Chapter 2 Outline

Implications for Business

The implications for international business of the material discussed in this chapter fall into two broad categories. First, the political, economic, and legal environment of a country clearly influences the attractiveness of that country as a market and/or investment site. The benefits, costs, and risks associated with doing business in a country are a function of that country's political, economic, and legal systems. Second, the political, economic, and legal systems of a country can raise important ethical issues that have implications for the practice of international business. Here we consider each of these issues.

Attractiveness

The overall attractiveness of a country as a market and/or investment site depends on balancing the likely long-term benefits of doing business in that country against the likely costs and risks. Below we consider the determinants of benefits, costs, and risks.

Benefits

In the most general sense, the long-run monetary benefits of doing business in a country are a function of the size of the market, the present wealth (purchasing power) of consumers in that market, and the likely future wealth of consumers. While some markets are very large when measured by number of consumers (e.g., China and India), low living standards may imply limited purchasing power

and, therefore, a relatively small market when measured in economic terms. While international businesses need to be aware of this distinction, they also need to keep in mind the likely future prospects of a country. In 1960, for example, South Korea was viewed as just another impoverished Third World nation. By 1996 it was the world's 11th largest economy, measured in terms of GDP. International firms that recognized South Korea's potential in 1960 and began to do business in that country may have reaped greater benefits than those that wrote off South Korea.

By identifying and investing early in a potential future economic star, international firms may build brand loyalty and gain experience in that country's business practices. These will pay back substantial dividends if that country achieves sustained high economic growth rates. In contrast, late entrants may find that they lack the brand loyalty and experience necessary to achieve a significant presence in the market. In the language of business strategy, early entrants into potential future economic stars may be able to reap substantial first-mover advantages, while late entrants may fall victim to late-mover disadvantages.⁵⁶ (First-mover advantages are the advantages that accrue to early entrants into a market. Late-mover disadvantages are the handicap that late entrants might suffer from.)

A country's economic system and property rights regime are reasonably good predictors of economic prospects. Countries with free market economies in which property rights are well protected tend to achieve greater economic growth rates than command economies and/or economies where property rights are poorly protected. It follows that a country's economic system and property rights regime, when taken together with market size (in terms of population), probably constitute reasonably good indicators of the potential long-run benefits of doing business in a country.⁵⁷

Costs

A number of political, economic, and legal factors determine the costs of doing business in a country. With regard to political factors, the costs of doing business in a country can be increased by a need to pay off the politically powerful in order to be allowed by the government to do business. The need to pay what are essentially bribes is greater in closed totalitarian states than in open democratic societies where politicians are held accountable by the electorate (although this is not a hard-and-fast distinction). Whether a company should actually pay bribes in return for market access should be determined on the basis of the legal and ethical implications of such action. We discuss this consideration below.

With regard to economic factors, one of the most important variables is the sophistication of a country's economy. It may be more costly to do business in relatively primitive or undeveloped economies because of the lack of infrastructure and supporting businesses. At the extreme, an international firm may have to provide its own infrastructure and supporting business if it wishes to do business in a country, which obviously raises costs. When McDonald's decided to open its first restaurant in Moscow, it found that in order to serve food and drink indistinguishable from that served in McDonald's restaurants elsewhere, it had to vertically integrate backward to supply its own needs. The quality of Russian-grown potatoes and meat was too poor. Thus, to protect the quality of its product, McDonald's set up its own dairy farms, cattle ranches, vegetable plots, and food processing plants within Russia. This raised the cost of doing business in Russia, relative to the cost in more sophisticated economies where high-quality inputs could be purchased on the open market. As for legal factors, it can be more costly to do business in a country where local laws and regulations set strict standards with regard to product safety, safety in the workplace, environmental pollution, and the like (since adhering to such regulations is costly). It can also be more costly to do business in a country like the United States, where the absence of a cap on damage awards has meant spiraling liability insurance rates. Moreover, it can be more costly to do business in a country that lacks well-established laws for regulating business practice (as is the case in many of the former Communist nations). In the absence of a well-developed body of business contract law, international firms may find that there is no satisfactory way to resolve contract disputes and, consequently, routinely face large losses from contract violations. Similarly, when local laws fail to adequately protect intellectual property, this can lead to the "theft" of an international business's intellectual property, and lost income (see the Management Focus on Microsoft).

Risks

As with costs, the risks of doing business in a country are determined by a number of political, economic, and legal factors. On the political front, there is the issue of political risk. Political risk has been defined as the likelihood that political forces will cause drastic changes in a country's business environment that adversely affect the profit and other goals of a particular business enterprise.⁵⁸ So defined, political risk tends to be greater in countries experiencing social unrest and disorder or in countries where the underlying nature of a society increases the likelihood of social unrest. Social unrest typically finds expression in strikes, demonstrations, terrorism, and violent conflict. Such unrest is more likely to be found in countries that contain more than one ethnic nationality, in countries where competing ideologies are battling for political control, in countries where economic mismanagement has created high inflation and falling living standards, or in countries that straddle the "fault lines" between civilizations, such as Bosnia.

Social unrest can result in abrupt changes in government and government policy or, in some cases, in protracted civil strife. Such strife tends to have negative economic implications for the profit goals of business enterprises. For example, in the aftermath of the 1979 Islamic revolution in Iran, the Iranian assets of numerous US companies were seized by the new Iranian government without compensation. Similarly, the violent disintegration of the Yugoslavian federation into warring states, including Bosnia, Croatia, and Serbia, precipitated a collapse in the local economies and in the profitability of investments in those countries.

On the economic front, economic risks arise from economic mismanagement by the government of a country. Economic risks can be defined as the likelihood that economic mismanagement will cause drastic changes in a country's business environment that adversely affect the profit and other goals of a particular business enterprise. Economic risks are not independent of political risk. Economic mismanagement may give rise to significant social unrest and hence political risk. Nevertheless, economic risks are worth emphasizing as a separate category because there is not always a one-to-one relationship between economic mismanagement and social unrest. One visible indicator of economic mismanagement tends to be a country's inflation rate. Another tends to be the level of business and government debt in the country.

In Asian states such as Indonesia, Thailand, and South Korea, businesses increased their debt rapidly during the 1990s, often at the bequest of the government, which was encouraging them to invest in industries deemed to be of "strategic importance" to the country. The result was overinvestment, with more industrial (factories) and commercial capacity (office space) being built than could be justified by demand conditions. Many of these investments turned out to be uneconomic. The borrowers failed to generate the profits required to meet their debt payment obligations. In turn, the banks that had lent money to these businesses suddenly found that they had rapid increases in nonperforming loans on their books. Foreign investors, believing that many local companies and banks might go bankrupt, pulled their money out of these countries, selling local stocks, bonds, and currency. This action precipitated the 1997 - 1998 financial crisis in Southeast Asia. The crisis included a precipitous decline in the value of Asian stocks markets, which in some cases exceeded 70 percent; a similar collapse in the value of many Asian currencies against the US dollar; an implosion of local demand; and a severe economic recession that will affect many Asian countries for years to come. In short, economic risks were rising throughout Southeast Asia during the 1990s. Astute foreign businesses and investors, seeing this situation, limited their exposure in this part of the world. More naive businesses and investors lost their shirts!

On the legal front, risks arise when a country's legal system fails to provide adequate safeguards in the case of contract violations or to protect property rights. When legal safeguards are weak, firms are more likely to break contracts and/or steal intellectual property if they perceive it as being in their interests to do so. Thus, legal risks might be defined as the likelihood that a trading partner will opportunistically break a contract or expropriate property rights. When legal risks in a country are high, an international business might hesitate entering into a long-term contract or joint-venture agreement with a firm in that country. For example, in the 1970s when the Indian government passed a law requiring all foreign investors to enter into joint ventures with Indian companies, US companies such as IBM and Coca-Cola closed their investments in India. They believed that the Indian legal system did not provide for adequate protection of intellectual property rights, creating the very real danger that their Indian partners might expropriate the intellectual property of the American companies--which for IBM and Coca-Cola amounted to the core of their competitive advantage.

Overall Attractiveness

The overall attractiveness of a country as a potential market and/or investment site for an international business depends on balancing the benefits, costs, and risks associated with doing business in that country. Generally, the costs and risks associated with doing business in a foreign country are typically lower in economically advanced and politically stable democratic nations and greater in less developed and politically unstable nations. The calculus is complicated, however, by the fact that the potential long-run benefits bear little relationship to a nation's current stage of economic development or political stability. Rather, the benefits depend on likely future economic growth rates. Economic growth appears to be a function of a free market system and a country's capacity for growth (which may be greater in less developed nations). This leads one to conclude that, other things being equal, the benefit, cost, risk trade-off is likely to be most favorable in the case of politically stable developed and developing nations that have free market systems and no dramatic upsurge in either inflation rates or private-sector debt. It is likely to be least favorable in the case of politically unstable developing nations that operate with a mixed or command economy or in developing nations where speculative financial bubbles have led to excess borrowing.

Country differences give rise to some important and contentious ethical issues. Three important issues that have been the focus of much debate in recent years are (1) the ethics of doing business in nations that violate human rights, (2) the ethics of doing business in countries with very lax labor and environmental regulations, and (3) the ethics of corruption.

Ethics and Human Rights

One major ethical dilemma facing firms from democratic nations is whether they should do business in totalitarian countries that routinely violate the human rights of their citizens (such as China). There are two sides to this issue. Some argue that investing in totalitarian countries provides comfort to dictators and can help prop up repressive regimes that abuse basic human rights. For instance, Human Rights Watch, an organization that promotes the protection of basic human rights around the world, has argued that the progressive trade policies adopted by Western nations toward China has done little to deter human rights abuses.⁵⁹ According to Human Rights Watch, the Chinese government stepped up its repression of political dissidents in 1996 after the Clinton administration removed human rights as a factor in determining China's trade status with the United States. Without investment by Western firms and the support of Western governments, many repressive regimes would collapse and be replaced by more democratically inclined governments, critics such as Human Rights Watch argue. Firms that have invested in Chile, China, Iraq, and South Africa have all been the direct targets of such criticisms. The 1994 dismantling of the apartheid system in South Africa has been credited to economic sanctions by Western nations, including a lack of investment by Western firms. This, say those who argue against investment in totalitarian countries, is proof that investment boycotts can work (although decades of US-led investment boycotts against Cuba and Iran, among other countries, have failed to have a similar impact).

In contrast, some argue that Western investment, by raising the level of economic development of a totalitarian country, can help change it from within. They note that economic well-being and political freedoms often go hand in hand. Thus when arguing against attempts to apply trade sanctions to China in the wake of the violent 1989 government crackdown on prodemocracy demonstrators, the Bush administration claimed that US firms should continue to be allowed to invest in mainland China because greater political freedoms would follow the resulting economic growth. The Clinton Administration used similar logic as the basis for its 1996 decision decoupling human rights issues from trade policy considerations.

Since both positions have some merit, it is difficult to arrive at a general statement of what firms should do. Unless mandated by government (as in the case of investment in South Africa) each firm must make its own judgments about the ethical implications of investing in totalitarian states on a case-by-case basis. The more repressive the regime, however, and the less amenable it seems to be to change, the greater the case for not investing.

Ethics and Regulations

A second important ethical issue is whether an international firm should adhere to the same standards of product safety, work safety, and environmental protection that are required in its home country. This is of particular concern to many firms based in Western nations, where product safety, worker safety, and environmental protection laws are among the toughest in the world. Should Western firms investing in less developed countries adhere to tough Western standards, even though local regulations don't require them to do so? This issue has taken on added importance in recent years following revelations that Western enterprises have been using child labor or very poorly paid "sweat-shop" labor in developing nations. Companies criticized for using sweatshop labor include the Gap, Disney, Wal-Mart, and Nike.⁶⁰

Again there is no easy answer. While on the face of it the argument for adhering to Western standards might seem strong, on closer examination the issue becomes more complicated. What if adhering to Western standards would make the foreign investment unprofitable, thereby denying the foreign country much-needed jobs? What is the ethical thing to do? To adhere to Western standards and not invest, thereby denying people jobs, or to adhere to local standards and invest, thereby providing jobs and income? As with many ethical dilemmas, there is no easy answer. Each case needs to be assessed on its own merits.

Ethics and Corruption

A final ethical issue concerns bribes and corruption. Should an international business pay bribes to corrupt government officials to gain market access to a foreign country? To most Westerners, bribery seems to be a corrupt and morally repugnant way of doing business, so the answer might initially be no. Some countries have laws on their books that prohibit their citizens from paying bribes to foreign government officials in return for economic favors. In the United States, for example, the Foreign Corrupt Practices Act of 1977 prohibits US companies from making "corrupt" payments to foreign officials to obtain or retain business, although many other developed nations lack similar laws. Trade and finance ministers from the member states of the Organization for Economic Cooperation and Development (the OECD), an association of the world's 20 or so most powerful economies, are working on a convention that would oblige member states to make the bribery of foreign public officials a criminal offense.

However, in many parts of the world, payoffs to government officials are a part of life. One can argue that not investing ignores the fact that such investment can bring substantial benefits to the local populace in terms of income and jobs. Given this, from a pragmatic standpoint, perhaps the practice of giving bribes, although a little evil, is the price that must be paid to do a greater good (assuming the investment creates jobs where none existed before and assuming the practice is not illegal). This kind of reasoning has been advocated by several economists, who suggest that in the context of pervasive and cumbersome regulations in developing countries, corruption may actually improve efficiency and help growth! These economists theorize that in a country where preexisting political structures distort or limit the workings of the market mechanism, corruption in the form of black marketeering, smuggling, and side payments to government bureaucrats to "speed up" approval for business investments may actually enhance welfare.⁶¹

However, other economists have argued that corruption can reduce the returns on business investment.⁶² In a country where corruption is common, the profits from a business activity may be siphoned off by unproductive bureaucrats who demand side payments for granting the enterprise permission to operate. This reduces the incentive that businesses have to invest and may hurt a country's economic growth rate. One economist's study of the connection between corruption and growth in 70 countries found that corruption had a significant negative impact on a country's economic growth rate.⁶³

Given the debate and the complexity of this issue, one again might conclude that generalization is difficult. Yes corruption is bad, and yes it may harm a country's economic development, but yes, there are also cases where side payments to government officials can remove the bureaucratic barriers to investments that create jobs. What this pragmatic stance ignores, however, is that corruption tends to "corrupt" both the bribe giver and the bribe taker. Corruption feeds on itself, and once an individual has started to walk down the road of corruption, pulling back may be difficult if not impossible. If this is so, it strengthens the moral case for never engaging in corruption, no matter how compelling the benefits might seem.