Unit 1 Globalization and Trade — An Overview

Structure
1.1 Introduction
Objectives
1.2 Introduction to International Finance
Impact of Globalization
1.3 Challenges for International Finance
1.4 Emerging Trends in Global Trade
1.5 Summary
1.6 Glossary
1.7 Terminal Questions
1.8 Answers
1.9 Case Study

Caselet

Globalization of Financial Markets

The globalization of financial markets as a result of technological changes,
removal of capital controls and financial market liberalization has forced the
multinational corporations to manage their foreign exchange exposures
created by the floating exchange rate system. Today, due to an environment
involving high volatility of exchange rates, the foreign exchange exposure
management strategy adopted by the Multinational Corporation (MNC) is
very significant and should be consistent with the changing structure of the
company. Further, as seen currently, firms are also frequently entering into
commercial and financial contracts denominated in foreign currencies. This
has necessitated the effective management of transaction exposure for the
ultimate success of an MNC.
Source: Compiled by author

1.1 Introduction

Globalization is as old as international trade that was prevalent in the most ancient
period. Adam Smith’s The Wealth of Nations (1776) was the first to point out
that international trade, facilitated by international finance, has been in existence
for more than 2,000 years. Letters of credit and gold coins were the primary
instruments of transaction. This tradition continued till the 20th century.
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Trade has not only influenced monetary and financing system of a country,
but even alliances among nations. The evolution of international financial
institutions is testimony to this fact. While we say so, we should remember that
nations have never formed monetary policies independent of other nations. So
much so that even capital flows, their negotiating costs, and the free-riding
behaviors often associated with them, have been subjected to inter-nation trade
relations.
By the end of the 19th century things were changing. Most Western nations
had established currencies which were redeemable in gold and silver coins at a
fixed price. The gold deposits allowed central banks to provide liquidity to their
member banks for letters of credit or foreign currency. This improvement in
international finance boosted international trade. World War I disrupted this fixed
relationships of currency to gold. From 1945 through 1971, under the Bretton
Woods System, we saw a departure from the gold standard and introduction of
exchange rates that were adjustable under specific conditions. We have moved
on since then. Today, fund transactions take place in a more liberal atmosphere.
This unit will tell you how international finance always backed international trade
and the challenges of international finance. We will also discuss globalization
and emerging trends of trade.

Objectives
After studying this unit, you will be able to:
• explain the scope of international finance
• describe the impact of globalization
• discuss the challenges of international finance
• analyse the emerging trend of global trade

1.2 Introduction to International Finance

International finance is the branch of economics that broadly studies monetary

and macroeconomic relationship between nations. It studies capital flows among
nation, exchange rate fluctuations, balance of trade, tax policies effects, and
other related issues.
The importance of international finance has increased in the last two
decades owing to the technological development and the deregulation of the
financial markets and products. With growing internationalization and

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globalization of economic activity across the nations of the world, complex

networks of financial relationships have emerged. International finance plays a
very important role in linking world trade and foreign investment.
Benefits of international finance
Some of the benefits of international finance are mentioned below:
• Integrates world economies and facilitates easy flow of capital across
countries worldwide
• Moderates domestic regulations through global financial institutions
• Leads to healthy competition and hence, more effective banking
• Promotes domestic growth and investment through capital import
• Leads to effective capital allocation by providing information on vital areas
of investment
• Gives countries access to capital markets across the world and, thus,
enables a country to lend in good times and borrow in bad times
Scope
Multinational corporations have subsidiaries or joint ventures in different countries.
The operations, structures, organizations and lines of business of these
companies depend on the global political, socio-cultural, economic and legal
environment of the countries in which these companies do business. For this
reason, international treaties like, Basel norms, Kyoto Protocol and WTO
guidelines lay down a uniform framework for how business should be conducted
between different countries.
The economics of international trade and international finance are much
the same except that international finance involves greater risks and uncertainties
as the assets being traded are claims to flow of returns that extend for many
years in the future. Besides, the markets of financial assets are more volatile as
compared to market in goods and services as financial decisions in financial
assets are more rapidly revised and implemented.
The knowledge of international finance is extremely useful to the MNCs in
two ways: First, it helps the companies to be prepared for the impact of negative
international events on their operations or the benefits that can be reaped from
positive international developments. Secondly, companies can also understand
and take necessary actions for the impact of the changes of the macroeconomic
variables such as exchange rates, interest rates, inflation rates and asset values.
For example, the sub-prime crisis in the US in 2008 led to the failures of many

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banks in the US and credit shortage in developed countries and also sudden
reversal of international capital flows in the developing countries.

1.2.1 Impact of Globalization

Globalization is defined as a concept which connects countries across the world
through information, trade and technology. In practical terms globalization means
the integration of economies and societies through flow of ideas, information,
technologies, capital, finance, goods, services and people from one country to
another. This is also termed as ‘cross-border integration’ and has many
dimensions such as social, political, cultural and of course economic. Economic
integration can happen through these channels:
• Movement of capital
• Flow of finance
• Trade in goods and services
• Through movement of human resource

Integration of Economics
Accountability
Equality/Inequality
Terrorism
Communication
Shrinking World
Recognition
Technology/The Internet
Trade versus Aid
Free Trade
Globalization Outsourcing
Culture
Brands
Capitalism
Exploitation
Monopoly Power
Growth
Environment
Poverty

Figure 1.1 Impact of Globalization

For most of the economies of the world, globalization has led to a large number
of beneficial effects. There is also a section of people who believe that globalization

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has only benefited the developed economies whereas the developing ones are
still struggling with inequality and poverty. Thus, we see that globalization can
have both positive and negative impact on the economy of a nation, its people
and the organizations within a specific industry.
Advantages
Some of the advantages of globalization are:
• Movement of capital: It has been seen that foreign capital flows in the
form of Foreign Direct Investment (FDI) and Foreign Institutional/Portfolio
Investments (FIIs) play a very important role in the development of an
economy by enhancing the production base of a developing economy
especially.
• Trade in goods and services: Globalization helps in the growth of emerging
economies by facilitating international trade in goods and services.
• Financial flows: The process of globalization leads to financial flows which
further leads to the development of the capital market.
Disadvantages
Some of the disadvantages of globalization are:
• Although globalization was responsible for the development of many
countries through increase in the international trade, there were also certain
disadvantages associated with it. Many studies released by UNDP revealed
that it has increased the disparities between the developed and developing
countries, thus increasing the gap between the rich and the poor.
• Unequal distribution of international trade gains is another disadvantage
of globalization. Various studies conducted in the past have proved that
there is a cost to this globalization. Findings have proved that since
developing countries have underdeveloped capital markets and high risk
premiums, they cannot fully participate in this growth and increased
investment brought about by globalization. As a result, these inadequacies
tilt the gains of globalization to developed and prospering nations.
• It has been found that developing nations have to face problems on
international trade due to rising tariff and trade barriers. Although
commodities produced by developing countries may be given higher value
and generate greater profits due to international trade, yet this may lead to
higher tariffs as well.

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Positive impacts
Some of the positive impacts of globalization for developing countries are varied
opportunities such as better access to developed markets, technology transfer
leading to improved standards of living and better productivity.
Negative impacts
The negative impacts of globalizations are various challenges such as volatility
in the financial markets, inequalities within and across different nations, and
slow participation of Third World countries due to trade, investment and financial
barriers.
Impact on India
• Increased GDP growth
• Increased foreign exchange reserves
• Rise in the share in the world’s export
• Broadening trade deficits
• Greater volatility in foreign portfolio investment than FDI
• Slow pace of industrialization
• Decrease in the share of agriculture in the GDP
• Decreased FDI
• Increase in the number of rural, landless families
• Ineffective management, corruption and lack of work efficiency in the PSUs.

Self Assessment Questions

1. International finance studies ________ relationship between nations.

2. International finance moderates domestic regulations through global _____
______.
3. Bad government policies can be corrected through worldwide cash flows.
(True/False)
4. The economics of international trade and international finance are similar.
(True/False)

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Activity 1
How do you think the sub-prime crisis of 2008 in the US affected the world
economy?
Hint: Refer to the Internet and analyse the impact on the European and
Asian countries.

1.3 Challenges for International Finance

The Asian financial crisis of 1997 and global economic crisis of 2007-2008
triggered by the fall of the Lehman Brothers reminded financial managers that
macroeconomic challenges could emerge without any notice and the road to
recovery could be further challenging. Some of these challenges are:
Policy options: The key policy priorities remain to restore the health of the
financial sector and to maintain supportive macroeconomic policies until the
recovery is on a firm footing, even though policymakers must begin preparing
for an eventual unwinding of extraordinary levels of public intervention. The
premature withdrawal of stimulus seems the greater risk in the near term, but
developing the medium-term macroeconomic strategy beyond the crisis is key
to maintaining confidence in fiscal solvency and to price and financial stability.
The challenge is to map a middle course between unwinding public interventions
too early, which would jeopardize the progress made in securing financial stability
and recovery, and leaving these measures in place too long, which carries the
risk of distorting incentives and damaging public balance sheets.
The key issues facing monetary policymakers are when to start tightening
and how to unwind large central bank balance sheets. Advanced and emerging
economies face different challenges. In advanced economies, central banks
can (with few exceptions) afford to maintain accommodative conditions for an
extended period because inflation is likely to remain subdued as long as output
gaps remain wide. Moreover, monetary policy will need to accommodate the
impact of the gradual withdrawal of fiscal support.
Rebalancing global demand: Achieving sustained healthy growth over the
medium term also depends critically on rebalancing the pattern of global demand.
Specifically, many current account surplus economies that have followed export-
led growth strategies will need to rely more on domestic demand growth to
offset likely subdued domestic demand in deficit economies that have undergone
asset price (stock and housing) busts. By the same token, many external deficit
countries will need to rely less on domestic demand and more on external

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demand. This will require significant structural reforms, many of which are also
necessary to boost potential output, which has taken a hit as a result of the crisis.
Foreign exchange fluctuations: Foreign exchange fluctuation is the risk due
to the rise or fall of value of one currency against another. Devaluation might
affect future sales, costs and remittances. International trade and transaction
always runs the risk of losing in these cases of unfavourable exchange rate. For
example, if the Indian rupee gains, the foreign buyer/borrower has to repay the
loan.
Financing facilities: Raising funds on favourable terms is another major concern
for the finance managers. The funds can be raised either from an internal source
or from an external source.

Self Assessment Questions

5. The two issues policymakers face are when to start ________ and how
to _________ large central bank balance sheets.
6. Foreign exchange fluctuation is the ________ due to the rise or fall of
value of one currency against another.
7. Achieving sustained healthy growth over the medium term depends
critically on rebalancing the pattern of global demand. (True/False)
8. Devaluation of a currency boosts future sales of that country. (True/False)

1.4 Emerging Trends in Global Trade

The past few decades have seen important shifts that have reshaped the global
trade landscape. As a share of global output, trade is now at almost three times
the level in the early 1950s, in large part driven by the integration of rapidly growing
Emerging Market Economies (EMEs). The share of developed countries in world
merchandise trade in value terms declined from 69 per cent to 55 per cent
between 1995 and 2010, while that of developing countries increased from 29
per cent to 41 per cent. The expansion in trade is mostly accounted for by growth
in non-commodity exports, especially of high-technology products such as
computers and electronics. It is also characterized by growing regional
concentration and an ongoing shift of technology content toward EMEs. These
developments in global trade have important implications for trade patterns, in
particular in response to relative price changes.

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1. Trade interconnectedness: Not only has the number of systemically

important trading nations increased over time, their trade links have also
multiplied. A chief contributor is the growing role of global supply chains in overall
trade, facilitated by lower tariffs and technology-led declines in transportation
and communication costs.
The expansion of global and regional trade was driven by trade liberalization
and subsequently by vertical specialization and income convergence. Multilateral
and bilateral liberalization since early 1950s has led to significantly lower trade
barriers in advanced economies followed more recently by developing countries.
Advanced countries and EMEs play different roles in global supply chains.
Advanced economies tend to be upstream in the supply chain. This position is
reflected in relatively small foreign contents in their exports and relatively large
contributions towards other downstream countries’ exports.
2. Emerging market economies as major players: In the early 1970s, trade
was largely confined to a handful of advanced economies, notably the United
States, Germany, and Japan, which together accounted for more than a third of
the global trade. By 1990, the global trading landscape had become more
diversified to include several EMEs, especially in east Asia. By 2010, China
became the second largest trading partner after the United States, overtaking
Germany and Japan.
3. The structure of trade has been characterized by a rising share of
higher technology goods: The role of global supply chains for trade in high
technology goods has increased over time, especially in China. The increase is
particularly pronounced for China—imported content of Chinese high-technology
exports increased by close to 30 percentage points from the mid-1990s to the
mid-2000s.
This result confirms that the emergence of China as a major exporter of
high technology goods has been boosted by processing trade, with significant
imported contributions from Japan and other countries in the Asian supply chain.
By the mid-2000s, China has by far the largest imported content in its high
technology exports. Japan and the United States make significantly less use of
imported intermediates.
4. The Asian supply chain is more dispersed compared to those in North
America or Europe: In the Asian supply chain, goods-in-process cross borders
several times, including through the hub (Japan), before reaching their final
destination. In contrast, in other regions, almost all foreign input is imported
directly from the hub—the United States in NAFTA and EU15 in Europe. The
greater dispersion of production in the Asian supply chain renders it potentially

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more vulnerable to disruptions of trade flows, whether policy induced, such as

preferential/regional trade agreements, or naturally caused, such as the recent
Tsunami in Japan.

Self Assessment Questions

9. _________ expansion was driven by trade liberalization and subsequently

by vertical specialization and income convergence.
10. Today, the expansion in trade is mostly accounted for by growth in ________
exports such as high-technology products.
11. In the Asian supply chain, goods-in-process cross borders several times.
(True/False)
12. Advanced economies tend to be upstream in the supply chain. (True/False)

Activity 2
State the various challenges faced by a multinational corporation in trying to
manage the currency exposure in various currencies.

1.5 Summary

Let us recapitulate the important concepts discussed in this unit:

• International finance is the branch of economics that broadly studies
monetary and macroeconomic interrelationship between nations.
• International treaties like, Basel norms, Kyoto Protocol and WTO guidelines
lay down a uniform framework for how business should be conducted
between different countries.
• For most of the economies of the world, globalization has led to a large
number of beneficial effects.
• The Asian financial crisis of 1997 and global economic crisis of 2007-
2008 triggered by the fall of the Lehman brothers reminded financial
managers that macroeconomic challenges could emerge without any
notice and the road to recovery could be further challenging.
• The key issues facing monetary policymakers are when to start tightening
and how to unwind large central bank balance sheets.
• The past few decades have seen important shifts that have reshaped the
global trade landscape.
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• The share of developed countries in world merchandise trade in value terms

declined from 69 per cent to 55 per cent between 1995 and 2010, while that
of developing countries increased from 29 per cent to 41 per cent.
• By 1990, the global trading landscape had become more diversified to
include several EMEs, especially in East Asia. By 2010, China became
the second largest trading partner after the United States, overtaking
Germany and Japan.
• The Asian supply chain is more dispersed compared to those in North
America or Europe.

1.6 Glossary

• EMEs: Emerging market economies like China, India.

• Macroeconomic variables: The variables such as exchange rates,
interest rates, inflation rates and asset values of an economy.
• Supply chain: It is a system where organizations, people, technology,
activities, information, and resources are interconnected in moving a
product or service from supplier to customer.

1.7 Terminal Questions

1. What is the relation between globalization and trade?

2. What is the importance of international finance?
3. International finance is prone to more challenges today. Discuss.
4. How can countries attempt to avoid international financial crisis?
5. What are the emerging trends in global trade?
6. What are the impacts of globalization?

1.8 Answers

Self Assessment Questions

1. Monetary
2. Financial institutions
3. True

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4. True
5. Tightening, unwind
6. Risk
7. True
8. False
9. Trade
10. Non-commodity
11. True
12. True

Terminal Questions

1. Globalization is as old as international trade that was prevalent in the most

ancient period. For more details, refer section 1.1.
2. International finance is the branch of economics that broadly studies
monetary and macroeconomic interrelationship between nations. For more
details, refer section 1.2.
3. The Asian financial crisis of 1997 and global economic crisis of 2007-
2008 triggered by the fall of the Lehman brothers reminded financial
managers that macroeconomic challenges could emerge without any
notice and the road to recovery could be further challenging. For more
details, refer section 1.3.
4. The key policy priorities is to restore the health of the financial sector. For
more details, refer section 1.3.
6. The past few decades have seen important shifts that have reshaped the
global trade landscape. For more details, refer section 1.4.
6. Globalization is defined as a concept which connects countries across
the world through information, trade and technology. For more details,
refer section 1.2.1.

1.9 Case Study

Chinese Economy to Overtake US by 2016

China’s economy is accelerating and will surpass the United States as the
world’s largest economy by 2016, the Organization for Economic

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Cooperation and Development (OECD) said. China has experienced a

declining rate of growth for three years.
The Paris-based organization of 34 global economies said China can
average 8 per cent growth during the current decade, after accounting for
price differences. The forecast is contingent on Beijing’s ability to continue
implementing certain economic, financial and regulatory reforms.
China’s growth slowed to 7.8 per cent in 2012, marking its lowest level in
more than a decade. However, the organization predicts that China’s
economy will rebound to 8.5 per cent growth in 2013 and 8.9 per cent the
following year. That prediction is well ahead of Beijing’s more conservative
target of 7 per cent average growth by 2015.
China’s current GDP is officially $8.25 trillion, though it’s estimated to be
much greater when adjusted for purchasing parity, making $12.38 trillion
more accurate, which is third in the world behind the EU ($15.70 trillion) and
the U.S. ($15.66 trillion), according to the International Monetary Fund.
OECD’s 2016 projection is significant because the IMF estimates that China
will overtake the US by 2017, when the US GDP will be $19.70 trillion
compared with China’s $20.33 trillion.
Discussion Questions
1. Find out how China was affected by the 2008 global crisis.
2. What are the factors that affected China’s leap as a major economic
power?
Source: Adapted from http://www.presstv.ir/usdetail/294894.html. (Retrieved
on 23 March 2013)

References
• Chrystal, A.K. A Guide to Foreign Exchange Markets. Federal Reserve
Bank of Louis Review, March, 1984: 5-18.
• Walmsley, J. (1983). Foreign Exchange Handbook: A User’s Guide. New
York: John Wiley.
• Porter, E. Michael. (1989). The Competitive Advantage of Nations.
Massachusetts: Harvard University Press.
• Krugman, R. Paul and Obstfeld, M. (2002). International Economics:
Theory and Policy. Massachusetts: Addison-Wesley.

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• Bilson, J.F.O. (1988). Currency Risk Management. Handbook of

International Financial Management. Dow-Jones-Irwin, Homewood, Ill.,
US.
• Doukas, J. and B. Arshanapalli. (1991). Decision Rules for Corporate
Management of Foreign Ex-change Risk. Journal of Multinational Financial
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• Anagol, M. (1990). Changing Global Financial Environment and Banks:
Emerging Concerns. Journal of Foreign Exchange and International
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• Casson, M. (1987). The Firm and the Market-Studies on the Multinational
Enterprise and the Scope of the Firm. Cambridge Massachusetts: MIT
Press.
• Caves, R. (1982). Multinational Enterprise and Economic Analysis.
Cambridge: Cambridge University Press.
E-References
• http://www.ey.com/GL/en/Issues/Business-environment/Trading-places—
Changes-in-geography—supply—sectors. Accessed on 22 March 2013
• http://www.imf.org/external/np/pp/eng/2011/061511.pdf. (Retrieved on 22
March 2013)
• http://www.fondad.org/uploaded/Regulatory%20and%20Supervisory%
20Challenges/Regulatory-Bakker.pdf (Retrieved on 22 March 2013)

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