copyright © 2013 pearson education, inc. publishing as prentice hall 5-1 a framework for...

Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

5-1

A Framework for International Business

by Cavusgil, Knight, & Riesenberger

Chapter 5: Political and Legal Systems in

International Business


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In this chapter, you’ll learn about:

1. The nature of country risk

2. Political systems

3. Legal systems

4. Types of country risk produced by political systems

5. The nature of government intervention

6. Instruments of government intervention

7. How firms can respond to government intervention

Learning Objectives


5-3

What is Country Risk?

• Exposure to potential loss or adverse effects on company operations and profitability caused by developments in a country’s political and/or legal environments

• Also known as ‘political risk’

• Each country has unique political & legal systems that often pose challenges for company performance


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Prevalence of Risk

• Degree of risk varies dramatically

• Risk is indexed by a combination of measures of:

– Political stability/situation in a country

– Various economic indicators

– Respect for the rule of law and ethical posture

• Degree of risk varies dramatically across countries and this is factored into economic decisions by firms


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Country Risk in Selected Countries


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Two Main Sources of Country Risk


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Political & Legal Systems

• Political systems: – A set of formal institutions that constitute a government – Includes legislative bodies, political parties, lobbying groups,

and trade unions – Main systems in world include: totalitarianism, socialism,

democracy

• Legal systems: – Methods for interpreting and enforcing laws, regulations, and

rules of conduct – Law provides procedures for ensuring order and resolving

disputes in business activities– Main examples: common law, civil law, religious law, hybrid

systems


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Political Systems: Totalitarianism

• Government controls all economic and political matters; usually one party where membership is mandatory

• Either theocratic (religion-based) or secular & led by dictator

• Power closely held; regulation of criticism

• Over time, totalitarian states have either disappeared or shifted toward more free systems

• Still today we have examples: North Korea, Burma, & some countries in the Middle East & Africa

• Former totalitarian states tend to have greater government intervention & bureaucracy (e.g., Spain, Russia, China)


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Political Systems: Socialism

• Capital & wealth is vested in the state• Capital is used primarily as a means of production for use rather

than for profit • Belief is that group welfare outweighs individual welfare• Government’s role is to control the basic means of production,

distribution, and commercial activity• Socialism, in the form of social democracy is seen via frequent

government intervention in private sector (Western Europe, Brazil, India)

• Corporate income tax rates are higher


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Political Systems: Democracy

• Economic activity occurs relatively freely, as per market forces – is the most common system among advanced economies

• System characterized by:– Private property rights: ability to own property/assets & to increase one’s

wealth/assets (land, buildings, stocks, contracts, patents) – Limited government: government performs only essential functions that

serve all citizens (national defense, maintaining order, foreign relations)

• System encourages initiative, ambition, & innovation• Virtually all democracies include elements of socialism (e.g.,

some form of government intervention). This mixed system is common (e.g., Australia, Canada, U.S., European countries)


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Relationship Between Political and Economic Freedom


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Democracy and Openness

• Democracy is associated with “openness,” - lack of regulation and barriers to the entry of firms in foreign markets

• Openness is indexed by: – Successful market entry– Increased market demand– Competition on quality, which

improves overall product quality

– Increased competition, leading to efficiencies and lower prices


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Connections Between Political & Economic Systems

• Totalitarianism is associated with command economies, wherein the state makes all decisions about what to produce, how much to produce, and what prices to charge

• Socialism is associated with mixed economies, which have features of both market and command economies, combining state intervention and market mechanisms (e.g., Sweden, Singapore)

• Democracy is associated with market economies and capitalism, in which decisions are largely left to market forces, that is, supply and demand


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The Rule of Law

• Common in the advanced economies

• The legal system is: (i) applied to all citizens equally; (ii) issued via recognized government authorities; and (iii) enforced fairly and systematically by police forces and formally organized judicial bodies

• Economic activity suffers and uncertainty increases when the rule of law is weak

A legal system where rules are clear, publicly disclosed, fairly enforced, & widely respected by individuals & governments.


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Legal Systems: Common Law

• A legal system that originated in England and spread to Australia, Canada, the U.S., and other former members of the British Commonwealth (also known as case law)

• Basis of law is tradition, past practices, and legal precedents set by courts via interpretation of statutes, legislation, and past rulings

• Judges have much power to interpret laws based on the circumstances of individual cases. Thus, common law is relatively flexible


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Legal Systems: Civil Law

• Found in France, Germany, Italy, Japan, Turkey, and much of Latin America

• Based on an all-inclusive system of laws that have been “codified”—clearly written by legislative bodies

• Laws are more “cast in stone” than common law and not strongly subject to interpretation by courts

• A key difference is that common

law is mainly judicial in origin &

based on court decisions, whereas civil law is mainly legislative

& based on laws passed by national and state legislatures


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Sampling of Differences Between Common Law and Civil Law


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Legal Systems: Religious Law

• Strongly influenced by religious beliefs, ethical codes, and moral values, which are viewed as mandated by a supreme being

• Most important religious legal systems are based on Hindu, Jewish, and Islamic law

• Islamic law spells out norms of behavior regarding politics, economics, banking, contracts, marriage, and many other social and business issues


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Legal Systems: Mixed Systems

• Two or more legal systems operating together

• The contrast between civil and common law has become blurred as countries combine both systems

• Totalitarianism is most associated with religious law and socialist law

• Democracy is associated with common law, civil law, and mixed systems

ExampleLegal systems in Lebanon, Morocco, and Tunisia share

elements of civil law and Islamic law.


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Country Risk Produced by Political Systems:Government Takeover of Corporate Assets

• Confiscation: Seizure of corporate assets without compensation

• Expropriation: Asset seizure with compensation

• Nationalization: Takeover of an entire industry, with or without compensation

Examples• In Venezuela, President Hugo Chavez confiscated an oil field owned by the French petroleum firm Total. • In 2006, the Bolivian government nationalized the oil and gas industries.


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Country Risk Produced by Political Systems:Creeping Expropriation

• The most common expropriation today

• The government gradually modifies regulations and laws after foreign MNEs have made big local investments in property and plants

Examples • Abrupt termination of contracts • Creation of laws that favor local firms • Governments in Bolivia, Russia, &

Venezuela have modified tax regimesto extract revenues from coal, oil, and gas companies


5-22

Country Risk Produced by Political Systems: Embargoes and Sanctions

• Governments may respond to offensive activities of foreign countries by imposing embargoes and sanctions

• Sanctions are bans on international trade, usually undertaken by a country, or a group of countries, against another country judged to have jeopardized peace and security

• Embargoes are bans on exports or imports that forbid trade in specific goods with specific countries. Example: The U.S. has enforced embargoes against Iran and North Korea, labeled as state sponsors of terrorism


5-23

Country Risk Produced by Political Systems: Boycotts against Firms and Nations

• Boycott: A voluntary refusal to engage in commercial dealings with a nation or a company

Examples from France• Citizens boycotted Disneyland Paris to express opposition to globalization & takeover of French farmland. • French farmers boycotted McDonald’s & crashed a tractor into a shop in a show of anger about agricultural policies & globalization.


5-24

Country Risk Produced by Political Systems: Wars, Insurrection, and Violence

• War and insurrection: Indirect effects can be disastrous for company activities

• Terrorism: The threat or actual use of force or violence to attain a political goal through fear and intimidation

• Some terrorism is sponsored by national governments

• Terrorism particularly affects certain industries, such as tourism, hospitality, aviation, finance, and retailing


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Types of Country Risk Produced by Legal Systems

Examples of risk due to host country’s legal environment:• Foreign investment laws• Controls on operating forms and practices• Marketing and distribution laws• Laws regarding income repatriation• Environmental laws• Contract laws• Internet and e-commerce regulations• Inadequate or underdeveloped legal systems


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Country Risk Arising from the Host Country

• Foreign investment laws affect the entry of foreign investment

Examples• Japan: The “large-scale retail store law” restricted foreigners

from opening warehouse-style stores like Toys “R” Us, in favor of smaller Japanese retailers.

• Mexico: Foreign oil companies cannot obtain 100% ownership of Mexican oil firms.

• U.S.: Restricted investment from Dubai Ports World to manage major U.S. ports because it was believed to affect national security.


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Country Risk Arising from the Host Country (cont.)

• Controls on operating forms and practices are laws and regulations on how firms can conduct production, marketing, and distribution activities

ExampleIn the telecom sector in China, government requires foreign investors to seek joint ventures with local firms. This ensures local control of the telecom industry, & China gains access to foreign capital & technology.


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• Marketing and distribution laws regulate practices in advertising, promotion, and distribution

Examples

• Finland, France, Norway, & New Zealand prohibit cigarette advertising on television.

• Canada and other countries cap prices in the pharmaceutical and other industries.


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• Laws on income repatriation limit the amount of net income or dividends that firms can bring back to the home country

• Environmental laws aim to preserve natural resources, combat pollution, and ensure safety

• Contract laws affect the sale of goods and services; intermediary agreements; licensing and franchising; foreign direct investment; and joint ventures

ExampleIn Germany, firms are responsible for recycling packaging from their products. Many set up collection sites that customers use.


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• Inadequate or underdeveloped legal systems, or poor enforcement of existing laws

• Laws may be weak regarding intellectual property, pollution, consumer protection, and other areas

• While the problem is common in developing economies, it can also occur in advanced economies


Examples• In China and Russia, foreign firms sometimes abandon business ventures due to erratic legal environments.• The recent global financial crisis was triggered partly by poor regulation in the United States and Europe.


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Country Risk Produced by Legal Systems (cont.)

Examples of risk due to home country’s legal environment:

• The Foreign Corrupt Practices Act (FCPA)

• Antiboycott regulations

• Accounting and reporting laws

• Transparency in financial reporting


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Country Risk Arising from the Home Country

• Extraterritoriality: The application of home-country laws to other countries. For example, the European Union pursued Microsoft for monopolistic practices

• The Foreign Corrupt Practices Act (1977; U.S.) made it illegal to offer bribes to foreign parties. But the act may harm U.S. firms becauseforeign competitors are usually not so constrained


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Country Risk Arising from the Home Country (cont.)

• Accounting and reporting laws differ widely around the world. Two examples:• Physical asset valuations: Canada and the U.S. use historical costs.

Some Latin American countries use inflation-adjusted market value

• R&D costs: Expensed as incurred in most of the world; capitalized in South Korea and Spain. Some countries use both conventions

• Transparency in financial reporting is the degree to which firms regularly reveal substantial financial and accounting information. Varies worldwide


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● Proactive environmental scanning: Management should develop a comprehensive understanding of the political and legal environment in target countries

● Scanning: Ongoing assessment of potential risks and threats to the firm, via intelligence sources such as: Employees working in the host country Embassy and trade association officials Consulting firms, such as Business Environment Risk

Intelligence (http://www.beri.com)● Goal is to minimize exposure to country risks

Managing Country Risk


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Managing Country Risk (cont.)

• Strict adherence to ethical standards: Firms that engage in questionable practices or operate outside the law invite redress from the governments of the host countries where they do business

• Alliances with qualified local partners: For example, firms often enter China and Russia by partnering with local firms, which assist in navigating the complex legal and political landscape


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Managing Country Risk (cont.)

• Protection through legal contracts: Contract law varies widely. The firm must follow the law in each country. Three approaches for resolving contract disputes are:• Conciliation is a formal process of negotiation with the objective of

resolving differences in a friendly manner. The least adversarial method, it is common in China

• In arbitration, a neutral third party hears both sides of a case and decides in favor of one party or the other, based on an objective assessment of the facts

• Litigation occurs when one party files a lawsuit against another. The most adversarial approach, it is common in the U.S.


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Government Intervention

• Governments intervene in trade and investment to achieve political, social, or economic objectives

• Governments impose trade and investment barriers that benefit interest groups, such as domestic firms, industries, and labor unions

• Government intervention alters the competitive landscape, by hindering or helping the ability of firms to compete internationally

• Government intervention is an important dimension of country risk


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Government Intervention (cont.)

• Protectionism — national economic policies that restrict free trade. Usually intended to raise revenue or protect domestic industries from foreign competition

• Customs — the checkpoint at national ports of entry where officials inspect imported goods and levy tariffs


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General Rationale for Government Intervention

• Tariffs can generate substantial government revenue. This is a key rationale for protectionism in undeveloped economies

• Helps ensure the safety, security, and welfare of citizens. E.g., most countries have basic regulations to protect the national food supply

• Helps the government pursue broad economic, political, and social objectives for the nation

• Can serve the interests of the nation’s firms and industries


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Defensive Rationale for Government Intervention

• Protection of the national economy – weak or young economies sometimes need protection from foreign competitors. E.g., India imposed barriers to shield its huge agricultural sector, which employs millions

• Protection of an infant industry – a young industry may need protection, to give it a chance to grow and succeed. E.g., Japan long protected its car industry

• National security – the United States prohibits exports of plutonium and similar products to North Korea

• National culture and identity – Canada restricts foreign investment in its movie and TV industries


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Offensive Rationale for Government Intervention

• National strategic priorities – protection helps ensure the development of industries that bolster a nation’s economy. Countries create better jobs & higher tax revenues when they support high value-adding industries (e.g., IT, automotive, pharmaceuticals, financial services)

• Increase employment – protection helps preserve domestic jobs, at least in the short term. However, protected industries become less competitive over time, especially in global markets, leading to job loss in the long run


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Types and Effects of Government Intervention


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Government Intervention Types and Effects (cont.)


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Government Intervention Types and Effects (cont.)


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Government Intervention: Tariffs

• Tariff – a tax on imports (e.g., citrus, textiles)

• Various forms:– Ad valorem (assessed on % of import value)

– Specific tariff (a flat fee as on weight, volume – e.g., barrel or oil)

– Protective tariff (to protect a domestic industry from foreign ones)

– Prohibitive tariff (one set so high that no one can make money importing)

• Tariffs can generate revenue for governments

• They inhibit free trade and growth – governments have reduced them over time

• More common in developing economies

but are there in adv. economies too


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Sampling of Import Tariffs


5-47

Government Intervention – Nontariff Barriers

• Nontariff trade barrier – government policy, regulation, or procedure that impedes trade (quotas, special import licenses, regulations, and more)

• The use of nontariff barriers by governments has grown substantially in recent decades

• One reason is that they are easier to conceal from international regulatory agencies such as the WTO (World Trade Organization)


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Nontariff Barriers

• Quotas – quantitative restriction on imports of a specific product (e.g., imports of Japanese cars)

• Import licenses – a formal permission to import; sold by governments on a competitive basis

• Local content requirements – these force importers to include some local value-added (e.g., requiring some manufacturing to occur in target country; requiring windshields and other parts to be made in target country)

• Regulations/technical standards – including health standards for imported food or pollution abatement devices on imported autos


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Nontariff Barriers (cont.)

• Investment barriers – rules or even laws that control foreign direct investment

– (e.g., Mexico has imposed restrictions on foreign ownership of its oil industry)

– France and Canada restrict foreign ownership of domestic film studies and TV networks

– Other governments cap ownership equity in many of their domestic firms

– Currency controls, rules that restrict the outflow of widely used currencies, are another investment barrier


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Subsidies

• Subsidies are government grants of money or resources to firms; intended to ensure their survival or success by facilitating production at reduced prices, or encouraging exports

• Grants include: cash, tax breaks, infrastructure construction, or government contracts at inflated prices. These are all examples that can act as barriers to trade

• Example: the U.S. grants subsidies for more than 12 commodities, including milk, wheat, cotton, peanuts, sugar, and tobacco

• The EU grants even more – subsidies represent 40% of total EU budget!


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Subsidies (cont.)

• These subsidies are seen as unfair because they promote higher prices and a noncompetitive market. In effect, these U.S. and EU subsidies lower food prices at home and make imports more expensive

• This can also lead to dumping – the charging of prices so low for exports that domestic producers can’t compete. Large MNEs could take a temporary loss in order to put a domestic firm out of business

• Some countries, therefore, have enacted anti-dumping duties – a tax imposed on products judged to be dumped (e.g., ones for sale at prices less than what they cost to manufacture)


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Economic Freedom

• Economic freedom is the absence of government coercion so that people can work, produce, consume, and invest however they wish

• The Index of Economic Freedom assesses the rule of law, trade barriers, regulations, and other criteria.• Virtually all advanced economies are ‘free’

• Emerging markets are either ‘free’ or ‘mostly free’

• Most developing economies are ‘mostly unfree’ or ‘repressed’

• Economic freedom flourishes with appropriate intervention; too much regulation harms the economy


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How Firms CouldRespond to Government Intervention

• Research to gather knowledge and intelligence. Understand trade and investment barriers abroad. Scan the business environment to identify the nature of government intervention

• Choose the most appropriate entry strategies. Most firms choose exporting as their initial strategy, but if high tariffs are present, other strategies should be considered, such as licensing, or FDI and JVs that allow the firm to produce directly in the market


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How Firms Should Respond to Intervention (cont.)

• Take advantage of foreign trade zones. FTZs are areas where imports receive preferential tariff treatment, intended to stimulate local economic development. E.g., a successful experiment with FTZs has been the maquiladoras — export-assembly plants in northern Mexico

• Seek favorable customs classifications for exported products. Reduce exposure to trade barriers by ensuring that products are classified properly


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How Firms Should Respond to Intervention (cont.)

• Take advantage of investment incentives and other government support programs

• Lobby for freer trade and investment. Increasingly, nations are liberalizing markets in order to create jobs and increase tax revenues

Examples• Hong Kong put up much of the cash to build a new Disney park there • Mercedes-Benz received several hundred million dollars in subsidies to build a plant in the U.S. state of Alabama


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copyright © 2013 pearson education, inc. publishing as prentice hall 5-1 a framework for...

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