1 ECONOMICS 3150B Fall 2015 Professor Lazar Office: N205J, Schulich

2 Lecture 18: November 19 Ch. 8

3 Mobility of Capital International capital movements – capital account transactions –Distinction between physical and financial capital Importance of rules – ownership, tax (repatriation of profits) Debt instruments – no change in control/ownership –Covenants restrict behavior of firms –Transparency, measurement of risk –Markets for risk Equity –May change ownership, control –Institutional investors –Sovereign funds –Foreign direct investment

4 Mobility of Capital H-O Model: –2 factors of production – capital (K), labor (L) –2 products – present (Y1) and future (Y2) production of same product –Y1 uses K more intensively –A has relative abundance of K Pre-trade: –{PK/PL} A < {PK/PL} B –{P1/P2} A < {P1/P2} B

5 Mobility of Capital Trade in products –No flows of factors of production; no capital flows  capital account = 0 and exchange rate determined by trade balance which must be = 0 Migration of L –From B to A  no capital flows, trade not necessary Mobility of K –From A to B  no labor migration, no trade flows –During period of capital flows, home country’s currency depreciates; when capital flows end, no further change in exchange rate and both current account and capital account = 0 –Future interest, dividend payments from foreign to home; so foreign must have surplus in trade in goods to offset deficit in trade in services –Basis for trade in H-O model?

6 Direct Foreign Investment Inflows(US$ B)Outflows(US$ B) Country Australia Canada France Germany Iceland Mexico NA Poland Spain UK US Brazil Russia

7 Mobility of Capital Capital should move from A to B in search of higher relative returns Lucas Paradox: Why doesn’t capital flow form rich to poor countries? Lower productivity of capital in capital poor countries (B in example) – why? –Management capabilities –Social efficiency – institutions (bad governance, corruption, red tape), public policies (taxation, absence of private property rules, inadequate infrastructure, poor education), culture –Risk premiums – country, currency

8 Mobility of Capital Foreign investment restrictions –Canada used to have FIRA (Foreign Investment Review Agency) All foreign takeovers involving asset beyond a certain size were subject to review Takeover had to produce benefits for Canada S. 20 Investment Canada Act: acceptability tests – enhanced employment, increased exports, improved productivity, greater technology development, compatibility with Canada’s national, industrial and cultural policies Weakened over time Intervened to stop acquisition of Potash by BHP Billiton –Limits on SOEs –Limits continue to exist in transportation, banking, broadcasting, telecommunications, uranium

9 Mobility of Capital Foreign investment restrictions –Competition Policy Review Panel recommends new screening criteria and removal of foreign ownership limits in number of industries (airlines, telecommunications, broadcasting) Only review acquisitions worth more than $1 B Criterion should be changed from approving deals demonstrating net benefit to Canada to rejecting deals that would be contrary to Canada’s national interest

10 Mobility of Capital Foreign investment restrictions in most countries Xenophobia –Restrictions against Chinese companies –U.S. actions against Dubai Ports –China restricts foreign companies –Major trade barrier going forward out of recession as companies restructure

11 Mobility of Capital Ethical funds, green funds – should they be supported Boycotts Human rights and sovereign funds –Should there be investment restrictions on sovereign funds from countries that do not meet certain human rights standards? Morgan Stanley: $US5 B (5%) stake sold to China Investment Corporation Citigroup: US$7.5 B (4.9%) stake sold to Abu Dhabi Investment Authority UBS: CHF11 B stake to Singapore Investment Corporation

12 Existence of Firms Internalization Technological Transactions costs

13 Existence of Firms Transactions costs Costs in using markets –Search costs – suppliers, prices –Negotiating, writing, monitoring and enforcing contracts Classical firm as nexus of contracts – hub/spoke Duration of contracts and increasing complexity –Uncertainty re. future states –Increasing number of contingencies – increasing complexity –Incomplete contracts – trade-offs between more complex contracts/higher costs and simpler, incomplete contracts –Opportunistic behavior – incentives to breach contracts Proprietary rights to information – investment ideas, market demands, product design, service innovations, etc. –Value depends on package of rights and other factors – cannot contract for all factors

14 Existence of Firms Options Markets and firms alternative means for completing related sets of transactions Short-term contracts – costs, uncertainty re. supply Long-term contracts – opportunistic behavior Ownership/control – internalization

15 Existence of Firms Advantages of engaging in market transactions – outsourcing a new term for an old idea, namely, using the market to acquire inputs or sell outputs –Specialization/focus for firm –Market prices serve as reference points for internal transfer pricing –Economies of scale – ability to serve 3 rd party customers –Link between performance/rewards

16 Existence of Firms Internalization (insourcing) – avoid using marketplace by ownership of inputs, expansion of value-added activities conducted within firm –Bargaining power vis a vis market – credible threat to shift production –Inefficiencies as firm becomes larger Control problems associated with bounded rationality (limits to information any person can absorb and massage); weak incentives (difficulty in measuring direct contributions of individuals or divisions to overall financial performance of company); distortion as information (decisions) pass through more levels within organization

17 Existence of Firms Internalization Vertical integration, horizontal diversification Reduce transactions costs Economies of scale, scope Transferability of source of competitive advantage (design, marketing, costs, superior management, reputation) Proprietary information Tax advantages – transfer pricing Quality control – minimize liability risks Entry deterrence