The Ten-Day MBA 4th Ed.

by Steven A. Silbiger

  USES OF FOREIGN EXCHANGE: Fees and Royalties Paid Abroad

  SOURCES OF FOREIGN EXCHANGE: Foreign Investment Income

  USES OF FOREIGN EXCHANGE: Interest and Dividends Paid Abroad

  SOURCES OF FOREIGN EXCHANGE: Government Foreign Aid Received

  USES OF FOREIGN EXCHANGE: Government Foreign Aid Given

  SOURCES OF FOREIGN EXCHANGE: Private Transfers of Money into the Country

  USES OF FOREIGN EXCHANGE: Private Transfers of Money Abroad

  SOURCES OF FOREIGN EXCHANGE: Increases in Foreign Liabilities

  USES OF FOREIGN EXCHANGE: Increases in Foreign Assets

  The sources and uses above show in broad terms the items that most frequently enter into a foreign exchange ledger. Excluded from the count are the international drug trade and other unreported activities. The press usually ignores the whole BOP picture and focuses only on the merchandise trade deficit. It is easier to say that the United States in 2010 ran a $650 billion merchandise trade deficit. Journalists ignore that the U.S. ran a $150 billion surplus in trading services, such as consulting and engineering, and a net surplus of investment income of $160 billion. That leaves a net trade deficit of $340 billion in a $14 trillion economy.

  Having enough foreign exchange is extremely important. The collapse of the currency in Zimbabwe in 2008 came as a result of insufficient foreign exchange in its central bank to make good on the purchases made by its government and citizens. When foreigners went to convert their claims into U.S. dollars, the central bank was emptied of its foreign exchange. Without convertibility, everyone dumped their nearly worthless Zimbabwe dollars. One U.S. dollar was worth a trillion Zimbabwe dollars, and the government abandoned its currency.

  EXCHANGE RATE AND PURCHASE PRICE PARITY

  The exchange rate is the rate at which one country’s currency is converted into another’s. In July 2011, one U.S. dollar could buy 6.5 Chinese yuan, 80 Japanese yen, 66 percent of one British pound, or 68 percent of one European Union euro. In the early and mid-1980s the dollar was more valuable. Americans found real bargains when they traveled to Europe. In the 2000s with a weaker U.S. dollar, traveling in Europe was expensive for American citizens. What makes one country’s currency worth more than another’s? It’s the old supply-and-demand relationship. International currency traders have to keep the following four factors in mind when trying to predict the gyrations of world currencies:

  Trading Demands for Currency to Pay for Goods and Services

  When the United States needs to buy French wine, importers sell U.S. dollars and buy euros to make payment in EU currency.

  Demands for Currency for Attractive Investments

  Higher relative interest rates in the United States prompt purchases of bonds by foreigners.

  Higher U.S. relative rate of economic growth prompts purchases of stocks by foreigners.

  Demands for a Safe Haven in Times of Uncertainty

  In times of war or chaos, investors seek the currencies of stable governments. During the Gulf War in 1991, investors bought U.S. dollars believing that in an unstable climate, the United States would fare better than other countries. After the Iraqi War in 2003, investors bought the European Union’s euro.

  Lower Inflation Relative to Other Countries

  In 1987 the U.S. inflation rate was 3.6 percent, and the Lebanese inflation rate 723 percent, which reflected the chaos of their civil war. Lebanese investors naturally wanted to hold their investments in U.S. dollars because their pound’s value was eroding quickly. The theory of purchasing-power parity describes the way that currencies’ values adjust versus each other because of inflation. If one country’s inflation is higher than another’s, then its currency will be adjusted downward to compensate for the annual loss of value. During the Lebanese civil war in 1986 and 1987, the country’s exchange rate went from 38 to 496 pounds to the dollar, a loss of 86 percent to compensate for the loss of inflation. In 2011 a dollar could buy 1,510 Lebanese pounds as a result of continued inflation and political instability, bad but not Zimbabwe.

  Exchange rate movements are critical for companies involved in international trade. If exchange rates change between the time of signing a contract and its settlement, anticipated profits can be wiped out by currency fluctuations. Imagine if a farmer wanted to sell one U.S. dollar’s worth of beef to Japan. At the 2011 exchange rate he would charge 80 yen, expecting a 5 percent profit. But when he got paid, he might need 100 yen to buy the same one dollar, because of a rate change. Although the yen payment would have remained constant at 80 yen, the currency fluctuation would have caused a 25 percent loss in U.S. dollar buying power. Companies and individuals use the futures and options markets to offset or hedge losses on this kind of currency transaction. This is not unlike the stock-option hedging described in the finance chapter.

  EXCHANGE RATE SYSTEMS

  Exchange rates are governed by the host country’s exchange rate system. With a floating exchange rate, the value of the country’s currency can freely move based on the factors described above. With a fixed exchange rate system, the host government tries to change interest rates or buy and sell foreign currencies to maintain a fixed value against the U.S. dollar, the EU’s euro, or a basket of currencies. This is called pegging the value of the currency to another. Between 1945 and 1971 under the Bretton Woods system, the U.S. dollar was pegged against a certain amount of gold, and all other currencies were pegged to the U.S. dollar. That system ended in 1971 when many countries decided to allow their currencies to float.

  Counties cannot just do anything with their currencies. A concept called the impossible trilogy says a government can have only two of the following three options:

  Independent monetary policy

  Fixed exchange rates

  Absence of capital controls

  For example, if a country chooses a fixed exchange rate, as China does, it has to abandon an independent monetary policy or impose capital controls to maintain its fixed peg versus the other independent currency. If a country decides to maintain a peg in volatile times, it becomes expensive to keep a fixed rate of exchange. When a fixed system begins to fail, as it did in Mexico in 1994 and Southeast Asia in 1998, there is a currency “crisis” as the currencies fall to their true levels, causing trade and investment disruptions.

  By pulling together the topics of domestic interest rates, international capital flows, and currency rates, Gregory Mankiw of the University of Chicago has created a three-panel diagram to represent the world’s economics system, as presented below.

  THE WORLD ECONOMY AND THE 3-PANEL DIAGRAM

  (From Wikipedia, the free encyclopedia)

  Within each country, such as the United States, the supply and demand for loanable funds determine the level of domestic real interest rates. At that equilibrium interest rate, savers of dollars supply funds and investors’ demand for dollars is satisfied.

  The interest rate paid on dollar-denominated investments can be either attractive or not in the international marketplace. The country’s riskiness, currency demands of international trade, and the interest rate itself determine the country’s net capital outflow. These outflows supply the international currency market with dollars. Based on the international supply and demand for dollars, the dollar’s exchange rate is established.

  These three variables—domestic interest rates, capital flows, and exchange rates—interact simultaneously in the international macroeconomic system at a constantly fluctuating point of equilibrium as depicted in a three-panel diagram. It’s macroeconomics in a nutshell.

  COUNTRY ANALYSIS

  B-schools teach students what to consider when trying to make predictions about a country’s future. Since MBA schools aspire to turn out presidents of large multinational corporations, they must prepare these future captains of industry to evaluate investment opportunities abroad.

  A country analysis, as developed at the Harvard Business School, is a four-step process that attempts to organize all ava
ilable economic, social, political, and geographic data for strategy development.

  1. Analyze Past Performance

  External Measures—balance of payments, exchange rates Internal Measures

  General: GNP, inflation, employment

  Supply Side: interest rates, investment, capacity

  Demand Side: consumption, income distribution

  Social Side: human migrations, population growth, education

  2. Identify the Country’s Strategy

  Goals: autonomy, productivity, equity

  Policies: fiscal, monetary, trade, social

  3. Analyze a Country’s Context

  Physical: size, population, geography

  Political: government type, stability, corruption, leaders

  Institutions: government agencies, business, labor, religion, agriculture

  Ideological: role of government, family, culture, individualism

  International: trade advantages, competitiveness

  4. Make a Prediction Based on Steps 1, 2, and 3

  Let’s take a country that is deep in debt and mired in political gridlock—as an example, the United States of America in 1990. Assume that you are in 1990 and that you are Franz Danninger, a Swiss banker at the Bank of Zurich. You are considering whether you should invest your clients’ money in the United States as part of your global portfolio. What follows is—in a broad sense—the type of analysis an MBA would do to decide.

  1. Analyze the past performance of the United States.

  External Measures. In 1990 the U.S. trade deficit was reduced to $60 billion, down from a huge $150 billion in 1987. The U.S. dollar has shown small but consistent weakening versus the other major currencies. Inflation has been kept steady at a low 2 to 5 percent over the past five years, with little indication of its heating up. In the same way, unemployment has been kept low, between 5 and 6 percent a year.

  Internal Measures. GNP increased a sluggish 1 percent in an economy of $5.4 trillion. The economy is the largest in the world, twice that of Japan, four times that of Germany, and seven times that of the United Kingdom.

  Supply Side. Interest rates have steadily been falling with the prime lending rate at 8 to 9 percent. Because of the low level of inflation, that is considered high.

  Demand Side. Personal consumption has shown small but steady growth of 6 percent in 1990. The distribution of income among the population is uneven. Minority populations are participating at a lesser percentage in the labor market than they had in the past.

  Social Side. There has been no major exodus or influx of people. The birth rate is low and population growth is near zero, a sign of a prosperous industrialized nation. Public education is available to all children, but illiteracy is a problem with many students and adults.

  From that collection of statistics, you conclude that the country’s economy is sluggish. It has some problems, but not anything cataclysmic. With some history under your belt, the next step is to see where the American leaders want to take the nation.

  2. Identify America’s strategy.

  Goals. The United States is known for its leadership in world affairs. After the recession of 1981 and 1982, politicians and businesspeople focused on making the nation’s industrial base more productive. Factory productivity has increased 3.1 percent a year since 1983 as the result of automation, new management practices, and layoffs. The Washington leadership has not made economic equity a priority. Leaders talk about “trickle down” economics; this theory suggests that if the economy is doing well, everyone will eventually participate.

  Policies. The spending policies of the legislature and the executive branch continue to show little fiscal restraint in 1990. The budget deficit remains at a high $220 billion. A steady decade of overspending has added a worrisome $2 trillion of additional debt. In 1990, fourteen cents of every federal dollar went to pay interest on that debt. Monetary policy, controlled by an independent Federal Reserve, shows great restraint by keeping a lid on the money supply, keeping inflation low but interest rates high. Because the nation considers itself a free-trading nation, the federal government does not follow a formal trade policy. Issues are dealt with case by case.

  3. Analyze the context of the United States.

  Physical. The United States is one of the largest nations in the world. It is rich in natural resources, but it needs to import oil and other metals.

  Political. The U.S. government is considered the world’s most stable constitutional democracy. It is a federal republic with power shared between the central government and the fifty state governments. Corruption does exist, but a vigilant press keeps it to a minimum.

  Institutions. The United States is an advanced industrialized nation. The infrastructure of governmental agencies, business, labor, religion, and agriculture exists and operates like most developed bureaucracies.

  Ideological. The United States views the government as a servant of the people. Its constitution gives individuals an explicit Bill of Rights, which the government cannot abridge. The culture of the United States is a reflection of its immigrant past and its capitalist economics. It is diverse. A common thread of deep respect for material wealth pervades this society.

  International. Being the largest consumer market in the world, the United States plays a dominant role in world trade. With a stable dollar and low inflation it continues to be a strong economy.

  4. Make a prediction and an investment decision.

  As Franz Danninger, your analysis and prediction might be as follows: Like Switzerland, the United States is a stable industrialized country that is experiencing a sluggish patch of growth in its business cycle. I, Franz Danninger, suggest that we at the Bank of Zurich maintain our exposure to the U.S. economy. Investments should be maintained in the U.S. stock and bond markets. I do not see any better safe haven for our clients’ funds.

  If Franz were to make several forecasts of the future, MBAs would call that scenario analysis. The same facts supporting a recessionary prediction could also support a scenario of an economic boom or bust in the United States. An astute manager should make contingency plans in the event that one of these alternative scenarios begins to develop.

  Country analysis is a multipurpose tool that provides a way to sort out all the reams of economic data that are available on a nation. As a new MBA you now have the framework that global strategists use in the boardrooms of multinational corporations and that economic analysis departments of the world’s most prestigious investment firms employ.

  ECONOMICS IN REVIEW

  As this chapter has shown, microeconomics and macroeconomics are not that complicated if you wish to know only the MBA basics.

  Microeconomics. Supply equals demand at an equilibrium price. Consumers try to minimize opportunity costs and maximize marginal profits and utility. If they respond to price changes, economists call their behavior elastic.

  Macroeconomics. Keynesians like government and consumer spending. Friedman and his monetarist friends place their faith in the control of the money supply. It looks like both camps have valid points to make, but neither has a corner on explaining how economies work. In any case, supply equals demand at an equilibrium price. That much they agree on.

  Global Macroeconomics. The economies of the world keep track of their activity using balance of payments accounting. If they are doing a good job, inflation stays low, economic growth remains steady, foreign reserves stay high, and the local currency maintains its value. If not, a country may end up in an economic quagmire like Lebanon. If you want to be a crystal ball reader and want to predict where your favorite nation is headed, use the country analysis framework to make a prediction.

  KEY ECONOMICS TAKEAWAYS

  Microeconomics—The study of individual, family, company, and industry economic behavior

  Macroeconomics—The study of the behavior of entire economies

  Equilibrium—The point at which the quantity supplied equals the quantity demanded and a mutually agreeable
price is determined

  Marginal Revenue and Cost—The added revenue and cost of producing and selling one additional unit

  Elasticity—The change in buyers’ demand as a result of price changes

  Market Structures—The competitive environment in an industry determined by the number of sellers and the product’s characteristics

  Keynesian Theory—Spending and consumption are the main drivers of an economy.

  Monetarist Theory—The size and growth of the money supply determines the growth of the economy. Money makes the world go around.

  Gross National Product—The total amount of final goods and services produced by an economy over a period of time

  The Spending Multiplier—The economic ripple effect of money being circulated in an economy: spending for one person is income for another.

  Fiscal Policy—A government’s spending policy

  Monetary Policy—A government’s policy of controlling the supply of money and interest rates

  Adam Smith—The economist who wrote about the “invisible hand” of capitalism in The Wealth of Nations in 1776

  Arthur Laffer—1980s economist who developed the Laffer curve, which illustrated that lower tax rates would result in higher tax revenues

  Balance of Payments—The accounting for the inflows and outflows of foreign exchange of a country

  Country Analysis—A systematic framework to organize economic data and make predictions about the prospects of a nation

  Day 9

  STRATEGY

  Strategy Topics

  The Seven S Model

  The Value Chain

  Integration and Expansion Strategies