1. Financial Environment Alternative types of financial sector organization (C) 2015 Melvin H Jameson

2. Functions of a financial system: Payment system - facilitate trade Link savers and borrowers ● Allocation of capital- investment decisions ● Corporate governance- control within the enterprise (C) 2015 Melvin H Jameson

3. Alternative forms of financial sector Arise from alternative approaches to its tasks for example allocation of investment capital ● Direct government allocation of all resources, =command economy ● Examples: Soviet Union, North Korea, Maoist China (C) 2015 Melvin H Jameson

4. Internal effects - command ● All production by state-owned enterprises following the central plan ● Banks provide financing where directed by plan ● Payment system not too different from market system Consequences ● Money, prices and interest rates viewed only as a means of account, not a means of allocation. Thus they need not reflect relative scarcity. ● Currency is non-convertible. ● Governance is a political function (managers appointed) (C) 2015 Melvin H Jameson

5. Implications for MNE - command ● Very limited opportunities for activity and tightly controlled by and negotiated with host government ● Trade: ● Limited to products deemed essential by host government ● Investment: even more limited ● Problems in realizing revenue or profit ● Internal markets controlled, currency non- convertible ● Host government approval of FX for purchases deemed essential ● Barter arrangements [Pepsi in Soviet Union] (C) 2015 Melvin H Jameson

6. Alternative: hybrid system Directed growth but without trying to plan the entire economy ● Investment (capital allocation) government directed. ● Production left to market forces and private enterprise Examples: ● Japan (post WWII) ● S. Korea ● China today (with both private and SOEs, “dual track”) (C) 2015 Melvin H Jameson

7. Internal implications - hybrid ● Producers respond to market ● Banks lend following government guidance Consequences ● “Financial repression” – distorted capital markets ● Savers offered artificially low interest rates ● Non-favored borrowers lack access to capital ● Creates pressure for a grey market (shadow banking) ● Requires currency controls to maintain ● Corporate governance can be more lender oriented than shareholder oriented. (C) 2015 Melvin H Jameson

8. Implications for MNE - hybrid ● Trade ● Product market functions normally ● Currency convertible for trade purposes ● Investment: ● Limited to highly controlled ventures negotiated with host government ● Capital account cash movements limited and subject to approval ● Problems in realizing revenue or profit ● currency non-convertible for capital acct. ● Host government approval of FX required (C) 2015 Melvin H Jameson

9. Alternative: weak market infrastructure Not policy as much as underdeveloped institutions ● Legal system ● Legal rights available ● Enforceability of legal rights ● Quality, cost and availability of information ● Thin markets/high transaction costs Examples: many emerging markets (C) 2015 Melvin H Jameson

10. Internal implications: weak institutions Generally limit access to external capital ● Legal system ● Weak shareholder rights limit equity ● Weak creditor rights limit lending ● Lack of information discourages external investment ● High transaction costs do the same Create incentive to avoid markets and contracts ● Conglomerate groups, often family controlled ● Personal relationships very important (C) 2015 Melvin H Jameson

11. Internal implications: weak institutions Create an incentive to avoid markets and contracts The financial system adapts in response ● Conglomerate groups, often family controlled ● Personal relationships very important (C) 2015 Melvin H Jameson

12. Some types of market financial systems Financial market emphasis Anglo-American system Bank emphasis German system (Family) Group structure Japan: Zaibatsu → Keiretsu Korea: Chaebol Latin America, SE Asia etc. (C) 2015 Melvin H Jameson

13. Financial system and legal system Market system Requires strong legal system, enforceable contracts - bankruptcy rules - minority shareholder rights Bank system Legal system available, but more relationship based Groups An “internal capital market” substitutes for enforceable external legal contracts (C) 2015 Melvin H Jameson

14. Implications for the MNE ● Potential Opportunity Underdeveloped local financial markets can be an advantage for the MNE with (reasonably) open access to world markets. ● Potential Challenges Underdeveloped local markets are often combined with financial repression limiting access to world markets or the corporate parent. (C) 2015 Melvin H Jameson

15. Quality of legal environment influences the financial system ● General rule of law Enforceability of contracts affects all areas; particularly finance ● Creditor rights If weak inhibit banking and all lending ● Shareholder rights If weak inhibit equity markets; lead to concentrated ownership (C) 2015 Melvin H Jameson

16. Market infrastructure Rule of Law ● Accounting standards ● Efficiency of legal system ● Corruption ● Will the government repudiate contracts (C) 2015 Melvin H Jameson

17. Market infrastructure Creditor rights ● Does a reorganization require creditor consent? ● Do secured creditors rank first in asset distribution? ● Does an automatic stay prevent secured creditors from seizing their security during the bankruptcy process? ● Does debtor control assets during the legal process? (C) 2015 Melvin H Jameson

18. Market infrastructure Shareholder rights ● Are all shares entitled to one and only one vote? ● Is proxy voting by mail allowed? ● Is cumulative voting (all my votes for one director) or proportional board representation of minorities allowed ● Do minority shareholders have a judicial venue to challenge board decisions? ● Do existing shareholders have a preemptive right to purchase new stock issues? (C) 2015 Melvin H Jameson

19. Alternative: minor intervention Intended to benefit politically favored group or industry, for example “industrial policy” ● Taxes or subsidies Consequences ● Relatively minor distortions ● Requires only limits on who benefits (C) 2015 Melvin H Jameson

20. Alternative: major intervention Intended to benefit politically favored group or industry ● Direct government spending ● Nationalization of select industries Consequences ● Price controls ● Generally requires currency controls as well ● In extreme cases can lead to partial collapse of the market system. (C) 2015 Melvin H Jameson

21. Zimbabwe 1994:25% 1998:48% 2002:199% 2006:1,281% ● August 2006: 1 st redenomination ZWD$1,000 → ZWN$1 2007:66,212% ● August 2008: 2 nd redenomination ZWN$10b → ZWR$1 Dec. 2008 (estimate):6.5x10 108 % or 91% per day ● March 2009: Zimbabwe dollar suspended: informal (U.S.) dollarization (C) 2015 Melvin H Jameson

22. Discussion: Venezuela ● Price controls ● Currency controls ● Rampant smuggling (C) 2015 Melvin H Jameson

23. Implications for MNE – intervention ● Interference in domestic market such as price controls ● Currency blockage ● MNE may better placed to meet resulting funds transfer challenge than other firms. (C) 2015 Melvin H Jameson