Balance of payments
Introduction
The activity of multinational companies has dramatically developed into major phenomenon in international economic relations. The large sizes, wide geographical spread, their multiplicity of activities, their command along with generation of resources across the globe, and the utilization of the resources to meet their objectives significantly rival the scope and effect of contemporary economic transactions among different nations. The growth of multinational companies has brought to light the important role of balance of payment in business, which is prominent in international trade (Bornschier, 1984, p.157). Balance of payment has great influence on the decisions of multinational companies pertaining to currency values (both internal and external), trading, international investing, production, marketing decisions among others. This paper discusses the relevance of balance of payment to multinational companies. It further provides the measures that managers can undertake to exploit opportunities presented by changes in the balance of payments.
Impact of Multinational Companies
Multinational companies or MNC’s have increasingly become large and powerful around the world. In fact, the total worth of some MCN’s is worth more than the GDP of several countries. In particular, the multinational companies have both positive and negative effect on the balance of payment of both home and foreign countries in which they operate in (Garlaschelli & Loffredo, 2005, p.140).
Multinational companies are primarily the key agents of foreign direct investment. They are the importers of large amounts of capital that pays for their existing business operations and investments in new businesses. From the accounting perspective, such capital outflow is essentially a debit element in the balance of payments for the reason that it includes money spent out on corporate capital stock, plant purchases, bond purchases, and related investment (Fatemi et al, 2000, p.154). The surplus on the capital accounts results in a deficit on the current account, translating that the country is importing more goods or services as compared to what it is exporting (Makin, 2005, p.20). There is a negative effect on the balance of payment when the MNC repatriates its profits, but no effect when the company re-invests its profits.
Theory of Multinational Companies
Multinational companies are oligopolies. Oligopoly has strong co-relation with multi-nationalization through the nature of market imperfection. Generally, any multinational company business is governed by similar factors (Müller & Morgenstern, 1974, p.308). First, multinational companies are identifies to have intangible capital in such forms as patents, trade marks, special organization competence, and general marketing skill. Secondly, according to the Industrial organization theory (IO), a multinational company uses imperfect market/product strategies to local production, licensing or exporting (Garlaschelli & Loffredo, 2005, p.142). The imperfection results in foreign direct investment (FDI). Lastly, multinational companies largely encounter political, economic, cultural, social, technological and legal risks which are unsystematic. MNCs assess the political risks, credit risks together with other economic performances through country risk analysis. A company would effectively respond to such situations through diversification.
MNC managers can take specific operational and financial measures so as to minimize political risk synonymous with foreign investment. These entail including political risk in the MNC’s capital budgeting process and adjusting the project’s NPV accordingly. In addition, managers can enter into joint ventures with their local partners of alternatively form a consortium with similar MNCs (Linda & Chyau, 2005, p.249). Furthermore, the manager can do well to purchase insurance against all political risks from top insurers such as Lloyd’s or OPIC.
Balance of Payments Export Import Relationships MNCs
Balance of payments (BOP) refers to a statistical statement which systematically summarizes, for a specified period of time, the economic transactions of an economy with the rest of the world (IMF, 1996, p.1). Every country has economic transaction with other countries, in which the country makes payments for imports and receives payments for imports. Thus, a balance of payments is basically a statement of accounts that states the receipts and payments of a country (Jain, 2002, p.325).
Multinational activities play a key role in benefitting the balance of payment of both the host country and the country that the company does business in (Makin, 2005, p.18). Currency inflow is obtained from exports while currency outflow results from imports that the MNC makes. The difference between currency inflow and currency outflow gives balance of payment. Capital account balance is true reflection of MNC’s investment in foreign countries whereas increase in trade is a partial indicator of MNC’s investment abroad (Townsend, 1966, p.280).
Category of Account in balance of payment:
i) Current Account- this is the account that records flow of goods, services and transfers.
ii) Capital Account – this account records public and private investment and lending.
iii) Official Reserve Account – this account tracks changes in hold of gold as well as foreign currencies (which is reserve assets in official monetary institutions.
Capital inflow, which could relate to purchasing land, buildings or stocks, is treated as Cr whereas capital outflow is treated as Dr. because gold imported in order to increase the stock of gold fund in a multinational company (Garlaschelli & Loffredo, 2005, p.145). Therefore,
Cr. – Dr. = Surplus
Dr. – Cr. = Deficit
Their effect on several items is thus as follows:
Trade Balance (a+c) – (b-d) (-111.3) – Deficit
C/A Balance = (a+c+e) – (b+d+f+g) = (-92.9) Deficit
Capital A/c Balance = (h+j_ – (i+k) = + 27.6 Surplus
Official Reserve Balance (-1.5)
The capital account is a reflection of a country’s wealth and net creditor position includes such items as
Portfolio investment – this entails purchase of financial assets that have a maturity period of greater than a year (long term investment), as well as purchase of securities which mature within 1 year (short term investment).
Direct investment – this involves direct involvement of the management, and includes government borrowing and lending reflected in balance on capital account.
In the above company illustration Balance on Capital Account + $27.6 billion
In terms of the MNC, an increase in ‘a’, ‘e’, ‘h’, ‘I’, and ‘k’ are the reflectors of increase in MBF.
On the hand, the Capital account balance is a true reflector of MNCs or Government investment abroad, whereas a partial indicator of MBF is in the form of increase in trade Cr./Dr. Multinational companies thus increases the amount of foreign business for the host country and thus significantly impact the balance of payment (Kline, 2006, p. 125). For example, the involvement of MNCs in the IT sector has provided a great chance of improving balance of payment for countries, especially capital account. Nonetheless, increased import and reduced domestic production has negative impact in the sense that it results in increased unemployment.
Consumption + Savings = International flow of goods – (services + capital) – Income (national product). [(Equation (i)].
National Spending = investment + consumption [(Equation (ii)].
National (income – spending) = savings – investment [(Equation (iii)].
The above situation results in surplus capital which creates opportunity for MNCs to investment abroad. As such,
Foreign Investment = Saving – Investment, or
Foreign Investment + Domestic Investment = Saving
Similarly, National Income – National Spending = Export – Import [(Equation (iv)]
Therefore, when equations (iii) and (iv) are used:
Savings – Investment = Export – Import [Equation (v)]
Also Net Foreign Investment = Export – Import [Equation (vi)]
Corporate strategy and Foreign Direct Investment (FDI)
Multinational companies are a good place to make serious investment in because of the scope of their business. Investors purchase many foreign stocks and bonds in MNCs for a number of reasons (Prakash & Potoski, 2007, p.735). First, multinational companies are experts of creating value for their share holders through foreign investment. Secondly, the net present value that results from activities of multinational companies often exceeds the expectations of the investors (Kline, 2006, p. 131). Thirdly, investors have confidence in multinational companies with good reputation at home and thus buy their foreign stocks with the belief that the MNCs would translate their competence abroad.
Strategies of Multinational Companies
Competitive Strategy
Competitive strategy refers to the unique approach that a multinational company adopts to employ so as to gain competitive advantage in the marketplace. Most MNCs choose to provide their consumers with what is perceived to be of superior value worth paying more for (Prakash & Potoski, 2007, p.737). This could also be in the form of a best value offering which represents an excellent combination of features, quality, prices, and services along with other attractive attributes. MNCs adopt competitive strategies for the purpose of establishing a profitable and sustainable position against industry competition.
The most popular types of competitive strategies that MNCs employ are cost leadership and differentiation. Those MNCs that pursue the cost leadership strategy aim to achieve advantages through lowering of their prices below those of their rivals (Townsend, 1966, p.280).. On the other hand, MNCs that follow the product differentiation strategies strive to achieve positives through improving the perceived value of their products or services.
a) Cost leadership strategy. It is common practice among many multinational companies that offer standard products different from competitors to produce at lower cost in order to gain significant cost advantage over rivals in the market (Venkataraman, 2011, p.19). The target is to realize growth in the market share. This way, a multinational company is able to build a plant and maintain without much strain, recruit and train labor to produce very low cost of production. In other words, the MNC makes sure that costs are reduced at every stage of the value chain to benefit its balance of payments (Townsend, 1966, p.280).. Toyota is a good example of MNC that has specialized in producing top notch autos at low price.
b) Differentiation strategy. MNCs strive to differentiate their goods and services in order to satisfy the needs of customers via a sustainable competitive advantage. The companies overlook prices and stress on values which provide relatively higher prices and better margins and ultimately impact their balance of payment positively. To do this, MNCs segment markets and target their goods and services at particular segments so as to generate higher than average price (Michalet, 2000, p.5). They focus on smaller market segments to be able to offer special customer needs. For instance, British Airways is known for differentiating its services for different market segments. In order to counter the higher threat of duplication by competition, MNCs usually offer an incentive to continuously improve and innovate (Townsend, 1966, p.281).. Some of the well known innovation-oriented MNCs include IBM, Sony, and Philips which spend huge amounts of money on R&D and create newer differentiated products.
Generally, MNCs that adopt competitive strategies realize competitive dominance which translates to undisputed levels of excellence and sustained leadership (Venkataraman, 2011, p.21). It is common for MNCs to combine the low cost and differentiation strategy in the effort to gain sustainable competitive advantage.
Furthermore, most MNCs employ other strategies as they diversify and create more divisions following their expansion. These include entering into strategic alliances, mergers, joint ventures as well as acquisitions of other firms (Linda & Chyau, 2005, p. 252). A multinational company is forced to seek growth opportunities elsewhere via diversification once it has grown and taken command of the traditional market.
Relevance of Balance of Payments on MNCs
Pricing Conventions & Cross Investment
Multinational companies often use high pricing strategy in the home county so as to be in a position to subsidize marginal cost price abroad. This attracts foreign firms to invest in domestic markets of the MNC’s home country. The theory of cross investments argues that firms from the host county in certain oligopolistic industries tend to invest in the mother country of the MNC that initiate aggressive strategies such as price cutting (Diebold & Despard, 1976, p.218). This concept is also supported by the life-cycle theory of foreign direct investment. Japanese MNCs, the likes of Toyota, Matsushita and Toshiba have increasingly invested in the Southeast Asian countries such as Thailand, Indonesia and Malaysia so as to take advantage of cheap factors of production especially under-priced labor services available. Similarly, Japan’s auto company, Toyota, slashes prices so as to gain sales in Italy on the one hand, and Italy’s Fiat responds by also reducing price of its products in Japan. Fiat has cut prices in Toyota’s domestic market (Japan).
Senescent MNCs
Faced with stiff competition from the competitors from a domestic firm and an imminent risk to its balance of payments, a foreign MNC would seek for a market within the host country where competition is comparatively less. For instance, Philadelphia-based MNC – Crown Cork & Seal- was forced to shift business to Thailand, Peru, Malaysia, Ecuador and Jambia from the US where competition was relatively stiff leading to slow performance (Malburg, 2000, p.31). The MNC did this in the hope that there would be lifestyle and product changes in the country to provide better market for its product. MNCs only result to such measures after conducting a global scan to identify favorable lower cost production sites and potential markets.
Economic scale: When MCNs face high fixed cost compared to variable cost, they often enhance the capacity and volume of production to levels that they would still survive with marginal cost/profit. The general motto in this case is low profit per unit and higher sales volumes. For example, US chip makers established production facilities MCNS in Japan where they would spend just a day (as opposed to between 7-10 days in US) testing the chips. It is economical for the MCN to spend less time testing the machines in Japan.
Global Expansion
MCNs have grown increasingly weary of the risk to their respective competitive advantage in the long run despite the advantages of technological and marketing skill they have. Consequently, more and more MCNs are exploring new ways of remaining relevant in the overly competitive environment. Global expansion of MCN thus demands for vast knowledge relating on how to maintain a desirable balance of payments. The necessary knowledge includes an understanding of those investments with highest prospects of turning out profitable. An MCN also needs to thoroughly explore its options by comparing alternatives. The company must also run audits of their present entry. For instance, Japan TV Company ventured into the US on grounds of better quality and attained their brand entry on the basis of lower cost high quality. Thus, there is greater need for systematic investment analysis towards global expansion. Lastly, an MCN should be in a position to correctly estimate the longevity of their competitor advantage. This calls for consistent monitoring and maintenance of the MNC’s competitive advantage in the marketplace.
Capital Budgeting of MCNs
While the initial decision to invest in a given foreign country is a combination of strategic, economic, and behavioral considerations, an MCN must evaluate the economic feasibility of such a project. This necessitates capital budgeting. For an MNC, capital budgeting exercise entails thorough economic analysis of the company’s direct investment opportunities. Regardless of the motive for foreign direct investment, the survival and sustainability of an MNC’s competitive advantage depends on the ability to identify and invest in the most profitable investment options. Often, MCNs experience capital budgeting problems because of disparity between the company’s cash flow and project cash flow, non-favorable foreign tax regulation, expropriation issues, changes in exchange rates, inflation, insufficient finance to fund project, and differences between the basic business risks of domestic and foreign projects.
Capital Budgeting Basic Needs
The basic needs capital budgeting for projects overseas is essentially similar to the theoretical framework for evaluating domestic projects. However, there are some specific factors that dictate treatment of foreign investments (Claus & Hand, 2009, p.249). The basic project evaluation steps thus include: 1) determining the net investment outlay; 2) estimating the net cash flows to received from the project in the long run, including estimations of salvage value; 3) identifying the appropriate discount rate to determine the current value of the expected cash flows; and 4) applying NPV of IRR approaches to determine the priority ranking or acceptability of the potential projects (Adelegan 2003, p.37). The set of rules that manager follow would entail the following formula:
Where,
NPV – Present value of future cash flow:
t=1 (1+D)t
Io = Initial cash investment
X1 = Net Cash flow in period t (time)
K = Project cost of capital
n = Investment Horizon
MCNs in particular, have unique factors relating to capital budgeting: converting cash flows drawn from foreign projects into the parent company’s currency; restrictions on full cash flow remittance from abroad; fluctuations of exchange rate; varied tax rates in the host and home country; management and royalties fees; concessions and amenities offered by host country; merits of international diversification to the parent firm’s shareholders; lost exports; problems in estimating the terminal value of overseas projects; varied rates of national inflation; knock-on impacts of foreign investments on other operations elsewhere; and political risk associated with foreign investment (Claus & Hand, 2009, p.242).
Incremental Cash Flows
Incremental cash flow refers to the difference between an MCN’s cash flow and their potential cash flow should they invest in a given project overseas. Determining the incremental cash flows is the one of the most significant and difficult elements of investment analysis (Forbes, 2005, p.157). This is because an MNC has to consider elements of incremental cash flow: the initial outlay; cash flows from running the project; terminal value/cost; and scale & timing of the investment project. A positive incremental cash flow implies that the MCN’s cash flow would increase with the implementation of the project. The importance of incremental cash flow supersedes that of the total cash flow for the following considerations:
Cannibalization: this implies of the danger of a new product taking away the sales of an existing product(s). The incremental effect of cannibalization thus equals lost profits from lost salts that would not have occurred if the new product was not introduced. For example, some car customer shifted to new models from Honda Accord when Honda launched its Accua Brand of cars.
Sales Creation: This is the direct opposite of cannibalization, where an MCN’s overall image may be bettered when it establishes business abroad and result in increased sales in the domestic market. For example, Black & Decker experienced massive sales in the local market when it begun exporting its products to Europe.
Opportunity Cost: Analysis of project cost ought to determine economic cost of asset required, regardless of whether the company has it at hand or will have to acquire it later. Opportunity cost implies to the exact cash that the asset would generate if sold or utilized in some other productive way (Forbes, 2005, p.162). For instance, if Apple Inc. chose to establish a new office in Rio de Janeiro will sell its iPads to its Brazilian subsidiary, thus increasing the company’s profitability.
Transfer pricing: the profitability of a planned investment can be dictated significantly by the transfer of internal product/services prices. The market prices are preferred to evaluate prices of project inputs and outputs . For example, raising the price of Ford Deorborn’s engines increases the plant’s profitability.
Fees and Royalties: Often MCNs would charge investment projects in terms of royalties and fees such as research and development, management costs, headquarters staff, rent, power, lighting, legal counsel, etc. The tax factor is important because it helps determine the taxes to be paid on specific foreign source projects (Adelegan, 2003, p.42). For instance, if an MNC’s after tax gains are $1,500,000 to its US parent plant as dividend (at tax rate of 25%; withholding tax on divided of 4%),
Dividend tax = $6000
Before tax local income = 200,000
Tax @ 25% = $50,000
Total Tax = $56,000.
Case Study
Foreign Investment Appraisal – International Diesel Corporation (IDC)
The International Diesel Corporation (IDC-US) is a U.S.-based MCN, which has cited an investment opening in England. A decision has to be made whether the company should proceed and build a diesel manufacturing plant in London, UK (IDC-UK). The objective of the company is to increase its European sales of the small diesel engines (40-160 HP) from a current meager export rate of 20,000. The export reflects the company’s residual balance after attaining its domestic US demand.
The strategic decision of IDC-US is to significantly boost its presence abroad, especially in Europe. The MNC is confident about market growth owing to the increase in fuel cost, translating that manufacturing in the UK would have an advantage. Launch is set for 2014 after construction of plant on a 1.5 million sq. ft piece of land outside Buckingham. It is hoped that the National Enterprise Board (NEB) will supply a 5 year loan of US$5 million, at 8% interest yearly repayment with principal meant to be settled at end of the 5 years. The total cost of F/A is estimated at $50 million. IDC-UK is expected to reach full capacity production after 6 months since acquisition of BL, a gasoline engine plant in UK.
The parent company IDC-US would sell 30% of materials and charge 7% of sales (in pound sterling, but IDC-UK would be billed in dollars at the current market price. The remaining raw materials would be purchased from the local market. IDC- US places the rate of return at 15% on the basis of US inflation rate of 8% and the business risk associated with this investment. The debt equity ratio is at 1:4 i.e. 20% is debt.
Analysis
For the purposes of simplifying this investment analysis, IDC-US has adopted a 5-year capital budgeting and then computes the terminal value of the remaining life of the investment project. If the project has a positive NPV in the initial 5 year, there would be no need to estimate its future cash flows. On the hand, a negative NPV would force IDC-US to calculate a B. Even terminal value which would transform the NPV to positive. The B. Even value would then be benchmarked to evaluate the projected cash flow after 5 years.
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