and concessions offered by the
host governments including local governments.
 The company can have latest models of the buildings, machinery and
equipment technology.
 The company can also have its own policies and styles of human resource management.
 The company can have its gestation period to understand and adjust to the new culture of
the host country. Thus, it can avoid the cultural shock

Disadvantages:
 This strategy results in a longer gestation period as the successful implementation takes
time and patience.
 Some companies may not get the land in the location of its choice.
 The company has to follow the rules and regulations imposed by the host country’s
Government in case of construction of the factory buildings.
 Host country’s Government may impose conditions that the company should recruit local
people and train them, if necessary, to meet the company’s requirements.

Mergers and Acquisitions

Domestic companies enter international business though mergers and acquisitions. A domestic
company selects a foreign company and mergers itself with the foreign company in order to enter
international business. Alternatively, the domestic company may purchase the foreign company
and acquires its ownership and control.

Though mergers and acquisitions provide easy and instant entry to global business, it would be
very difficult to appraise the cases of acquisitions and mergers. Sometimes it would be cheaper
to a domestic company to have a green field strategy than by acquisitions. Sometimes mergers
and acquisitions also result in purchasing the problems of a foreign company.
Advantages:

 The company immediately gets the ownership and control over the acquired firm’s
factories, employees, technology, brand names and distribution networks.
 The company can formulate international strategy and generate more revenues.
 If the industry already reached the stage of optimum capacity level or over capacity level
in the host country. This strategy helps the economy of the host country.

Disadvantages:

 Acquiring a firm in a foreign country is a complex task involving bankers, lawyers,

regulations, mergers and acquisition specialists from the two countries.
 This strategy adds no capacity to the industry.
 Sometimes host countries imposed restrictions on acquisitions of local companies by the
foreign companies.
 Labour problems of the host country’s company are also transferred to the acquired
 Company

Joint Ventures:
Two or more firms join together to create a new business entity that legally separate and
distinct from its parents. Joint ventures are established as corporations and owned by the
funding partners in the predetermined proportions. American Motor Corporation entered
into joint venture with Beijing Automotive Works called Beijing Jeep to enter Chinese
markets by producing jeep sand other vehicles. Joint ventures involve shared ownership.
Joint ventures are common in international business. Various environmental factors like
social, technological, economical and political encourage the formation of joint ventures.
Joint ventures provide required strengths in terms of required capital, latest technology
required human talent etc. and enable the companies to share the risk in the foreign
markets.
Advantages:

 Joint ventures provide large capital funds. They are suitable for major products.
 Joint ventures spread the risk between or among partners.
  Different parties to the joint venture bring different kinds of skills like technicalskills,
technology, human skills, expertise, marketing skills or marketing networks.
 Joint ventures make large projects and turnkey projects feasible and possible.
 Joint ventures provide synergy due to combined efforts of varied parties.

Disadvantages:

 Joint ventures are also potential for conflicts. They result in disputes between or among
parties due to varied interests. For example, the interest of a host country’s company in
developing countries would be to get the technology from its partner while the interest of
a partner of an advanced county would be to get the marketing expertise from the host
country’s company.
 The partners delay the decision-making once the dispute arises. Then the operations
become unresponsive and inefficient.
 Decision-making is normally slowed down in joint ventures due to the involvement of a
number of parties.
 Scope for collapse of a joint venture is more due to entry of competitors, changes in
business in business environment in the two countries, changes in partners’ strengths etc.
 Life cycle of a joint venture is hindered by many causes of collapse.

Question-3 what is International Business Environment? What do you understand by

the basic structure of International Business Environment?

Answer: Business Environment:

It refers to all external forces which have a bearing on the functioning of the business. In fact
Environment consists of factors that are largely if not totally, external and beyond the control
of individual industrial enterprise and their managements. These are essentially the ‘givers’
within which firms and their management must operate in a specific country and they vary,
often greatly, from country to country. Business environment can be defined as the process
by which strategists monitor the economic, governmental, market, supplier, technological,
geographic, and social settings to determine opportunities and threats to their firms.
 From the above definitions we can extract that business environment consists of factors that
are internal and external which poses threats to a Business Organization or these provide
opportunities for exploitation.

In business all the activities are being organized and also carried out by the people to satisfy
the needs of the consumers. So, it is an activity carried out by the people for the people which
mean people occupy a central place around which all the activities revolve. It means business
is people and a human is always a dynamic entity who believes in change and it may be right
to say that the only certainty today is change. It poses a huge challenge for today’s and
especially tomorrow’s businessmen and managers to be aware of specific changes so as to
keep themselves abreast with the latest happenings in the field of business to maintain their
survival and sustainability in the market. Therefore, the study of business environment is of
at most importance for the managers and practitioners.

International Business Environment

International Business Environment can be defined as the environment in

different sovereign countries, with factors exogenous to the home environment of the
organization, influencing decision making on resource use and capabilities. This includes the
social, Cultural, Technological, Economic, Politico-Legal or regulatory, tax, Global and
Natural environments.

As Business Organizations have no control over the external environment, their success
depends upon how well they adapt to the external environment. A Business Organization's
ability to design and adjust its internal variables to take advantage of opportunities offered by
the external environment, and its ability to control threats posed by the same environment,
determine its success.

Basic Structure of International Business Environment

The Basic structure of international Business environment is very complex, dynamic and
multifarious in nature so it is very much significant to study, understand and conceptualize the
structure of International Business Environment in a comprehensive manner. The structure of
International Business Environment can be categorized in to some very significant categories
which can be understood by a simple Word STEP IN as follows1.

 S–Socio Cultural Environment

 T–Technological Environment
 E-Economic Environment
 P–Politico-Legal Environment
 I–International Environment
 N–Natural Environment

Socio-Cultural Environment

Social and cultural factors in various countries of the globe affect the international business.
These factors include attitude of the people to work, attitude to wealth, family, marriage,
religion, education, ethics, human relations, social responsibilities etc.

Social and Cultural Environment

Religion-Religion is one of the most important social institutions influencing business.

Religions play significant role in normal and ethical standards in production and marketing of
goods and services. Most of the religions indicate in providing truthful and honest information.
But most of the marketing practice deviates from these standards.

Family Systems-In addition to religion, family system has its impact on international business.
In most of the Islamic countries, women play less significant role in the economy and also in the
family with limited rights. In Latin Americans countries, though the role of women is better
compared to that in Islamic countries, women’s role is limited in economies and in families. But, women
play a dominant role in European and North American countries. In addition, joint families are
more prevalent in Islamic and Hindu religions. Joint family system reduces the demand for
goods and service compared to nucleus families.

Culture- Culture is, the thought and behavior patterns that member of a society earns through
language and other forms of symbolic interaction- their customs, habits , beliefs and values, the
common viewpoints which bind them together as an social entities.
Cultures change gradually picking up new ideas and dropping old ones, but many of the cultures
of the past have been so persistent and self contained that the impact of such sudden change has
torn them apart, uprooting their people psychologically.

Characteristics of culture:

1. Learned-culture is not inherited nor biologically based; it is acquired by learning and

experience.
2. Shared-People as members of a group, organization, or society share culture; it isnot
specific to specific individuals.
3.Trans generational-Culture is correlative passed from one generation to the next.
4. Symbolic-culture is based on the human capacity to symbolize or use one thing to
represent another.
5. Patterned-Culture has structure and is integrated; a change in one part will bring
changes in another.
6.Adaptive-Culture is based on the human capacity to change or adapt, as opposed to the
more genetically driven adaptive process of animals.
Language and Culture
Language is the foundation of any culture. It is an abstract system of word meanings and
symbols for all aspects of culture. Language includes speech, written characters, numerals,
symbols, and gestures of non-verbal communication. The interrelationship between language
and culture is very strong and often the former determines the latter. Words provide the
concepts for understanding the world. In an organization, different people related with
different culture speak different languages. Sometimes this language creates communication
barriers so we can say that there is close interrelationship between language and culture.
Cultural Attitude and Organization
Dressing habits, living styles, eating habits and other consumption patterns, priority of needs
are dictated or influenced by culture. Some Thai and Chinese and Indians do not consume beef.
Thailand and Chinese believe that consumption of beef is improper and Indians believe that
eating beef is a sin because cow is sacred. On the other hand, Americans and European eats
mostly non-vegetarian foods and also prefer beef.
Similarly, dressing habit also vary from country to country based on their culture. For example
an Indian woman wears ‘saree’ and the woman of Middle East wears burka, naqab aur parda.
Education and culture
In its broad sense, education is the lifelong process of learning through which members of a
society acquire knowledge and develop skills, ideas, values, norms, and attitudes which they
share other members of the society Countries rich in educational facilities attract high-wage
industries. Educationally advanced countries such as England, France, and Germany are more
likely to be markets for computers and high-tech equipment than are less educated countries
such as Poland, the Czech Republic, and Romania.
Technological Environment
“Technological Environment means the development in the field of technology which Affects
business by new inventions of productions and other improvements in techniques to perform the
business work.
Explanation
We see that in 21st century, technology is changing fastly. Now, all work is done online and
business shops are using machinery at high level. There are following technological
environment factors which affects business.
 New inventions to produce the products.
 New inventions relating to marketing like BPO for selling online in international market.

Technology is a critical factor in economic development. Because of the advances of

international communication, the increasing economic interdependence of nations, and the
serious scarcity of vital natural resources, the transfer of technology has become an important
preoccupation of both industrialized and developing countries. For many industrialized countries,
the changes in the technological environment over the last 30years have been immense
particularly in such areas as chemicals, drugs, and electronics. It is vital that organizations stay
abreast of these changes - not only because this will allow them to incorporate new and
innovative designs into their products, but also because it will give them a firmer base from
which to anticipate and counteract competition from other organizations.
Economic Environment

International business is mostly and directly influenced by the economic environment of various
countries. Global economy has undergone a sea change during the last 50 years. The change is
revolutionary after1990. The results of these changes are emergence of global markets,
establishment of World Trade organization, emergence o0f global business houses and global
competitors rather than local competitors. The major changes include:

 Capital flow rather than trade or product flow across the globe.
 Establishment of production facilities in various countries
 Technological revolution delinked the relation between the size of production and level
of employment.
 Primary products are delinked from the industrial economies.
 The macroeconomic factors of individual nations independently do not significantly
control the global economic outcomes.
 The contest between ‘capitalism’ and ‘communism’ is over. Capitalism succeeded over
communism/socialism as a model for the organization of economic activity.

Economic Systems
Economic system is an organization of institutions established to satisfy human needs/wants.
There are three types of economic system, viz., capitalism, communism and mixed. These are as
follows:
1. Capitalism Economic Systems-

Under this system, customer allocates resources. Customers’ choice for product/services decides
what will be produced by whom. This economic system provides for economic democracy, thus
giving the customer, his choice for products/services.

This system emphasizes on the philosophy of individualism believing in private ownership of

production and distribution facilities. The limitation of this economic system made the
governments to introduce the welfare state concept which includes: workmen’s compensation
law, provision for social security, labor legislation for state and housing, agriculture, medical,
food, transportation, communication, security, education, water, power supply etc.
USA, Japan and UK are the examples of capitalistic countries. Most of the other countries like
India, France, Italy and Malaysia have started shifting their economic system towards this
economic system.

ii. Mixed Economic System-

Under this economic system, major factors of production and distribution are owned, managed
and controlled by the state. The purpose is to provide the benefits to the public more or less on
equity basis. The other factors of mixed economic system are development of strong public
sector, agrarian reforms, control over private wealth, regulation of private investment and
national self-reliance.

This system does not distribute the existing wealth equally among the people, but advocates the
egalitarian principle. It believes in full employment, suitable rewards for the workers’ efforts.
This is also called ‘Fabian socialism.’

The trend that is taking place in the globe today is the move towards privatization i.e. move
towards market allocation. UK, France, Holland and India, for example, have reduced their
command sector after 1990.

iii. Communistic Economic System-

In this, economic system, private property and property rights to income are abolished. The state
owns all the factors of production and distribution. Communism is also called Marxism.

In communistic/command allocation countries, the resource allocation decisions are made by the
government planners. The number of automobiles, shoes, shirts, television sets- their size, color,
quality, features etc., motor cycles, and scooters are determined by government planners.

Under this system, consumers are free to spend their income on what is available. The major
limitations of this system include:

 It reduces individual freedom of choice due to restrictions on items to be produced.

 It fails to get total commitment of people to work and country’s welfare.
 It failed to achieve significant economic growth.
 It could not achieve equality- the main plank of Marxism.
 The rules of this system did not set fine examples for the executors to follow or
implement
 It has been obsessed with rights of workers.

Cuba is an example of the last remaining predominantly communist country.

Business Development

Stages of business Development

Different countries in the world are at different stages of development. Countries are
segments based on GNP per capita. World countries are divided into four categories, viz.,
Low-Income Countries, Lower-Middle- Income Countries, Upper-Middle Income Countries
and High-Income Countries.

Politico-Legal Environment

Politico-Legal environment factors also influence the operations of international business

firms enormously. The influence of the political system of a country influences the business
from multi-angles, viz., deciding, promoting, and fostering, encouraging, sheltering, directing
and controlling the business activities. The success and growth of international business
depend upon the stable, dynamic, honest, people participative, secured political system in a
country.

International Environment

The International (or global) environment consists of all those factors that operate at the
transnational, cross-cultural, and across-the-border level which have an impact on the
business of an organization. Some of the important factors and influences operating in the
international environment are as below:

 Globalization, its process, content, and direction

 Global economic forces, organizations, blocs, and forums.
 Global trade and commerce, its process and trends.
 Global financial system, source of financing, and accounting standards
  Geopolitical situation, equations alliances, and strategic interest of nations
 Global demographic pattern and shifts.
 Global human resources- institutions, availability, nature and quality of
skills63999and expertise, mobility of labor and other skilled personnel.
 Global information systems, communication networks, and media.
 Global technological and quality systems and standards
 Global markets and competitiveness
 Global legal system, adjudication and arbitration mechanisms
 Globalization of management and allied disciplines, and the diffusion of management
techniques in industry

Natural Environment

Equally significant, but sadly ignored, are the factors like climate, minerals, soil, land form,
rivers and oceans, coast lines, natural resources, flora and fauna etc. Which have considerable
influence on the functioning of a business? It is the natural environment which decides the
resources for any business. Manufacturing, which is one of the aspects of business, depends on
physical environment for inputs like raw material, labor of various skills, water, fuel etc. Trade
between two regions of a nation or between two nations is the result of geographic factors.
Because of natural factors, certain areas are more suitable for production of certain goods and
other areas are in need of such goods. Transportation and communication, the main prop of
business, depend to a larger extent on geographic factors. Uneven landforms, desserts, oceans,
forest, rivers etc. are barriers to develop this vital infrastructure. Some businesses like mining of
coal and ores, drilling of oil and most important agriculture which depends most on nature. Thus
the impact of natural environment cannot be ignored moreover it should be given top priority for
any successful business.

Question- 4. What are the prominent Risks in International Business and How these can be
averted in International Business Organizations ?Or

Question- Explain the major risks and challenges faced by a firm involved in International
Business. July, 2010
Answer: Risks in International Business

Just as there are reasons to get into global markets, and benefits from global markets, there are
also risks involved in locating companies in certain countries. Each country may have its
potentials; it also has its woes that are associated with doing business with major companies.
Some of the rogue countries may have all the natural minerals but the risks involved in doing
business in those countries exceed the benefits.

Some of the risks in international business are:

(1) Strategic Risk (2) Operational Risk (3) Political Risk (4) Country Risk (5) Technological
Risk (6) Environmental Risk (7) Economic Risk (8) Financial Risk (9) Terrorism Risk

Strategic Risk: The ability of a firm to make a strategic decision in order to respond to the
forces that are a source of risk. These forces also impact the competiveness of a firm. Porter
defines them as: threat of new entrants in the industry, threat of substitute goods and services,
intensity of competition within the industry, bargaining power of suppliers, and bargaining
power of consumers.

Operational Risk: This is caused by the assets and financial capital that aid in the day-to-day
business operations. The breakdown of machineries, supply and demand of their sources and
products, shortfall of the goods and services, lack of perfect logistic and inventory will lead
to inefficiency of production. By controlling costs, unnecessary waste will be reduced, and
the process improvement may enhance the lead-time, reduce variance and contribute to
efficiency in globalization.

Political Risk: The political actions and instability may make it difficult for companies to
operate efficiently in these countries due to negative publicity and impact created by
individuals in the top government. A firm cannot effectively operate to its full capacity in
order to maximize profit in such an unstable country's political turbulence. A new and hostile
government may replace the friendly one, and hence expropriate foreign assets.
Country Risk: The culture or the instability of a country may create risks that may make
it difficult for multinational companies to operate safely, effectively, and efficiently. Some
of the country risks come from the governments' policies, economic conditions, security
factors, and political conditions. Solving one of these problems without all of the problems
(aggregate) together will not be enough in mitigating the country risk.

Technological Risk: Lack of security in electronic transactions, the cost of developing new
technology, and the fact that these new technology may fail, and when all of these are
coupled with the outdated existing technology, the result may create a dangerous effect in
doing business in the international arena.

Environmental Risk: Air, water, and environmental pollution may affect the health of the
citizens, and lead to public outcry of the citizens. These problems may also lead to damaging
the reputation of the companies that do business in that area.

Economic Risk: This comes from the inability of a country to meet its financial obligations.
The changing of foreign-investment or/and domestic fiscal or monetary policies. The
effect of exchange-rate and interest rate make it difficult to conduct international business.

Financial Risk: This area is affected by the currency exchange rate, government flexibility in
allowing the firms to repatriate profits or funds outside the country. The devaluation and
inflation will also impact the firm's ability to operate at an efficient capacity and still be
stable. Most countries make it difficult for foreign firms to repatriate funds thus forcing these
firms to invest its funds at a less optimal level. Sometimes, firms' assets are confiscated and
that contributes to financial losses.

Terrorism Risk: These are attacks that may stem from lack of hope; confidence; differences
in culture and religious philosophy, and/or merely hate of companies by citizens of
host countries. It leads to potential hostile attitudes, sabotage of foreign companies and/or
kidnapping of the employers and employees. Such frustrating situations make it difficult to
operate in these countries.

Although the benefits in international business exceed the risks, firms should take a
risk assessment of each country and to also include intellectual property, red tape and
corruption, human resource restrictions, and ownership restrictions in the analysis, in order to
consider all risks involved before venturing into any of the countries.

Dr. Sidney Okolo is a professor, consultant, strategist, and Africa expert. He is affiliated to
several universities, the Managing Director of International Business Associates, a
management consulting firm, and also the CEO of Global Education Support, an education
assistance program.

Among other things, he engages in all aspects of learning, knowledge, organization and
human change. His focus is on leadership, management, entrepreneurship, profit engineering,
human potential, excellence, achievement, business strategy, research and development.
Product management, change management, conflict management, athlete management,
marketing, business development and operations. He works with clients’ to adapt to change
due to change in factors of production, technology, goods and services. He engages clients in
training, retraining, development, skills enhancement, association, behavior modification,
ways of thinking, and attitude adjustment. In addition to his work in the United States, his
focus is also on developing countries in the continent of Africa, their leadership, culture,
economic and market structure, community planning and development, and his created four
letter word, "PIES", which stands for: poverty, instability, ethnicity, and sectarianism.

Question 5. What are the motives of entering in International Business?Or

Question- What are the major reasons for getting engaged in International Business?

Answer: Motives of International Business:

All organizations, irrespective of their size, are keen to enter in to international business.
Established companies are expanding their business. Many countries encourage trade, and
removal of strangulating trade barriers. It motivates companies to aggressively multiply their
targets. The governments of various countries are also determined to make their economy
grow through international business that has therefore become a inevitable part of their
economic policy. The objective behind international business can be looked at:

1. from an individual company’s angle.

2. from the government angle

From an individual company’s angle

1. Managing the product life cycle:

All companies have products, which pass through different stages of their life cycles. After
the product reaches the last stage of the life cycle called the declining stage in one country, it
is important for the company to identify other countries where the whole cycle process could
be encased. For example, Enfield India reached maturity and declining stage in India for the
350 cc motorcycle. The company entered Kenya, West Indies, Mauritius and other
destinations where the heavy engine two-wheeler became popular. The Suzuki 800 cc vehicle
reached the last stage of its life cycle in Japan and entered India in the early 1980’s, where it
is still doing good business today. HP laptops are moving all the developing countries the
moment they reached maturity in the U.S. market.

2. Geographic expansion as a growth strategy:

Even if companies expand their business at home, they may still look overseas for new
markets and better prospects. For example, Arvind mills expanded their business by either
setting up units or opening warehouses abroad. Ranbaxy’s growth is mainly attributed to
geographic expansion every year to new territories. Arobindo Pharma, Cipla and Dr.Reddys
follow the same.

3. The adventurous spirit of the younger generation

The younger generation of business families has considerable International exposure. They
are willing to take risks and challenges and also create opportunities for their business.
Laxmi Mittal has Emerged as the steel king of the world and Vijay Mallya of the UB Group
took a major risk in setting up operations in South Africa. Kumar Birla expands to Australia
and Europe through acquisitions.
4. Corporate ambition:

Every corporate in the country has strategic plans to multiply its sales turnover. In case some
of the ventures fail, others will offset the losses because of multi-location operations. For
example; Coco Cola is still to day not earning any profit in a number of countries. But this
will not affect the company because more than a hundred countries are contributing to offset
losses. Kellogge cannot think of profits in India for further five years. They are ambitious to
be visible and then revenue.

5. Technology advantage:

Some companies have outstanding technology through which they enjoy core competency.
There is a need for such technology in all countries. Biocon, Infosys, Gharda chemicals are
known for their core competency in biotechnology, IT and pesticides respectively and a huge
demand exists throughout the world for their technology. Thermax, Ion Exchange, Bharat
Heavy Electricals and Larsen & Toubro have marched ahead in International business.

6. Building a corporate image

Prior to profits and revenue generation, many companies first build their corporate image
abroad. Once the image is built, generating revenues is a comparatively easy task. Samsung
and LG built their image in India for the first three years and generation of revenue and
profits has been considerable, as they have expanded to semi-urban and rural India as well.
Today their market share and penetration levels have gone far ahead of other players’ in
India.

7. Incentives and business impact

Companies, which are involved in international business, enjoy fiscal, physical and
infrastructural incentives while they setup business in the host country. The Aditya Birla
Group enjoyed such incentives in Thailand and Indonesia. All such incentives contribute to
the company to enjoy multiple advantages like economies of scale, access to import inputs,
competitive pricing and aggressive promotion.

8. Labor advantage

Many companies have a highly productive labor force. Their unique skills may not be
available throughout the world. Manufacturing units in India have consistently performed
well, whether in a diamond industry, handicraft, woodwork or leather. Companies nurture the
skills of the artisans and win world markets. Knitwear, handlooms, embroidery, metal ware,
carpet weaving, cashew processing and seafood call for cost-effective labor force. India is
endowed with such skills.

9. New business opportunities

Many companies have entered in to business abroad, seeing unlimited opportunities. National
foreign trade policy emphasizes focus markets. Enormous amount of growth potential is
untapped in Latin America, Sub-Saharan Africa, CIS countries and China.

10. Emergence of SEZ’S, EOU’S, AEZ Current approvals of Special economic zones,
Agrizones and Technology parks by Ministry of Commerce & Industry give new dimensions
to international business. The companies setting up units in SEZ’s enjoy innumerable
benefits and competitiveness.

From a Government Angle

1. Earning valuable foreign exchange

Foreign exchange earnings are necessary to balance the payments for imports. India imports
crude oil, defense equipments, essential raw materials and medical equipments for which the
payments have to be made in foreign exchange. If the exports are high and imports are low it
indicates a surplus balance of payment. On the other hand if imports are high and exports are
low it indicates an adverse balance of payment, which all economies would want to avoid. A
vast majority of the nations in the world are facing adverse balance of payment.

2. Interdependency of nations
From time immemorial, nations have depended on each other. Even during the era of Indus
valley civilization, Egypt and the Indus Valley depended on each other for various items.
Today, India depends on the Gulf regions for crude oil and in turn the Gulf region depends
on India for tea, rice etc. Developed countries depend on developing countries for primary
goods, whereas developing countries depend on developed countries for value added finished
products. No single country is endowed with all the resources to survive on her own.

3. Trade theories and their impact

The theories of absolute advantage, comparative advantage and competitive advantage,

which have been propounded by classical economists, indicate that a few nations have certain
advantages of resources. The resources may be in the form of labour or infrastructure or
technology or even a proactive policy of the government. Such theories are remaining
foundations till today, for international business practices with few changes and trends.

4. Diplomatic relations

Diplomacy and trade always go hand in hand. Many sovereign nations send their diplomatic
representatives to other countries with a motive of promoting trade besides maintaining
cordial relations. Indian diplomats in Latin America have done a remarkable job of
promoting India’s business in the 1990’s. Indian embassies and high commissions in all the
countries around the world play a catalytic role of promoting trade and investment.

5. Core competency of nations

Many countries are endowed with resources, which are produced at an optimum level. Such
countries can compete well anywhere in the world. Rubber products from Malaysia, knitwear
from India, rice from Thailand and wool from Australia are a few illustrations. Competing
with a focused competency in any major resource or technology gives core competency
status. India’s core competency in IT is known throughout the world.

6. Investment for infrastructure

Over the years all countries have invested huge amounts of money on infrastructure by
building airports, seaports, economic zones and inland container terminals. If the trade
activities do not increase, the country cannot recover the amounts invested. Hence, the
government fixes targets for every infrastructure unit and time frame to achieve it.
Economies like Mauritius, Hong Kong, Singapore, Malta and Cyprus invest in trade related
infrastructure in order to elevate themselves to be foreign trade oriented economies.
Infrastructure and international business are the two eyes of a growing economy.

7. National image

A new era has emerged from conquering countries by sword to winning it by trade. A
businessman gives priority to the image of the country he belongs to. We come across
products with labels such as “made in China” and “Japan” & “made in India”. Businessmen
from India, China and Japan bring credentials to their country. When L.N.Mittal operates in
Indonesia or Kazakhstan or Trinidad he is perceived by the people as Indian. The stigma
cannot be detached.

8. Foreign trade policy and targets

All developing countries announce their trade policies. A clear road map is drafted and given
to promotional bodies so that timely implementation is possible. Every trade policy in India,
in the past had its agenda and action plans right from import control order in1947. All the
trade policies had three fold objectives in their agenda- production promotion and
competitiveness.

9. National targets

By the year 2010, India aims to have a 2% share of the global market from the current level
of 1.5 %. By the year 2009-10, our trade status was expected to cross $ 500 billion. The
global melt down and its impact on low consumption around the world has limited the target
unachievable for India.

10. WTO and international agencies

The apex body of world trade, the WTO, a free, transparent and regulatory body up holds
provisions related to the elimination of tariffs and non-tariff barriers. The International Bank
for Reconstruction and Development (IBRD), popularly called the World Bank extends
financial assistance on a soft loan basis in order to assist developing countries in their
infrastructure and industrial development. The International Monetary Fund (IMF) maintains
currency stability in various countries through regulatory mechanisms. Many more
organizations like International Maritime Organization, International Standard Organization,
International Telecommunication Union, and International Civil Aviation Organization are
major catalysts to promote trade between nations. Over the past few years their role in
promotion of trade, especially amongst developing economies is unprecedented

Question-6. What do you mean by Trade barriers? What are the different barriers to
International Trade? Or

Question. Give arguments for and against protection. July 2010

Answer: trade Barriers

Trade barriers are government-induced restrictions on international trade. By international

trade we mean the exchange of goods and/or services. This exchange usually takes place
between two parties from different countries or between two countries located anywhere on
the globe. If the international trade takes place between two parties, it is known as bilateral
trade and if the trade takes place between more than two parties, it is known as multi-lateral
trade. There are basically three barriers to international trade that are used by countries. The
barriers can take many forms, including the following:

1. Tariffs Barriers-

This is barrier is in the form of duties, taxes, quotas etc. Because of this barrier, imports
decrease and price of imported products increase which results in the fall in the demand
giving boost to domestic products. Tariffs refer to the tax imposed on imports. Tariffs are of
two types, viz., specific tariffs and ad valorem tariffs. Specific tariffs are levied as a fixed
charge for each unit of the product imported. For example, a tariff of Rs. 1000 on each TV
imported.
The tariff levied as a proportion of the value of the imported goods is called ‘advalorem’
tariff. For example, imposition of 30 per cent tax on the value of computers imported.

Parties gaining from Tariffs: The following parties gain from the tariffs:

 Government of the importing country: Government of the importing country getsthe

revenue in the form of import duties.
 Industry of the importing country: The products of the importing country wouldfind
market as the cost of imported goods is higher than that of domestic goods.
 Jobs in the domestic country are saved.
 Business for the ancillary industry, serving, market intermediation etc. is also
protected.

However, the following parties are adversely affected by the tariffs:

 Consumers of the domestic country lose as they have to pay higher price. Thus, the
customers pay for the inefficiency of the domestic industry.
 The industry of the exporting country loses the demand for its product, sales and
profit.

Ultimately, a tariff enhances the efficiency of some countries and curtails the growth of the
most efficient countries. Thus tariffs reduce the efficiency of world economies. This process
results in inefficient utilization of all kinds of resources. The purpose of tariffs is to protect
the domestic industry by increasing the cost of imported goods. Government of India
imposed tariffs to protect domestic automobile industry, sugar industry, cement industry and
steel industry

2. Non-Tariff Barriers-

Usually this type of barrier is imposed by a country on imports so that the quantity of
imported items is restricted. Due to this, the availability of the imported item or items is
restricted in the domestic market and the price too is very high.
 A second category of government intervention on international trade relates to non-tariff
barriers. Any government regulation, or procedure other than a tariff that has the effect of
restricting international trade, or affecting overseas investment, becomes a non-tariff barrier.

 Import licenses-An import license is a document issued by a national government

authorizing the importation of certain goods into its territory. Import licenses are
considered to be non-tariff barriers to trade when used as a way to discriminate
against another country's goods in order to protect a domestic industry from foreign
competition.
 Export licenses-An export license is a document issued by the appropriate licensing
agency after which an exporter is allowed to transport his product in a foreign market.
The license is only issued after a careful review of the facts surrounding the given
export transaction. Export license depends on the nature of goods to be transported as
well as the destination port.
 Import quotas-Import quota is direct restriction on the quantity of goods which are
imported into a country. These restrictions are imposed by issuing import licenses to
certain firms and individuals to import certain quantity of the goods.
 Subsidies- In order to encourage domestic production or to protect the domestic
producer from the foreign competitors, government pays to domestic producer by
reducing operation cost. Such payments are called subsidies. Subsidies are indifferent
forms. They are cash grants, loans and advances at low rate of interest, tax holidays,
and government procurement of output at a higher rate, equity participation and
supply of inputs at lower prices.

Subsidies help the domestic procedures in the following ways:

 Acquire the character of a low cost producer and have all the advantages of a low cost
producer like high profit margin or fixing the price at lower level.
 Compete with a foreign producer in the domestic market.
 Enter the foreign markets.
  Voluntary Export Restraints- A voluntary export restraint (VER) or voluntary export
restriction is a government imposed limit on the quantity of goods that can be
exported out of a country during a specified period of time. Typically VERs arises
when the import-competing industries seek protection from a surge of imports from
particular exporting countries. VERs are then offered by the exporter to appease the
importing country and to deter the other party from imposing even more explicit (and
less flexible) trade barriers.
 Local content requirements-Local content requirement is a popular government
policy in developing countries to regulate foreign direct investment.
 Administrative Policies -Governments in addition to the quotas and other restrictions,
use formal and informal policies to restrict imports and boost exports. Administrative
policies are bureaucratic rules and procedures which are formulated to make it
difficult to imports to enter the country. Formal trade barriers like tariffs and quotas
are lowest in Japan. Japan mostly uses the administrative policies.
 Currency devaluation-Devaluation of currency is a reduction in the value of a
currency with respect to those goods, services or other monetary units with which that
currency can be exchanged. In common modern usage, it specifically implies an
official lowering of the value of a country’s currency within a fixed exchange rate
system, by which the monetary authority formally sets a new fixed rate with respect
to a foreign reference currency

3. Voluntary Constraints-

This is a type of international trade barrier wherein a country voluntarily restricts or stops
imports from coming in. This is usually used to limit the competition that domestic industries
will face with the coming in of imported goods. Whenever a country starts international trade
with another country, these three barriers to international trade are always taken into account.
It has been seen that lower developed countries and developing countries tend to favors these
three barriers to international trade as the countries can earn foreign exchange by introducing
tariff and non-tariff barrier. The local industries are protected from competition by foreign
companies and industries and as less imported goods are available in the country, consumers
tend to buy local products giving the local industries a boost. A voluntary export restraint is
the opposite form of import quotas. A voluntary export restraint is a quota on exports of the
domestic firm imposed by the exporting country. Exporting country imposes such restriction,
mostly at the request of the importing country. For example, Japanese automobile exporters
had such restraint in 1981 due to the request of the US government. Foreign exporters mostly
accept for the voluntary export restraint as its violation leads to imposition of import tariffs,
import quotas etc.

Import quotas and voluntary export restraints help the domestic firms by providing protection
from the foreign competitors. These enhance the prices of import goods and make the
domestic goods cheap.

Most trade barriers work on the same principle: the imposition of some sort of cost on trade
that raises the price of the traded products. If two or more nations repeatedly use trade
barriers against each other, then a trade war results.

Economists generally agree that trade barriers are detrimental and decrease over all economic
efficiency; this can be explained by the theory of comparative advantage. In theory, free trade
involves the removal of all such barriers, except perhaps those considered necessary for
health or national security. In practice, however, even those countries promoting free trade
heavily subsidize certain industries, such as agriculture and steel.

Trade barriers are often criticized for the effect they have on the developing world. Because
rich-country players call most of the shots and set trade policies, goods such as crops that
developing countries are best at producing still face high barriers. Trade barriers such as
taxes on food imports or subsidies for farmers in developed economies lead to over
production and dumping on world markets, thus lowering prices and hurting poor-country
farmers. Tariffs also tend to be anti-poor, with low rates for raw commodities and high rates
for labor-intensive processed goods. The Commitment to Development Index measures the
effect that rich country trade policies actually have on the developing world.

Another negative aspect of trade barriers is that it would cause a limited choice of products
and would therefore force customers to pay higher prices and accept inferior quality.
Question-7. What do you understand by Global Trading and Financial System and how these
can be coordinated at Global Scenario? Give an overview. Or

Question-What is meant by Exchange rate? Explain various factors affecting exchange rates.

Answer: The global trading and financial system is the financial system consisting of
institutions and regulators that act on the international level, as opposed to those that act on a
national or regional level. The main players are the global institutions, such as International
Monetary Fund and Bank for International Settlements, national agencies and government
departments, e.g., central banks and finance ministries, private institutions acting on the
global scale, e.g., banks and hedge funds, and regional institutions, e.g., the Euro zone.
Deficiencies and reform of the GFS have been hotly discussed in recent years.

Euro Currency Market

Another component of international financial markets is the Eurocurrency market. Originally

called the Eurodollar market, the Eurocurrency market first made its appearance in the early
1950s when the communist-controlled governments of Central and Eastern Europe needed
dollars to finance their international trade but feared that the US government would
confiscate or block their holdings of dollars in the US banks for political reasons. These
governments solved their problem by using European banks that were willing to hold their
dollar accounts for them. In this way, the Eurodollar was born-US dollar deposited in the
European bank accounts. As other currencies became stronger in the post-war era-
particularly the yen and the Deutsche mark-the Eurocurrency market broadened to include
Euro pounds, Euroyen, Euro marks, and other currencies. Today, a Eurocurrency is defined
as a currency on deposit outside of its country of issue. Obviously, the terms Eurocurrency is
a misnomer because a Eurocurrency can be created anywhere in the world; the persistent
Euro-prefix reflects only the European origin of the market. Eurocurrency markets serve two
valuable purposes:

1. Eurocurrency deposits are an efficient and convenient market device for holding surplus
cash;
 2. Eurocurrency market is a major source of short-term bank loans to finance corporate
working capital needs, including the financing of imports and exports. The unique feature of
the Eurocurrency market is the relatively low cost of borrowings. The Eurocurrency market
loans are low cost because of three reasons-

1. Firstly, the loans are free from costly government banking regulations, such as revenue
requirements, that are designed to control the domestic money supply but which push up
lending cost.

2. Secondly, these loans involve large transactions, so the average cost of making the loan is
less.

3. Thirdly, since the most creditworthy borrowers avail the loans, the risk premium that
lenders charge is also less.

Exchange Rate

In finance, an exchange rate (also known as the foreign-exchange rate, forex rate or FX rate )
between two currencies is the rate at which one currency will be exchanged for another. It is also
regarded as the value of one country’s currency in terms of another currency. For example, an
interbank exchange rate of 91Japanese yen (JPY, ¥) to the United States dollar (US$) means that
¥91 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥91. Exchange
rates are determined in the foreign exchange market, which is open to a wide range of different
types of buyers and sellers where currency trading is continuous: 24 hours a day except
weekends, i.e. trading from20:15GMTon Sunday until 22:00 GMT Friday.

The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to
an exchange rate that is quoted and traded today but for delivery and payment on a specific
future date.

In the retail currency exchange market, a different buying rate and selling rate will be quoted by
money dealers. Most trades are to or from the local currency. The buying rate is the rate at which
money dealers will buy foreign currency, and the selling rate is the rate at which they will sell
the currency. The quoted rates will incorporate an allowance for a dealer's margin (or profit) in
trading, or else the margin may be recovered in the form of a "commission" or in some other
way. Different rates may also be quoted for cash (usually notes only), a documentary form (such
as traveler’s cheques) or electronically (such as a credit card purchase). The higher rate on
documentary transactions is due to the additional time and cost of clearing the document, while
the cash is available for resale immediately. Some dealers on the other hand prefer documentary
transactions because of the security concerns with cash.

Exchange Rate Determination

The transactions in the foreign exchange market, viz., buying and selling foreign currency take at
a rate, which is called ‘exchange rate’. Exchange rate is the price paid in the homecurrency for a
unit of foreign currency. The exchange rate can be quoted in two ways, viz.,

 One unit of foreign money to a number5 of units of domestic currency

 A certain number of units of foreign currency to one unit of domestic currency.

For example, 1 US $ = Rs. 50 or Re. 1 = US $ 0.02

Exchange rate in a free market is determined by the demand for and the supply of exchange of a
particular country. The equilibrium exchange rate is demand for foreign exchange and the supply
of foreign exchange is equal. Ragnar Nurske defined the equilibrium exchange rate as, “that rate which
over a certain period of time keeps the balance of payments in equilibrium.” Equilibrium exchange
rate can be determined by two methods.

 The exchange rate between US dollars and Indian Rupees can be determined by demand
for and supply of US dollars in India or by Indians. The price of US $ is fixed in Indian
Rupees.
 The exchange rate between Indian Rupees and US dollars can also be determined by
demand for and supply of Indian Rupees by Americans or in USA. The price of Indian
Rupee is determined in US dollars.
 The prices are the same in both these methods

Determinants of Exchange Rates

Numerous factors determine exchange rates, and all are related to the trading relationship
between two countries. Remember, exchange rates are relative, and are expressed as a
comparison of the currencies of two countries. The following are some of the principal
determinants of the exchange rate between two countries. Note that these factors are in no
particular order; like many aspects of economics, the relative importance of these factors is
subject to much debate.

1. Differentials in Inflation

As a general rule, a country with a consistently lower inflation rate exhibits a rising currency
value, as its purchasing power increases relative to other currencies. During the last half of the
twentieth century, the countries with low inflation included Japan, Germany and Switzerland,
while the U.S. and Canada achieved low inflation only later. Those countries with higher
inflation typically see depreciation in their currency in relation to the currencies of their trading
partners. This is also usually accompanied by higher interest rates.

2. Differentials in Interest Rates

Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest
rates, central banks exert influence over both inflation and exchange rates, and changing interest
rates impact inflation and currency values. Higher interest rates offer lenders in an economy a
higher return relative to other countries. Therefore, higher interest rates attract foreign capital
and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if
inflation in the country is much higher than in others, or if additional factors serve to drive the
currency down. The opposite relationship exists for decreasing interest rates - that is, lower
interest rates tend to decrease exchange rates.

2. Current-Account Deficits

The current account is the balance of trade between a country and its trading partners, reflecting
all payments between countries for goods, services, interest and dividends. A deficit in the
current account shows the country is spending more on foreign trade than it is earning, and that it
is borrowing capital from foreign sources to make up the deficit. In other words, the country
requires more foreign currency than it receives through sales of exports, and it supplies more of
its own currency than foreigners demand for its products. The excess demand for foreign
currency lowers the country's exchange rate until domestic goods and services are cheap enough
for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

4. Public Debt

Countries will engage in large-scale deficit financing to pay for public sector projects and
governmental funding. While such activity stimulates the domestic economy, nations with large
public deficits and debts are less attractive to foreign investors. The reason? A large debt
encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off
with cheaper real dollars in the future. In the worst case scenario, a government may print
money to pay part of a large debt, but increasing the money supply inevitably causes inflation.
Moreover, if a government is not able to service its deficit through domestic means (selling
domestic bonds, increasing the money supply), then it must increase the supply of securities for
sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to
foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less
willing to own securities denominated in that currency if the risk of default is great. For this
reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for example)
is a crucial determinant of its exchange rate.

5. Terms of Trade

A ratio comparing export prices to import prices, the terms of trade is related to current accounts
and the balance of payments If the price of a country's exports rises by a greater rate than that of
its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater
demand for the country's exports. This, in turn, results in rising revenues from exports, which
provides increased demand for the country's currency (and an increase in the currency's value). If
the price of exports rises by a smaller rate than that of its imports, the currency's value will
decrease in relation to its trading partners.

6. Political Stability and Economic Performance

Foreign investors inevitably seek out stable countries with strong economic performance in
which to invest their capital. A country with such positive attributes will draw investment funds
away from other countries perceived to have more political and economic risk. Political turmoil,
for example, can cause a loss of confidence in a currency and a movement of capital to the
currencies of more stable countries.

The exchange rate of the currency in which a portfolio holds the bulk of its investments
determines that portfolio's real return. A declining exchange rate obviously decreases the
purchasing power of income and capital gains derived from any returns. Moreover, the exchange
rate influences other income factors such as interest rates, inflation and even capital gains from
domestic securities. While exchange rates are determined by numerous complex factors that
often leave even the most experienced economists flummoxed, investors should still have some
understanding of how currency values and exchange rate play an important role in the rate of
return on their investments.

Demand for Foreign Exchange

The demand for foreign exchange is determined by the countries:

 Import of goods and service.

 Investment in foreign countries (flow of capital to other countries), i.e., establishment of
an industry by Indians in USA.
 Other payments involved in international transactions like payment of Indian
Government to various foreign governments for settlement of their transactions.
 Other types of outflow of foreign capital like giving donations etc. The demand curve
indicates the amount of foreign exchange demanded (for example, US dollars).

Supply of Foreign Exchange

Supply of foreign exchange of a particular country (i.e., US dollars) indicates the availability of
foreign currency of a particular country to the country concerned (i.e., India) in its foreign
exchange market. The supply of foreign exchange includes:

 Country’s exports of goods and services to foreign countries.

 Inflow of foreign capital.
  Payments made by the foreign governments to Indian government for settling their
transactions.
 Other types of inflow of foreign capital like remittances by the Non-Resident Indians,
donations received etc.

The supply curve of foreign exchange is shown by ‘SS’. The equilibrium exchange rate is
determined at ‘P’ where the demand curve ’DD’ intersects the supply curve‘ SS’. Both the supply of
foreign exchange and demand for foreign exchange is ‘OQ’ and the exchange rate is ‘OP’.
If the demand for foreign exchange is in excess of supply, i.e., the demand is at the point of ‘b’
on the demand curve and the supply is ‘a’ on the supply curve (demand>supply), the exchange
rate is fixed at ‘OP2’. In contrast, if the demand is less than the supply, i.e. , demand is at point
‘c’ on demand curve and the supply is at point ‘d’ on the supply curve (demand< supply), the
exchange rate is fixed at ‘OP1’.
Thus the excess demand over supply results in the exchange rate higher than the equilibrium
exchange rate and vice versa is true if the demand is less than the supply.
Foreign Exchange Market Mechanism
The subject of foreign exchange is, in the words of H.E. Evitt , “that section of economic
science which deals with the means and methods by which rights to wealth in one country’s
currency are converted into rights to wealth in terms of another country’s currency.” As he
further observes, it “involves the investigate one of the method by which the currency of one
country is ex changed for that of another, the causes which render such exchange necessary, the
forms which such exchange may take, and the ratios or equivalent values at which such
exchanges are affected.”
There are different interpretations of the term foreign exchange, of which the following two are
important and common:

1. Foreign exchange is the system or process of converting one national currency into
another, and of transferring money from one country to another.

2. Secondly, the foreign exchange is used to refer to foreign currencies. For example, the
Foreign Exchange Regulation Act, 1973 (FERA) defines foreign exchange as foreign
currency and includes all deposits, credits and balance payable in any foreign currency and
any drafts, travelers’ cheques, letters of credits and bills of exchange, expressed or drawn in
Indian currency, but payable in any foreign currency.

Functions of Foreign Exchange Market

The foreign exchange market is a market in which foreign exchange transactions take place.
In other words; it is a market for sale and purchase of different currencies. A foreign
exchange market performs three important functions:

1. Transfer of Purchasing Power-The primary function of a foreign exchange market is the

transfer of purchasing power from one country to another and from one currency to another.
The international clearing function performed by foreign exchange market plays a very
important role in facilitating international trade and capital movements.

2. Provision of Credit-the credit function performed by foreign exchange markets also plays a
very important role in the growth of foreign trade, for international trade depends to a great
extent on credit facilities. Exporters may get pre-shipment and post-shipment credit. Credit
facilities are available also for importers. The Euro-dollar market has emerged as a major
international credit market.

3. Provision of Hedging Facilities-

The other important function of the foreign exchange market is to provide hedging facilities.
Hedging refers to covering of export risks, and it provides a mechanism to exporters and
importers to guard themselves against losses arising from fluctuations in exchange rates.