PART A

1. With the help of examples describe the gains from international trade.

Gains from trade in economics refers to net benefits to agents from allowing an increase in

voluntary trading with each other. In technical terms, it is the increase of consumer surplus

plus producer surplus from lower tariffs or otherwise liberalizing trade. It is commonly

described as resulting from:

specialization in production from division of labor, economies of scale, scope,

and agglomeration and relative availability of factor resources in types of output by

farms, businesses, location and economies

a resulting increase in total output possibilities

trade through markets from sale of one type of output for other, more highly valued

goods.

Market incentives, such as reflected in prices of outputs and inputs, are theorized to

attract factors of production, including labor, into activities according to comparative

advantage, that is, for which they each have a low opportunity cost. The factor owners then use

their increased income from such specialization to buy more-valued goods of which they would

otherwise be high-cost producers, hence their gains from trade. The concept may be applied to

an entire economy for the alternatives of autarky (no trade) or trade. A measure of total gains

from trade is the sum of consumer surplus and producer profits or, more roughly, the increased

output from specialization in production with resulting trade.Gains from trade may also refer to

net benefits to a country from lowering barriers to trade such as tariffs on imports.

The benefits of international trade have been the major drivers of growth for the last half of the

20th century. Nations with strong international trade have become prosperous and have the

power to control the world economy. The global trade can become one of the major

contributors to the reduction of poverty.

2. What are the recent trends in world trade?

International trade is increasingly recognized as a vital engine for economic development

(World Bank, 2005a; UNCTAD, 2004a). In 2004, the value of world merchandise trade rose by

nearly 21%, the highest growth rate in 25 years (WTO, 2005a), amounting to nearly USD 8.9

trillion. Taking account of dollar price changes, real world merchandise trade expanded by 9%

in 2004, almost doubling from 5% in 2003. It continues to grow more rapidly than global Gross

Domestic Products (GDP). For example, world trade grew at nearly 6% on average in 1994-

2004, while global GDP at market exchange rates grew less than 3% in the same period. In the

meantime, a number of new trends in international trade have been observed over recent years.

Those mentioned below are among such trends which, in particular, are relevant when

preparing the Framework.

Trade in agricultural and manufactured goods

Manufactured goods, excluding mining products, recorded above average growth in world

merchandise trade during the past two decades (WTO, 2004a; 2005b). As a result, they

accounted for around three-quarters of world merchandise trade in 2003. By contrast, the share

of agricultural goods trade remained at around 9% in the three preceding years, which

represented approximately 2% below the average level in the 1990s. One of the notable trends

is that processed agricultural goods have become more important within trade in agricultural

goods over the past decade. They accounted for 48% of global trade in agricultural goods in

2001-2, rising from 42% in 1990-1. This upward trend can be observed across countries and

agricultural product groups throughout the 1990-2002 period.

Trade between partners of Regional Trade Agreements (RTAs)

A surge in trade between RTA partners was achieved mainly by a recent proliferation of RTAs.

According to a recent WTO report (2004b), some 220 RTAs were estimated operational as of

October 2004, of which 150 had been notified to the GATT/WTO. Nearly all WTO Members

belong to at least one RTA, and each belongs to six RTAs on average (World Bank, 2005b).

The number of RTAs is likely to continue to increase in coming years, considering the number

of RTAs under negotiation. Consequently, it was estimated that the share of trade between

RTA partners of world merchandise trade will grow to 55% by 2005 if all expected RTAs are

concluded, rising from 43% at present (OECD, 2002a).

Developing countries’ trade

In 2004, the share of developing countries in world merchandise trade stood at 31%, having

increased from about 20% in the mid-1980s (WTO, 2005a; UNCTAD, 2004a). This is the

highest level since 1950. It is observed that developing countries are increasingly becoming an

important destination for the exports of developed countries. Among those, in particular, some

problems have been recognized in identifying tariff classification and assessing the Customs

value3 of second-hand goods such as used cars, computer equipment, machinery and clothing.

Also, developing countries contributed more to the 2003 growth of world merchandise trade

than developed countries. It was estimated that nearly four-fifths of the real growth in 2003 was

attributable to developing countries, including transition economies (UNCTAD, 2004a). This

trend requires caution, given that many developing countries, including African countries, Less

Developed Countries (LDCs) and Small Island Developing States (SIDS) remain relatively

marginalized from international trade (UNCTAD, 2005). However, it is observed that new

efforts are being made in order to reinvigorate their regional liberalization programmes and

take initiatives aimed at deeper integration into global trade. For example, the New Partnership

for Africa’s Development (NEPAD) in African counties was initiated in 2001. One of its

primary objectives is to “halt the marginalization of Africa in the global process and enhance

its full and beneficial integration into the global economy” (NEPAD, 2004).

South-South trade

Merchandise trade between developing countries, i.e. South-South trade, has significantly

increased at an annual average rate of 11% during the past decade, accounting for nearly 13%

of world merchandise trade in 2000 (UNCTAD, 2005). Around 40% of exports from

developing countries were destined for other developing countries. Intra-regional trade, in

particular through RTAs, played a central role in the rise of South-South trade. Also, inter-

regional trade showed signs of growth, albeit on a smaller basis. In addition, intra-Asia trade

took a dominant position in this trend, accounting for around 80% of the total South-South

trade in 2000, but strong growth in intra-regional trade in Africa and Latin America was also

observed.

Containerized cargo

There are a number of freight containers in use within different modes, for example, Unit Load

Devices (ULDs) for aviation, Swap Bodies for road-rail carriage in Europe, and various types

of maritime containers (e.g. dry and refrigerated containers) for seaborne shipping (OECD,

2003a). Among those, maritime containers are the most numerous container types involved in

international trade. They are also used for inter-modal transportation, in which they are carried

by maritime, inland waterway, road, and rail operators. It was estimated that that over 6 billion

tons of goods were traded by sea in 2003 (UNCTAD, 2004c).This accounts for over 80% of

world trade by weight (OECD, 2003a). With 36% for tanker cargo (i.e. crude oil and oil

products) and 24% for bulk cargo (e.g. steel, iron ore and coal), non-bulk cargo accounted for

40% by weight of the total seaborne cargo, most of which was carried in maritime containers

(UNCTAD, 2004c). It was also estimated that there were 10.8 million maritime containers in

circulation worldwide in mid-2003 (World Shipping Council, 2003).

Air Cargo; Express cargo

It is reported that world air cargo accounts at present for a small portion of world merchandise

trade by weight, but a significant portion by value. World air cargo traffic has rapidly grown at

a rate of over 10% during the past decade, and it is expected to continue to grow rapidly in

coming years. For example, air cargo traffic has doubled over the past decade as measured in

Revenue Tonne-Kilometres (RTKs: weight multiplied by distance for charged cargo). Within

air cargo, the share of express cargo has also grown rapidly from 4.1% in 1992 to nearly 11%

in 2003 in terms of RTKs (Boeing, 2004). This important growth in express traffic can be

attributed to several factors: globalization and associated Just-In-Time production and

distribution systems; increased trade in high-value low-weight products; and the provision of a

service that assists SMEs to compete effectively in an increasingly global market.

Global production network

Global production specialization has advanced, in particular in manufactured goods (World

Bank, 2005b). Firstly, the share of manufactured goods within world merchandise trade has

grown significantly throughout the world. Secondly, the share of parts and components exports

of total merchandise exports has greatly increased in all six regions of the world, for example

from 6% in 1980 to 15% in 2002 in the East Asia region (Figure 1). Thirdly, exported goods

contain a significant portion of imported intermediate inputs. In the “international segmentation

of production”, intermediate inputs are exported for more processed intermediate inputs, which

are then exported to the next stage in production.

3. Discuss the reasons for the increase in international trade in developing regions.

Trade policies in today’s “flat world” (Thomas Friedman’s famous analogy to the supposed

‘evening’ effects of globalization) are an issue of utmost concern to developing countries

because these policies dictate the terms on which LDCs will be integrated into the global

economy. In fact, the development debate is often framed as “trade versus aid,” suggesting that

participation in global markets is sufficient for LDCs to begin to climb the development ladder

and address poverty among their citizens. In reality, trade is just one more tool for development

and is closely related to the other instruments discussed. Theoretically, aid, combined with in-

country economic and governance reforms, should create the conditions for LDCs to take

advantage of globalization for growth. However, LDCs’ preparations for global competition are

only one part of the equation; international trade policy is what they inevitably encounter when

they enter the market.

In many developing countries, agriculture employs a large proportion of the labor force, whilst

food consumption accounts for a large share of household income. The United Nations

Conference on Trade and Development (UNCTAD) notes that this means that “even small

changes in agricultural employment opportunities, or prices, can have major socio-economic

effects in developing countries”. Thus whatever the development strategy a particular country

adopts, the role of agriculture will often be crucial. In 1994, the agricultural sector employed

over 70 % of the labor force in low-income countries, 30 % in middle-income countries, and

only 4 % in high-income countries (UNCTAD 1999).

Generally, LDCs have a comparative advantage in labor-intensive, low-skilled activities, such

as agriculture and light industry. In a free market, LDCs’ corn, sugar, and cotton is cheaper to

grow, to pick, and to pack because of lower land values, and a larger, lower-priced labor pool

that will engage in such activities. Easily manufactured goods such as textiles capitalize on the

same features of LDC economies. Developed nations, on the other hand, have comparative

advantage in producing technology-intensive goods and services. In a free market, they should

be abandoning agriculture and light industry because their production costs are much higher for

these products than in LDCs. Developed countries have skilled, educated workers concentrated

in urban areas where innovation and investment become agglomerated and increase in value.

In theory, they should be producing high technology goods and engaging in the delivery of

services that capitalize on their expertise, such as banking, accounting, engineering,

entertainment, and biotechnology. In sum, free markets allow the world to make purchasing

and production decisions (imports and exports) based on competitive pricing and expertise. It

is all about efficiency.

4. Explain the comparative advantage theory of international trade.

According to the classical theory of international trade, every country will produce their

commodities for the production of which it is most suited in terms of its natural endowments

climate quality of soil, means of transport, capital, etc. It will produce these commodities in

excess of its own requirement and will exchange the surplus with the imports of goods from

other countries for the production of which it is not well suited or which it cannot produce at

all. Thus all countries produce and export these commodities in which they have cost

advantages and import those commodities in which they have cost disadvantages.

Types of Cost Difference in Production

Economists speak about three types of cost difference in production, they are

1. Absolute cost difference,

2. Equal cost difference, and

3. Comparative cost difference.

Ricardo's Assumptions:-

Ricardo explains his theory with the help of following assumptions:-

1. There are two countries and two commodities.

2. There is a perfect competition both in commodity and factor market.

3. Cost of production is expressed in terms of labour i.e. value of a commodity is

measured in terms of labour hours/days required to produce it. Commodities are also

exchanged on the basis of labour content of each good.

4. Labour is the only factor of production other than natural resources.

5. Labour is homogeneous i.e. identical in efficiency, in a particular country.

6. Labour is perfectly mobile within a country but perfectly immobile between countries.

7. There is free trade i.e. the movement of goods between countries is not hindered by any

restrictions.

8. Production is subject to constant returns to scale.

9. There is no technological change.

10. Trade between two countries takes place on barter system.

11. Full employment exists in both countries.

12. There is no transport cost.

David Ricardo, working in the early part of the 19th century, realised that absolute advantage

was a limited case of a more general theory. Consider Table 1. It can be seen that Portugal can

produce both wheat and wine more cheaply than England (ie it has an absolute advantage in

both commodities). What David Ricardo saw was that it could still be mutually beneficial for

both countries to specialise and trade.

Table 1

Country Wheat Wine

Cost Per Unit In Man Hours Cost Per Unit In Man Hours

England 15 30

Portugal 10 15

In Table 1, a unit of wine in England costs the same amount to produce as 2 units of wheat.

Production of an extra unit of wine means foregoing production of 2 units of wheat (ie the

opportunity cost of a unit of wine is 2 units of wheat). In Portugal, a unit of wine costs 1.5 units

of wheat to produce (ie the opportunity cost of a unit of wine is 1.5 units of wheat in Portugal).

Because relative or comparative costs differ, it will still be mutually advantageous for both

countries to trade even though Portugal has an absolute advantage in both commodities.

Portugal is relatively better at producing wine than wheat: so Portugal is said to have

a COMPARATIVE ADVANTAGE in the production of wine. England is relatively better at

producing wheat than wine: so England is said to have a comparative advantage in the

production of wheat.

Table 2 shows how trade might be advantageous. Costs of production are as set out in Table 1.

England is assumed to have 270 man hours available for production. Before trade takes place it

produces and consumes 8 units of wheat and 5 units of wine. Portugal has fewer labour

resources with 180 man hours of labour available for production. Before trade takes place it

produces and consumes 9 units of wheat and 6 units of wine. Total production between the two

economies is 17 units of wheat and 11 units of wine.

Table 2

C o u n t r y

Production

Before Trade After Trade

Wheat Wine Wheat Wine

E n g l a n d 8 5 18 0

P o r t u g a l 9 6 0 12

T o t a l 17 11 18 12

If both countries now specialise, Portugal producing only wine and England producing only

wheat, total production is 18 units of wheat and 12 units of wine. Specialisation has enabled the

world economy to increase production by 1 unit of wheat and 1 unit of wine.

The simple theory of comparative advantage outlined above makes a number of important

assumptions:

• There are no transport costs.

• Costs are constant and there are no economies of scale.

• There are only two economies producing two goods.

• The theory assumes that traded goods are homogeneous (ie identical).

• Factors of production are assumed to be perfectly mobile.

• There are no tariffs or other trade barriers.

• There is perfect knowledge, so that all buyers and sellers know where the cheapest

goods can be found internationally.

5. Briefly describe the mercantilism theory of international trade.

Mercantilism is the economic doctrine in which government control of foreign trade is of

paramount importance for ensuring the prosperity and military security of the state. In

particular, it demands a positive balance of trade. Mercantilism dominatedWestern

European economic policy and discourse from the 16th to late-18th centuries. Mercantilism

was a cause of frequent European wars in that time and motivated colonial expansion.

Mercantilist theory varied in sophistication from one writer to another and evolved over time.

Favors for powerful interests were often defended with mercantilist reasoning.

Mercantilist policies have included:

Building a network of overseas colonies

Forbidding colonies to trade with other nations

Monopolizing markets with staple ports;

Promote accumulation of gold and silver

Forbidding trade to be carried in foreign ships;

Export subsidies;

Maximizing the use of domestic resources;

Restricting domestic consumption with non-tariff barriers to trade.

To encourage export, Government can impose tax or other charges on import. This can help to

promote sales and to earn more Gold or Foreign currency. It will help to prevent Trade deficit

and experience Trade Surplus.

The Suggestions by Mercantilism theory can be summarised as-

-Country should have more Export than Import in Monetary Value

-So country can experience Trade Surplus

- Government can help to improve export by imposing tax and some other charges on import

-Maintain favorable balance of Trade

Decay of Gold Standard reduced the validity of this theory and then this theory was modified

and named as Neo-Mercantilism.

PART B

1. Critically examine the Heckscher–Ohlin theory of international trade.

The Heckscher-Ohlin theory explains why countries trade goods and services with each other.

One condition for trade between two countries is that the countries differ with respect to the

availability of the factors of production. They differ if one country, for example, has many

machines (capital) but few workers, while another country has a lot of workers but few

machines. According to the Heckscher-Ohlin theory, a country specializes in the production of

goods that it is particularly suited to produce. Countries in which capital is abundant and

workers are few, therefore, specialize in production of goods that, in particular, require capital.

Specialization in production and trade between countries generates, according to this theory, a

higher standard-of-living for the countries involved.

The Heckscher-Ohlin theory says that two countries trade goods with each other (and thereby

achieve greater economic welfare), if the following assumptions hold:

• The major factors of production, namely labor and capital, are not available in the same

proportion in both countries.

• The two goods produced either require relatively more capital or relatively more labor.

• Labor and capital do not move between the two countries.

• There are no costs associated with transporting the goods between countries.

• The citizens of the two trading countries have the same needs.

Bigger Differences - Greater Gains

• Of the above conditions, the central one is the assumption that capital and labor are not

available in the same proportion in the two countries. This condition leads to

specialization. The country with relatively more capital specializes - but not necessarily

fully - in production of capital-intensive goods (which it exports in exchange for labor-

intensive goods) while the country with relatively little capital specializes in production

of labor-intensive goods (which it exports in exchange for capital-intensive goods).

• According to the theory, the more different the countries are - regarding the capital-to-

labor ratio - the greater the economic gain from specialization and trade.

Example:

Imagine two countries that each produce both jeans and cell phones. Although both countries

use the same production technologies, one has a lot of capital but a limited number of workers,

while the other country has little capital but lots of workers.

The country that has a lot of capital but few workers can produce many cell phones but few

pairs of jeans because cell phones are capital intensive and jeans are labor intensive. The

country with many workers but little capital, on the other hand, can produce many pairs of

jeans but few cell phones.

According to the Heckscher-Ohlin theory, trade makes it possible for each country to

specialize. Each country exports the product the country is most suited to produce in exchange

for products it is less suited to produce. The country that has a lot of capital specializes in the

production of cell phones, whereas the country that has more labor specializes in the production

of jeans.

2. Explain the non-tariff barriers of international trade.

Non-tariff barriers to trade (NTBs) are trade barriers that restrict imports but are not in the

usual form of a tariff. Some common examples of NTB's are anti-dumping measures

andcountervailing duties, which, although they are called "non-tariff" barriers, have the effect

of tariffs once they are enacted.

Their use has risen sharply after the WTO rules led to a very significant reduction in tariff use.

Some non-tariff trade barriers are expressly permitted in very limited circumstances, when they

are deemed necessary to protect health, safety, or sanitation, or to protect depletable natural

resources. In other forms, they are criticized as a means to evade free trade rules such as those

of the World Trade Organization (WTO), the European Union (EU), or North American Free

Trade Agreement (NAFTA) that restrict the use of tariffs.

Some of non-tariff barriers are not directly related to foreign economic regulations, but

nevertheless they have a significant impact on foreign-economic activity and foreign trade

between countries.

Trade between countries is referred to trade in goods, services and factors of production. Non-

tariff barriers to trade include import quotas, special licenses, unreasonable standards for the

quality of goods, bureaucratic delays at customs, export restrictions, limiting the activities of

state trading, export subsidies, countervailing duties, technical barriers to trade, sanitary and

phyto-sanitary measures, rules of origin, etc. Sometimes in this list they include

macroeconomic measures affecting trade.

There are several different variants of division of non-tariff barriers. Some scholars divide

between internal taxes, administrative barriers, health and sanitary regulations and government

procurement policies. Others divide non-tariff barriers into more categories such as specific

limitations on trade, customs and administrative entry procedures, standards, government

participation in trade, charges on import, and other categories. We choose traditional

classification of non-tariff barriers, according to which they are divided into 3 principal

categories.

The first category includes methods to directly import restrictions for protection of certain

sectors of national industries: licensing and allocation of import quotas, antidumping and

countervailing duties, import deposits, so-called voluntary export restraints, countervailing

duties, the system of minimum import prices, etc. Under second category follow methods that

are not directly aimed at restricting foreign trade and more related to the administrative

bureaucracy, whose actions, however, restrict trade, for example: customs procedures, technical

standards and norms, sanitary and veterinary standards, requirements for labeling and

packaging, bottling, etc. The third category consists of methods that are not directly aimed at

restricting the import or promoting the export, but the effects of which often lead to this result.

The non-tariff barriers can include wide variety of restrictions to trade. Here are some example

of the “popular” NTBs.

Licenses

The most common instruments of direct regulation of imports (and sometimes export) are

licenses and quotas. Almost all industrialized countries apply these non-tariff methods. The

license system requires that a state (through specially authorized office) issues permits for

foreign trade transactions of import and export commodities included in the lists of licensed

merchandises. Product licensing can take many forms and procedures. The main types of

licenses are general license that permits unrestricted importation or exportation of goods

included in the lists for a certain period of time; and one-time license for a certain product

importer (exporter) to import (or export). One-time license indicates a quantity of goods, its

cost, its country of origin (or destination), and in some cases also customs point through which

import (or export) of goods should be carried out. The use of licensing systems as an

instrument for foreign trade regulation is based on a number of international level standards

agreements. In particular, these agreements include some provisions of the General Agreement

on Tariffs and Trade and the Agreement on Import Licensing Procedures, concluded under the

GATT (GATT).

Quotas

Licensing of foreign trade is closely related to quantitative restrictions – quotas - on imports

and exports of certain goods. A quota is a limitation in value or in physical terms, imposed on

import and export of certain goods for a certain period of time. This category includes global

quotas in respect to specific countries, seasonal quotas, and so-called "voluntary" export

restraints. Quantitative controls on foreign trade transactions carried out through one-time

license.

Quantitative restriction on imports and exports is a direct administrative form of government

regulation of foreign trade. Licenses and quotas limit the independence of enterprises with a

regard to entering foreign markets, narrowing the range of countries, which may be entered into

transaction for certain commodities, regulate the number and range of goods permitted for

import and export. However, the system of licensing and quota imports and exports,

establishing firm control over foreign trade in certain goods, in many cases turns out to be more

flexible and effective than economic instruments of foreign trade regulation. This can be

explained by the fact, that licensing and quota systems are an important instrument of trade

regulation of the vast majority of the world.

The consequence of this trade barrier is normally reflected in the consumers’ loss because of

higher prices and limited selection of goods as well as in the companies that employ the

imported materials in the production process, increasing their costs. An import quota can be

unilateral, levied by the country without negotiations with exporting country, and bilateral or

multilateral, when it is imposed after negotiations and agreement with exporting country. An

export quota is a restricted amount of goods that can leave the country. There are different

reasons for imposing of export quota by the country, which can be the guarantee of the supply

of the products that are in shortage in the domestic market, manipulation of the prices on the

international level, and the control of goods strategically important for the country. In some

cases, the importing countries request exporting countries to impose voluntary export restraints.

Agreement on a "voluntary" export restraint

In the past decade, a widespread practice of concluding agreements on the "voluntary" export

restrictions and the establishment of import minimum prices imposed by leading Western

nations upon weaker in economical or political sense exporters. The specifics of these types of

restrictions is the establishment of unconventional techniques when the trade barriers of

importing country, are introduced at the border of the exporting and not importing country.

Thus, the agreement on "voluntary" export restraints is imposed on the exporter under the

threat of sanctions to limit the export of certain goods in the importing country. Similarly, the

establishment of minimum import prices should be strictly observed by the exporting firms in

contracts with the importers of the country that has set such prices. In the case of reduction of

export prices below the minimum level, the importing country imposes anti-dumping duty

which could lead to withdrawal from the market. “Voluntary" export agreements affect trade in

textiles, footwear, dairy products, consumer electronics, cars, machine tools, etc.

Problems arise when the quotas are distributed between countries, because it is necessary to

ensure that products from one country are not diverted in violation of quotas set out in second

country. Import quotas are not necessarily designed to protect domestic producers. For

example, Japan, maintains quotas on many agricultural products it does not produce. Quotas on

imports is a leverage when negotiating the sales of Japanese exports, as well as avoiding

excessive dependence on any other country in respect of necessary food, supplies of which may

decrease in case of bad weather or political conditions.

Export quotas can be set in order to provide domestic consumers with sufficient stocks of

goods at low prices, to prevent the depletion of natural resources, as well as to increase export

prices by restricting supply to foreign markets. Such restrictions (through agreements on

various types of goods) allow producing countries to use quotas for such commodities as coffee

and oil; as the result, prices for these products increased in importing countries.

Quota can be of the following types:

1) Tariff rate quota

2) Global quota

3) Discriminating quota

4) Export quota

Embargo

Embargo is a specific type of quotas prohibiting the trade. As well as quotas, embargoes may

be imposed on imports or exports of particular goods, regardless of destination, in respect of

certain goods supplied to specific countries, or in respect of all goods shipped to certain

countries. Although the embargo is usually introduced for political purposes, the consequences,

in essence, could be economic.

Standards

Standards take a special place among non-tariff barriers. Countries usually impose standards on

classification, labeling and testing of products in order to be able to sell domestic products, but

also to block sales of products of foreign manufacture. These standards are sometimes entered

under the pretext of protecting the safety and health of local populations.

Administrative and bureaucratic delays at the entrance

Among the methods of non-tariff regulation should be mentioned administrative and

bureaucratic delays at the entrance which increase uncertainty and the cost of maintaining

inventory.

Import deposits

Another example of foreign trade regulations is import deposits. Import deposits is a form of

deposit, which the importer must pay the bank for a definite period of time (non-interest

bearing deposit) in an amount equal to all or part of the cost of imported goods.

At the national level, administrative regulation of capital movements is carried out mainly

within a framework of bilateral agreements, which include a clear definition of the legal

regime, the procedure for the admission of investments and investors. It is determined by mode

(fair and equitable, national, most-favored-nation), order of nationalization and compensation,

transfer profits and capital repatriation and dispute resolution.

Foreign exchange restrictions and foreign exchange controls

Foreign exchange restrictions and foreign exchange controls occupy a special place among the

non-tariff regulatory instruments of foreign economic activity. Foreign exchange restrictions

constitute the regulation of transactions of residents and nonresidents with currency and other

currency values. Also an important part of the mechanism of control of foreign economic

activity is the establishment of the national currency against foreign currencies.

The transition from tariffs to non-tariff barriers

One of the reasons why industrialized countries have moved from tariffs to NTBs is the fact

that developed countries have sources of income other than tariffs. Historically, in the

formation of nation-states, governments had to get funding. They received it through the

introduction of tariffs. This explains the fact that most developing countries still rely on tariffs

as a way to finance their spending. Developed countries can afford not to depend on tariffs, at

the same time developing NTBs as a possible way of international trade regulation. The second

reason for the transition to NTBs is that these tariffs can be used to support weak industries or

compensation of industries, which have been affected negatively by the reduction of tariffs.

The third reason for the popularity of NTBs is the ability of interest groups to influence the

process in the absence of opportunities to obtain government support for the tariffs.

Non-tariff barriers today

With the exception of export subsidies and quotas, NTBs are most similar to the tariffs. Tariffs

for goods production were reduced during the eight rounds of negotiations in the WTO and the

General Agreement on Tariffs and Trade (GATT). After lowering of tariffs, the principle of

protectionism demanded the introduction of new NTBs such as technical barriers to trade

(TBT). According to statements made at United Nations Conference on Trade and

Development (UNCTAD, 2005), the use of NTBs, based on the amount and control of price

levels has decreased significantly from 45% in 1994 to 15% in 2004, while use of other NTBs

increased from 55% in 1994 to 85% in 2004.

Increasing consumer demand for safe and environment friendly products also have had their

impact on increasing popularity of TBT. Many NTBs are governed by WTO agreements, which

originated in the Uruguay Round (the TBT Agreement, SPS Measures Agreement, the

Agreement on Textiles and Clothing), as well as GATT articles. NTBs in the field of services

have become as important as in the field of usual trade.

Most of the NTB can be defined as protectionist measures, unless they are related to difficulties

in the market, such as externalities and information asymmetries information asymmetries

between consumers and producers of goods. An example of this is safety standards and labeling

requirements.

The need to protect sensitive to import industries, as well as a wide range of trade restrictions,

available to the governments of industrialized countries, forcing them to resort to use the NTB,

and putting serious obstacles to international trade and world economic growth. Thus, NTBs

can be referred as a “new” of protection which has replaced tariffs as an “old” form of

protection.

3. Briefly describe Raymond Vernon’s theory of international product life cycle and

international trade.

The product life-cycle theory is an economic theory that was developed by Raymond Vernon in

response to the failure of the Heckscher-Ohlin model to explain the observed pattern

ofinternational trade. The theory suggests that early in a product's life-cycle all the parts and

labor associated with that product come from the area in which it was invented. After the

product becomes adopted and used in the world markets, production gradually moves away

from the point of origin. In some situations, the product becomes an item that is imported by its

original country of invention. A commonly used example of this is the invention, growth and

production of the personal computer with respect to the United States.

The model applies to labor-saving and capital-using products that (at least at first) cater to high-

income groups.

In the new product stage, the product is produced and consumed in the US; no export trade

occurs. In the maturing product stage, mass-production techniques are developed and foreign

demand (in developed countries) expands; the US now exports the product to other developed

countries. In the standardized product stage, production moves to developing countries, which

then export the product to developed countries.

There are five stages in a product's life cycle:

Introduction

Growth

Maturity

Saturation

Decline

The location of production depends on the stage of the cycle.

The initial phase is the New Product phase. The product is developed and introduced in an

advanced country. Research and development capability is one reason why. Also,the market

is believed to exist for it in that country, and in other similar countries. Most sales will be

domestic and exports will be limited. The product is, to a degree, experimental -- customer

acceptance is uncertain and specific product features are not yet completely

identified. Production is not yet carried out on a large scale, pending answers to the above

questions. The price is initially high. Xerox and Apple are two companies/products which

could be used as examples.

The middle stage is the Maturing Stage. Here the product demand grows tremendously, and

export sales become important. Profits are substantial and competition, both domestic and

foreign appears. Greater emphasis is placed on efficient production, and product characteristics

and consumer preferences become more settled. The price is still comparatively high.

In the Standardized Product Stage the design of the product is well understood and the product

starts to resemble a commodity. The emphasis is on mass production using efficient techniques

and low cost labor. The number of producing firms multiplies and competition becomes very

vigorous. The product will be imported into the originating country from elsewhere, especially

areas suited to low-cost production (Korea, Taiwan, Mexico, Indonesia). Domestic production

in the originating country will slump and may halt altogether. Firms may take up overseas

production in order to remain competitive.

The impact of the theory is tosuggest that advanced countries must rely on a stream of high-

tech products. They must depend on research and development and innovation. With high

labor costs, they can not compete head to head with less developed nations when it comes to

"cookie cutter" production -- stamping them out by the millions. Advanced nations must cash

in while prices are high. In short their high standard of living and high labor costs can best be

supported under quasi-monopoly conditions -- but where the uniqueness of their products and

the lack of competition can be expected to last a relatively short while.

The model helps organisations that are beginning their international expansion or are carrying

products that initially require experimentation to understand how the competitive playground

changes over time and how their internal workings need to be refitted. The model can be used

for product planning purposes in international marketing.

New product development in a country does not occur by chance. A country must have a ready

market, an able industrial capability and enough capital or labour to make a new product

flourish. No two countries exist with identical local market conditions. Countries with high per

capita incomes foster newly invented products. Countries with lower per capita incomes will

focus on adapting existing products to create lower priced versions.

The IPLC model was widely adopted as the explanation of the ways industries migrated across

borders over time, e.g. the textile industry. Furthermore, Vernon was able to explain the logic

of an advanced, high income country such as the USA that exports slightly more labour-

intensive goods than those that are subject to competition from abroad.

According to Vernon, most managers are “myopic”. Production is only moved outside the

home market when a “triggering event” occurs that threatens export such as a new local

competitor or new trade tariffs. Managers act when the threat has become greater than the risk

in or uncertainty from reallocating operations abroad.

The model’s validity was proved by empirical evidence from the teletransmission equipment

industry in the post-war years. The model is best applied to consumer-oriented physical

products based on a new technology at a time when functionality supersedes cost

considerations and satisfies a universal need.

Cons:

Vernon’s main assumption was that the diffusion process of a new technology occurs slowly

enough to generate temporary differences between countries in their access and use of new

technologies. By the late 1970’s, he recognised that this assumption was no longer valid.

Income differences between advanced nations had dropped significantly, competitors were able

to imitate product at much higher speeds than previously envisioned and MNCs had built up an

existing global network of production facilities that enabled them to launch products in

multiple markets simultaneously. Investments in an existing portfolio of production facilities

made it harder to relocate plants.

The model assumed integrated firms that begin producing in one nation, followed by exporting

and then building facilities abroad. The business landscape had become much more interrelated

since the 1950’s and early 1960’s, less US-centric and created more complex organisational

structures and supplier relations. The trade-off between export or foreign direct investments

was too simplistic: more entry modes exist.

The model assumed that technology can be captured in capital equipment and standard

operating procedures. This assumption underpinned the discussion on labour-intensity,

standardization and unit cost.

The model stated that the stages are separate and sequential in order. Vernon’s Harvard

Multinational Enterprise Project that took place from 1963 through 1986, was a massive study

of global marketing activities at US, European, Japanese and emerging-nation corporations.

The study found that companies design strategies around their product technologies. High-

technology producers behave differently from firms with less advanced goods. Companies that

invested more R&D to improve their products and to refresh their technologies were able to

‘push’ these products back to the new product phase.

The relative simplicity of the model makes it difficult to use as a predictive model that can help

anticipate changes. In general, it is difficult to determine the phase of a product in product life

cycles. Furthermore, an individual phase reflects the outcome of numerous factors that facilitate

or hamper a product’s rate of sales making it difficult to see what is happening ’underwater’.

The relation between the organisation and the country level was not well structured. Vernon

emphasized the country level. Furthermore, he used the product side of the product life cycle,

not the consumer side, thereby stressing the supply side. Selling ‘older’ products to a lesser

developed market does not work if transportation costs for imports is low and information is

accessible globally through the Internet and satellite TV.

Foreign markets are not just composed of average income consumers, but contain multiple

segments. The research did not consider the emergence of global consumer segments.

4. What are the benefits and lessons of trade liberalization in India?

Trade liberalization can lead to higher economic growth. Gains in total factor productivity

achieved through the economies of scale and enhanced efficiency are likely to translate into

higher growth of potential output. In addition, a liberalized trade regime is likely to attract FDI,

as an economy with larger access to regional markets becomes more attractive to foreign

investors. Higher FDI, in turn, may lead to increased technology transfer and total factor

productivity. Moreover, trade liberalization can be seen as part of the broader process of

regional integration, which may foster closer relations between India and its trading partners.

There are other benefits besides increased size. A poor country merging with a rich one stands

to gain from access to improved growth fundamentals. However, there can be negative effects

on the rich country.If there is full integration—the borders are dropped and the two countries

are allowed to share all their fundamentals—the richer country is likely to see its human

capital, savings rate, and average salary drop.It might also have to contend with worse

infrastructure, a higher fertility rate, and a larger, more bureaucratic government. All these

factors could put the brakes on the richer country's economy and work to diminish the size

effect. The net effect of borders depends both on the size of the merged country and on

preexisting levels of income.

5. What role is played by MNCs in the host country? Explain with reference to the Indian

economy.

Multinational corporations (MNCs) are huge industrial organizations having a wide network of

branches and subsidiaries spread over a number of countries. The two main characteristics of

MNCs are their large size and the fact that their worldwide activities are centrally controlled by

the parent companies. Such a company may enter into joint venture with a company in another

country. There may be agreement among companies of different countries in respect of division

of production, market, etc. These companies are to be found in almost all the advanced

countries, with the USA perhaps the biggest amongst them. Their operations extend beyond

their own countries, and cover not only the advanced countries but also the LDCs.

Many MNCs have annual sales volume in excess of the entire GNPs of the developing

countries in which they operate. MNCs have great impact on the development process of the

Underdeveloped countries.

The MNCs play an important role in the economic development of underdeveloped countries.

1. Filling Savings Gap: The first important contribution of MNCs is its role in filling the

resource gap between targeted or desired investment and domestically mobilized savings. For

example, to achieve a 7% growth rate of national output if the required rate of saving is 21%

but if the savings that can be domestically mobilised is only 16% then there is a ‘saving gap’ of

5%. If the country can fill this gap with foreign direct investments from the MNCs, it will be in

a better position to achieve its target rate of economic growth.

2. Filling Trade Gap: The second contribution relates to filling the foreign exchange or trade

gap. An inflow of foreign capital can reduce or even remove the deficit in the balance of

payments if the MNCs can generate a net positive flow of export earnings.

3. Filling Revenue Gap: The third important role of MNCs is filling the gap between targeted

governmental tax revenues and locally raised taxes. By taxing MNC profits, LDC governments

are able to mobilize public financial resources for development projects.

4. Filling Management/Technological Gap: Fourthly, Multinationals not only provide

financial resources but they also supply a “package” of needed resources including

management experience, entrepreneurial abilities, and technological skills. These can be

transferred to their local counterparts by means of training programs and the process of

‘learning by doing’.

Moreover, MNCs bring with them the most sophisticated technological knowledge about

production processes while transferring modern machinery and equipment to capital poor

LDCs. Such transfers of knowledge, skills, and technology are assumed to be both desirable

and productive for the recipient country.

5. Other Beneficial Roles: The MNCs also bring several other benefits to the host country.

(a) The domestic labour may benefit in the form of higher real wages.

(b) The consumers benefits by way of lower prices and better quality products.

(c) Investments by MNCs will also induce more domestic investment. For example, ancillary

units can be set up to ‘feed’ the main industries of the MNCs

(d) MNCs expenditures on research and development(R&D), although limited is bound to

benefit the host country.

Apart from these there are indirect gains through the realization of external economies.

MNCs have contributed significantly to the development of world economy at large. They have

also served as an engine of growth in many host countries. Their importance in a developing

country may be traced as follows:

1. MNCs help a developing host country by increasing investment, income and employment in

its economy.

2. They contribute to the rapid process of development of the country through transfer of

technology, finance and Tnodern management.

3. MNCs promote professionalisation management in the companies of the host countries.

4. MNCs help in promoting exports of the host country.

5. MNCs by producing certain required goods in the host country help in reducing its

dependence on imports.

6. MNCs due to their wide network of productive activity equalise the cost of production in the

global market.

7. Entry of MNCs in the host country makes its market more competitive and break the

domestic monopolies.

8. MNCs accelerate the growth process in the host country through rapid industrialisation and

allied activities.

9. The growth of MNCs creates a positive impact on the business environment in the host

country.

10. MNCs are regarded as agents of modernisation and rapid growth.

11. MNCs are the vehicles for peace in the world. They help in developing cordial political

relations among the countries of the world.

12. MNCs bring ideas and help in exchange of cultural values.

13. MNCs through their positive attitude and efforts work for the establishment of social

welfare institutions and improvement of health facilities in the host countries.

14. Growth of MNCs help in improving the balance of payment status of the host country.

15. The MNCs integrate national and international markets. Their growth in these days has

remarkably influenced economic, industrial, social environment and business conditions.

In short, through basically seeking maximisation of profits by using all types of resources and

strategies of the global economy, eventually globalisation has become the main focus of their

business. In this way, it has become a main propelling force behind the expansion of world

economy at large.

PART C

1. What are the benefits of use of letter of credit in international transactions? Explain the

steps and parties involved in the operation of letter of credit.

A letter of credit is a document that a financial institution or similar party issues to a seller of

goods or services which provides that the issuer will pay the seller for goods or services the

seller delivers to a third-party buyer.[1] The issuer then seeks reimbursement from the buyer or

from the buyer's bank. The document serves essentially as a guarantee to the seller that it will

be paid by the issuer of the letter of credit regardless of whether the buyer ultimately fails to

pay. In this way, the risk that the buyer will fail to pay is transferred from the seller to the letter

of credit's issuer.

Letters of credit are used primarily in international trade for large transactions between a

supplier in one country and a customer in another. In such cases, the International Chamber of

Commerce Uniform Customs and Practice for Documentary Credits applies (UCP 600 being

the latest version).They are also used in the land development process to ensure that approved

public facilities (streets, sidewalks, storm water ponds, etc.) will be built. The parties to a letter

of credit are the supplier, usually called the beneficiary, 'the issuing bank,' of whom the buyer

is a client, and sometimes an advising bank, of whom the beneficiary is a client. Almost all

letters of credit are irrevocable, i.e., cannot be amended or canceled without the consent of the

beneficiary, issuing bank, and confirming bank, if any. In executing a transaction, letters of

credit incorporate functions common to giros and Traveler's cheques.

Letter of credit advantages for the seller

• The seller has the obligation of buyer's bank's to pay for the shipped goods;

• Reducing the production risk, if the buyer cancels or changes his order

• The opportunity to get financing in the period between the shipment of the goods and

receipt of payment (especially, in case of deferred payment).

• The seller is able to calculate the payment date for the goods.

• The buyer will not be able to refuse to pay due to a complaint about the goods

Letter of credit advantages for the buyer

• The bank will pay the seller for the goods, on condition that the latter presents to the

bank the determined documents in line with the terms of the letter of credit;

• The buyer can control the time period for shipping of the goods;

• By a letter of credit, the buyer demonstrates his solvency;

• In the case of issuing a letter of credit providing for delayed payment, the seller grants a

credit to the buyer.

• Providing a letter of credit allows the buyer to avoid or reduce pre-payment.

Participants in LC Process

• Buyer

• Issuing Bank

• Advising Bank

• Seller (Beneficiary)

9 Steps in the Letter of Credit Process

I. Buyer and seller agree to terms including means of transport, period of credit offered (if

any), and latest date of shipment acceptable.

II. Buyer applies to bank for issue of letter of credit. Bank will evaluate buyer's credit

standing, and may require cash cover and/or reduction of other lending limits.

III. Issuing bank issues LC, sending it to the Advising bank by airmail or electronic means

such as telex or SWIFT.

IV. Advising bank establishes authenticity of the letter of credit using signature books or

test codes, then informs seller (beneficiary).

V. Seller should now check that LC matches commercial agreement and that all its terms

and conditions can be satisfied.

VI. Seller ships the goods, then assembles the documents called for in the LC (invoice,

transport document, etc.).

VII. The Advising bank checks the documents against the LC. If the documents are

compliant, the bank pays the seller and forwards the documents to the Issuing bank.

VIII. The Issuing bank now checks the documents itself. If they are in order, it reimburses the

seller's bank immediately.

IX. The Issuing bank debits the buyer and releases the documents (including transport

document), so the buyer can claim the goods from the carrier.

2. What are the reasons for disequilibrium in balance of payments? State the methods to

adjust the deficit.

The Balance of Payment is comprised of two main components

• The Current Account (trade in goods, services + investment incomes)

• The Financial Account (used to be called capital account)

The balance of payments measures the value of imports and exports. If the UK import more

goods and services than we export then we have a deficit on the Current Account. A significant

deficit on the current account is generally referred to as disequilibrium.

Disequilibrium in Economy

A large current account deficit may be an indication that the economy is too much geared

towards spending (e.g. spending on imports) and too little on exports.

• A current account deficit may also be a sign of underlying inflationary pressures. As

domestic goods increase in price, people buy imports instead.

• It may also be an indication the country is losing competitiveness.

Overall Equilibrium in Balance of Payments

In a floating exchange rate, the two components of the Balance of Payments should balance

each other out. If the UK has a deficit on the current account of £38bn. Then in a floating

exchange rate, the financial account should have a surplus of £38bn. This is because financial

outflows must be matched by financial inflows.

Example, If we buy more imported Goods than exported goods then we need financial flows

(e.g. hot money, long term capital investment to finance the purchase of imports)

Balance of Payments Disequilibrium and Fixed Exchange Rates

When a country has a fixed exchange rate, there is more likely to be a balance of payments. For

example, in 2011, several Euro countries were relatively uncompetitive. However, because they

are in the Euro, it is not possible to devalue against other European countries. Therefore, they

are stuck with exports which are too expensive. Therefore, we tend to see a large current

current account deficit.

Meaning of Disequilibrium in Balance of Payment

Though the credit and debit are written balanced in the balance of payment account, it may not

remain balanced always. Very often, debit exceeds credit or the credit exceeds debit causing an

imbalance in the balance of payment account. Such an imbalance is called the disequilibrium.

Disequilibrium may take place either in the form of deficit or in the form of surplus.

Disequilibrium of Deficit arises when our receipts from the foreigners fall below our payment

to foreigners. It arises when the effective demand for foreign exchange of the country exceeds

its supply at a given rate of exchange. This is called an 'unfavourable balance'.

Disequilibrium of Surplus arises when the receipts of the country exceed its payments. Such a

situation arises when the effective demand for foreign exchange is less than its supply. Such a

surplus disequilibrium is termed as 'favourable balance'.

Causes of Disequilibrium in Balance of Payment

1. Population Growth

Most countries experience an increase in the population and in some likeIndia and China the

population is not only large but increases at a faster rate. To meet their needs, imports become

essential and the quantity of imports may increase as population increases.

2. Development Programmes

Developing countries which have embarked upon planned development programmes require

importing capital goods, some raw materials which are not available at home and highly skilled

and specialized manpower. Since development is a continuous process, imports of these items

continue for the long time landing these countries in a balance of payment deficit.

3. Demonstration Effect

When the people in the less developed countries imitate the consumption pattern of the people

in the developed countries, their import will increase. Their export may remain constant or

decline causing disequilibrium in the balance of payments.

4. Natural Factors

Natural calamities such as the failure of rains or the coming floods may easily cause

disequilibrium in the balance of payments by adversely affecting agriculture and industrial

production in the country. The exports may decline while the imports may go up causing a

discrepancy in the country's balance of payments.

5. Cyclical Fluctuations

Business fluctuations introduced by the operations of the trade cycles may also cause

disequilibrium in the country's balance of payments. For example, if there occurs a business

recession in foreign countries, it may easily cause a fall in the exports and exchange earning of

the country concerned, resulting in a disequilibrium in the balance of payments.

6. Inflation

An increase in income and price level owing to rapid economic developmentin developing

countries, will increase imports and reduce exports causing a deficit in balance of payments.

7. Poor Marketing Strategies

The superior marketing of the developed countries have increased their surplus. The poor

marketing facilities of the developing countries have pushed them into huge deficits.

8. Flight Of Capital

Due to speculative reasons, countries may lose foreign exchange or gold stocks People in

developing countries may also shift their capital to developed countries to safeguard against

political uncertainties. These capital movements adversely affect the balance of payments

position.

9. Globalisation

Due to globalisation there has been more liberal and open atmosphere for international

movement of goods, services and capital. Competition has beer increased due to the

globalisation of international economic relations. The emerging new global economic order has

brought in certain problems for some countries which have resulted in the balance of payments

disequilibrium.

How to correct the Balance of Payment?

Solution to correct balance of payment disequilibrium lies in earning more foreign exchange

through additional exports or reducing imports. Quantitative changes in exports and imports

require policy changes. Such policy measures are in the form of monetary, fiscal and non-

monetary measures.

Monetary Measures for Correcting the BoP ↓

The monetary methods for correcting disequilibrium in the balance of payment are as follows:-

1. Deflation

Deflation means falling prices. Deflation has been used as a measure to correct deficit

disequilibrium. A country faces deficit when its imports exceeds exports.

Deflation is brought through monetary measures like bank rate policy, open market operations,

etc or through fiscal measures like higher taxation, reduction in public expenditure, etc.

Deflation would make our items cheaper in foreign market resulting a rise in our exports. At

the same time the demands for imports fall due to higher taxation and reduced income. This

would built a favourable atmosphere in the balance of payment position. However Deflation

can be successful when the exchange rate remains fixed.

2. Exchange Depreciation

Exchange depreciation means decline in the rate of exchange of domestic currency in terms of

foreign currency. This device implies that a country has adopted a flexible exchange rate

policy.

Suppose the rate of exchange between Indian rupee and US dollar is $1 = Rs. 40. If India

experiences an adverse balance of payments with regard to U.S.A, the Indian demand for US

dollar will rise. The price of dollar in terms of rupee will rise. Hence, dollar will appreciate in

external value and rupee will depreciate in external value. The new rate of exchange may be

say $1 = Rs. 50. This means 25% exchange depreciation of the Indian currency.

Exchange depreciation will stimulate exports and reduce imports because exports will become

cheaper and imports costlier. Hence, a favourable balance of payments would emerge to pay off

the deficit.

Limitations of Exchange Depreciation :-

1. Exchange depreciation will be successful only if there is no retaliatory exchange

depreciation by other countries.

2. It is not suitable to a country desiring a fixed exchange rate system.

3. Exchange depreciation raises the prices of imports and reduces the prices of exports. So

the terms of trade will become unfavourable for the country adopting it.

4. It increases uncertainty & risks involved in foreign trade.

5. It may result in hyper-inflation causing further deficit in balance of payments.

3. Devaluation

Devaluation refers to deliberate attempt made by monetary authorities to bring down the value

of home currency against foreign currency. While depreciation is a spontaneous fall due to

interactions of market forces, devaluation is official act enforced by the monetary authority.

Generally the international monetary fund advocates the policy of devaluation as a corrective

measure of disequilibrium for the countries facing adverse balance of payment position. When

India's balance of payment worsened in 1991, IMF suggested devaluation. Accordingly, the

value of Indian currency has been reduced by 18 to 20% in terms of various currencies. The

1991 devaluation brought the desired effect. The very next year the import declined while

exports picked up.

When devaluation is effected, the value of home currency goes down against foreign currency,

Let us suppose the exchange rate remains $1 = Rs. 10 before devaluation. Let us suppose,

devaluation takes place which reduces the value of home currency and now the exchange rate

becomes $1 = Rs. 20. After such a change our goods becomes cheap in foreign market. This is

because, after devaluation, dollar is exchanged for more Indian currencies which push up the

demand for exports. At the same time, imports become costlier as Indians have to pay more

currencies to obtain one dollar. Thus demand for imports is reduced.

Generally devaluation is resorted to where there is serious adverse balance of payment

problem.

Limitations of Devaluation :-

1. Devaluation is successful only when other country does not retaliate the same. If

both the countries go for the same, the effect is nil.

2. Devaluation is successful only when the demand for exports and imports is elastic.

In case it is inelastic, it may turn the situation worse.

3. Devaluation, though helps correcting disequilibrium, is considered to be a weakness for

the country.

4. Devaluation may bring inflation in the following conditions :-

i. Devaluation brings the imports down, When imports are reduced, the domestic

supply of such goods must be increased to the same extent. If not, scarcity of

such goods unleash inflationary trends.

ii. A growing country like India is capital thirsty. Due to non availability of capital

goods in India, we have no option but to continue imports at higher costs. This

will force the industries depending upon capital goods to push up their prices.

iii. When demand for our export rises, more and more goods produced in a country

would go for exports and thus creating shortage of such goods at the domestic

level. This results in rising prices and inflation.

iv. Devaluation may not be effective if the deficit arises due to cyclical or structural

changes.

4. Exchange Control

It is an extreme step taken by the monetary authority to enjoy complete control over the

exchange dealings. Under such a measure, the central bank directs all exporters to surrender

their foreign exchange to the central authority. Thus it leads to concentration of exchange

reserves in the hands of central authority. At the same time, the supply of foreign exchange is

restricted only for essential goods. It can only help controlling situation from turning worse. In

short it is only a temporary measure and not permanent remedy.

Non-Monetary Measures for Correcting the BoP ↓

A deficit country along with Monetary measures may adopt the following non-monetary

measures too which will either restrict imports or promote exports.

1. Tariffs

Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the prices of imports

would increase to the extent of tariff. The increased prices will reduced the demand for

imported goods and at the same time induce domestic producers to produce more of import

substitutes. Non-essential imports can be drastically reduced by imposing a very high rate of

tariff.

Drawbacks of Tariffs :-

1. Tariffs bring equilibrium by reducing the volume of trade.

2. Tariffs obstruct the expansion of world trade and prosperity.

3. Tariffs need not necessarily reduce imports. Hence the effects of tariff on the balance of

payment position are uncertain.

4. Tariffs seek to establish equilibrium without removing the root causes of

disequilibrium.

5. A new or a higher tariff may aggravate the disequilibrium in the balance of payments of

a country already having a surplus.

6. Tariffs to be successful require an efficient & honest administration which

unfortunately is difficult to have in most of the countries. Corruption among the

administrative staff will render tariffs ineffective.

2. Quotas

Under the quota system, the government may fix and permit the maximum quantity or value of

a commodity to be imported during a given period. By restricting imports through the quota

system, the deficit is reduced and the balance of payments position is improved.

Types of Quotas:-

1. the tariff or custom quota,

2. the unilateral quota,

3. the bilateral quota,

4. the mixing quota, and

5. import licensing.

Merits of Quotas:-

1. Quotas are more effective than tariffs as they are certain.

2. They are easy to implement.

3. They are more effective even when demand is inelastic, as no imports are possible

above the quotas.

4. More flexible than tariffs as they are subject to administrative decision. Tariffs on the

other hand are subject to legislative sanction.

Demerits of Quotas:-

1. They are not long-run solution as they do not tackle the real cause for disequilibrium.

2. Under the WTO quotas are discouraged.

3. Implements of quotas are open invitation to corruption.

3. Export Promotion

The government can adopt export promotion measures to correct disequilibrium in the balance

of payments. This includes substitutes, tax concessions to exporters, marketing facilities, credit

and incentives to exporters, etc.

The government may also help to promote export through exhibition, trade fairs; conducting

marketing research & by providing the required administrative and diplomatic help to tap the

potential markets.

4. Import Substitution

A country may resort to import substitution to reduce the volume of imports and make it self-

reliant. Fiscal and monetary measures may be adopted to encourage industries producing

import substitutes. Industries which produce import substitutes require special attention in the

form of various concessions, which include tax concession, technical assistance, subsidies,

providing scarce inputs, etc.

Non-monetary methods are more effective than monetary methods and are normally applicable

in correcting an adverse balance of payments.

Drawbacks of Import Substitution :-

1. Such industries may lose the spirit of competitiveness.

2. Domestic industries enjoying various incentives will develop vested interests and ask

for such concessions all the time.

3. Deliberate promotion of import substitute industries go against the principle of

comparative advantage.

3. State the significance for compilation of the balance of payments by a country.

Balance of payment (BoP) is a statistical statement that summarizes, for a specific period,

transactions between residents of a country and the rest of the world. BoP positions indicate

various signals to businesses. BoP comprises current account, capital account and financial

account and services, income and current transfers. In the capital account, transactions of

capital transfers, capital acquisition and non-produced non-financial assets like buildings and

patents are included, while in the financial account, transactions relating to financial assets and

liabilities like portfolio investments and foreign exchange reserves are included.

However, the BoP account of most countries still classify transactions under two heads only—

capital account and current account. In such a case, financial and capital accounts are treated as

one. Transactions in BoP are recorded on a double-entry bookkeeping system that is, a

transaction is recorded on each side—debit and credit of the BoP account.

There are many signals that the BoP account of a country gives out. For example, large current

account transactions indicate towards openness of an economy. This was the case with India as

reduction in trade restrictions and duties led to increase in both exports and imports after 1991.

Also large capital account transactions may indicate well-developed capital markets of an

economy.

Capital and current account balances for India were quite stable between 1991 and 2001. After

2001, primarily because of increased exports of IT services and transfers, current account

balance went into surplus. But due to increasing imports and an increasing oil bill, it started

deteriorating after 2004 and went into deficit.

Sound fundamentals and a large untapped market coupled with a deregulated regime allowed

foreign investors to invest in India, thereby increasing capital inflows after 2000. However, the

global meltdown has led to an outflow of capital, which has led to a sudden fall in the capital

account balance after 2007.

Reserves were built up over the years mainly because of capital inflows. But a recent deficit in

current account and capital outflow led to a fall in 2008-09.

Healthy BoP positions or surplus in capital and current account keeps confidence in the

economy and among investors. However, healthy BoP positions may be different for different

countries. For example, surplus in current account is often more important for developed

countries than surplus in capital account as most of them have sufficient capital to fund their

investments. On the other hand, developing countries like India may place more importance on

capital account as reserves and funding for investment is crucial for them at present.

Large balances often attract foreign investors into an economy, thus bringing in precious

foreign exchange. Often credit ratings are based on BoP positions, thereby affecting the flows

of credit to businesses. Businesses can make predictions about exchange rates by studying BoP

positions. A healthy BoP position can signal domestic currency appreciation, hence

encouraging businesses to engage in future contracts accordingly. Also, the BoP position

influences the decisions of policy makers, which are crucial for any business.

How does BoP influence economic policy?

The policies of a nation are highly affected and determined by the position and status of its

BoP. While formulating or deciding any economic policy, BoP position and policy effect on

BoP is given special consideration. While all the policies affect BoP, policies like tariff policy,

those related to foreign flows etc affect it in greater magnitude.

Earlier, trade-related policies used to have special focus. But over the years the share of current

account transactions in total BoP transactions has decreased. For example, in India its share

was almost 60% in 1991-92, but reduced to around 44% in 2007-08. Also, mismatch has been

much greater in capital account in recent years, which gave rise to India’s foreign exchange

reserves. Over the years, these trends have forced policy makers to make policies keeping in

mind foreign flows (capital) and effects of policies on them. However, policies at the same time

could be held responsible for such flows.

To improve BoP positions countries have lately often leaned towards the capital account side.

The trend has shifted from import substituting policies, that is, policies in which imports are

discouraged by way of tariffs, quotas toward more of foreign inflows enhancing policies in the

belief that such inflows may make a country crisis-proof and lead to investments that would

increase productive capacity and also may increase exports that would earn foreign exchange in

future.

However, BoP position in itself affects decisions of policy makers. Often, a deteriorating

current account is supported by capital or financial account. A healthy BoP position often

allows countries to open up their trade and to appropriate gains from it.

India’s BoP

India presently has a deficit in its current account of BoP, which has increased substantially

after reforms in 1991. In 1991-92, current account deficit was $1,178 million, which rose to

$17,403 million in 2007-08, and accounted for $36,469 million for the last three quarters of

2008. After the reforms in 1991, India’s position of merchandise trade (exports and imports of

goods) kept on deteriorating, but its position on invisibles (services, current transfers etc)

improved during the period. However, one of the major factors for increasing current account

deficit in the last few years has been a rising oil import bill. Some countries like Japan and

Germany have current account surpluses, while the USA and UK have deficits.

India has done fairly well on the capital account side. In 2007-08 it had a capital account

surplus of $108,031 million. In the same year it increased its foreign exchange reserves by

$92,164 million, which provided stability to the economy. Foreign investments have increased

manifold since 1991, peaking in 2007-08 to $44,806 million.

India’s overall current account and capital account deficit is $20,380 million for April–

December 2008, which is expected to rise to a figure between $25 and 30 billion by the year

ending March 31, 2009. There has been dip in reserves from $309,723 million in March 2008

to $253,000 million in March 2009. Reasons for this are portfolio flows from foreign

institutional investors and the appreciation of the US dollar. But this may not pose a significant

threat to the Indian economy and businesses because of large pool of reserves that are still

providing enough cushion. However, some businesses like those related to equities and realty

are hit when outflows from these sectors occur. Not only is there fall in asset prices and erosion

of investment value, but economic activity also gets reduced in these sectors.

However, recent profitability/growth numbers have indicated signs of a revival. Also political

change and expected stability might bring in foreign exchange and may improve India’s capital

account position and reserves. This may lead to the appreciation of the Indian rupee and may

affect exporters and importers accordingly. At the same time, reserves infuse stability into the

system, which in turn has positive effects on businesses and investments.

4. How does IMF help in promotion of international trade?

The IMF works to foster global growth and economic stability. It provides policy advice and

financing to members in economic difficulties and also works with developing nations to help

them achieve macroeconomic stability and reduce poverty. The rationale for this is that private

international capital markets function imperfectly and many countries have limited access to

financial markets. Such market imperfections, together with balance of payments financing,

provide the justiciation for official financing, without which many countires could only correct

large external payment imbalances through measures with adverse affects on both national and

international economic prosperity. The IMF can provide other sources of financing to countries

in need that would not be available in the absence of an economic stabilization program

supported by the Fund.

Upon initial IMF formation, its two primary functions were: to oversee the fixed exchange rate

arrangements between countries, thus helping national governments manage theirexchange

rates and allowing these governments to prioritize economic growth, and to provide short-term

capital to aid balance-of-payments. This assistance was meant to prevent the spread of

international economic crises. The Fund was also intended to help mend the pieces of the

international economy post the Great Depression and World War II.

The IMF’s role was fundamentally altered after the floating exchange rates post 1971. It shifted

to examining the economic policies of countries with IMF loan agreements to determine if a

shortage of capital was due to economic fluctuations or economic policy. The IMF also

researched what types of government policy would ensure economic recovery. The new

challenge is to promote and implement policy that reduces the frequency of crises among the

emerging market countries, especially the middle-income countries that are open to massive

capital outflows. Rather than maintaining a position of oversight of only exchange rates, their

function became one of “surveillance” of the overall macroeconomic performance of its

member countries. Their role became a lot more active because the IMF now manages

economic policy instead of just exchange rates.

In addition, the IMF negotiates conditions on lending and loans under their policy

of conditionality, which was established in the 1950s. Low-income countries can borrow an

onconcessional term, which means there is a period of time with no interest rates, through the

Extended Credit Facility (ECF), the Standby Credit Facility (SCF) and the Rapid Credit

Facility (RCF). Nonconcessional loans, which include interest rates, are provided mainly

through Stand-By Arrangements (SBA), the Flexible Credit Line (FCL), the Precautionary and

Liquidity Line (PLL), and the Extended Fund Facility. The IMF provides emergency assistance

via the newly-introduced Rapid Financing Instrument (RFI) to all its members facing urgent

balance of payments needs.

In 1995 the International Monetary Fund began work on data dissemination standards with the

view of guiding IMF member countries to disseminate their economic and financial data to the

public. The International Monetary and Financial Committee (IMFC) endorsed the guidelines

for the dissemination standards and they were split into two tiers: The General Data

Dissemination System (GDDS) and the Special Data Dissemination Standard (SDDS).

The International Monetary Fund executive board approved the SDDS and GDDS in 1996 and

1997 respectively, and subsequent amendments were published in a revised Guide to the

General Data Dissemination System. The system is aimed primarily at statisticians and aims to

improve many aspects of statistical systems in a country. It is also part of the World Bank

Millennium Development Goals and Poverty Reduction Strategic Papers.

The primary objective of the GDDS is to encourage IMF member countries to build a

framework to improve data quality and increase statistical capacity building. Upon building a

framework, a country can evaluate statistical needs, set priorities in improving the

timeliness, transparency, reliability and accessibility of financial and economic data. Some

countries initially used the GDDS, but later upgraded to SDDS.

5. What is the role of SAPTA in promotion of trade in the region?

In December 1991, the Sixth Summit held in Colombo approved the establishment of an Inter-

Governmental Group (IGG) to formulate an agreement to establish a SAARC Preferential

Trading Arrangement (SAPTA) by 1997. Given the consensus within SAARC, the Agreement

on SAPTA was signed on 11 April 1993 and entered into force on 7 December 1995 well in

advance of the date stipulated by the Colombo Summit. The Agreement reflected the desire of

the Member States to promote and sustain mutual trade and economic cooperation within the

SAARC region through the exchange of concessions.

The basic principles underlying SAPTA are:

a. overall reciprocity and mutuality of advantages so as to benefit equitably all

Contracting States, taking into account their respective level of economic and industrial

development, the pattern of their external trade, and trade and tariff policies and

systems;

b. negotiation of tariff reform step by step, improved and extended in successive stages

through periodic reviews;

c. recognition of the special needs of the Least Developed Contracting States and

agreement on concrete preferential measures in their favour; and

d. inclusion of all products, manufactures and commodities in their raw, semi-processed

and processed forms.

Four rounds of trade negotiations have been concluded under SAPTA covering over 5000

commodities. Each Round contributed to an incremental trend in the product coverage and the

deepening of tariff concessions over previous Rounds.

CASE STUDY 1

1. Why did Toyota prefer joint venture rather than exporting, to enter US market? What

were the reasons for GM to enter into the joint venture and finally to discontinue it?

Investment in the automotive industry over the past 25 years was not limited to the Japanese

firms, and with it came increased cooperation. American automakers invested in Japanese

companies, with each of the Big Three entering into a joint venture (JV) with a Japanese

counterpart. From 1998 to 2002,General Motors owned a 49% share of Isuzu, up from the 34%

it held since the early 1970s, with Ford and Chrysler historically holding large shares of Mazda

and Mitsubishi respectively. The American companies used these relationships to import

vehicles to supplement their domestic lines, which they rebadged and sold as their own. The

Dodge Colt, sold in the US by Chrysler in the 70s and 80s, was actually produced by

Mitsubishi.

Joint ventures in which American and Japanese automakers jointly produce vehicles began in

1984 with the establishment of New United Motor Manufacturing Inc. (NUMMI) in Fremont,

California by GM and Toyota. While manufacturing vehicles for each company, through

NUMMI GM was able to study Toyota’s assembly methods and Toyota studied US labor

relations and management. The Ford-Mazda partnership, which goes back to 1979, started a

50-50 JV the following year in Flat Rock, Michigan; making it the only Japanese company to

produce vehicles in the heart of America’s automobile country. The two companies cooperated

extensively on small cars and pickup trucks, resulting in the joint development of the

Ford Explorer, the Detroit automaker’s most successful model. Diamond-Star Motors, a JV

between Chrysler and Mitsubishi, built cars for both companies in Normal, Illinois from 1985-

1991, before the plant became wholly owned by Mitsubishi.

Nearly a quarter-century on, while cooperation in technology and development continues,

many of the JV plants run by US and Japanese partnerships have either closed their doors or

become the sole property of a single party due to corporate restructuring. Last

spring, Californian autoworkers shed tears as the finalCorolla rolled off the assembly line at

NUMMI, which Toyota closed after GM pulled out the year before as part of bankruptcy

restructuring. Mazda appears poised to do the same at the AutoAlliance plant it shares with

Ford in Flat Rock, after announcing earlier last month that it will stop producing

the Mazda6 sedan there by next year. While the knowledge gained by both sides in the JV

experiments had been valuable, this did not change the fact that vehicles produced at the same

plant often had to compete against each other in the market, creating winners and losers within

the partnership.

Back then, GM and Toyota needed each other. GM had to build small cars, but they were lousy

and lost money.

Toyota had its own problems. The company was facing import restrictions from the U.S.

Congress. So, it had to start building cars in United States.

It wanted a U.S. partner who would teach it how to deal with American workers. Toyota settled

on the rough bunch in Fremont.

"It was considered the worst workforce in the automobile industry in the United States," said

Bruce Lee, who ran the western region for the United Auto

Workers and oversaw the Fremont plant. "And it was a reputation that was well earned.

Everything was a fight. They had strikes all the time. It was just chaos constantly."

The idea of reopening the plant emerged out of the need that GM had to build high-quality and

profitable small cars and the need Toyota had to start building cars in the United States, a

requirement due to the possibility of import restrictions by the U.S. Congress. GM saw the joint

venture as an opportunity to learn about lean manufacturing from the Japanese company, while

Toyota gained its first manufacturing base in North America and a chance to implement its

production system in an American labor environment.

2. Why did GM select Fremont, California, automobile manufacturing plant for

NUMMI?

By 1982, GM had had enough and put the Fremont factory out of its misery, Two years later,

GM and Toyota reopened the factory with — incredibly — most of the same workforce.

But first, they sent some of them to Japan to learn the Toyota way.

The key to the Toyota Production System was a principle so basic, it sounds like an empty

management slogan: Teamwork.

At Toyota, people were divided into teams of just four or five and they switched jobs every few

hours to relieve the monotony. A team leader would step in to help when anything went wrong.

At the old GM plant in Fremont, Calif., the system had been totally different and there was one

cardinal rule that everyone knew: the assembly line could never stop.

"You just didn't see the line stop," Madrid said. "I saw a guy fall in the pit and they didn't stop

the line."

Lee, the supervisor who oversaw the plant summed it up this way: "You saw a problem, you

stopped that line: you were fired."

As a result, vehicles at the plant had lots of defects. Haggerty saw all kinds of mistakes go right

down the line.

3. What are the other modes of entry that Toyota could have selected to enter US market?

The two parties to this joint venture entered with different aims, and left with different

gains. On the face of it, GM found use for a 20-year old plant that it had shuttered. And Toyota

contributed the blueprint for a weak-selling car. But salvaging old assets is not what this deal

was about.

For Toyota, this was its first major manufacturing investment in the United States. What better

way to learn about the peculiarities of the US automotive market than from GM? Toyota

learned how to adapt its famed Toyota Production System to work with US suppliers, US

government regulations, and, most importantly, the UAW. After just two years in school with

GM, Toyota invested in its first wholly-owned plant in the USA; this new plant in Kentucky

eventually became Toyota's largest outside of Japan.

General Motors, for its part, also sought to learn from the venture. But its task was more

challenging. GM indeed sought to glean tips from Toyota's magic. But the way the joint

venture was run kept this learning to a minimum. GM placed a dozen or so managers at the

plant; Toyota was in charge of operating the plant and filling other managerial positions. The

learning-by-doing of Toyota managers turned out to be the more useful way to learn.

GM also faced an uphill battle in incorporating what it did learn from Toyota. Yes, GM saw

that Toyota organized the factory floor and relations with suppliers differently. But transferring

this to GM's legacy plants in Detroit proved difficult. The new Saturn line was launched to try

to capture this learning, but even a new nameplate could not change old corporate habits.

So, what does this mean for today? That many industries with wasting assets can expect an

onslaught of investment from cash-rich, technology-hungry, brand-hungry buyers. Aside from

the automotive sector, other industrial sectors, chemicals, raw materials, and consumer brands

appear ripe for the plucking. This restructuring of industries can be a good thing for both buyer

and seller, and for partners in the JVs that will be formed. But will US firms take advantage of

this opportunity to transform themselves, or will they take the cash and close their eyes?

Joint ventures can take on many different looks, which can make it confusing to navigate the

JV world today. However, the diversity in joint ventures can also be an opportunity, allowing

both companies to design a partnership that works for their specific needs. Peruse these 10

ideas for joint ventures and make your partnerships reap the rewards for which you hope.

1. Brochure Exchange – A joint venture may be as simple as agreeing to display one

another’s brochures in the other’s business. Offer them to customers you think might be

interested in your partner’s goods or services.

2. Link Exchange - This is a particularly effective method of online advertising. Instead of

offering a brochure for your partner, you provide a link to his website on your own to drive

more traffic to his website as well, and vice-versa.

3. Cross-Endorsement – Word of mouth is one of the most effective methods of advertising,

particularly when it comes from a business customers already know and respect. Endorse your

JV partner through joint mailings, product reviews on your website or simple, direct referrals.

4. Sharing Advertising – Even online advertising can add up quickly in costs, but if you split

the cost of your virtual ads with your JV partner, you get that much more bang for your

advertising buck. This can also be effective with print advertising or even a booth rental at a

trade show.

5. Sharing Customer Lists – Any business owner knows the challenge of forming a really

good customer list, but when you pool your resources; you get exponentially more customers

with little additional effort.

6. Co-Writing Articles - Articles effectively establish the writer as an expert in his field,

while directing customers to his product website. When you work together toward this end, you

leverage your resources for even greater results.

7. Co-Hosting Marketing Events – When you share the cost of renting a space and

advertising an event, you get a lot more value from your marketing efforts. You are also

pooling talent and expertise to present potential customers with enticing information.

8. Bundling Products - When you and your JV partner offer related products, you can create

bundles of items that can sell for a reduced price. This can be an effective way of attracting

new customers who enjoy the value of the “package deal.”

9. Offering Product Reviews – You are already considered an expert in your field, as is your

JV partner. When you “objectively” review one another’s products or services, you add

legitimacy to the process. Provide reviews on your own websites, with links to your partner’s

website included.

10. Exchanging Marketing for Profits - If you don’t have the customer base or the reputation

to offer a potential JV partner, offer a percentage of your profits for every sale you get from

your partner’s efforts.

These types of joint ventures are just the tip of the iceberg, but they can inspire you to form

the right type of partnership for your needs. As long as you and your JV partner are both

satisfied with the arrangement and are profiting from the joint venture, there is no right or

wrong way to partner with another business for the sake of increasing your customer base and

profits.

Toyota could have adopted any of the above form of Joint venture.

CASE STUDY 2

1. WTO cannot punish individual companies for dumping and can only take actions

against individual countries. Is this a wise policy? Why or why not?

Where any article is exported from any country or territory to India at less than its normal value

then upon the importation of such article to India the central Govt. may be notification in the

official gazette impose an anti dumping duty not exceeding the margin of dumping in relation

to such article. For purpose of identification, assessment and collection of Anti Dumping Duty

on dumped articles and for determination of injury, the Govt. has appointed Additional

Secretary to the Govt. of India Ministry of Commerce as designated Authority for purpose of

above rules.

It is to be understood that imposition of Anti Dumping Duty is based on Commodity to

Commodity, country to country and suppliers in Exporting countries.

The Anti-Dumping Agreement of the World Trade Organization (WTO), commonly known as

the AD Agreement, governs the application of anti-dumping measures by WTO member

countries.

A product is considered to be "dumped" if it is exported to another country at a price below the

normal price of a like product in the exporting country. Anti-dumping measures are unilateral

remedies (the imposition of anti-dumping duties on the product in question) that the

government of the importing country may apply after a thorough investigation has determined

that the product is, in fact, being dumped, and that sales of the dumped product are causing

material injury to a domestic industry that produces a like product.

All members of the WTO (offsite link) are parties to this Agreement, whose full name is the

"Agreement on Implementation of Article VI of the General Agreement on Tariffs and Trade

1994". It went into effect on January 1, 1995. Pursuant to the Doha Ministerial Declaration,

negotiations for the Anti-Dumping Agreement are currently underway. The agreement has no

expiration date. The negotiations are scheduled to be completed by January 1, 2005.

This is a wise decision and WTO should implement it strictly.

2. Why is protectionism on the rise in recent years?

As the recession deepens in the Western countries, many of them are resorting to

protectionism. This adds to the problems in developing countries, which are already

increasingly facing the effects of the global economic turmoil.

Protectionism is the policy of protecting the markets, industries or jobs of one's own country,

usually by restricting the entry of products or services from other countries.

It can take, and is taking, many forms. The most recognizable protectionist method is to restrict

imports by imposing a tariff, a ban or a quota. There are also non-tariff trade barriers, such as

imposing anti-dumping measures or using safety standards as an excuse to block imports.

Protectionism can also take the form of requiring (or giving incentives to) government agencies

or companies to make use of locally produced goods and services, thereby putting foreign

products at a disadvantage.

Then there are the subsidies that governments give to industries or financial institutions, either

to keep bankrupt companies afloat or to strengthen viable ones. Without these state aids, they

may fall or be taken over, including by foreigners.

If enough subsidies are given, they may even be able to export, and at prices below their cost of

production, as is taking place in agricultural goods like rice, wheat or chicken coming from

the United States and Europe.

Most economists are against protectionism, partly because it is bad overall for the country

practicing it (the costs of consumer goods or production inputs increase as a negative effect,

that may outweigh the benefits of increased local business and jobs) but mainly because it will

invite retaliation from affected countries, lead to "trade wars" and reduce global trade overall,

to the detriment of all parties.

The protectionist measures taken by the United States in the 1930s are said to have triggered

trade wars and to have worsened the Great Depression.

New forms of protection are now emerging in the global crisis. The most notable is the "Buy

American" clause in the US$800-plus billion stimulus package now being negotiated in the US

Congress.

In the House of Representatives version of the Bill, increased government spending on steel

and some manufactured products will only be for made-in-America products.

After protests from political leaders in Canada and many European countries, this clause is to

be watered down (that it will be in line with international law) in the Senate version, but is

likely to remain, thus violating the spirit if not the letter of the non-protection principle.

France is another country where blatantly protectionist policies are on the rise. According to a

Financial Times report on 3 February, French President Nicolas Sarkozy wants French car

companies Peugeot and Renault to commit to buy specific volumes of parts and services from

local suppliers in return for soft loans and loan guarantees.

Last Friday, he also called on the two car companies to close their factories in eastern Europe

and move production back to France, sparking a protest from the Czech Republic.

The biggest protectionist measures however are in the area of subsidies. Until the current crisis,

the most notorious subsidies were in agriculture, with developed countries providing over

US$300 billion in state aid to farmers and food companies, and in high prices paid by

consumers.

This has enabled otherwise uncompetitive Western farm products to flood international

markets, at the expense of developing countries' farmers.

The subsidy phenomenon is now rising in the industrial and services sectors. In industry, most

subsidies are banned by the rules of the World Trade Organisation. Recently, however, the

United States Congress approved a US$17.4 billion aid package to two crisis-hit car companies

Chrysler and General Motors.

Some European leaders originally threatened to take action against this US move, but their

countries are instead now joining the US to also give subsidies to save their car companies.

Sweden is providing US$3.4 billion to Volvo and Saab in loan guarantees and support for

research and development, France has promised US$7.8 billion in loans and loan guarantees to

its car companies, and the German finance minister said it is "fatal" not to support German auto

companies when the US is giving its own firms billions of dollars in aid.

Although protectionism is spreading in the manufacturing sector, it has arrived with incredible

force in services, where the United Stares and European governments have doled out more than

US$1 trillion in various types of aid to banks, insurance companies and other financial

institutions, such as house-mortgage companies.

Without these massive injections of equity, loans and loan guarantees, giant companies such as

Citigroup and AIG in the US, UBS in Switzerland and Royal Bank of Scotland in the United

Kingdom would have gone under.

Developing countries are at a disadvantage because they do not have the same amounts of

public funds to bail out their troubled manufacturing companies or financial institutions.

As the recession worsens, more firms and banks in the developing countries will get into

difficulties. Not only will their business and very existence be threatened, their markets or

equity could even ironically be taken over by giant foreign companies which are massively

subsidized by their own governments.

The US was first off the mark with the new protectionism. Europe followed, taking the

principle "if you can't beat them, join them." Many developing countries can neither beat them

nor join them, simply because they lack the large funds needed to play this subsidy game.

One other concern of developing countries is the approach taken to curb or discourage

protectionism.

At the G20 summit in Washington last September, it was agreed that there would be a one-year

moratorium on protectionist measures.

This presumably did not cover subsidies, as there has been more than a trillion dollars of new

subsidies to financial institutions and now motorcar companies in the West.

If this only meant tariffs, and also a discouragement of increases in applied tariffs, it will affect

developing countries, rather than developed countries.

This is because there is generally little difference between applied and bound tariffs in

developed countries, whereas in many developing countries, there is a wide gap between the

applied and the bound tariff.

This gap allows developing countries to have the policy space to increase their applied tariffs,

which is their right, and which they may need to use, especially if their domestic industries or

agriculture are weakened by the global crisis, or if they have an increase in their trade deficit.

If there is a general prohibition against increasing the applied tariffs, then developing countries

will be doubly hit. They would not be able to exercise the right of using their policy space. And

at the same time, the developed countries are increasing their subsidies, and thus their

companies are strengthening their ability to export.

The main defence the developing countries may have against increased subsidies of developed

countries is to increase their applied tariffs, but if this defence is taken away from them, then

the discriminatory interpretation of what to do about protectionism will hit the developing

countries adversely.