International Trade

Outline
Rationale for international trade - Trade Theories. Costs and Benefits of Free Trade. Concepts Relating to International Trade & Exchange Rates. Balance of Payments (BOP). Policy Measures to correct Dis-equilibrium in BOP. Exchange Rate in India. Indias BOP.

Trade Theories

Trade Theories
Absolute Advantage- Adam Smith (1776). Comparative Advantage- David Ricardo (1817). Factor Endowments- Heckscher-Ohlin (1919 & 1933). National Competitive Advantage- Michael Porter (1990).

 Absolute Advantage in production of any product is possessed by a country if it is more efficient than any other in producing it. In other words, the productivity is higher for that good compared to other countries. Therefore, Adam Smith argued that countries should specialise in the production of such goods in which they have an Absolute Advantage.

Absolute Advantage as the basis of trade

Resources required to produce 1 ton of cocoa and rice in a two-commodity, two-country world. Country Cocoa Rice A 10 20 B 40 10 Here, country A has an absolute advantage in production of Cocoa, while B has it in Rice (why?). Therefore, A should specialise in Cocoa and B in Rice.

Illustration of Absolute Advantage

 It assumes that every country has Absolute Advantage in some good or the other. It is, however, possible that some countries might possess an Absolute Advantage in all goods it produces relative to others. Is it, therefore, still profitable for such a country to trade?

Main Limitation of Smiths Theory

Comparative Advantage as the Basis of Trade.

In Ricardos view even if a country had absolute advantage in producing all goods, it could still gain from international trade if it specialised in goods where it had the most efficient production or comparative advantage. Comparative Advantage is the comparison among producers of a good according to their opportunity cost. The good that has the least opportunity cost is the one in which the country possesses the most Comparative Advantage.

Comparative Advantage as the Basis of Trade (Contd).

The benefit from international trade accrued from Comparative Advantage because this would result in enlarging the overall consumption possibility, relative to a situation where each country produced all goods. We first illustrate how opportunity cost may be used as the basis to judge a countrys Comparative Advantage in a two-country, two-commodity world. We next show how trade might be profitable to both countries in a two-country, two-commodity world in which one country has absolute advantage in both commodities.

Illustration of Comparative Advantage

In our hypothetical example we give details of resources needed to make one unit of the commodity (here we assume that one unit of commodity equals 1000 tons or metres). Country Food Clothing A 10 / ton 20 / metre B 8 / ton 5 / metre Here, as will be noticed, country B has absolute advantage in producing both commodities, i.e., the productivity for each commodity is higher relative to that in country A.

Comparative Advantage based on Opportunity Cost

Comparative Advantage based on opportunity costs differ: Opportunity Cost of: 1 unit of food 1unit of cloth Country A metre cloth 2 tons food Country B 1.6 metres cloth 0.625 ton food

Gains from trade

Assuming that both economies have 80 resource units each, we first show the Output or Production Possibility for each good if all resources were used to produce food or clothing by each country. This helps us define a straight line Production Possibility Frontier.

Output / Production Possibility Country Food Clothing A 8000 tons 4000metres B 10000 tons 16000 metres

Gains from trade (contd)

Next we fix how resources are used by both countries in a no-trade environment. We assume that both economies distribute productive resources equally between food and clothing to arrive at the pre-trade consumption levels. Pre-trade output / consumption Country A B Total Food 4000tons 5000tons 9000tons Clothing 2000metres 8000metres 10000metres

Gains from trade (contd)

Gains from trade will only accrue if as a result of trade the consumption level of both commodities goes up in both countries. This implies that the combined output of both countries for both commodities has to be higher than in the pre-trade situation. (What is the combined output in the pre-trade situation?). According to the Comparative Advantage Theory this would be possible if the respective countries focussed / specialised in the good they had the least opportunity cost. (What is it for A & B?).

Gains from trade (contd)

But the matter is not that simple. If we examine the intrinsic capabilities of both countries in our example, if both countries exclusively use their entire resources to produce the good they have comparative advantage in profitable trade may not be possible. Let us see why? Possible Output with Exclusive Specialisation Country A B Total Food 8000 0 8000 Clothing 0 16000 16000

Pre-Trade total

9000

10000

Gains from trade (contd)

As we observed in the preceding slide, with exclusive specialisation, the total Food output would fall short of the pre-existing combined consumption level of both countries. But, total output of Clothing substantially exceeds the pre-existing combined consumption level. Does this mean trade is not possible? This only emphasises the point that the solution lies in partial specialisation, to start with, so that the consumption level of both goods rises in the two countries. It also highlights that changes in production combinations can only take place gradually. In this case a possible solution could be for A to totally specialise and for B to partially specialise. Let us see how.

Gains from trade (contd)

Possible Combination of Outputs Country Food
A
B Total

Clothing
0
12000 12000

8000
2500 10500

Assuming that one unit of Food exchanges for one unit of Clothing the Gains from Trade are: Country A B Food (5000 4000)= +1000 (5500 5000)= +500 Clothing (3000-2000)= +1000 (9000-8000)= +1000 (12000 10000)= +2000

Combined Gain (10500 9000)= +1500

Limitations of this Approach

Our two-commodity, two-country analytical framework illustrates that Comparative Advantage may not necessarily lead to exclusive specialisation as has been postulated by theorists. The extent to which specialisation might take place very much depends on relative capabilities of the countries concerned. If an economy already enjoys a high level of consumption the rest of the world may not be able to fulfil its needs. Therefore, it might have to persist with production of even such goods in which it may have a relatively low Comparative Advantage. But the real world is more complex than the world we employed to appreciate the benefits of trade. In the simple world we constructed it is very easy for two countries to arrive at an exchange ratio of goods that benefits both countries and a win-win situation can be arrived at where the countries can shift their Consumption Possibility Frontier rightwards.

Limitations of this Approach

In the real world there are many countries and multiple goods. In such a world it may not be possible to negotiate a win-win situation as mush depends on complex market forces and the dynamic changes in relative disparities in the world. Therefore, gains from trade would depend on the prevalent price levels in a fiercely competitive world market. Moreover, the impact of prices on trade dynamics would very much depend on the exchange rates between currencies. But before we move to considering these aspects very briefly it must be clarified that (i) Comparative Advantage is the major underlying basis for international trade (ii) more advanced theories, which we have excluded from our discussion, really outline micro factors that inter-temporally influence Comparative Advantage, bringing us to the final point (iii) that Comparative Advantage is dynamic, which may not remain permanently with a nation for a particular good, shifting from nation to nation as the world evolves and develops.

Costs and Benefits of International Trade

Free Trade has Costs and Benefits

So far we have considered the rosier side of free trade and how it results in everyone gaining in terms of a larger volume of goods that accrue at the aggregate level from a given set of resources. But within the economy there may be large segments who might lose out, while there might be equally large, if not larger segments, who might be gainers. Therefore, benefits may not be realised without some costs. For instance, we have not considered the fact that moving from a regime of trade restrictions to a situation of free trade takes time. And, over that time, via the dynamic process of change a restructuring of output takes place. To take a balanced view on the issue we have must consider the costs.

Free Trade has Costs and Benefits

In theory we presume that such restructuring takes place overnight and economies redeploy resources to channels of activity where a country might have Comparative Advantage instantaneously. But does such a smooth transformation take place? A major fallout of transition would obviously be the closure of certain industries on account of increased competition, which would result in unemployment. As a group, therefore, such people would be classified as losers consequential to free trade. Depending on the size the costs to society would vary. But just as certain industries might face closure many other industries would get a boost as other nations open up their economies. Therefore, many of those who we have identified as losers would possibly be absorbed in emerging industries overtime.

Free Trade has Costs and Benefits

Ultimately, the impact on society would depend on how employable workers of waning industries are growing industries and whether or not they are able to get at least the same rewards as they got earlier. Quite apart from the humanitarian perspective from which we have looked at costs and benefits of free trade so far, we may more generally look at these from the viewpoint of producers and consumers. A general impression created is that as a consequence of free trade the dynamics of global competition should always lead consumers benefiting relative to producers. But this outcome presumes that global competition would always lead to a fall in prices via potential imports.

Free Trade has Costs and Benefits

It would, however, be more accurate to judge the impact as long-term global price equalisation process where in the case of a particular country the prices of some goods might fall, while for residual goods it might rise. The direction of change would very much depend on the relative differences between global prices and the domestic pre-free trade equilibrium prices, which would vary from industry to industry. In industries where the global prices are lower than the pre-free trade equilibrium level there would certainly be the ones where there would be a downward pressure on domestic prices. Here consumers would be the gainers, while the producers the losers.

Free Trade has Costs and Benefits

On the other hand, in industries where global prices turn out to be higher than pre-free trade equilibrium levels there would be a price rise as domestic prices would rise towards global levels. Here producers would tend to gain more than consumers. At the aggregative of macro level the impact of free trade on a particular country would very much depend on its pre-free trade structure of production and price relativities. This would determine whether economies are net beneficiaries or net losers for a considerable period of time after opening up.

Free Trade has Costs and Benefits

In the long-term economies generally always adjust to change. But it is the vision of the interim adverse impact that attracts opponents to free trade and it is the vision of the ultimate beneficial impact that has, at the same time, developed a considerable body of economic opinion in favour of free trade. It must be remembered that even if absolute free trade emerges in the world, it would not remove dynamic problems. Relative changes in different economies will always take place anyhow and individual countries will have to constantly adjust to minimise the costs of change. Ultimately it is true to say that there is no gain without pain.

Arguments for restricting trade

The jobs Argument. The National Security Argument. The Infant Industry Argument. The Unfair Competition Argument. The Protection as a Bargaining Chip Argument.

Arguments for restricting trade

These arguments are the outcome of domestic political economy, where politicians are sensitive to short term impact of policies. Some of these are valid from certain perspectives. At the same time we cannot ignore that at the global level politicians have taken a different posture, which is epitomised in the formation of the World Trade Organisation (Why?).

Concepts relating to International Trade and Exchange Rates.

Basic Concepts
Closed Economy:- An economy that does not interact with other economies of the world. Open Economy:- An economy that interacts freely with other economies around the world. Exports:- Goods and Services that are produced domestically and sold abroad. Imports:- Goods and Services that are produced abroad and sold domestically. Net Exports=Trade Balance:- The value of a nations exports minus value of its imports. Trade Deficit:- An excess of imports over exports, i.e., when net exports is a negative value. Trade Surplus:- An excess of exports over imports , i.e., when net exports is a positive value.

Balanced Trade:- A situation where Exports equal Imports.

Basic Concepts (contd)

Net Foreign Investment:- The purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.

There are two classes / types of foreign investment (i) Foreign Direct Investment (ii) Foreign Portfolio Investment.
As far as India is concerned we may also add external debt taken / given by the Indian government. Foreign Direct Investment:- A capital Investment that is owned and invested by a foreign entity is called foreign direct investment. Foreign Portfolio Investment:- An Investment that is financed with foreign money, but operated by domestic residents.

Exchange Rates
The exchange rate is the rate at which it converts against foreign currencies, which is the nominal exchange rate. Nominal Exchange Rate may also be defined as the rate at which a person can trade (i.e., buy or sell) the currency of one country for another. An Appreciation in the nominal exchange rate takes place when one unit of a currency can buy more of a foreign currency relative to the past or it is an increase in its value measured by the amount of foreign currency it can buy. A Depreciation in the nominal exchange rate takes place when one unit of a currency can buy less of a foreign currency relative to the past or it is a decrease in its value measured by the amount of foreign currency it can buy.

Exchange Rates (contd)

An appreciation in the nominal exchange rate makes foreign goods appear cheaper relative to the past and would, therefore, encourage imports or foreign purchases. It would also reduce export earnings measured in nominal terms relative to the past. A depreciation in the nominal exchange rate makes foreign goods appear more expensive relative to the past and would, therefore, discourage imports or foreign purchases. It would also increase export earnings relative to the past. However, appreciation / depreciation cannot make adjustments for relative differences in prices of goods between countries. The competitiveness or costliness of goods and hence the impact of nominal exchange rates on exports / imports depends on how relative prices change over time. Therefore, we also have a measure called the Real Exchange Rate.

Exchange Rates (contd)

Real Exchange Rate is the relative price of goods and services of two countries. Real Exchange Rate = Nominal Exchange Rate x Domestic Price Foreign Price In general Real Exchange Rate is computed for a basket of goods and services rather than a single commodity. An appreciation / depreciation of nominal exchange rate will only impact the real exchange rate if relative prices remain stable. On the other hand, real exchange rate would be affected without change in the nominal rate if relative prices alter. This makes relative inflation rates in countries as a key determinant of the real exchange rate.

Exchange Rates (contd)

A theory of determination of nominal exchange rates is the Purchasing Power Parity Theory, which states that a unit of currency should be able to buy the same quantity of goods and services in all countries. In other words, nominal exchange rate adjusts to equalise purchasing power of a currency globally and real exchange rate cannot change. While in the long-term there is a strong correlation between nominal exchange rates and inflation, there are major relative price differences in many goods and services that are not equalised by the nominal exchange rate. This is largely because the global economy is not completely free in terms of flows of goods, services and factors of production. Moreover, some goods are not tradable and many goods are not perfect substitutes.

Factors influencing exports, imports and net exports

The tastes of consumers for domestic and foreign goods. The prices of goods at home and abroad. The exchange rates at which people can use domestic currencies to buy foreign currencies. The cost of transporting goods from country to country.

The policies of government towards International trade.

Factors Influencing net foreign investment

The real rate of interest being paid on foreign assets. The real interest rates being paid on domestic assets. The perceived economic and political risks of holding assets abroad. Government policies that affect foreign ownership of domestic assets.

Some Macroeconomic Aspects

Net Exports always equal Net Foreign Investment. This is because every transaction related to Net Exports also affects the Net Foreign Investments by a like amount. For instance, Exports earn foreign currency, which may be treated as an investment in foreign asset. Similarly, foreign currency assets of the banking system are purchased by importers to import goods, which while increasing imports reduces the value of Net foreign investment. Given, Y= C + I + G + NX and S = Y C G, we have, S = I + NX. Since NX = NFI, S = I + NFI or the sum of Domestic Investment and Net Foreign Investment.

The Balance of Payments

What is the BOP?

The BOP of a country can be defined as a systematic statement of all economic transactions of a country with the rest of the world during a period of time, usually one year

...What is the BOP?

The systematic accounting does not refer to any particular system However this system which is generally adopted is double entry book-keeping system In this accounting system both sides of a transaction 'debit' and 'credit' are recorded Hence the BOP account always balances While some transactions involve physical transfer of goods, money and assets along with the transfer of the title, in some transactions, physical transfer is not necessary

Purpose of the BOP

The purpose of BOP accounting is to take stock of a country's foreign receipts and payment obligations and of assets and liabilities arising out of international economic transactions with a view to correcting unhealthy trends

...Purpose of the BOP

BOP accounting yields necessary information on the strength and weakness of the country in international economic relations By analysing the BOP accounts of past years, one can find the overall gains and losses from international economic transactions BOP statements give warning signals for future policy formulation, for eg. Building foreign exchange reserves on borrowed funds leads to an increase in indebtedness

Categories in the BOP Account

Current Transactions or Current Account These include export and import of goods and services, visible and invisible, unrequited receipts and payments.
Capital Transactions or Capital Account Include inflows and outflows of capital, which may increase or decrease a country's total stock of capital

Distinction between the Current and Capital Accounts

Current Transactions change (increase or decrease) the current level of consumption of the country or change the current level of its nominal income, whereas capital transactions change the capital stock of the country While current transactions are of flow nature, capital transactions are mostly of stock nature

...Current Account
Current Account items are also classified as Visible and Invisible items Visible Items include export/import of goods called 'merchandise trade' Invisible items include export/import of services, net inflow of remittances, net investment income (interest, dividends), banking sector flows

Balance of Trade Net Balance of the 'visible trade', i.e., difference between exports and imports of merchandise goods is called trade balance. If X>M it shows a trade surplus If X<M it shows a trade deficit

Current Account Balance

Sum of 'visible net' and 'invisible net' gives the balance on the current account and is called'Current Account Balance' If sum of the entries in the credit column is greater than that of the debit column it shows a Current Account Surplus If sum of the credit items is less than that of the debit items it shows a Current Account Deficit

Capital Account
Items of the capital account are: 1. External Assistance which means borrowings from foreign countries/agencies at a concessional rate of interest 2. Commercial Borrowings under which the Indian Govt. and Private sector borrow funds from world money markets at a higher market rate of interest 3. Non-resident Deposits- investments by NRIs who keep their surplus funds with Indian banks

Capital Account
4. Foreign Direct Investment in physical assets, or in bonds, shares in which the investor holds controlling power 5. Portfolio investment, including shares or bonds, either govt or private which do not entitle the holder with controlling power

Causes of Dis-equilibrium
1. Inflation : It makes imports relatively cheaper & exports relatively costlier; thus brings out DE especially when X & M are price elastic. 2. Business cycles : Countries will have high trade deficit in the period of prosperity when the prices are rising & vice versa.
3. Structural changes : Changes in stock of natural resources, demand & supply factors, technology, etc. bring out changes in capacity to export & import.

Causes of Dis-equilibrium
4. Developmental & Investment programme : Developing countries are heavily dependent on their imports for eco development & at the same time their exports do not rises due to inelastic nature of demand for their commodities 5. Seasonal variations caused by crop-failures (India before the mid-1970s) 6. Rapid growth of population and hence food imports 7. Demonstration effect of advanced countries

Policy Measures to Correct Dis-equilibrium in BOP

The Expenditure Switching Policy The Expenditure Switching Policy (Devaluation) - aims at correcting the dis-equilibrium in the BOP by switching domestic expenditure from imported to domestic goods or the other way round -it works through the changes in relative prices of imports and domestic goods

...The Expenditure Switching Policy

Devaluation is a deliberate policy action taken by the govt., to reverse the flow of domestic consumer expenditure from imported to domestic goods Devaluation increases prices of imports and reduces prices of exports Imports decrease, exports increase, BOP deficit reduces (Appreciation/Depreciation, is the result of the market mechanism)

BOP Adjustment through Expenditure Changing Policies BOP Adjustment through Monetary Policy -Contractionary monetary policy- interest rates rise- investment falls- income fallsdemand for imports falls- BOP deficit falls -Increase in interest rates result in short-term capital inflow- reduces BOP deficit

BOP Adjustment through Expenditure Changing Policies

BOP Adjustment through Fiscal Policy
-Contractionary fiscal policy- reduces aggregate demandfall in imports-investment falls- interest rate falls- but outflow of capital more than offsets decrease in importsBOP deficit increases
-Expansionary fiscal policy- aggregate demand risesinvestment rises- imports increase-interest rates rise- inflow of capital- but inflow of capital may be more than increase in imports- exports may also increase due to higher investment and production- overall BOP deficit falls

Trade Policy Measures

Trade Policy measures : Export promotion & Import substitutions Import duties, import quotas, encouragement to X through fiscal & monetary measures.

Instruments of Trade Policy

Tariffs Subsidies Import Quotas Voluntary Export Restraints Local Content Requirements Administrative Policies Anti-dumping Policies

Tariffs
Tax levied on imports which raises the cost of imports and also protects domestic producers from foreign competition Two categories - Specific tariffs: Levied as a fixed charge for each unit of a good imported - Ad valorem tariffs: Levied as a proportion of the value of the imported good. For eg. EU imposes tariff on imports of bananas from Latin America; the tariff amounts to 15-20% by value on the first 2.5 million tons of imports of bananas from Latin America.

Subsidies
Govt. payment to a domestic producer which lowers production costs, help them compete against foreign imports, and gain export markets Cash grants, low-interest loans, tax breaks, govt. equity participation in domestic firms

Import Quotas & Voluntary Export Restraints (VER)

Direct restriction on the quantity of a good imported into a country. Restriction is enforced by issuing import licenses to a group of individuals or firms. Voluntary Export Restraint is a quota on trade imposed by the exporting country, at the request of the importing countrys government. For eg. VER on auto exports to the US enforced by Japanese automobile producers in 1981. VERs often made more sense to to foreign producers as very often tariffs and import quotas might seem to be more damaging.

Local Content Requirements

Producers have to compulsorily source inputs required for production from domestic sources rather than use imported inputs Local content regulations have been widely used by developing countries to shift their manufacturing base from the simple assembly of products whose components are manufactured elsewhere into the local manufacture of component parts
Also been used by developed countries to try to protect local jobs and industry from foreign competition

Administrative Policies
Bureaucratic rules designed to make it difficult for imports to enter a country. For eg. Customs checks and barriers.

Anti-dumping Policies
Dumping- selling goods in a foreign market below their costs of production, or selling goods in a foreign market below their fair market value (includes a fair profit margin). Dumping is a method by which firms unload excess production in foreign markets. Anti-dumping duties/countervailing duties can be imposed by the govt. on offending foreign importsspecial tariff.

Exchange Rate in India

 Basic level determination of exchange rates takes place through the forces of demand and supply of one currency relative to another. Eg., if the demand for the dollar outstrips its supply and if the supply of rupee is greater than its demand, the dollar-rupee exchange rate will change. The dollar will appreciate against the rupee and the rupee will depreciate against the dollar. What are the factors that underlie the demand for and the supply of a currency? When will the demand for dollars exceed supply or when will the supply of yen exceed its demand

Exchange Rate Determination

The Purchasing Power Parity theory : Developed by Gustav Cassel after 1st world war. It states that exchange rate between two currencies is determined by equality of their purchasing power. Thus rate of exchange is determined by their relative price levels. If India requires to spend Rs. 50/ to purchase goods worth $ 1; then exchange rate would be Rs. 50 per $1.

Absolute & Relative PPP

Absolute PPP- refers to Equalisation of prices across countries through arbitrage (buying cheaper & selling costlier) Relative PPP- States that the rate of appreciation/depreciation of a currency is equal to the difference in inflation rates between the foreign and the home country. Eg. If Canada has an inflation of 1% and US has an inflation of 3%, US dollar will depreciate against the Canadian dollar by 2%. This Proposition holds well empirically especially when inflation differentials are large.

Fixed VS Flexible Exc Rate

Fixed Exchange Rate : Govt or monetary authority agrees to maintain the convertibility of their currency at a fixed rate either by enforcing or through pegging operations. Flexible Exchange Rate : Value of currency is allowed to be determined free by the market forces of D & S of foreign exchange.

Indias BOP

Current Account Deficit in BOP

Phase I (1956-57 to 1975-76) -Heavy deficits in BOP: period witnessed 3 wars, several droughts and first oil shock of 1973 -Govt resorted to severe import controls and foreign exchange regulations -Forex reserves at a low level, enough to finance 3 months imports -BOP deficit was financed through concessional assistance

Current Account Deficit in BOP

Phase II (1976-77 to 1979-80) -India had a small Current Account Surplus-0.6% of GDP -Forex reserves equivalent to 7 months of imports -Comfortable position due to rise in remittances of Indians abroad, strong growth in exports due to favourable international conditions, due to conservation efforts and increase in domestic production, India succeeded in controlling oil import bill -Expansion of activities of Indian firms in MiddleEast countries- export of construction services

Current Account Deficit in BOP Phase III (1980-81 to 1990-91) -Severe BOP difficulties -Earnings from invisibles since latter half of 1980s declined -Gulf Crisis further aggravated the scenario

Reasons for satisfactory BOP situation in 1990s

High Earnings from Invisibles- software service exports, private transfers (remittances) Rise in External Commercial Borrowings- over the period 1993-94 to 2001-02, ECBs accounted for 22% of total net capital inflows Non-Resident Deposits- Govt offered various incentives to NRIs to increase forex reserves of the country Role of Foreign Investment- incentives were offered for Foreign Direct Investment and Foreign Portfolio Investment

Why Current Account Deficit now?

From a current account surplus of $10.5 bn in 2003-04 the economy moved to a current account deficit of $6.3 bn in 2004-05 Apr-Aug 2005 Trade Deficit was $17431.2 mn compared with $9728.5 mn same period last year Due to rise in value of oil imports Also rise in value of non-oil imports (April-Aug 2005 value of both oil as well as non-oil imports increased 37%) Smaller invisible surplus Is a Current Account Deficit necessarily bad?

Capital account of the BoP

Net capital flows rose from $20.5 bn in 2003-04 to $32.2 bn in 2004-05 In 2004-05 there has been a shift in the nature of inflows, while net Foreign Direct Investment and Portfolio Investment inflows fell in 2004-05 compared to 2003-04, flow of loans increased There has been a return to reliance on debt which is again private rather than govt., and this increases the external vulnerability of the economy These capital inflows are necessary to finance the Current Account Deficit