The Economic Environment

Poverty does not destroy virtue, nor does wealth bestow it. - Spanish Provers Learning Objective • To learn the criteria for the dividing countries into different

economic categories • To learn the difference among the world’s major economic

systems • To discuss key economic issues that influence international

business • To assess the transition process certain countries are

undertaking in changing to market economic-and how this transition affects international firms and managers CASE Study McDonald’s Corporation in Emerging Markets Nearly everyone has an opinion about McDonald’s, including Jerry Seinfeld. In one of his live standup acts, he relayed the following observations. Why McDonald’s Still counting? How insecure is this company? 40 million, 80 jillion, billion, zillion, killion, tillion. . .. Is anyone really impressed anymore? “Oh, 89 billion sold . . .. alright, I’ll have one. I’m satisfied.” . . . Who cares? I would love to meet the chairman of the board of McDonald’s and just say to him, “Look, We all get it. OK, you’ve sold a lot of hamburgers, whatever the number is. Just put on the sign, ‘McDonald’s-We’re doing very well: We are tired of hearing about every dang one of them.” What is their ultimate goal, to have cows just surrendering voluntarily or something? Showing up at the door: “We’d like to turn ourselves in. We see the sign. We realize we have very little chance out there. We’d like to be a Happy Meal® if that’s at all possible.” With 30,000 outlets in 121 countries, McDonald’s Corporation is “doing very well” by many measures. It has taken an aggressive growth stance by entering into risky emerging markets and riding on the eco-nomic growth spurt of the 1990s. But as the world slipped into an economic recession in 2001, McDonald’s has felt the blow, showing six consecutive quarters of declining results. Although prosperous in some emerging markets, like Russia and China, it has done poorly in others, like Turkey, Malaysia, and the Philippines, where it closed 163 unproductive stores at a cost of $91 million in 2001. As the world economy has taken a downward turn, McDonald’s is facing risks and challenges that raise questions and doubts about the future of its worldwide operations. McDonald’s entry into Russia in 1990 exemplifies the process and difficulties it has encountered in most developing countries where it has begun operations. During the 1976 Olympics in Montreal, George A Cohon, president of McDonald’s Canadian 11.154

subsidiary, made the first contact with Soviet officials. They began lengthy negotiations, which lasted until 1988 when a formal agreement was signed. In the mean-time, McDonald’s had opened restaurants in Hungary and Yugoslavia, thus providing the company with valuable experience in operating in communist countries. By the mid-1980s, the company was expanding more rapidly outside the United States than inside, and company executives reasoned that if they were to meet the company’s rapid growth objectives, that trend must continue. Although the Moscow City Council was a partner of McDonald’s in the Russian joint venture, the com-pany repeatedly ran into negative responses, such as “Sorry, you’re not in my five-year plan,” when it attempted to obtain such materials as sand or gravel to build the restaurant. The company had to negoti-ate to ensure it would be allocated, in the thenSoviet Union central plan, sufficient sugar and flour, which were in chronically short supply. Even for some products in sufficient supply, such as mustard, government regulations prevented Soviet manufacturers from deviating from standard recipes in order to comply with McDonald’s needs. In other cases, strict allocation regulations dictated that Soviet plants sell all output to existing Soviet companies, thus leaving them no opportunity to produce products for McDonald’s. Yet another problem was that some supplies simply were not produced or consumed in the Soviet Union, including iceberg lettuce, pickling cucumbers, and the Russet Burbank potatoes that are the secret behind McDonald’s French fries. To handle these problems, McDonald’s scoured the country for supplies, contracting for such items as milk, cheddar cheese, and beef. To help ensure ample supplies of the quality products it needed, it undertook to educate Soviet farmers and cattle ranchers on how to grow and raise those products. In addition, it built a $40 million food-processing center about 45 minutes from its first Moscow restaurant. One problem McDonald’s did not encounter was attracting employees and customers. The company placed one small helpwanted ad and received about 27,000 Russian applicants for its 605 positions. McDonald’s did no advertising prior to its Moscow opening. However, Russian television covered the upcoming event extensively. When the restaurant’s doors opened for the first time in January 1990, it was almost impossible to accommodate the crowd, even though it was the largest McDonald’s in the world. An estimated 30,000 people were served the first day, eclipsing the previous daily record of 9,100 set in Budapest. The crowds continued to arrive, even though the price of a Big Mac, French fries, and soft drink equaled a Russian worker’s average pay for four hours of work. In contrast, lunch at a state-run or private sector cafe cost 15 to 25 percent as much as a meal at McDonald’s. The entry of McDonald’s into China in 1990 resembled its experience in Russia. However, the Chinese government moved

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LESSON 18 THE ECONOMIC ENVIRONMENT

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faster and was more accommodating than the Russian government had been. China’s government wanted to establish its fast-food market and felt that Western companies like McDonald’s could take the risks in proving its success. McDonald’s encountered similar roadblocks in China, such as lack of quality supplies and distribution difficulties, and it has found analogous benefits, like high volumes of cus-tomers and employees. In 1997, the Asian financial crisis hit, devastating most of the economies in Asia: However, China’s economy, including its catering industry, kept growing. In fact, the Chinese government in 1998 designated the catering industry as a new economic growth sector, growing at an annual rate of 20 percent in the 1990s. Because China avoided most, f the economic turmoil its neighboring countries experienced, McDonald’s prospered. Much of this growth is attributed to increases in individual’s income, changing con-sumer patterns, development of the tourism sector, and overall growth in the fast-food industry-all signs of a growing economy. McDonald’s success in China has continued into the twenty-first century. In the first six months of 2001, McDonald’s opened 96 restaurants in China, totaling 430 restaurants altogether. It plans to open 100 stores each year from 2003 to 2013. McDonald’s record of success in Russia did a turnaround in 1998 when the Russian economy collapsed because of the devaluation of the ruble. However, with, sales and growth on the rebound in Russia, McDonald’s had 73 stores by the end of 2001. In fact, it is McDonald’s success in China, Russia, and a couple of European countries that is one of the few positive notes in McDonald’s 2001 annual report. The 2001 letter to shareholders written by the chairman and CEO of McDonald’s opens by saying, “From many different perspectives, 2001 was one tough year.” He goes on to say, “Our 2001 performance was hampered by the strong U.S. dollar and weak economies in many countries in which we operate.” The continued economic crisis in Asia and Latin America and the economic recession in the United States led to reduced profits. In 2001, McDonald’s was forced to close down 163 unproductive stores in countries whose economies are struggling. When questioned about how world economic situations affect the company’s expansion plans, Matt Paull, the chief financial officer (CFO) of McDonald’s replied, When planning openings, we consider each market’s current economic conditions, long-term demo-graphic and lifestyle trends, competitive environment and stage of development, as well as the poten-tial effect on existing McDonald’s restaurants and returns.

countries, this tem-porary slowdown makes good business sense. What will be the future of McDonald’s worldwide operations? Will it continue to focus more on the United States, Canada, and Europe as stated earlier, or will it return to the emerging markets where growth is higher, although more unstable? Will McDonald’s management be able to choose the right countries, commit the right amount of resources, and provide a strategy for sound economic growth for the future? Introduction Understanding the economic environments of foreign countries and markets can help man-agers predict how trends and events in those environments might affect their companies’ future performance there. In this lesson, we discuss the economic environments of the countries in which an MNE may want to operate. An MNE such as McDonald’s knows how to operate in its home-country economic system. However, when such a company wants to do business in another country for the first time, it needs answers to questions such as these: 1. Under what type of economic system does the country operate? 2. What are the size, growth potential, and stability of the market? 3. Is the company’s industry in that country’s public or private sector? 4. If it is in the public sector, does the government also allow private competition in that sector? 5. If the company’s industry is in the private sector, is it moving toward public ownership? 6. Does the government view foreign capital as being in competition with or in partnership with public or local private enterprises? 7. In what ways does the government control the nature and extent of private enterprise? 8. How much of a contribution is the private sector expected to make in helping the gov-ernment formulate overall economic objectives? These questions appear simple to answer. However, because of the dynamic nature of political and economic events, the answers are complex-or yet to be seen. For example, foreign companies have continued to invest in Hong Kong since the United Kingdom returned Hong

Based on these criteria, we reduced the number of restaurant additions over the past few years and expect to add 1,300 to 1,400 McDonald’s restaurants in 2002. About 60 percent of these open-ings will be in the U.S., Europe, and Canada, where economies are relatively stable and returns are strong. We also are adding restaurants in China, where the near- and long-term growth potential is enormous. At the same time, we are reducing openings iii-markets with weak economic environments until we see signs of improvement. Since we already have a clear competitive lead in these 160

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Kong to China in 1997, even though the business world is wondering whether China will sti-fle some of Hong Kong’s economic freedoms. Companies like McDonald’s, which invest in emerging markets, are experiencing enormous difficulties because the changes taking place in those countries are so rapid and unpredictable. The question is whether today’s global compa-nies can keep up with the world’s changing economic landscape. As Figure7.1 notes, economic forces are an important part of the physical and societal factors that help comprise the external influences on company strategy. Economic forces include such issues as the general economic framework of a country, economic stability, the existence and influence of capital markets, factor endowments, the size of the market, and the availability of a good economic infrastructure, such as transportation and communica-tions. Managers need to understand the nature of the world’s economies if they are going to make wise investment decisions. To provide them with a frame of reference, we will first describe countries by income level, location, and economic system. Then we will look at key economic indicators, such as economic growth, inflation, and surpluses and deficits that affect the decision of management on where to commit MNE resources and efforts. Finally, we will examine the potential of the major geographic regions in the world, with special emphasis on countries in economic transition. An Economic Description of Countries There are 207 countries in the world with populations of more than 30,000. Which of those countries are the ones where managers should commit resources? Although the answers vary by company, it is true that companies do business abroad for a variety of reasons, such as access to factors of production or demand conditions. Factor conditions, or production fac-tors, include essential inputs to the production process, such as human resources, physical resources, knowledge resources, capital resources, and infrastructure. Physical resources include weather, the existence of waterways to get goods to and from market, and the avail-ability of crucial minerals and agricultural products. Knowledge resources are best represented by research and development conducted by companies and governments. For example, the Silicon Valley in the United States is a hotbed of high-tech research. The U.S. government has also poured significant resources into the U.S. aviation industry for the development of mili-tary aircraft, and this technology has been helpful in developing the civilian aircraft industry as well. Capital resources include the availability of debt and equity capital that firms can use to expand. Infrastructure includes roads, port facilities, energy, and communications. Figure 7.1 Physical and Societal Influences on International Business

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Demand conditions, also known as market potential, include three dimensions: the composition of home demand (or the nature of buyer needs), the size and pattern of growth of home demand, and the internationalization of demand. The composition of demand is mown as the quality of demand, and size is known as the quantity of demand. Factor conditions are especially crucial for investments made for the production of goods, but demand conditions are crucial for market-seeking investments. The combination of factor and demand conditions, along with other qualities, makes up the location-specific advantage that a country has to offer domestic and foreign investors. Countries Classified by Income Although we can classify countries along any of the dimensions mentioned earlier, the key dimension we use to distinguish one country from another is the size of demand, or gross national income (GNI), formerly referred to as gross national product (GNP). In particular, we classify countries according to per capita GNI, or the size of GNI of a nation divided by its total population. Those countries with high populations and high per capita GNI are most desirable in terms of market potential. Those with low per capita GNI and low popula-tions are least desirable, and the other countries fit somewhere in between. What is GNI? It is the broadest measure of economic activity. It is the market value of final goods and services newly produced by domestically owned factors of production. For example, the value of a Ford car manufactured in the United States and the portion of the value of a Ford manufactured in Mexico using U.S. capital and management counts in U.S. GNI. However, the portion of the value of a Japanese Toyota manufactured in the United States using Japanese capital and management would not be counted in U.S. GNI, but it would be counted in Japanese GNI. The World Bank and other institutions now use GNI, but the definition and measurements remain the same as GNP used previously. An alterna-tive to GNI is gross domestic product (GDP), the value of production that takes place within a nation’s borders, without regard to whether the production is done by domestic or foreign factors of production. So both a Ford and a Toyota manufactured in the United States would be counted in U.S. GDP, but a Ford produced in Mexico would not be. Why do we use GNI to describe countries? The World Bank (www.worldbank.org), a multilateral lending agency, uses per capita GNI as a basis for its lending policies. The World Bank Group was founded in 1944 by the United Nations. It consists of five closely associated institutions: the International Bank for Reconstruction and Development (IBRD), the International

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A global concern is the growing gap between rich and poor, especially in many developing countries. The photo shows the stark contrast between urban slums and upper-income housing in Caracas, Venezuela.

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Development Association (IDA), the International Finance Corporation (IFC), the Multilateral Guarantee Agency (MIGA), and the International Center for Settlement of Investment Disputes (ICSID). The World Bank is comprised of 183 countries, and its major objective is to provide development assistance to countries, especially the poorest of the poor. It uses the measure per capita income to identify those countries that need the most help. In particular, its programs include • Investing in people, particularly through basic health and

education. • Focusing on social development, inclusion, governance, and

institution-building as key elements of poverty reduction. • Strengthening the ability of the government to deliver

quality services, both efficiently and transparently. • Protecting the environment. • Supporting and encouraging private business development. • Promoting reforms to create a stable macroeconomic

environment, one that is conducive to investment and longterm planning? The activities of the World Bank are important to MNEs, because they build infrastruc-ture and promote economic growth and stability, thus improving the quality and quantity of demand. In particular, the World Bank is most interested in eliminating poverty and its demand-reducing influences. The World Bank classifies economies into one of the following categories according to per capita GNI. Low income

$755 or less in 1999

Middle income

$756-$9,265

Lower middle income

$756-$2,995

Upper middle income

$2,996-$9,265

High income

$9,266 or more

The World Bank refers to the low- and middle-income countries as developing countries, even though it recognizes that not all “developing” countries are alike-nor are they all “developing.” Developing countries are also known as emerging countries, a term also used to distinguish the capital markets (debt and equity markets) in those countries from the cap-ital markets in the more advanced countries. In addition, the World Bank’s terminology does not imply that the high-income countries have reached some preferred or final stage of development. High-income countries are also sometimes called developed countries or industrial countries. Initially, this was because those countries had a relatively high percentage of their GNP and employment from industry rather than from agriculture. Now, however, these countries have a larger percentage of their GNP and employment tied up in services rather than industry. But the term industrial country is still popular. The developing countries; adude different types of countries-some with large populations, such as China (1.2 billion people) and India (997 million people), and others with small populations, such as Guyana (697,181 people). These countries also include counties in economic transition to a market economy, such as China, Poland, Russia, and Vietnam. Some developing countries, especially those in Asia and Latin America, are generally moving

forward, whereas others, especially some in Africa, are not making much progress. The high-income countries are clustered in just a few geographic areas, whereas the developing countries are found in all areas of the world the relative imbalance among the low-, middle-, and high-income countries in terms of number of countries, total GNI, and population. The high-income countries generate nearly 80 percent of the world’s GNI, but they represent a relatively small number of countries and population. This illustrates the quandary that manager’s face. The high-income countries are a natural place to do business because of the quality and quantity of demand, but the developing countries exhibit tremendous potential because of the sheer size of the population-74.8 percent of the total number of countries and 85 percent of the total population. It might be safer to focus on the high-income countries because of their relative political and economic stability, but the future is in the developing countries, and managers must establish a strategy for penetrating them in the short and long-term. Another measure of wealth, per capita GNI, is computed by taking the GNI of a country and converting it into dollars at market rates and then dividing the total by the population. However, the World Bank points out that nominal exchange rates (the actual market rates not adjusted for inflation) do not always reflect international differences in prices. So the World Bank has come up with GNI per capita in international dollars converted at purchasing power parity (PPP) rates. PPP is the number of units of a country’s currency required to buy the same amounts of goods and services in the domestic market that $1 would buy in the United States provides some striking comparisons between GNI per capita and PPP GNI per capita for a small sample of countries. Note how much higher PPP income is for China and the Czech Republic than regular per capita GNI and how much lower Japan’s PPP income is. In China’s case, measuring its per capita income in PPP terms would raise it from a lower-middle-income country to an upper-middle-income country, which is more consistent with people’s perceptions of economic improvements in China. The United Nations publishes an annual report, the Human Development Report that ranks countries according to the Human Development Index. The index measures a coun-try’s achievements by looking at life expectancy, education, and income per person. The index does not include political freedom or inequality measures. The index for 2002, as shown in that the United States ranks second in per capita GDP but only sixth in the Human Development Index; it is outranked by neighboring country Canada. Countries Classified by Region Much of the World Bank data for developing countries is provided by geographic region, and this factor will be especially important as we discuss economic growth in a later section of the lesson. East Asia and Pacific Latin America and the Caribbean The Middle East and North Africa South Asia

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These designations are important to MNEs, which tend to organize their operations along geographic lines. Managers can use the data compiled and disclosed by the World Bank to spot trends in key markets. Investors can use the data to analyze where potential growth and risks exist in the regions where their companies operate. Countries Classified by Economic System A final way of classifying countries is by their economic system. Every government struggles with the right mix of ownership and control of the economy, as illustrated in Figure 7.2. Ownership means those who own the resources engaged in economic activity-the public sector, the private sector, or both. Public sector ownership of economic activity refers to the existence of state-owned enterprises. A good example would be China prior to the reforms initiated in 1978 by Chinese leader Deng Xiaoping. At that time, all enterprises in the coun-try were owned by the state. Private enterprise was neither permitted nor encouraged. The same could be said of all the countries under the control of the Soviet Union, such as Poland and Czechoslovakia (now the countries of the Czech Republic and Slovakia), where state- owned enterprises generated most of the economic activity of the country. However, state- owned enterprises are not just a phenomenon of the communist countries. Countries like Brazil in South America, India in South Asia, and France in Europe also have large state -owned enterprises that are an important part of the overall economy. Hong Kong and the United States are examples of the absence of state ownership in major economic activity. Although there are extremes, most countries are a mixture of public and private ownership of economic activity. The degree varies, but most countries with sig-nificant state-owned enterprises, such as those mentioned earlier, are moving toward less, not more, ownership of enterprises. This is known as the process of privatization, which we will discuss later in the lesson. Control of economic activity refers to the fact that resources may be allocated and controlled by the public or the private sector. Each year, the Heritage Foundation and the Wall Street Journal publish an index of economic freedom in which they rate countries according to 50 variables organized into 10 economic factors: trade policy, fiscal burden of government, government intervention in the economy, monetary policy, capital flows and investment, banking and finance, wages and prices, property rights, regulation, and black markets. The study is helpful insofar as it identifies ways that governments control economic activity and the degree to which they do so.

Figure 7.2 Relationships Between Control of Economic Activity and Ownership of Production Factors Their 2002 index classifies 156 countries as follows: Categories Countries

Number of Countries

Examples Of

Free

14

Hong Kong, Singapore, United States

Mostly free

57

Czech Republic, Japan, Canada

Mostly unfree

72

Zambia, Russia

Repressed

13

Iraq, Cuba, North Korea

In most cases, countries at the top of the index also have a high degree of political freedom; all of the countries at the bottom of the index have no political freedom. In addition, there is a high correlation between economic freedom and economic growth: the freer an economy, the bet-ter off the people-at all economic levels. Countries that are high in economic freedom have more control in the private than in the public sector. However, there are some advanced countries with significant government interference in the economy. Two examples are Japan and South Korea. After World War II, the Japanese government intervened in the economy in a significant way, even though it was not involved in the ownership of companies. For example, government agencies such as the Ministry of Finance, the Bank of Japan, and the Ministry of International Trade and Industry (MITI) helped establish a broad vision of Japan’s future that rejected individualism and open mar-kets. The government protected industry from outside competition; supported funding of preferred industries; told private banks which companies to lend to; and controlled access to technology, foreign exchange, and raw materials imports. South Korea and much of Asia followed that same model, also known as state capitalism, by permitting government inter-vention in the operation of the economy. This led to spectacular growth during the decades of the 1970s, 1980s, and early 1990s. Market Economy Now we need to take the concepts of ownership and control and put them into the context of two major economic systems: a market economy and a command economy. A market economy is one in which resources are primarily owned and controlled by the private sector, not the public sector. The key factors that make the market economy work are consumer sovereignty-that is, the right of consumers to decide what to buy-and freedom for companies to operate in the market. Prices are determined by supply and demand. In a market economy, for example, the price of gasoline rises during holidays because of the excess of demand over supply. Rising prices bring supply and demand into balance. At higher prices, consumers will eventually consume less, resulting in a drop in demand to match existing supply. Command Economy In a command economy, also known as a centrally planned econ-omy, all dimensions of economic activity, including pricing and production decisions, are determined by a central government plan. The government owns and controls all resources. The government sets goals for all business enterprises in the country-how much they pro-duce and for whom. In this type of economy, the government considers itself a better judge of resource allocation than its

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Sub-Saharan Africa

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businesses or citizens. To use the gasoline example described earlier in the market context, the price of gasoline always stays the same in a command econ-omy, because the government determines its price. When supply becomes tight, people line up and buy gasoline until the supply is exhausted, so supply is allocated by the queue rather than by price. Before prices were freed in Russia, people used to say that if they ever saw a line, they just stood in it. When they got to the front of the line, they bought whatever was being sold. Even if they didn’t need the item, they figured that someone in their extended family did, so they just bought it. When the supply ran out, there wouldn’t be any more left, no matter what price you were willing to pay.

Notes -

Mixed Economy In actuality, no economies are purely market or completely command. Most market economies have some degree of government ownership and control, whereas most command economies are moving toward a market economy and away from command concepts. If you think of economic systems as a spectrum with market on one end and com-mand on the other, Hong Kong and the United States would represent two of the countries at the market end of the spectrum, and Vietnam and North Korea would represent two countries at the command end of the spectrum. In Hong Kong and the United States, the government plays a very small role in economic activity, desiring instead to provide a stable environment in which economic activity can take place. In communist countries such as Vietnam arid North Korea, the government still owns and controls most aspects of economic activity. China is an example of a communist country that is trying to move from command to market. Another example of a mixed economy is market socialism, in which the state owns sig-nificant resources, but in which allocation of the resources comes from the market-price mechanism. France, as mentioned earlier, is a good case in point. Although the government owns significant economic resources, it allows supply and demand-rather than government fiat-to set prices. Sweden is a country that owns few economic resources, but it levies heavy taxes to fund an aggressive social program. Although the market determines prices, a lot of economic activity is controlled by government fiscal policies. As mentioned in the eight questions raised at the beginning of the lesson, managers need to be aware of both the type of economic system in which they are doing business and what the role of their companies is and is likely to become. Many Western managers com-plain about the government bureaucracy in China and the degree of influence of the Chinese government in economic decision-making. However, China is going through a transition, so it is important for managers to understand the direction and speed of change and how their own industries will be affected by these changes. The same is true of any country, especially those going brough transition, so managers need to understand the context of the owner-ship and control of resources of the countries where they wish to operate. In addition, the degree of interference by the government may vary by state within a country, especially those that are quite decentralized.

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