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Multinational Corporations, Trade and the Dollar

Introduction

The following paper is a midterm essay exam from a 400 level University Economics course from just a few years ago. The paper is very self explanatory as one would expect from an exam but I'll give a quick overview in more simple terms which some may find helpful when reading the actual answers to the essay questions.

First of all - most people don't know that the majority of successful American corporations are Multinationals which is simply a term for a corporation which is so big that it conducts business in numerous countries and continents. Another thing most people don't know is that many of the countries in which these Multinationals conduct business use some form of the dollar. These foreign dollars are not dollars like in the US but rather some variation such as the Canadian Dollar or the Eurodollar which was used before the actual Euro was launched in the late 90's.

What's important about this, and why I'm posting this exam on Devtome, is that Economics can be very complex to understand and to be honest, even a very high GPA Bachelor of Science, gives one barely just a decent glance at this enormous piece of complex machinery which is constantly changing with many heads and many unknown variables. To better grasp Economics one should imagine a big science project done in a controlled laboratory environment where you control all the inputs yet the outcome is often still unexpected and unpredictable and can often surprise and shock even the most learned and brilliant scientists.

Now take away the controlled laboratory environment and take away many of the known inputs and replace them with unknown variables and add many more constantly changing variables such as the unpredictable behavior of consumers or heads of state, and that's when you start to get an animal or an experiment called Economics. The unfortunate thing about Economics and Economic theory is that it cannot be tested inside a safe environment, Economics is a science where the theories are all tested on live subjects (you and me) and in real time and the consequences are always real and cannot be reversed and sometimes the conclusion or consequence has to be lived with by the masses for many years to come.

This is precisely why on any given Economics situation such as the massive printing of dollars right now or the current high unemployment, one can listen to numerous PhD professors from the very best Ivy League Universities and you'll get many different conclusions - and in the end, the one who just so happens to have been right is the genius but when the next real life experiment happens a few years down the road it is rare that the same “genius” is correct again and that's because a lot of luck has to do with predicting Economic trends and outcomes.

Another important reason I'm posting this essay exam and its answers is because another fact most people don't know is that all of these dollar denominated foreign currencies are very much tied to the dollar. They're not pegged to the dollar necessarily, but they are tied to the destiny of the dollar. So if some unfortunate event would happen to the dollar, such as hyper inflation, then many other countries and their citizens would also suffer unknown economics and financial consequences.

For this reason, many countries, powerful countries such as China, very much wish there would be a one world currency. That way no country would have their future in the hands of one country such as America and also because there are certain market efficiencies which come from having just one currency. The point I'm trying to make is when you have many powerful and rich Multinational Corporations and many very powerful and rich Countries all pulling and trying to find a way to get the world into one single currency then it doesn't take a prophet to predict that eventually they'll find a way to do it. The outcome is what is difficult to predict as far as privacy rights and wealth destruction vs. wealth creation, etc., but it's not a matter of if, but rather just a matter of when.

And seeing how the Fed has been printing the dollar as if it's going out of style and seeing how the EU has its own massive problems with the Euro it would seem like an opportune time to get together and create a currency which would solve both of their problems. And since so many other countries want a single currency and the smaller countries which may wish to retain their national identity simply cannot say no because currently so many of them use some derivative of the dollar, then it would make sense that if the US and Europe got together, in theory of course, it would not take much to get the rest of the world to play ball.

And finally, as you read this paper keep in mind these powerful Multinationals who do business in hundreds of countries and have to deal with so many currencies and the nightmare of logistics in moving this money all over the globe and the nightmare and sometimes billions in losses due to unexpected changes in exchange rates and one should get a feeling that Multinationals would really benefit not only from a one world currency but also from a more simple and streamlined currency such as a digital currency which requires no effort or cost to move around and loses no value overnight due to exchange rates or political instability and doesn't wear out or get stolen without you knowing about it and the benefits for banks, Multinationals and the government just keeps going.

I may as well add another inevitable reason a one world currency is going to happen and that is the many decades long effort toward globalization and its many reported benefits to many (smaller) countries such as equalization of wages. It only makes sense if you're going to equalize labor and wages that eventually you're going to pay all of the globe's employees in the same denomination, the same currency. And going digital simply makes all of these efforts easier and gives all of the governments and corporations involved much more control and power. Sure we as citizens will lose more privacy and more control over our lives and of course such power and control over the world's supply of money and especially on an individual level can be a risky proposition should a tyranny driven government take over but let's face it, there is too much money and too much power behind these efforts and there is simply nothing big enough to stop it so then the next best thing is to be aware of it and to prepare in whatever way possible, legally and ethically I might add. Yes, regardless of what government may do or not do which displeases us, we as a people must keep in mind that we are not animals and should try to respond in a civilized manner. Voting is probably the single most powerful tool a free person possesses yet it is rarely used. A proper and truthful education leads to the desire and need to vote which in turn leads to true change, but it all starts with each individual and right now I see America as a divided nation and divided we cannot stand.

I hope this paper gives the average non-economics person a better glimpse in how global business is conduced, the vital role the dollar plays and then one may be able to at least imagine why and how a switch to digital money would emerge and who the winners would be and in any game where you have winners, by default - by the laws of the universe, there must be losers. And if one can see and predict these trends then perhaps one could position himself so that one can gain or at least limit the loss when and if such an enormous change does occur in our lifetime.

A quick note about the exam - the reason the question numbers jump and are not complete is not because I failed to answer all the questions and there are no missing parts, it's simply that this particular Economics Professor, which was the best I ever had, gave very complex and incredibly involved questions to his essay tests and to make it fair he had a few additional questions from which to choose. Furthermore, there are no citations (although one can easily google anything on this exam and verify its authenticity and since this Economics Course is only a few years old, 2009 to be exact, not much has changed from a macro point of view) since this was an exam and everything was done from memory which largely came from lecture as I rarely read the actual textbooks. This is a good thing in my opinion since it allows a reader to see my personal interpretation on each question or subject matter which should prove easier to understand than if one were to read the textbook version written by some Harvard PhD, which this professor was.

Thank you for reading and I hope you find the remainder of this paper both educational and interesting.

Multinationals: Trade and the Global Dollar

Part A


Question 1.
Identify the various debt financing alternatives in the Euromarkets and the advantages and disadvantages of each to the MNE (Multinational Enterprises).

A) Eurocurrency Loans: Eurocurrency loans are loans made in a foreign currency. The most important characteristic of the Eurocurrency market is that loans are made on a floating-rate basis. They are set a fixed margin above LIBOR for the given period and currency chosen. The maturity of a loan can vary from 3 to 10 years. Borrowing can be done in many different currencies but the dollar is still the dominant currency. A borrower can choose to switch currencies on any rollover or reset date. One of the advantages of a Eurocurrency loan is that the rate can be lower due to lower regulatory costs and lower costs on information and credit gathering. Another is that Eurocurrency loans can take place out of tax-haven countries providing for higher after tax returns. The disadvantage is that at some point in the future the lender or borrower will not be able to transfer funds across a border, also known as sovereign risk.

B) Eurobonds: Eurobonds are similar to public debt sold here at home, consisting of fixed rate, floating rate, and equity related debt. The biggest difference and advantage to the MNE is that the Eurobond market is almost entirely free of official regulation and is instead self-regulated by the AIBD. As a note of interest, 70% of Eurobond issues are swap-driven. Eurobonds are sold outside of the countries in whose currencies they are dominated. Another positive is that borrowers in the Eurobond market are well known and have impeccable credit ratings. Another advantage for the MNE is that this is a good way to diversify your investor base and avoid higher taxes. A major disadvantage is that the bond buyers are anonymous.

C) Note Issuance Facilities (NIF): The NIF is a low-cost substitute for syndicated credits and allows borrowers to issue their own short-term Euronotes, which are then placed by the financial institutions providing the NIF. Notes under NIFs are unsecured short-term debt generally issued by large corporations with excellent credit ratings. One advantage of NIFs is that they are more flexible than floating-rate notes and cheaper than syndicated loans. Another advantage is that many NIFs include underwriting services which take the form of RUF or revolving underwriting facility. The RUF gives the borrowers long-term continuous access to short-term money at a fixed margin. One disadvantage of NIFs is that they are in effect, put options. The primary risk is that someday they may have to make good on their pledge to buy paper at a spread that is too low for the credit risks involved.

D) Euro-Medium-Term Notes: Euro-Medium-Term Notes (MTNs) are a non-underwritten Euronote issued directly to the market. Euro-MTNs are offered continuously rather than all at once like a bond issue which can be an advantage to the MNE. Most Euro-MTN maturities are under 5 years. There are 3 benefits to MNE who choose to use Euro-MTNs – speed, cost and flexibility – in part as noted above, these notes are continuous. A risk or disadvantage to the MNE is that they may not be able to rollover its existing notes or place additional notes when necessary. This risk can be minimized by extending the maturity dates of the MTNs.

E) Euro-Commerical Paper: Euro-commercial paper is in essence a non-underwritten Euronote. One advantage to the MNE is that the average maturity of the Euro-CP is about twice as long as a U.S. CP. Another advantage is the Euro-CP is actively traded in the secondary market where in the U.S. it is held until Maturity. One more advantage of the Euro-CP is its flexibility. Issuers can borrow in a range of currencies. A disadvantage to the MNE is that the Euro-CP is not as liquid as the U.S. CP. The U.S. CP is much bigger and provides more liquidity and depth.

Part B


Question 2 - Modern Trade Theory and Specialization of Labor

Modern Trade Theory is often viewed by economists as one of the supreme achievements of modern economics – going back to Adam Smith in 1776 – in the sense that it demonstrates, in particular, the advantages of specialization, in terms of the basic model called comparative advantage. This is a concept that came out of the 1830’s British economist by the name of David Ricardo, who was of Portuguese decent, who argued that the British policy driven economics was doing more damage than good to the domestic economy and its citizens. At this point Britain had imposed tariffs on agricultural goods termed the Corn Laws, in an attempt to protect British farmers. First, I must point out the main aspect of the Standard Trade Theory, and that is to assume perfect competition. To illustrate what Ricardo essentially said was that, if for example there were only two countries in the world, U.S. and RoW, (see exhibit A) and they produced only two goods, food and clothing and let’s assume production technologies are different in the two countries. Let’s also assume that in the U.S. 1 unit of food requires 1 unit of Labor where in RoW, 1 unit of Food require 3 units of Labor. In terms of clothing production, 1 unit of clothing requires 4 units of Labor in the U.S. where in RoW 1 unit of clothing requires only 2 units of Labor. As one can see, in an absolute sense, the U.S. is the efficient producer of Food while the RoW is the efficient producer of Clothing. Next we assume we are of equal size – each country having a total labor supply of 60 units.

If the U.S. employs all of its labor in food production then they would be able to produce at a maximum, 60 units of food and zero units of clothing. If the U.S. chooses to produce no food and instead all clothing then they would be able to produce only 15 units of clothing. Likewise, if the RoW devoted all of their production to food they would be able to produce only 20 units of food, but if they instead choose to put all of their 60 units of labor in clothing they would be able to produce 30 units of clothing.

As one can see, if the U.S. specializes in food where it is more efficient and vice versa, RoW specializes in clothing, where it is more efficient, total global production of food and clothing will increase substantially. Globally, we now have more food we can consume and globally more clothes we can consume so instead of being bound by our own production possibilities we could end up consuming beyond our own production possibilities and the RoW can also consume beyond its own production possibilities. So it makes sense for the U.S. to specialize in food and export it to the RoW while importing clothing from RoW and likewise RoW will export clothing to the U.S. while importing food from the U.S. And because RoW can produce clothing for much less than the U.S., and the U.S. can produce food for much less than RoW then both food and clothing become relatively cheaper in each respective country which leads to a higher standard of living and a higher real global income.

Price differentials between the two countries bring about a profit motive which will cause companies in the U.S. to want to tend to specialize in the production in food. Now we are not only more efficient but that efficiency translates into profitability. The same happens in the RoW – they tend to specialize in clothing production where they are efficient and profitable. This profitability creates jobs and combined with lower prices for goods leads to higher global income and a higher standard of living. In addition, as both countries are the same size, prices will eventually stabilize and in the long run become equalized as entrepreneurs are driven by the profit potential take advantage of this arbitrage situation, will essentially drive prices down until prices for labor and capital are equalized and the arbitrage is eliminated.

As good as specialization of labor sounds, in the real world there are many forces and barriers which prevent free trade from having a full impact. Some of these barriers are tariffs, quotas, subsidies and other non-tariff barriers. Government policies to become self sufficient, such as those of the Eastern Communist bloc, also have a direct negative impact on free trade and specialization of labor. For these reasons companies become Multinationals. When these trade barriers become higher than the trade costs plus the production of a new production facility abroad then it makes perfect sense for a company to become an MNE. By being a multinational a company can now replicate its production facilities inside a foreign country which may be charging it hefty tariffs or quotas, and by producing in that foreign country it can effectively bypass these trade barriers because it can now produce and distribute its goods from inside the foreign country itself.

Question 2.1 - Ways for a Company to Multinationalize

There are two ways for a company to multinationalize. The first is through M&A activity while the second is via “Greenfield” horizontal foreign direct investment (HFDI). The latter is where a firm replicates its production processes in a foreign market, by building a new plant, in an attempt to avoid high trade costs in order to decrease long term costs associated with exporting while increasing its total market share, profitability and diversifying away from the general risk associated with having your production facilities and main market in a single country. For this question I will be discussing the various aspects associated with Greenfield HFDI and its key variables. Another important note is that MNEs tend to be oligopolies in nature, and other than large initial fixed costs there is little to no barrier to enter foreign markets and to become an MNE (Multinational Enterprise).

First, the key variables which play part in a firm’s decision to do a Greenfield investment are as follows: Greenfield HFDI is more likely if trade costs are high; if fixed plant-level costs relative to market size are low, and if countries under study are relatively similar in factor costs and in market size. High trade costs are conducive to the firm choosing local production, becoming a MNE, over exporting. The higher the trade cost the more a firm wants to become a MNE. High trade costs come in different forms. There are trade barriers such as tariffs, quotas and other non-tariff trade barriers which can add substantially to a firm’s costs. Transport costs are the other part of trade costs which cannot be avoided. Transport costs can range anywhere from 5% for high volume countries like the U.S., to as high as 30% of the value of merchandise being shipped for smaller countries. When these trade costs exceed the fixed costs of building a new plant abroad and the foreign market size is also large enough to justify the additional cost, then a firm will be more profitable in making a Greenfield foreign direct investment.

The size of the market in the country under study and its factor costs are crucial when deciding to make a Greenfield investment. The larger the market abroad the more a company will want to become a MNE. This says that national production and international trade occurs when there are large comparative advantage gains to be made, due to differences in costs. When these gains are more modest, Foreign Direct Investment takes over. These results have been termed a “convergence hypothesis” (Markusen and Venables 1996), as they suggest that it is when economies are similar, in either size or comparative costs, that horizontal multinational activity is most likely seen. Basically, if a firm is going to commit to a long term plan to supply a foreign market through local production, and incur significant fixed plant-level costs, then it has to be a decision driven greater profit potential and increased market share which means that the country in question must have a large market and similar factor costs.

It is clear then that the major motives for national firms to multinationalize involve reduction in long term costs associated with trade costs and trade barriers, increasing total market share by being able to better compete and offer cheaper goods abroad, increasing overall profitability through economies of scale, diversification of talent pool, reduction of the overall risk of doing business by having markets and production facilities in multiple countries, and most importantly increasing profits through economies of scale – reducing costs, including finance costs by borrowing and lending in a currency other than the home country and mitigating currency fluctuations by using the forward markets, and growing market share in what may be a bigger, better and more diverse market.

As world trade barriers and transportation costs fall, such as we’re seeing in the European Union and around the world in general, the decision to make large Greenfield foreign investments for the purpose of becoming a multinational will become increasingly more difficult. Instead of an M&A or Greenfield investment another option a firm may have is to enter into a licensing agreement or partnership. However, keeping in mind that even though tariffs and transport costs have been falling for the past few decades, since 1971 currencies have been allowed to float and their volatility has only gotten more pronounced. For the purpose of reducing overall risk, growing market share and especially for mitigating the risk of fluctuating currencies, a firm would still be better off becoming an MNE whether it’s through a Greenfield investment or M&A (Mergers and Acquisitions).

Part C


Question 4 - History and Purpose of the Eurodollar

Eurodollars are deposits denominated in United States dollars at banks outside the United States, and thus are not under the jurisdiction of the Federal Reserve. For this reason deposits are subject to much less regulation than deposits within the United States, allowing for higher margins. Some of this regulation is the required FDIC insurance for U.S. banks currently at $250,000. This insurance is paid by depositors via lower interest rate returns on their savings and checking accounts. Another example is the requirement that U.S. banks have to maintain specific reserves which can add to the cost of borrowing money. This limits loan activity and raises the cost associated with lending and borrowing from U.S. banks. There is nothing “European” about Eurodollar deposits; a US dollar-denominated deposit in Tokyo or Caracas would likewise be deemed Eurodollar deposits. Neither is there any connection with the euro currency.

To get a better understanding of the meaning of the Eurodollar one has to go back to World War II. After World War II the quantity of U.S. dollars held in foreign banks increased significantly due to imports into the U.S. and the Marshall Plan. The increase in imports was due to the fact that the U.S. by this time had become the largest consumer market. The Marshall plan, originally known as the European Recovery Program, was the primary plan of the United States for rebuilding Western Europe in an attempt to repel communism. Even though many countries had U.S. dollars in foreign banks some countries, like the Soviet Union, also had dollars in U.S. banks. During the cold war period, in the 1950s, Russia feared that its money in U.S. banks would be confiscated by the U.S. government. As a result, Russia decided to move its money to the Moscow Narodny Bank, a Soviet-owned bank with a British charter. The idea was to have this British bank deposit that money in U.S banks. The Soviet’s money was now safe as the money now belonged to the British bank and not directly to the Soviets. On February 28th, 1957 the sum of $800,000 was transferred, creating the first Eurodollars. They became known as Eurodollars because such deposits were at first held mostly by European banks.

The expansion of the Eurodollar markets greatly increased in 1971 when the U.S. went off the gold standard and the Bretton Woods System collapsed and countries no longer had to maintain the exchange rates of their respective currency within a fixed value plus or minus 1%. This gave birth to currency arbitrage.

The Eurodollar markets are the choice for International firms and banks because of its lower interest rates when lending and borrowing, higher interest rates on savings, no government intervention and most importantly MNEs can use the Eurodollar markets for currency and interest swaps and to hedge against currency fluctuations. By leveraging currency options, futures or forwards they can effectively mitigate currency risk. They are also able to borrow and lend money in a currency other than the lender’s home country currency. Another reason banks like the Eurodollar markets is because they have better access to long run non-$ markets while U.S. companies have better access to short run $ markets.

A currency swap is a foreign exchange agreement between two parties to exchange principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal (regarding net present value) loan in another currency. An interest rate swap is a derivative in which one party exchanges a stream of interest payments for another party's stream of cash flows. There are several reasons why a company would want to do a currency or interest rate swap. First, U.S. accounting laws do not consider a currency swap a loan and thus is not reflected on a company’s balance sheet. It is instead a foreign exchange transaction. Secondly, a firm would want a currency swap in order to get the cheapest debt regardless of its denomination and then seek to exchange it for the debt in desired currency. Currency swaps are motivated by comparative advantage. If company A has access at a fixed rate loan which company B find attractive and vice versa company B has access to a floating rate loan which company A finds attractive then they both take the loans out and swap either just the interest payments or the entire loan, including the principal. In this way both companies are better off. A motive to using interest rate swaps for a firm is to hedge in order to mitigate any currency fluctuations in their fixed or floating assets and liabilities. The most common daily reference rate when doing swaps is the LIBOR, London Interbank Offered Rate.

Question 6 - Main Reasons for Multinationals

The very act of becoming a multinational firm can help reduce the overall risk of doing business. There are several reasons for this. One is the fact that if you have your production plants in multiple countries you are able to continue producing in the event your production facility in one country is negatively affected by factors you cannot control – such as natural disasters or political instability. Another way risk is reduced is by having multiple supply chains. Plants in different countries can supply to different markets thus reducing transport costs and providing a sort of insurance should other supply chains have issues with getting your product to their particular market. A third way is by having diversity in your sales market which can help level fluctuations offset unpredictable behavior in currency or consumer demand. For example, Ford motor right now is in a better position than Chrysler and GM because over 50% of their sales market is overseas. Other MNEs, like Nike, whose majority of sales are also derived from overseas can use fluctuations in currency to their advantage. Firms who are not MNEs cannot diversify in this manner and are at the mercy of the events that occur in their home country and when negative events occur they are magnified by the fact that they do not have overseas operations to help offset any harmful event, such as a bad economy, natural disasters, political instability or currency fluctuations.

MNEs also see a general increase in profitability by means of more effective use of the firm’s assets. There are two reasons for this. First is the concept of underutilized assets which is generally true for firms that are not MNEs. By the time a company becomes big enough to be an MNE management achieves economies of scale, or more correctly put, internalization of externalities, and as a result, like most large companies, they have proprietary assets, human and non-human and knowledge that are not fully utilized. When it comes to international cross border expansion management achieves greater economies of scale due to the fact that every firm has assets that are underutilized. Human and non-human assets are more efficiently utilized when a firm becomes an MNE. Second, is the concept of “best practice”. On the human side of a firm’s assets an employee, is more efficient and more effective if there are new challenges coupled with practice. The gain of knowledge and the new perspective people gain by being tested by foreign markets and a foreign environment will lead to better and more efficiency. All of these externalities and synergies are captured internally once a company becomes big enough and becomes a MNE.

- Maximilian Wilhelm


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