International Business

 

 The Definition of International Business
As the opening case study on Google suggests, international business relates to any situation
where the production or distribution of goods or services crosses country borders.
Globalization—the shift toward a more interdependent and integrated global
economy—creates greater opportunities for international business. Such globalization can
take place in terms of markets, where trade barriers are falling and buyer preferences are
changing. It can also be seen in terms of production, where a company can source goods and
services easily from other countries. Some managers consider the definition of international
business to relate purely to “business,” as suggested in the Google case. However, a broader
definition of international business may serve you better both personally and professionally in
a world that has moved beyond simple industrial production. International business
encompasses a full range of cross-border exchanges of goods, services, or resources between
two or more nations. These exchanges can go beyond the exchange of money for physical
goods to include international transfers of other resources, such as people, intellectual
property (e.g., patents, copyrights, brand trademarks, and data), and contractual assets or
liabilities (e.g., the right to use some foreign asset, provide some future service to foreign
customers, or execute a complex financial instrument). The entities involved in international
business range from large multinational firms with thousands of employees doing business in
many countries around the world to a small one-person company acting as an importer or
exporter. This broader definition of international business also encompasses for-profit border-
crossing transactions as well as transactions motivated by nonfinancial gains (e.g., triple
bottom line, corporate social responsibility, and political favor) that affect a business’s future.
Forms of International Business
 International businesses take on a variety of forms. Importers sell goods and services
obtained from other countries, while exporters sell goods and services from their
home country abroad.
 Firms can also make choices about the extent and structure of their foreign direct
investments, from simply an array of satellite sales offices to integrated production,
sales, and distribution centers in foreign countries.
 Government and nongovernmental organizations also comprise international business.
International Trade and FDI
It’s easy to think that trade is just about business interests in each country. But global trade is much
more. There’s a convergence and, at times, a conflict of the interests of the different
stakeholders—from businesses to governments to local citizens. In recent years, advancements in
technology, a renewed enthusiasm for entrepreneurship, and a global sentiment that favors free
trade have further connected people, businesses, and markets—all flatteners that are helping
expand global trade and investment. An essential part of international business is understanding the
history of international trade and what motivates countries to encourage or discourage trade within
their borders.
Types of International Investments
There are two main categories of international investment—portfolio investment and foreign
direct investment. Portfolio investment refers to the investment in a company’s stocks, bonds,

or assets, but not for the purpose of controlling or directing the firm’s operations or
management. Typically, investors in this category are looking for a financial rate of return as
well as diversifying investment risk through multiple markets.
Foreign direct investment (FDI) refers to an investment in or the acquisition of foreign
assets with the intent to control and manage them. Companies can make an FDI in several
ways, including purchasing the assets of a foreign company; investing in the company or in
new property, plants, or equipment; or participating in a joint venture with a foreign
company, which typically involves an investment of capital or know-how. FDI is primarily a
long-term strategy. Companies usually expect to benefit through access to local markets and
resources, often in exchange for expertise, technical know-how, and capital. A country’s FDI
can be both inward and outward. As the terms would suggest, inward FDI refers to
investments coming into the country and outward FDI are investments made by companies
from that country into foreign companies in other countries. The difference between inward
and outward is called the net FDI inflow, which can be either positive or negative.
Governments want to be able to control and regulate the flow of FDI so that local political
and economic concerns are addressed. Global businesses are most interested in using FDI to
benefit their companies. As a result, these two players—governments and companies—can at
times be at odds. It’s important to understand why companies use FDI as a business strategy
and how governments regulate and manage FDI.
Factors That Influence a Company’s Decision to Invest
Let’s look at why and how companies choose to invest in foreign markets. Simply purchasing
goods and services or deciding to invest in a local market depends on a business’s needs and
overall strategy. Direct investment in a country occurs when a company chooses to set up
facilities to produce or market their products; or seeks to partner with, invest in, or purchase a
local company for control and access to the local market, production, or resources. Many
considerations influence its decisions:
 Cost. Is it cheaper to produce in the local market than elsewhere?
 Logistics. Is it cheaper to produce locally if the transportation costs are significant?
 Market. Has the company identified a significant local market?
 Natural resources. Is the company interested in obtaining access to local resources or
commodities?
 Know-how. Does the company want access to local technology or business process
knowledge?
 Customers and competitors. Does the company’s clients or competitors operate in
the country?
 Policy. Are there local incentives (cash and noncash) for investing in one country
versus another?
 Ease. Is it relatively straightforward to invest and/or set up operations in the country,
or is there another country in which setup might be easier?
 Culture. Is the workforce or labor pool already skilled for the company’s needs or
will extensive training be required?
 Impact. How will this investment impact the company’s revenue and profitability?
 Expatriation of funds. Can the company easily take profits out of the country, or are
there local restrictions?

 Exit. Can the company easily and orderly exit from a local investment, or are local
laws and regulations cumbersome and expensive?
These are just a few of the many factors that might influence a company’s decision. Keep in
mind that a company doesn’t need to sell in the local market in order to deem it a good option
for direct investment. For example, companies set up manufacturing facilities in low-cost
countries but export the products to other markets.
There are two forms of FDI—horizontal and vertical. Horizontal FDI occurs when a company
is trying to open up a new market—a retailer, for example, that builds a store in a new
country to sell to the local market. Vertical FDI is when a company invests internationally to
provide input into its core operations—usually in its home country. A firm may invest in
production facilities in another country. When a firm brings the goods or components back to
its home country (i.e., acting as a supplier), this is referred to as backward vertical FDI. When
a firm sells the goods into the local or regional market (i.e., acting as a distributor), this is
termed forward vertical FDI. The largest global companies often engage in both backward
and forward vertical FDI depending on their industry.
Many firms engage in backward vertical FDI. The auto, oil, and infrastructure (which
includes industries related to enhancing the infrastructure of a country—that is, energy,
communications, and transportation) industries are good examples of this. Firms from these
industries invest in production or plant facilities in a country in order to supply raw materials,
parts, or finished products to their home country. In recent years, these same industries have
also started to provide forward FDI by supplying raw materials, parts, or finished products to
newly emerging local or regional markets.
There are different kinds of FDI, two of which—greenfield and brownfield—are increasingly
applicable to global firms. Greenfield FDIs occur when multinational corporations enter into
developing countries to build new factories or stores. These new facilities are built from
scratch—usually in an area where no previous facilities existed. The name originates from the
idea of building a facility on a green field, such as farmland or a forested area. In addition to
building new facilities that best meet their needs, the firms also create new long-term jobs in
the foreign country by hiring new employees. Countries often offer prospective companies
tax breaks, subsidies, and other incentives to set up greenfield investments.
A brownfield FDI is when a company or government entity purchases or leases existing
production facilities to launch a new production activity. One application of this strategy is
where a commercial site used for an “unclean” business purpose, such as a steel mill or oil
refinery, is cleaned up and used for a less polluting purpose, such as commercial office space
or a residential area. Brownfield investment is usually less expensive and can be implemented
faster; however, a company may have to deal with many challenges, including existing
employees, outdated equipment, entrenched processes, and cultural differences.
You should note that the terms greenfield and brownfield are not exclusive to FDI; you may
hear them in various business contexts. In general, greenfield refers to starting from the
beginning, and brownfield refers to modifying or upgrading existing plans or projects.
Why and How Governments Encourage FDI

Many governments encourage FDI in their countries as a way to create jobs, expand local
technical knowledge, and increase their overall economic standards.Ian Bremmer, The End of
the Free Market: Who Wins the War Between States and Corporations (New York: Portfolio,
2010). Countries like Hong Kong and Singapore long ago realized that both global trade and
FDI would help them grow exponentially and improve the standard of living for their
citizens. As a result, Hong Kong (before its return to China) was one of the easiest places to
set up a new company. Guidelines were clearly available, and businesses could set up a new
office within days. Similarly, Singapore, while a bit more discriminatory on the size and type
of business, offered foreign companies a clear, streamlined process for setting up a new
company.
In contrast, for decades, many other countries in Asia (e.g., India, China, Pakistan, the
Philippines, and Indonesia) restricted or controlled FDI in their countries by requiring
extensive paperwork and bureaucratic approvals as well as local partners for any new foreign
business. These policies created disincentives for many global companies. By the 1990s (and
earlier for China), many of the countries in Asia had caught the global trade bug and were
actively trying to modify their policies to encourage more FDI. Some were more successful
than others, often as a result of internal political issues and pressures rather than from any
repercussions of global trade.UNCTAD compiles statistics on foreign direct investment
(FDI): “Foreign Direct Investment database,” UNCTAD United Nations Conference on
Trade and Development, accessed February 16, 2011,
http://unctadstat.unctad.org/ReportFolders/reportFolders.aspx?sRF_ActivePath=P,5,27&sRF
_Expanded=,P,5,27&sCS_ChosenLang=en .
How Governments Discourage or Restrict FDI
In most instances, governments seek to limit or control foreign direct investment to protect
local industries and key resources (oil, minerals, etc.), preserve the national and local culture,
protect segments of their domestic population, maintain political and economic
independence, and manage or control economic growth. A government use various policies
and rules:
 Ownership restrictions. Host governments can specify ownership restrictions if they
want to keep the control of local markets or industries in their citizens’ hands. Some
countries, such as Malaysia, go even further and encourage that ownership be
maintained by a person of Malay origin, known locally as bumiputra. Although the
country’s Foreign Investment Committee guidelines are being relaxed, most foreign
businesses understand that having a bumiputra partner will improve their chances of
obtaining favorable contracts in Malaysia.
 Tax rates and sanctions. A company’s home government usually imposes these
restrictions in an effort to persuade companies to invest in the domestic market rather
than a foreign one.
How Governments Encourage FDI
Governments seek to promote FDI when they are eager to expand their domestic economy
and attract new technologies, business know-how, and capital to their country. In these
instances, many governments still try to manage and control the type, quantity, and even the
nationality of the FDI to achieve their domestic, economic, political, and social goals.

 Financial incentives. Host countries offer businesses a combination of tax incentives
and loans to invest. Home-country governments may also offer a combination of
insurance, loans, and tax breaks in an effort to promote their companies’ overseas
investments. The opening case on China in Africa illustrated these types of incentives.
 Infrastructure. Host governments improve or enhance local infrastructure—in
energy, transportation, and communications—to encourage specific industries to
invest. This also serves to improve the local conditions for domestic firms.
 Administrative processes and regulatory environment. Host-country governments
streamline the process of establishing offices or production in their countries. By
reducing bureaucracy and regulatory environments, these countries appear more
attractive to foreign firms.
 Invest in education. Countries seek to improve their workforce through education
and job training. An educated and skilled workforce is an important investment
criterion for many global businesses.
 Political, economic, and legal stability. Host-country governments seek to reassure
businesses that the local operating conditions are stable, transparent (i.e., policies are
clearly stated and in the public domain), and unlikely to change.
International Monetary Systems
Global trade depends on the smooth exchange of currencies between countries. Businesses rely on a
predictable and stable mechanism. This chapter takes a look at the recent history of global monetary
systems and how they have evolved over the past two centuries. While the current monetary system
continues to evolve, lessons learned over the past fifty years help determine the best future options.
As part of the post–World War II monetary environment, two institutions were created; these
institutions have expanded to play an increasingly larger role in world economy. Understanding the
role of the IMF and the World Bank provides insight into how governments in developing countries
prioritize and fund projects and work with the private sector to implement these initiatives.

Before the current monetary system can be fully appreciated, it’s helpful to look back at
history and see how money and systems governing the use of money have evolved.
Thousands of years ago, people had to barter if they wanted to get something. That worked
well if the two people each wanted what the other had. Even today, bartering exists.
History shows that ancient Egypt and Mesopotamia—which encompasses the land between
the Euphrates and Tigris Rivers and is modern-day Iraq, parts of eastern Syria, southwest
Iran, and southeast Turkey—began to use a system based on the highly coveted coins of gold
and silver, also known as bullion, which is the purest form of the precious metal. However,
bartering remained the most common form of exchange and trade.
Gold and silver coins gradually emerged in the use of trading, although the level of pure gold
and silver content impacted the coins value. Only coins that consist of the pure precious metal
are bullions; all other coins are referred to simply as coins. It is interesting to note that gold
and silver lasted many centuries as the basis of economic measure and even into relatively
recent history of the gold standard, which we’ll cover in the next section. Fast-forward two
thousand years and bartering has long been replaced by a currency-based system. Even so,
there have been evolutions in the past century alone on how—globally—the monetary system

has evolved from using gold and silver to represent national wealth and economic exchange
to the current system.

Let’s take a look at the last century of the international monetary system evolution.
International monetary system refers to the system and rules that govern the use and
exchange of money around the world and between countries. Each country has its own
currency as money and the international monetary system governs the rules for valuing and
exchanging these currencies.
Until the nineteenth century, the major global economies were regionally focused in Europe,
the Americas, China, and India. These were loosely linked, and there was no formal monetary
system governing their interactions. The rest of this section reviews the distinct chronological
periods over the past 150 years leading to the development of the modern global financial
system. Keep in mind that the system continues to evolve and each crisis impacts it. There is
not likely to be a final international monetary system, simply one that reflects the current
economic and political realities. This is one main reason why understanding the historical
context is so critical. As the debate about the pros and cons of the current monetary system
continues, some economists are tempted to advocate a return to systems from the past.
Businesses need to be mindful of these arguments and the resulting changes, as they will be
impacted by new rules, regulations, and structures.
Pre–World War I
As mentioned earlier in this section, ancient societies started using gold as a means of
economic exchange. Gradually more countries adopted gold, usually in the form of coins or
bullion, and this international monetary system became known as the gold standard. This
system emerged gradually, without the structural process in more recent systems. The gold
standard, in essence, created a fixed exchange rate system. An exchange rate is the price of
one currency in terms of a second currency. In the gold standard system, each country sets the
price of its currency to gold, specifically to one ounce of gold. A fixed exchange rate
stabilizes the value of one currency vis-à-vis another and makes trade and investment easier.
Our modern monetary system has its roots in the early 1800s. The defeat of Napoleon in
1815, when France was beaten at the Battle of Waterloo, made Britain the strongest nation in
the world, a position it held for about one hundred years. In Africa, British rule extended at
one time from the Cape of Good Hope to Cairo. British dominance and influence also
stretched to the Indian subcontinent, the Malaysian peninsula, Australia, New
Zealand—which attracted British settlers—and Canada. Under the banner of the British
government, British companies advanced globally and were the largest companies in many of
the colonies, controlling trade and commerce. Throughout history, strong countries, as
measured mainly in terms of military might, were able to advance the interests of companies
from their countries—a fact that has continued to modern times, as seen in the global prowess
of American companies. Global firms in turn have always paid close attention to the political,
military, and economic policies of their and other governments.
In 1821, the United Kingdom, the predominant global economy through the reaches of its
colonial empire, adopted the gold standard and committed to fixing the value of the British

pound. The major trading countries, including Russia, Austria-Hungary, Germany, France,
and the United States, also followed and fixed the price of their currencies to an ounce of
gold.
The United Kingdom officially set the price of its currency by agreeing to buy or sell an
ounce of gold for the price of 4.247 pounds sterling. At that time, the United States agreed to
buy or sell an ounce of gold for $20.67. This enabled the two currencies to be freely
exchanged in terms of an ounce of gold. In essence,
£4.247 = 1 ounce of gold = $20.67.
The exchange rate between the US dollar and the British pound was then calculated by
$20.67/£4.247 = $4.867 to £1.
The Advantages of the Gold Standard
The gold standard dramatically reduced the risk in exchange rates because it established fixed
exchange rates between currencies. Any fluctuations were relatively small. This made it
easier for global companies to manage costs and pricing. International trade grew throughout
the world, although economists are not always in agreement as to whether the gold standard
was an essential part of that trend.
The second advantage is that countries were forced to observe strict monetary policies. They
could not just print money to combat economic downturns. One of the key features of the
gold standard was that a currency had to actually have in reserve enough gold to convert all
of its currency being held by anyone into gold. Therefore, the volume of paper currency
could not exceed the gold reserves.
The third major advantage was that gold standard would help a country correct its trade
imbalance. For example, if a country was importing more than it is exporting, (called a trade
deficit), then under the gold standard the country had to pay for the imports with gold. The
government of the country would have to reduce the amount of paper currency, because there
could not be more currency in circulation than its gold reserves. With less money floating
around, people would have less money to spend (thus causing a decrease in demand) and
prices would also eventually decrease. As a result, with cheaper goods and services to offer,
companies from the country could export more, changing the international trade balance
gradually back to being in balance. For these three primary reasons, and as a result of the
2008 global financial crises, some modern economists are calling for the return of the gold
standard or a similar system.
Collapse of the Gold Standard
If it was so good, what happened? The gold standard eventually collapsed from the impact of
World War I. During the war, nations on both sides had to finance their huge military
expenses and did so by printing more paper currency. As the currency in circulation exceeded
each country’s gold reserves, many countries were forced to abandon the gold standard. In
the 1920s, most countries, including the United Kingdom, the United States, Russia, and

France, returned to the gold standard at the same price level, despite the political instability,
high unemployment, and inflation that were spread throughout Europe.
However, the revival of the gold standard was short-lived due to the Great Depression, which
began in the late 1920s. The Great Depression was a worldwide phenomenon. By 1928,
Germany, Brazil, and the economies of Southeast Asia were depressed. By early 1929, the
economies of Poland, Argentina, and Canada were contracting, and the United States
economy followed in the middle of 1929. Some economists have suggested that the larger
factor tying these countries together was the international gold standard, which they believe
prolonged the Great Depression.The Concise Encyclopedia of Economics, s.v. “Great
Depression,” accessed July 23, 2010,
http://www.econlib.org/library/Enc/GreatDepression.html . The gold standard limited the
flexibility of the monetary policy of each country’s central banks by limiting their ability to
expand the money supply. Under the gold standard, countries could not expand their money
supply beyond what was allowed by the gold reserves held in their vaults.
Too much money had been created during World War I to allow a return to the gold standard
without either large currency devaluations or price deflations. In addition, the US gold stock
had doubled to about 40 percent of the world’s monetary gold. There simply was not enough
monetary gold in the rest of the world to support the countries’ currencies at the existing
exchange rates.
By 1931, the United Kingdom had to officially abandon its commitment to maintain the value
of the British pound. The currency was allowed to float, which meant that its value would
increase or decrease based on demand and supply. The US dollar and the French franc were
the next strongest currencies and nations sought to peg the value of their currencies to either
the dollar or franc. However, in 1934, the United States devalued its currency from $20.67
per ounce of gold to $35 per ounce. With a cheaper US dollar, US firms were able to export
more as the price of their goods and services were cheaper vis-à-vis other nations. Other
countries devalued their currencies in retaliation of the lower US dollar. Many of these
countries used arbitrary par values rather than a price relative to their gold reserves. Each
country hoped to make its exports cheaper to other countries and reduce expensive imports.
However, with so many countries simultaneously devaluing their currencies, the impact on
prices was canceled out. Many countries also imposed tariffs and other trade restrictions in an
effort to protect domestic industries and jobs. By 1939, the gold standard was dead; it was no
longer an accurate indicator of a currency’s real value.
Post–World War II
The demise of the gold standard and the rise of the Bretton Woods system pegged to the US
dollar was also a changing reflection of global history and politics. The British Empire’s
influence was dwindling. In the early 1800s, with the strength of both their currency and
trading might, the United Kingdom had expanded its empire. At the end of World War I, the
British Empire spanned more than a quarter of the world; the general sentiment was that “the
sun would never set on the British empire.” British maps and globes of the time showed the
empire’s expanse proudly painted in red. However, shortly after World War II, many of the
colonies fought for and achieved independence. By then, the United States had clearly
replaced the United Kingdom as the dominant global economic center and as the political and
military superpower as well.

Bretton Woods
In the early 1940s, the United States and the United Kingdom began discussions to formulate
a new international monetary system. John Maynard Keynes, a highly influential British
economic thinker, and Harry Dexter White, a US Treasury official, paved the way to create a
new monetary system. In July 1944, representatives from forty-four countries met in Bretton
Woods, New Hampshire, to establish a new international monetary system.
“The challenge,” wrote Ngaire Woods in his book The Globalizers: The IMF, the World
Bank, and Their Borrowers, “was to gain agreement among states about how to finance
postwar reconstruction, stabilize exchange rates, foster trade, and prevent balance of
payments crises from unraveling the system.”Ngaire Woods, Globalizers: The IMF, the
World Bank, and Their Borrowers (Ithaca, NY: Cornell University Press, 2006), 16.

The resulting Bretton Woods Agreement created a new dollar-based monetary system, which
incorporated some of the disciplinary advantages of the gold system while giving countries
the flexibility they needed to manage temporary economic setbacks, which had led to the fall
of the gold standard. The Bretton Woods Agreement lasted until 1971 and established several
key features.
Fixed Exchange Rates
Fixed exchange rates are also sometimes called pegged rates. One of the critical factors that
led to the fall of the gold standard was that after the United Kingdom abandoned its
commitment to maintaining the value of the British pound, countries sought to peg their
currencies to the US dollar. With the strength of the US economy, the gold supply in the
United States increased, while many countries had less gold in reserve than they did currency
in circulation. The Bretton Woods system worked to fix this by tying the value of the US
dollar to gold but also by tying all of the other countries to the US dollar rather than directly
to gold. The par value of the US dollar was fixed at $35 to one ounce of gold. All other
countries then set the value of their currencies to the US dollar. In reflection of the changing
times, the British pound had undergone a substantial loss in value and by that point, its value
was $2.40 to £1. Member countries had to maintain the value of their currencies within 1
percent of the fixed exchange rate. Lastly, the agreement established that only governments,
rather than anyone who demanded it, could convert their US dollar holdings into gold—a
major improvement over the gold standard. In fact, most businesspeople eventually ignored
the technicality of pegging the US dollar to gold and simply utilized the actual exchange rates
between countries (e.g., the pound to the dollar) as an economic measure for doing business.
National Flexibility
To enable countries to manage temporary but serious downturns, the Bretton Woods
Agreement provided for a devaluation of a currency—more than 10 percent if needed.

Countries could not use this tool to competitively manipulate imports and exports. Rather, the
tool was intended to prevent the large-scale economic downturn that took place in the 1930s.
Creation of the International Monetary Fund and the
World Bank
Section 6.2 "What Is the Role of the IMF and the World Bank?" looks at the International
Monetary Fund and the World Bank more closely, as they have survived the collapse of the
Bretton Woods Agreement. In essence, the IMF’s initial primary purpose was to help manage
the fixed rate exchange system; it eventually evolved to help governments correct temporary
trade imbalances (typically deficits) with loans. The World Bank’s purpose was to help with
post–World War II European reconstruction. Both institutions continue to serve these roles
but have evolved into broader institutions that serve essential global purposes, even though
the system that created them is long gone. Section 6.2 "What Is the Role of the IMF and the
World Bank?" explores them in greater detail and addresses the history, purpose, evolution,
and current opportunities and challenges of both institutions.
Collapse of Bretton Woods
Despite a fixed exchange rate based on the US dollar and more national flexibility, the
Bretton Woods Agreement ran into challenges in the early 1970s. The US trade balance had
turned to a deficit as Americans were importing more than they were exporting. Throughout
the 1950s and 1960s, countries had substantially increased their holdings of US dollars,
which was the only currency pegged to gold. By the late 1960s, many of these countries
expressed concern that the US did not have enough gold reserves to exchange all of the US
dollars in global circulation. This became known as the Triffin Paradox, named after the
economist Robert Triffin, who identified this problem. He noted that the more dollars foreign
countries held, the less faith they had in the ability of the US government to convert those
dollars. Like banks, though, countries do not keep enough gold or cash on hand to honor all
of their liabilities. They maintain a percentage, called a reserve. Bank reserve ratios are
usually 10 percent or less. (The low reserve ratio has been blamed by many as a cause of the
2008 financial crisis.) Some countries state their reserve ratios openly, and most seek to
actively manage their ratios daily with open-market monetary policies—that is, buying and
selling government securities and other financial instruments, which indirectly controls the
total money supply in circulation, which in turn impacts supply and demand for the currency.
The expense of the Vietnam War and an increase in domestic spending worsened the Triffin
Paradox; the US government began to run huge budget deficits, which further weakened
global confidence in the US dollar. When nations began demanding gold in exchange for
their dollars, there was a huge global sell-off of the US dollar, resulting in the Nixon Shock in
1971.
The Nixon Shock was a series of economic decisions made by the US President Richard
Nixon in 1971 that led to the demise of the Bretton Woods system. Without consulting the
other member countries, on August 15, 1971, Nixon ended the free convertibility of the US
dollar into gold and instituted price and wage freezes among other economic measures.

Later that same year, the member countries reached the Smithsonian Agreement, which
devalued the US dollar to $38 per ounce of gold, increased the value of other countries’
currencies to the dollar, and increased the band within which a currency was allowed to float
from 1 percent to 2.25 percent. This agreement still relied on the US dollar to be the strong
reserve currency and the persistent concerns over the high inflation and trade deficits
continued to weaken confidence in the system. Countries gradually dropped out of
system—notably Germany, the United Kingdom, and Switzerland, all of which began to
allow their currencies to float freely against the dollar. The Smithsonian Agreement was an
insufficient response to the economic challenges; by 1973, the idea of fixed exchange rates
was over.
Before moving on, recall that the major significance of the Bretton Woods Agreement was
that it was the first formal institution that governed international monetary systems. By
having a formal set of rules, regulations, and guidelines for decision making, the Bretton
Woods Agreement established a higher level of economic stability. International businesses
benefited from the almost thirty years of stability in exchange rates. Bretton Woods
established a standard for future monetary systems to improve on; countries today continue to
explore how best to achieve this. Nothing has fully replaced Bretton Woods to this day,
despite extensive efforts.
Post–Bretton Woods Systems and Subsequent Exchange
Rate Efforts
When Bretton Woods was established, one of the original architects, Keynes, initially
proposed creating an international currency called Bancor as the main currency for clearing.
However, the Americans had an alternative proposal for the creation of a central currency
called unitas. Neither gained momentum; the US dollar was the reserve currency. Reserve
currency is a main currency that many countries and institutions hold as part of their foreign
exchange reserves. Reserve currencies are often international pricing currencies for world
products and services. Examples of current reserve currencies are the US dollar, the euro, the
British pound, the Swiss franc, and the Japanese yen.
Many feared that the collapse of the Bretton Woods system would bring the period of rapid
growth to an end. In fact, the transition to floating exchange rates was relatively smooth, and
it was certainly timely: flexible exchange rates made it easier for economies to adjust to more
expensive oil, when the price suddenly started going up in October 1973. Floating rates have
facilitated adjustments to external shocks ever since.
The IMF responded to the challenges created by the oil price shocks of the 1970s by adapting
its lending instruments. To help oil importers deal with anticipated current account deficits
and inflation in the face of higher oil prices, it set up the first of two oil facilities.“The End of
the Bretton Woods System (1972–81),” International Monetary Fund, accessed July 26, 2010,
http://www.imf.org/external/about/histend.htm .
After the collapse of Bretton Woods and the Smithsonian Agreement, several new efforts
tried to replace the global system. The most noteworthy regional effort resulted in the
European Monetary System (EMS) and the creation of a single currency, the euro. While
there have been no completely effective efforts to replace Bretton Woods on a global level,
there have been efforts that have provided ongoing exchange rate mechanisms.

Jamaica Agreement
In 1976, countries met to formalize a floating exchange rate system as the new international
monetary system. The Jamaica Agreement established a managed float system of exchange
rates, in which currencies float against one another with governments intervening only to
stabilize their currencies at set target exchange rates. This is in contrast to a completely free
floating exchange rate system, which has no government intervention; currencies float freely
against one another. The Jamaica Agreement also removed gold as the primary reserve asset
of the IMF. Additionally, the purpose of the IMF was expanded to include lending money as
a last resort to countries with balance-of-payment challenges.
The Gs Begin
In the early 1980s, the value of the US dollar increased, pushing up the prices of US exports
and thereby increasing the trade deficit. To address the imbalances, five of the world’s largest
economies met in September 1985 to determine a solution. The five countries were Britain,
France, Germany, Japan, and the United States; this group became known as the Group of
Five, shortened to G5. The 1985 agreement, called the Plaza Accord because it was held at
the Plaza Hotel in New York City, focused on forcing down the value of the US dollar
through collective efforts.
By February 1987, the markets had pushed the dollar value down, and some worried it was
now valued too low. The G5 met again, but now as the Group of Seven, adding Italy and
Canada—it became known as the G7. The Louvre Accord, so named for being agreed on in
Paris, stabilized the dollar. The countries agreed to support the dollar at the current valuation.
The G7 continued to meet regularly to address ongoing economic issues.
The G7 was expanded in 1999 to include twenty countries as a response to the financial crises
of the late 1990s and the growing recognition that key emerging-market countries were not
adequately included in the core of global economic discussions and governance. It was not
until a decade later, though, that the G20 effectively replaced the G8, which was made up of
the original G7 and Russia. The European Union was represented in G20 but could not host
or chair the group.
Keeping all of these different groups straight can be very confusing. The news may report on
different groupings as countries are added or removed from time to time. The key point to
remember is that anything related to a G is likely to be a forum consisting of finance
ministers and governors of central banks who are meeting to discuss matters related to
cooperating on an international monetary system and key issues in the global economy.
The G20 is likely to be the stronger forum for the foreseeable future, given the number of
countries it includes and the amount of world trade it represents. “Together, member
countries represent around 90 per cent of global gross national product, 80 per cent of world
trade (including EU intra-trade) as well as two-thirds of the world’s population.”“About G-
20,” G-20, accessed July 25, 2010, http://www.g20.org/en .

Today’s Exchange Rate System
While there is not an official replacement to the Bretton Woods system, there are provisions
in place through the ongoing forum discussions of the G20. Today’s system remains—in
large part—a managed float system, with the US dollar and the euro jostling to be the premier
global currency. For businesses that once quoted primarily in US dollars, pricing is now just
as often noted in the euro as well.

some smaller nations have chosen to voluntarily set exchange rates against the dollar while
other countries have selected the euro. Usually a country makes the decision between the
dollar and the euro by reviewing their largest trading partners. By choosing the euro or the
dollar, countries seek currency stability and a reduction in inflation, among other various
perceived benefits. Many countries in Latin America once dollarized to provide currency
stability for their economy. Today, this is changing, as individual economies have
strengthened and countries are now seeking to dedollarize.

Foreign Exchange and the Global Capital Markets
Foreign exchange is one aspect of the global capital markets. Companies access the global
capital markets to utilize both the debt and equity markets; these are important for growth.
Being able to access transparent and efficient capital markets around the world is another
important component in the flattening world for global firms. Finally, this chapter discusses
how the expansion of the global capital markets has benefited entrepreneurship and venture
capitalists.
What Are Currency and Foreign Exchange?
In order to understand the global financial environment, how capital markets work, and their
impact on global business, we need to first understand how currencies and foreign exchange
rates work.

Briefly, currency is any form of money in general circulation in a country. What exactly is a
foreign exchange? In essence, foreign exchange is money denominated in the currency of
another country or—now with the euro—a group of countries. Simply put, an exchange rate
is defined as the rate at which the market converts one currency into another.
Any company operating globally must deal in foreign currencies. It has to pay suppliers in
other countries with a currency different from its home country’s currency. The home country
is where a company is headquartered. The firm is likely to be paid or have profits in a
different currency and will want to exchange it for its home currency. Even if a company
expects to be paid in its own currency, it must assess the risk that the buyer may not be able
to pay the full amount due to currency fluctuations.
If you have traveled outside of your home country, you may have experienced the currency
market—for example, when you tried to determine your hotel bill or tried to determine if an
item was cheaper in one country versus another. In fact, when you land at an airport in
another country, you’re likely to see boards indicating the foreign exchange rates for major
currencies. These rates include two numbers: the bid and the offer. The bid (or buy) is the
price at which a bank or financial services firm is willing to buy a specific currency. The ask
(or the offer or sell), refers to the price at which a bank or financial services firm is willing to
sell that currency. Typically, the bid or the buy is always cheaper than the sell; banks make a
profit on the transaction from that difference. For example, imagine you’re on vacation in
Thailand and the exchange rate board indicates that the Bangkok Bank is willing to exchange
currencies at the following rates (see the following figure). GBP refers to the British pound;
JPY refers to the Japanese yen; and HKD refers to the Hong Kong dollar, as shown in the
following figure. Because there are several countries that use the dollar as part or whole of
their name, this chapter clearly states “US dollar” or uses US$ or USD when referring to
American currency.

This chart tells us that when you land in Thailand, you can use 1 US dollar to buy 31.67 Thai baht.
However, when you leave Thailand and decide that you do not need to take all your baht back to the
United States, you then convert baht back to US dollars. We then have to use more baht—32.32
according to the preceding figure—to buy 1 US dollar. The spread between these numbers, 0.65
baht, is the profit that the bank makes for each US dollar bought and sold. The bank charges a fee
because it performed a service—facilitating the currency exchange. When you walk through the
airport, you’ll see more boards for different banks with different buy and sell rates. While the
difference may be very small, around 0.1 baht, these numbers add up if you are a global company

engaged in large foreign exchange transactions. Accordingly, global firms are likely to shop around
for the best rates before they exchange any currencies.

What Is the Purpose of the Foreign Exchange Market?
The foreign exchange market (or FX market) is the mechanism in which currencies can be
bought and sold. A key component of this mechanism is pricing or, more specifically, the rate
at which a currency is bought or sold. We’ll cover the determination of exchange rates more
closely in this section, but first let’s understand the purpose of the FX market. International
businesses have four main uses of the foreign exchange markets.
Currency Conversion
Companies, investors, and governments want to be able to convert one currency into another.
A company’s primary purposes for wanting or needing to convert currencies is to pay or
receive money for goods or services. Imagine you have a business in the United States that
imports wines from around the world. You’ll need to pay the French winemakers in euros,
your Australian wine suppliers in Australian dollars, and your Chilean vineyards in pesos.
Obviously, you are not going to access these currencies physically. Rather, you’ll instruct
your bank to pay each of these suppliers in their local currencies. Your bank will convert the
currencies for you and debit your account for the US dollar equivalent based on the exact
exchange rate at the time of the exchange.
Currency Hedging
One of the biggest challenges in foreign exchange is the risk of rates increasing or decreasing
in greater amounts or directions than anticipated. Currency hedging refers to the technique of
protecting against the potential losses that result from adverse changes in exchange rates.
Companies use hedging as a way to protect themselves if there is a time lag between when
they bill and receive payment from a customer. Conversely, a company may owe payment to
an overseas vendor and want to protect against changes in the exchange rate that would
increase the amount of the payment. For example, a retail store in Japan imports or buys
shoes from Italy. The Japanese firm has ninety days to pay the Italian firm. To protect itself,
the Japanese firm enters into a contract with its bank to exchange the payment in ninety days
at the agreed-on exchange rate. This way, the Japanese firm is clear about the amount to pay
and protects itself from a sudden depreciation of the yen. If the yen depreciates, more yen
will be required to purchase the same euros, making the deal more expensive. By hedging,
the company locks in the rate.
Currency Arbitrage
Arbitrage is the simultaneous and instantaneous purchase and sale of a currency for a profit.
Advances in technology have enabled trading systems to capture slight differences in price
and execute a transaction, all within seconds. Previously, arbitrage was conducted by a trader
sitting in one city, such as New York, monitoring currency prices on the Bloomberg terminal.
Noticing that the value of a euro is cheaper in Hong Kong than in New York, the trader could

then buy euros in Hong Kong and sell them in New York for a profit. Today, such
transactions are almost all handled by sophisticated computer programs. The programs
constantly search different exchanges, identify potential differences, and execute transactions,
all within seconds.

Currency Speculation
Speculation refers to the practice of buying and selling a currency with the expectation that
the value will change and result in a profit. Such changes could happen instantly or over a
period of time.
High-risk, speculative investments by nonfinance companies are less common these days
than the current news would indicate. While companies can engage in all four uses discussed
in this section, many companies have determined over the years that arbitrage and speculation
are too risky and not in alignment with their core strategies. In essence, these companies have
determined that a loss due to high-risk or speculative investments would be embarrassing and
inappropriate for their companies.
Understand How to Determine Exchange Rates
How to Quote a Currency
There are several ways to quote currency, but let’s keep it simple. In general, when we quote
currencies, we are indicating how much of one currency it takes to buy another currency.
This quote requires two components: the base currency and the quoted currency. The quoted
currency is the currency with which another currency is to be purchased. In an exchange rate
quote, the quoted currency is typically the numerator. The base currency is the currency that
is to be purchased with another currency, and it is noted in the denominator. For example, if
we are quoting the number of Hong Kong dollars required to purchase 1 US dollar, then we
note HKD 8 / USD 1. (Note that 8 reflects the general exchange rate average in this
example.) In this case, the Hong Kong dollar is the quoted currency and is noted in the
numerator. The US dollar is the base currency and is noted in the denominator. We read this
quote as “8 Hong Kong dollars are required to purchase 1 US dollar.” If you get confused
while reviewing exchanging rates, remember the currency that you want to buy or sell. If you
want to sell 1 US dollar, you can buy 8 Hong Kong dollars, using the example in this
paragraph.
Direct Currency Quote and Indirect Currency Quote
Additionally, there are two methods—the American terms and the European terms—for
noting the base and quoted currency. These two methods, which are also known as direct and
indirect quotes, are opposite based on each reference point. Let’s understand what this means
exactly.

The American terms, also known as US terms, are from the point of view of someone in the
United States. In this approach, foreign exchange rates are expressed in terms of how many
US dollars can be exchanged for one unit of another currency (the non-US currency is the
base currency). For example, a dollar-pound quote in American terms is USD/GP (US$/£)
equals 1.56. This is read as “1.56 US dollars are required to buy 1 pound sterling.” This is
also called a direct quote, which states the domestic currency price of one unit of foreign
currency. If you think about this logically, a business that needs to buy a foreign currency
needs to know how many US dollars must be sold in order to buy one unit of the foreign
currency. In a direct quote, the domestic currency is a variable amount and the foreign
currency is fixed at one unit.
Conversely, the European terms are the other approach for quoting rates. In this approach,
foreign exchange rates are expressed in terms of how many currency units can be exchanged
for a US dollar (the US dollar is the base currency). For example, the pound-dollar quote in
European terms is £0.64/US$1 (£/US$1). While this is a direct quote for someone in Europe,
it is an indirect quote in the United States. An indirect quote states the price of the domestic
currency in foreign currency terms. In an indirect quote, the foreign currency is a variable
amount and the domestic currency is fixed at one unit.
A direct and an indirect quote are simply reverse quotes of each other. If you have either one,
you can easily calculate the other using this simple formula:
direct quote = 1 / indirect quote.
To illustrate, let’s use our dollar-pound example. The direct quote is US$1.56 = 1/£0.64 (the
indirect quote). This can be read as
1 divided by 0.64 equals 1.56.
In this example, the direct currency quote is written as US$/£ = 1.56.
While you are performing the calculations, it is important to keep track of which currency is
in the numerator and which is in the denominator, or you might end up stating the quote
backward. The direct quote is the rate at which you buy a currency. In this example, you need
US$1.56 to buy a British pound.
Tip: Many international business professionals become experienced over their careers and are
able to correct themselves in the event of a mix-up between currencies. To illustrate using the
example mentioned previously, the seasoned global professional knows that the British pound
is historically higher in value than the US dollar. This means that it takes more US dollars to
buy a pound than the other way around. When we say “higher in value,” we mean that the
value of the British pound buys you more US dollars. Using this logic, we can then deduce
that 1.56 US dollars are required to buy 1 British pound. As an international businessperson,
we would know instinctively that it cannot be less—that is, only 0.64 US dollars to buy a
British pound. This would imply that the dollar value was higher in value. While major
currencies have changed significantly in value vis-à-vis each other, it tends to happen over
long periods of time. As a result, this self-test is a good way to use logic to keep track of
tricky exchange rates. It works best with major currencies that do not fluctuate greatly vis-à-
vis others.

A useful side note: traders always list the base currency as the first currency in a currency pair. Let’s
assume, for example, that it takes 85 Japanese yen to purchase 1 US dollar. A currency trader would
note this as follows: USD 1 / JPY 85. This quote indicates that the base currency is the US dollar and
85 yen are required to purchase a dollar. This is also called a direct quote, although FX traders are
more likely to call it an American rate rather than a direct rate. It can be confusing, but try to keep
the logic of which currency you are selling and which you are buying clearly in your mind, and say
the quote as full sentences in order to keep track of the currencies.

Spot Rates
The exchange rates discussed in this chapter are spot rates—exchange rates that require
immediate settlement with delivery of the traded currency. “Immediate” usually means within
two business days, but it implies an “on the spot” exchange of the currencies, hence the term
spot rate. The spot exchange rate is the exchange rate transacted at a particular moment by
the buyer and seller of a currency. When we buy and sell our foreign currency at a bank or at
American Express, it’s quoted at the rate for the day. For currency traders though, the spot
can change throughout the trading day even by tiny fractions.
To illustrate, assume that you work for a clothing company in the United States and you want
to buy shirts from either Malaysia or Indonesia. The shirts are exactly the same; only the
price is different. (For now, ignore shipping and any taxes.) Assume that you are using the
spot rate and are making an immediate payment. There is no risk of the currency increasing
or decreasing in value. (We’ll cover forward rates in the next section.)
The currency in Malaysia is the Malaysian ringgit, which is abbreviated MYR. The supplier
in Kuala Lumpur e-mails you the quote—you can buy each shirt for MYR 35. Let’s use a
spot exchange rate of MYR 3.13 / USD 1.
The Indonesian currency is the rupiah, which is abbreviated as Rp. The supplier in Jakarta e-
mails you a quote indicating that you can buy each shirt for Rp 70,000. Use a spot exchange
rate of Rp 8,960 / USD 1.
It would be easy to instinctively assume that the Indonesian firm is more expensive, but look
more closely. You can calculate the price of one shirt into US dollars so that a comparison
can be made:
For Malaysia: MYR 35 / MYR 3.13 = USD 11.18 For Indonesia: Rp 70,000 / Rp 8,960 =
USD 7.81
Indonesia is the cheaper supplier for our shirts on the basis of the spot exchange rate.
Cross Rates
There’s one more term that applies to the spot market—the cross rate. This is the exchange
rate between two currencies, neither of which is the official currency in the country in which
the quote is provided. For example, if an exchange rate between the euro and the yen were
quoted by an American bank on US soil, the rate would be a cross rate.

The most common cross-currency pairs are EUR/GBP, EUR/CHF, and EUR/JPY. These
currency pairs expand the trading possibilities in the foreign exchange market but are less
actively traded than pairs that include the US dollar, which are called the “majors” because of
their high degree of liquidity. The majors are EUR/USD, GBP/ USD, USD/JPY, USD/CAD
(Canadian dollar), USD/CHF (Swiss franc), and USD/AUD (Australian dollar). Despite the
changes in the international monetary system and the expansion of the capital markets, the
currency market is really a market of dollars and nondollars. The dollar is still the reserve
currency for the world’s central banks. Table 7.1 "Currency Cross Rates" contains some
currency cross rates between the major currencies. We can see, for example, that the rate for
the cross-currency pair of EUR/GBP is 1.1956. This is read as “it takes 1.1956 euros to buy
one British pound.” Another example is the EUR/JPY rate, which is 0.00901. However, a
seasoned trader would not say that it takes 0.00901 euros to buy 1 Japanese yen. He or she
would instinctively know to quote the currency pair as the JPY/EUR rate or—more
specifically—that it takes 111.088 yen to purchase 1 euro.
Forward Rates
The forward exchange rate is the exchange rate at which a buyer and a seller agree to transact
a currency at some date in the future. Forward rates are really a reflection of the market’s
expectation of the future spot rate for a currency. The forward market is the currency market
for transactions at forward rates. In the forward markets, foreign exchange is always quoted
against the US dollar. This means that pricing is done in terms of how many US dollars are
needed to buy one unit of the other currency. Not all currencies are traded in the forward
market, as it depends on the demand in the international financial markets. The majors are
routinely traded in the forward market.
For example, if a US company opted to buy cell phones from China with payment due in
ninety days, it would be able to access the forward market to enter into a forward contract to
lock in a future price for its payment. This would enable the US firm to protect itself against a
depreciation of the US dollar, which would require more dollars to buy one Chinese yuan. A
forward contract is a contract that requires the exchange of an agreed-on amount of a
currency on an agreed-on date and a specific exchange rate. Most forward contracts have
fixed dates at 30, 90, or 180 days. Custom forward contracts can be purchased from most
financial firms. Forward contracts, currency swaps, options, and futures all belong to a group
of financial instruments called derivatives. In the term’s broadest definition, derivatives are
financial instruments whose underlying value comes from (derives from) other financial
instruments or commodities—in this case, another currency.
Swaps, Options, and Futures
Swaps, options, and futures are three additional currency instruments used in the forward
market.
A currency swap is a simultaneous buy and sell of a currency for two different dates. For
example, an American computer firm buys (imports) components from China. The firm needs
to pay its supplier in renminbi today. At the same time, the American computer is expecting
to receive RMB in ninety days for its netbooks sold in China. The American firm enters into
two transactions. First, it exchanges US dollars and buys yuan renminbi today so that it can
pay its supplier. Second, it simultaneously enters into a forward contract to sell yuan and buy

dollars at the ninety-day forward rate. By entering into both transactions, the firm is able to
reduce its foreign exchange rate risk by locking into the price for both.
Currency options are the option or the right—but not the obligation—to exchange a specific
amount of currency on a specific future date and at a specific agreed-on rate. Since a currency
option is a right but not a requirement, the parties in an option do not have to actually
exchange the currencies if they choose not to. This is referred to as not exercising an option.
Currency futures contracts are contracts that require the exchange of a specific amount of
currency at a specific future date and at a specific exchange rate. Futures contracts are similar
to but not identical to forward contracts.
Exchange-Traded and Standardized Terms
Futures contracts are actively traded on exchanges, and the terms are standardized. As a
result, futures contracts have clearinghouses that guarantee the transactions, substantially
reducing any risk of default by either party. Forward contracts are private contracts between
two parties and are not standardized. As a result, the parties have a higher risk of defaulting
on a contract.
Settlement and Delivery
The settlement of a forward contract occurs at the end of the contract. Futures contracts are
marked-to-market daily, which means that daily changes are settled day by day until the end
of the contract. Furthermore, the settlement of a futures contract can occur over a range of
dates. Forward contracts, on the other hand, only have one settlement date at the end of the
contract.
Maturity
Futures contracts are frequently employed by speculators, who bet on the direction in which a
currency’s price will move; as a result, futures contracts are usually closed out prior to
maturity and delivery usually never happens. On the other hand, forward contracts are mostly
used by companies, institutions, or hedgers that want to eliminate the volatility of a
currency’s price in the future, and delivery of the currency will usually take place.
Companies routinely use these tools to manage their exposure to currency risk. One of the
complicating factors for companies occurs when they operate in countries that limit or control
the convertibility of currency. Some countries limit the profits (currency) a company can take
out of a country. As a result, many companies resort to countertrade, where companies trade
goods and services for other goods and services and actual monies are less involved.
The challenge for companies is to operate in a world system that is not efficient. Currency
markets are influenced not only by market factors, inflation, interest rates, and market
psychology but also—more importantly—by government policy and intervention. Many
companies move their production and operations to overseas locations to manage against
unforeseen currency risks and to circumvent trade barriers. It’s important for companies to
actively monitor the markets in which they operate around the world.