Unit 4. International Trade

Transcription

1 Unit 4 International Trade

2 Balance of Payment The balance of payments (henceforth BOP) is a consolidated account of the receipts and payments from and to other countries arising out of all economic transactions during the course of a year. Balance of payments refers to the recording of all economic transactions of a given country with rest of the world. Each country has got to enter into economic transactions with other countries of the world. As a result of such transactions, it receives payments to other countries. Balance of Payments is a statement of accounts of these receipts and payments. Definition Acc. to Kindleberger The balance of payments of a country is a systematic record of all economic transactions between its residents and residents of foreign countries. In words of Benham Balance of payments of a country is record of the monetary transactions over a period of time with the rest of the world. In the words of C. P. Kindleberger : The balance of payments of a country is a systematic record of all economic transactions between the residents of the reporting and the residents of the foreign countries during a given period of time. Here by residents we mean individuals, firms and government. By all economic transactions we mean individuals, firms and government. By all economic transactions we mean transactions of both visible goods (merchandise) and invisible goods (services), assets, gifts, etc. In other words, the BOP shows how money is spent abroad (i.e., payments) and how money is received domestically (i.e., receipts). Thus, a BOP account records all payments and receipts arising out of all economic transactions. All payments are regarded as debits (i.e., outflow of money) and are recorded in the accounts

3 with a negative sign and all receipts are regarded as credits (i.e., inflow or money) and are recorded-in the accounts with a positive sign. The International Monetary Fund defines BOP as a statistical statement that subsequently summarises, for a specific time period, the economic transactions of an economy with the rest of the world. Features of Balance of Payments 1. Systematic Record: It is a systematic record of receipts and payments of a country with other countries. 2. Fixed Period of Time: It is a statement of account pertaining to a given period of time, usually one year. 3. Comprehensiveness: It includes all the three items i.e. visible, invisible and capital transfers 4. Double entry System: Receipts and payments are recorded on the basis of double entry system. 5. Adjustment of Differences: Whenever there is difference in actual total receipts and payments need for necessary adjustment is felt. In case of unfavorable balance of payments, government will have to take foreign loans or to promote foreign investment, so as to meet the difference in balance of payments. 6. All Items-Government and Non-Government. Components of BOP Accounts: A. The Current Account: The current account of BOP includes all transaction arising from trade in currently produced goods and services, from income accruing to capital by one country and invested in another and from unilateral transfers both private and official. The current account is usually divided in three sub-divisions.

4 The first of these is called visible account or merchandise account or trade in goods account. This account records imports and exports of physical goods. The balance of visible exports and visible imports is called balance of visible trade or balance of merchandise trade [i.e., items 1(a), and 2(a) of Table 6.1]. The second part of the account is called the invisibles account since it records all exports and imports of services. The balance of these transactions is called the balance of invisible trade. As these transactions are not recorded in the customs office unlike merchandise trade we call them invisible items. It includes freights and fares of ships and planes, insurance and banking charges, foreign tours and education abroad, expenditures on foreign embassies, transactions out of interest and dividends on foreigners investment and so on. Items 2(a) and 2(b) comprise services balance or balance of invisible trade. The difference between merchandise trade and invisible trade (i.e., items 1 and 2) is known as the balance of trade. There is another flow in the current account that consists of two items [3(a) and 3(b)]. Investment income consists of interest, profit and dividends on bonus and credits. Interest earned

5 by a US resident from the TELCO share is one kind of investment income that represents a debit item here. There may be a similar money inflow (i.e., credit item). Unrequited transfers include grants, gifts, pension, etc. These items are such that no reverse flow occurs. Or these are the items against which no quid pro quo is demanded. Residents of a country received these cost-free. Thus, unilateral transfers are one-way transactions. In other words, these items do not involve give and take unlike other items in the BOP account. Thus the first three items of the BOP account are included in the current account. The current account is said to be favourable (or unfavourable) if receipts exceed (fall short of) payments. B. The Capital Account: The capital account shows transactions relating to the international movement of ownership of financial assets. It refers to cross-border movements in foreign assets like shares, property or direct acquisitions of companies bank loans, government securities, etc. In other words, capital account records export and import of capital from and to foreign countries. The capital account is divided into two main subdivisions: short term and the long term movements of capital. A short term capital is one which matures in one year or less, such as bank accounts. Long term capital is one whose maturity period is longer than a year, such as long term bonds or physical capital. Long term capital account is, again, of two categories: direct investment and portfolio investment. Direct investment refers to expenditure on fixed capital formation, while portfolio investment refers to the acquisition of financial assets like bonds, shares, etc. India s investment (e.g., if an Indian acquires a new Coca- Cola plant in the USA) abroad represents an outflow of money. Similarly, if a foreigner acquires a new factory in India it will represent an inflow of funds. Thus, through acquisition or sale and purchase of assets, capital movements take place. Investors then acquire controlling interests over the asset. Remember that exports and imports of equipment do not appear in the capital account. On the other hand, portfolio investment refers to

6 changes in the holding of shares and bonds. Such investment is portfolio capital and the ownership of paper assets like shares does not ensure legal control over the firms. [In this connection, the concepts of capital exports and capital imports require little elaboration. Suppose, a US company purchases a firm operating in India. This sort of foreign investment is called capital import rather than capital export. India acquires foreign currency after selling the firm to a US company. As a result, India acquires purchasing power abroad. That is why this transaction is included in the credit side of India s BOP accounts. In the same way, if India invests in a foreign country,, it is a payment and will be recorded on the debit side. This is called capital export. Thus, India earns foreign currency by exporting goods and services and by importing capital. Similarly, India releases foreign currency by importing visible and invisibles and exporting capital.] C. Statistical Discrepancy Errors and Omissions: The sum of A and B (Table 6.1) is called the basic balance. Since BOP always balances in theory, all debits must be offset by all credits, and vice versa. In practice, it rarely happens particularly because statistics are incomplete as well as imperfect. That is why errors and omissions are considered so that the BOP accounts are kept in balance (Item C). D. The Official Reserve Account: The total of A, B, C, and D comprise the overall balance. The category of official reserve account covers the net amount of transactions by governments. This account covers purchases and sales of reserve assets (such as gold, convertible foreign exchange and special drawing rights) by the central monetary authority. Now, we can summarise the BOP data: Current account balance + Capital account balance + Reserve balance = Balance of Payments (X M) + (CI CO) + FOREX = BOP X is exports,

7 M is imports, CI is capital inflows, CO is capital outflows, FOREX is foreign exchange reserve balance. BOP Always Balances: A nation s BOP is a summary statement of all economic transactions between the residents of a country and the rest of the world during a given period of time. A BOP account is divided into current account and capital account. Former is made up of trade in goods (i.e., visible) and trade in services (i.e., invisibles) and unrequited transfers. Latter account is made up of transactions in financial assets. These two accounts comprise BOP A BOP account is prepared according to the principle of double-entry book keeping. This accounting procedure gives rise to two entries a debit and a corresponding credit. Any transaction giving rise to a receipt from the rest of the world is a credit item in the BOP account. Any transaction giving rise to a payment to the rest of the world is a debit item. The left hand side of the BOP account shows the receipts of the country. Such receipts of external purchasing power arise from the commodity export, from the sale of invisible services, from the receipts of gift and grants from foreign governments, international lending institutions and foreign individuals, from the borrowing of money from the foreigners or from repayment of loan by the foreigners. The right hand side shows the payments made by the country on different items to the foreigners. It shows how the total of external purchasing power is used for acquiring imports of foreign goods and services as well as the purchase of foreign assets. This is the accounting procedure. However, no country publishes BOP accounts in this format. Rather, by convention, the BOP figures are published in a single column with positive (credit) and negative (debit) signs. Since payments side of the account enumerates all the uses which are made up of the total foreign

8 purchasing power acquired by this country in a given period, and since the receipts of the accounts enumerate all the sources from which foreign purchasing power is acquired by the same country in the same period, the two sides must balance. The entries in the account should, therefore, add up to zero. In reality, why should they add up to zero? In practice, this is difficult to achieve where receipts equal payments. In reality, total receipts may diverge from total payments because of: (i) the difficulty of collecting accurate trade information; (ii) the difference in the timing between the two sides of the balance; and (iii) a change in the exchange rates, etc. Because of such measurement problems, resource is made to balancing item that intends to eliminate errors in measurement. The purpose of incorporating this item in the BOP account is to adjust the difference between the sums of the credit and the sums of the debit items in the BOP accounts so that they add up to zero by construction. Hence the proposition the BOP always balances. It is a truism. It only suggests that the two sides of the accounts must always show the same total. It implies only an equality. In this book-keeping sense, BOP always balances. Thus, by construction, BOP accounts do not matter. In fact, this is not so. The accounts have both economic and political implications. Mathematically, receipts equal payments but it need not balance in economic sense. This means that there cannot be disequilibrium in the BOP accounts. A combined deficit in the current and capital accounts is the most unwanted macroeconomic goal of,an economy. Again, a deficit in the current account is also undesirable. All these suggest that BOP is out of equilibrium. But can we know whether the BOP is in equilibrium or not? Tests are usually three in number: (i) movements in foreign exchange reserves including gold, (ii) increase in borrowing from abroad, and (iii) movements in foreign exchange rates of the country s currency in question. Firstly, if foreign exchange reserves decline, a country s BOP is considered to be in disequilibrium or in deficit. If foreign exchange reserves are allowed to deplete rapidly it may shatter the confidence of people over the domestic currency. This may ultimately lead to a run on the bank.

9 Secondly, to cover the deficit a country may borrow from abroad. Thus, such borrowing occurs when imports exceed exports. This involves payment of interest on borrowed funds at a high rate of interest. Finally, the foreign exchange rate of a country s currency may tumble when it suffers from BOP disequilibrium. A fall in the exchange rate of a currency is a sign of BOP disequilibrium. Thus, the above (mechanical) equality between receipts and payments should not be interpreted to mean that a country never suffers from the BOP problems and the international economic transactions of a country are always in equilibrium. Implications of an Unbalance in the BOP: Although a nation s BOP always balances in the accounting sense, it need not balance in an economic sense. An unbalance in the BOP account has the following implications: In the case of a deficit: (i) Foreign exchange or foreign currency reserves decline, (ii) Volume of international debt and its servicing mount up, and (iii) The exchange rate experiences a downward pressure. It is, therefore, necessary to correct these imbalances. BOP Adjustment Measures: BOP adjustment measures are grouped into four: (i) Protectionist measures by imposing customs duties and other restrictions, quotas on imports, etc., aim at restricting the flow of imports,

10 (ii) Demand management policies these include restrictionary monetary and fiscal policies to control aggregate demand [C + I + G + (X M)], (iii) Supply-side policies these policies aim at increasing the nation s output through greater productivity and other efficiency measures, and, finally, (iv) exchange rate management policies these policies may involve a fixed exchange rate, or a flexible exchange rate or a managed exchange rate system. As a method of connecting disequilibrium in a nation s BOP account, we attach importance here to exchange rate management policy only. Exchange Rate Management: An exchange rate is the price at which one currency is converted into or exchanged for another currency. Exchange rate connects the price system of two countries since this (special) price shows he relationship between all domestic prices and ill foreign prices. Any change in the exchange rate between rupee and dollar will cause a change in the prices of all American goods for Indians and the prices of all Indian goods for the Americans. In the process, equilibrium in the BOP accounts will be restored. Every government has to make international decisions of what type of exchange rate it wants to adopt. This means that government will have to decide how its own currency should be related to other currencies of the world. For instance, it may choose to fix the value of its currency to other currencies of the world so as to adjust its BOP difficulties, or it may choose to allow its currency to move free against other currencies of the world so as to adjust its BOP difficulties. This means that there are two important exchange rate systems the fixed (or pegged) exchange rate, and the flexible (or fluctuating or floating) exchange rate. These two exchange rates have been tried and tested in the past. Fixed exchange rate system had been tried by the IMF during when this system was abandoned. After 1971, the world s exchange rate became a flexible one or a floating one. Truly speaking, the exchange rate

11 that is being followed by the IMF now is known as the managed floating system, or the managed flexibility. (A) Fixed Exchange Rate: A fixed exchange rate is an exchange rate that does not fluctuate or that changes within a pre- determined rate at infrequent intervals. Government or the central monetary authority intervenes in the foreign exchange market so that exchange rates are kept fixed at a stable rate. The rate at which the currency is fixed is called par value. This par value is allowed to move in a narrow range or band of ± 1 per cent. If the sum of current and capital account is negative, there occurs an excess supply of domestic currency in the world markets. The government then intervenes using official foreign exchange reserves to purchase domestic currency. Fixed or the pegged exchange rate can be explained graphically. Let us suppose that India s demand for US goods rises. This increased demand for imports causes an increase in the supply of domestic currency, rupee, in the exchange market to obtain US dollars. Let DD1 and SS1 be the demand and supply curves of dollar in Fig These two curves intersect at point A and the

12 corresponding exchange rate is Rs. 40 = $1. Consequently, the supply curve shifts to SS2 that cuts the demand curve DD1 at point B. This means a fall in the exchange rate. To prevent this exchange rate from falling, the Reserve Bank of India will demand more rupees in exchange for US dollars. This will restrict the excess supply of rupee and there will be an upward pressure in exchange rate. Demand curve will now shift to DD2. The end result is the restoration of the old exchange rate at point C. Thus, it is clear that the maintenance of fixed exchange rate system requires that foreign exchange reserves are sufficiently available. Whenever a country experiences inadequate foreign currency reserves it won t be able to purchase domestic currency in sufficient quantities. Under the circumstances, the country will devalue its currency. Devaluation refers to an official reduction in the value of one currency in terms of another currency. (B) Flexible Exchange Rate: Under the flexible or floating exchange rate, the exchange rate is allowed to vary to international foreign exchange market influences. Thus, government does not intervene. Rather, it is the market forces that determine the exchange rate. In fact, automatic variations in exchange rates consequent upon a change in market forces are the essence of freely fluctuating exchange rates. A deficit in the BOP account means an excess supply of the domestic currency in the world markets. As price declines, imbalances are removed. In other words, excess supply of domestic currency will automatically cause a fall in the exchange rate and BOP balance will be restored.

13 Flexible exchange rate mechanism has been explained in Fig where DD1 and SS1 are the demand and supply curves. When Indians buy US goods, there arises supply of dollar and when US people buy Indian goods, there occurs demand for rupee. Initial exchange rate Rs. 40 = $1 is determined by the intersection of DD1 and SS1 curves in both the Figs. 6.10(a) and 6.10(b). An increase in demand for India s exportable means an increase in the demand for Indian rupee. Consequently, demand curve shifts to DD2 and the new exchange rate rises to Rs. 50 = $1. At this new exchange rate, dollar appreciates while rupee depreciates in value [Fig. 6.10(a)]. Fig. 6.10(b) shows that the initial exchange rate is Rs. 40 = $1. Supply curve shifts to SS2 in response to an increase in demand for the US goods. SS2 curve intersects the demand curve DD1 at point B and exchange rate drops to Rs. 30 = $1. This means that dollar depreciates while Indian rupee appreciates. (C) Managed Exchange Rate: Under this heading, floating exchange rates are managed partially. That is to say, exchange rates are determined in the main by market forces, but the central bank intervenes to stabilise fluctuations in exchange rates so as to bring orderly conditions in the market, or to maintain the desired exchange rate values.

14 Unfavourable or favourable balance of payments Balance of payments is said to be unfavourable when the payments (debit) of the country are more than its receipts (credit). On the other hand, when the payments (debit) of the country are less than its receipts (credit), the balance of payments is said to be favourable. Disequilibrium in balance of payments may be of two kinds: 1.Favourable balance of Payments When receipts are more than payments then balance of payments turns favourable. This situation increases foreign exchange reserves. In this case exports of goods, services and capital receipts are more than import of goods, services and capital payments. It is also known as surplus balance of payments. (Here Bf =Balanced balance of Payment; R-P>0=Receipts are greater than payments or their difference is positive.) 2. Unfavorable Balance of Payments Balance of payments is unfavorable when its payments are more than its receipts. This situation reduces foreign exchange reserves. In this case exports of goods, services and capital receipts are less than import of goods, services and capital receipts are less than import of goods, services and capital payments. It is also known as deficient balance of payments.

15 (Here, BF= Favourable balance of payments; R-P <0=Receipts, are less than payments or their difference is negative.) Equilibrium in Balance of Payments When capital receipts of a country and exports(visible and invisible) are to its capital payments and imports(visible and invisible) then its balance of payments is in equilibrium. (Here, B = balanced balance of payments; R =Reciepts, P=Payments) In short, balance of payments is unfavourable, if to meet the deficit between receipts and payments a country either makes payments in terms of gold or borrows from abroad for a short period. On the contrary, if to meet the surplus between receipts and payments a country either receives payment in terms of gold or lends to foreign countries for a short period, the balance of payments is said to be favourable. Causes of Unfavourable Balance of Payments/Unfavourable Balance of Trade Main Causes of unfavourable balance of payment of India are as follows: 1.Import of Machinery: Since independence, import of machines has increased on two scores: i. During World War II, machines in Indian industries overworked. Consequently, these were large-scale depreciation and wear and tear of machines. In order to replace he same, large quantity of new machines was imported. ii. Industrialisation of the country in the wake of Five year Plans also necessitated import of machines worth crores of rupees. This turned India s Balance of payments unfavourable.

16 2. Import of War equipments: In order to defend itself against China and Pakistan, large amount of war equipment were imported by India. These imports also caused disequilibrium in the balance of payments. 3. More demand of Consumption Goods In the post war period, demand not only of foreign goods but also of Indian goods went up. Previously, large amount of oilseeds, tea, iron ores etc. used to be exported out of India. Now because of increase in population their demand within the country has gone up. So export of these goods has gone down very much. 4. Price disequilibrium There has been wide difference in the domestic prices of the goods and the prices of goods in foreign countries. Due to inflation, domestic prices have increased more than the increase in prices of foreign goods. This has led to increase in imports and decrease in exports. 5. Expenditure on Embassies Independent India had to establish its political relations with other countries. To that end, it had to set up its embassies in foreign countries. It was an expensive affair. It also turned balance of payments unfavourable. This item does not affect balance of trade, as it is an invisible item,but it does affect balance of payments. 6. Foreign Competition India mainly exports jute, tea and textiles, but now foreign competition in these goods is growing. Bangladesh is India s rival in jute export and Sri Lanka and Indonesia in the export of tea and Korea and china in the export of cloth. This has also adversely affected our exports. 7. Increase in price of Crude Oil Value of imports has gone up on account of constant hike in the price of crude oil. Of the exports 30% is spent on petroleum products.

17 8. Payments of interest on foreign Debts The huge interest burden also caused disequilibrium in the balance of payments. This item does not affect balance of trade, as it is an invisible item. 9. Less growth in Exports Despite various export promotion schemes, our exports are still less than our imports. Moreover growth rate of exports is less than the growth rate of imports. 10. Gulf War In 1991,Gulf War(War between Iraq and several western countries)had also its adverse effect on India s balance of payments. On the one hand, price of petrol shoot up and on the other, foreign remittances by Indians working in gulf area, viz., Kuwait, Iraq, etc. to India altogether stopped. It rendered the imports expenses and reduced the foreign remittances. 11. Disintegration of USSR India had large amount of foreign trade with USSR. The disintegration of USSR had an adverse effect on India s foreign trade. Besides, there are some other minor factors also accounting for adverse balance of payments, viz., poor quality, malpractices of Indian traders causing impediments in exports, bad effects of high cost of production on exports, etc. Measures/Suggestions to correct disequilibrium in the Balance of Payments The main factor accounting for disequilibrium of payments is the excess of imports over exports. Two measures are, therefore called for to correct this disequilibrium. Exports should be promoted and imports discouraged. Import substitution should be resorted to. Following specific measures are suggested to correct disequilibrium in the balance of payments: 1. Promotion of Exports

18 Promotion of exports is the best measure to correct an adverse balance of payments. To achieve this end, all taxes on export goods be withdrawn, export industries should be provided raw materials and transport facilities at reduced prices, so that prices of these goods remain low. These industries should be provided credit facilities at liberal rates. To promote exports, intensive publicity of Indian goods be undertaken in foreign markets and goods be designed to the tastes of the foreign consumers. 2. Increase in Production To cut down imports and encourage exports, it is essential that agricultural, industrial and mineral production be increased. Jute manufactured products; tea and coffee are of great importance among exports from India. Efforts have been made to increase the production of these products in Five Year Plans. Their production needs to be further increased. Recently, several new items have entered the export list viz. machines, electric fans, cycles, ready made garments, gems and jewellery etc. Raw materials should be made available to export industries at international prices. Production capacity of cement, fertilizers, iron and steel etc. should be utilized fully. 3. Trade Agreements Government of India enters into trade agreements with the governments of other countries in order to expand trade. Many foreign trade delegates visit India to strengthen trade ties. India has negotiated trade agreements with many countries viz. Bangladesh, Bulgaria, Germany, Egypt, France, Korea, Iran, Iraq etc. On 15April,1994,India enters into trade agreements with all other countries signing GATT, automatically. India has entered into trade agreement with WTO nations, SAARC nations. As a member of World Trade Organization, India is having trade relations with other 149 member nations of WTO. More trade agreements should be done with foreign countries to promote our foreign trade and exports. 4.Encouragement to Foreign Investment Foreign industries and multinational corporations (MNCs) are encouraged to invest their capital in India. Special facilities are provided to attract foreign capital. It leads to inflow of foreign

19 exchange in the country. It also increases production of export goods and thus exports are encouraged. However, care should be taken that foreign capitalists do not dominate our economy. 5. Attraction to Foreign Tourists Attractive picnic spots be developed in different parts of the country to attract foreign tourists. Government spends lot of money to develop such spots. Besides, foreign tourists be provided with transport and other facilities. Large amount of foreign exchange can be earned from foreign tourists. 6. Devaluation of Indian Currency Lowering of the value of domestic currency in terms of foreign currencies is called devaluation. A country resorts to devaluation when its exports fall short of imports. As a result of devaluation imports become dearer and exports cheaper. India devalued its rupee in the year 1949,1966, and twice in the year 1991.But now this measure is not used, as now exchange rate of rupee with other currencies of the world is determined by market forces of demand and supply and not by government. 7. Deflation It means that prices of the goods produced in the country should be brought down. As a result of it, foreigners will get export goods at cheaper price. Thus exports will be encouraged. Moreover, because of availability of Indian goods at lower rates the demand of imports will also come down. 8. Restriction on Imports Another important method of correcting balance of payments is restriction on imports. Following measures can be adopted to cut down imports. i. Restrictions on the import of luxury goods.

20 ii. Issue of licenses for the import of essential goods only. iii. Fixation of quotas for the import of different goods. iv. Levying of new import duties and enhancing of the rates old duties. v. Motivating the Indians to use indigenous goods. vi. Less credit facilities for imported goods etc. 9. Import Substitution Import substitution plays an important role to correct an adverse balance of payments. Import substitution means total or partial replacement of an imported product of the same functional requirement mainly from indigenous material and know how. Its main objective is to reduce imports. For instance, prior to independence, cycles, sewing machines, electric fans etc. used to be imported from abroad. Now, the same are being produced in the country. Similarly, in place of copper wire imported for power industry, aluminum wire produced in the country is being increasingly used. In short, disequilibrium in the balance of payments can be corrected by increasing exports and reducing imports. Government of India has taken several measures to promote exports and popularize import substitutions. Causes and Measures of Disequilibrium Overall account of BOP is always in equilibrium. This balance or equilibrium is only in accounting sense because deficit or surplus is restored with the help of capital account. In fact, when we talk of disequilibrium, it refers to current account of balance of payment. If autonomous receipts are less than autonomous payments, the balance of payment is in deficit reflecting disequilibrium in balance of payment.

21 1. Causes of disequilibrium in BOP: There are several factors which cause disequilibrium in the BOP indicating either surplus or deficit. Such causes for disequilibrium in BOP are listed below: (i) Economic Factors: (a) Imbalance between exports and imports. (It is the main cause of disequilibrium in BOR), (b) Large scale development expenditure which causes large imports, (c) High domestic prices which lead to imports, (d) Cyclical fluctuations (like recession or depression) in general business activity, (e) New sources of supply and new substitutes. (ii) Political Factors: Experience shows that political instability and disturbances cause large capital outflows and hinder Inflows of foreign capital. (iii) Social Factors: (a) Changes in fashions, tastes and preferences of the people bring disequilibrium in BOP by influencing imports and exports; (b) High population growth in poor countries adversely affects their BOP because it increases the needs of the countries for imports and decreases their capacity to export. 2. Measures to correct disequilibrium in BOP: Sustained or prolonged deficit has to be settled by short term loans or depletion of capital reserve of foreign exchange and gold.

22 Following remedial measures are recommended: (i) Export promotion: Exports should be encouraged by granting various bounties to manufacturers and exporters. At the same time, imports should be discouraged by undertaking import substitution and imposing reasonable tariffs. (ii) Import: Restrictions and Import Substitution are other measures of correcting disequilibrium. (iii) Reducing inflation: Inflation (continuous rise in prices) discourages exports and encourages imports. Therefore, government should check inflation and lower the prices in the country. (iv) Exchange control: Government should control foreign exchange by ordering all exporters to surrender their foreign exchange to the central bank and then ration out among licensed importers. (v) Devaluation of domestic currency: It means fall in the external (exchange) value of domestic currency in terms of a unit of foreign exchange which makes domestic goods cheaper for the foreigners. Devaluation is done by a government order when a country has adopted a fixed exchange rate system. Care should be taken that devaluation should not cause rise in internal price level. (vi) Depreciation: Like devaluation, depreciation leads to fall in external purchasing power of home currency. Depreciation occurs in a free market system wherein demand for foreign exchange far exceeds the supply of foreign exchange in foreign exchange market of a country (Mind, devaluation is done in fixed exchange rate system.)

23 Free Trade versus Protection Introduction: The foreign trade policy is concerned with whether a country should adopt the policy of free trade or of protection. If the policy of protection of domestic industries is adopted, the question which is faced whether protection should be achieved through imposing tariffs on imports or through the fixation of quota or through licensing of imports. The foreign trade policy has been the subject of heated discussion since the time of Adam Smith who advocated for free trade and recommended that tariffs should be removed to avail of the advantages of free trade. Even today, economists are divided over this question of foreign trade policy. Various arguments have been given for and against free trade. If the policy of protection of domestic industries is adopted, the question is whether for this purpose tariffs should be imposed on imports or quantitative restrictions through quota and licensing be applied. In India certain political parties and group have been demanding a policy of Swadeshi which in essence means that domestic industries should be protected against low-priced imports of goods from abroad, that is, free foreign trade should not be allowed. Besides Adam Smith, the other famous classical economist David Ricardo in his famous work On the Principles of Political Economy and Taxation also defended free trade to promote efficiency and productivity in the economy. Adam Smith and the other earlier economists thought that it pays a country to specialise in the production of those goods it can produce more cheaply than any other country and import those goods it can obtain at less cost or price than it would cost to produce them at home. This means they should specialise according to absolute cost advantage.

24 However, Ricardo put forward the Theory of Comparative Cost where he demonstrated that to obtain benefits from trade it is not necessary that countries should produce these goods for which their absolute cost of production is the lowest. He proved that it could pay a country to import a good even though it could produce that good at a lower cost, if its cost is relatively lower in the production of some other good. Ricardo s theory of trade rests on the idea of relative efficiency or comparative cost. Despite the classical arguments for free trade to promote efficiency and well-being of the people, various countries have been following the protectionist policies which militate against free trade. By imposing heavy tariff duties on imports of goods or fixing quotas of imports they have prevented free trade to take place between countries. Several arguments have been given in favour of protection. In what follows we spell out this free trade vs. protection controversy. Trade Policy: Tariffs and Quotas: Despite many benefits of free trade, the various countries have put up barriers to trade to protect their domestic industries. A number of instruments are used to protect the domestic industries to free trade but most important are tariffs and quotas. Both tariffs and quotas can be imposed either on imports or exports but they are mostly imposed on imports. Barriers to exports are quite uncommon. tariff barriers: 1. Tariffs: Tariffs are excise duties imposed on imported goods. The objective of imposing tariffs may be either raising revenue for the Government or providing protection to the domestic industries. Therefore, two types of tariffs are distinguished: (1) Revenue tariffs, and (2) Protective tariffs.

25 Revenue tariffs are usually imposed on the imports of those products which are not produced domestically. Rates of revenue tariffs are generally small but yields a good revenue for the Government. For example in USA, tariffs are imposed on tin, coffee and bananas which are not produced in that country. Their obvious purpose is to provide revenue to the Government. Protective tariff, on the other hand are imposed to provide protection to the domestic producers from foreign competition. The rates of these tariffs are not so high as to completely prohibit their imports into a country. Rise in prices of their products as a result of imposition of tariffs, foreign producers lose their superior competitive power. 2. Import Quotas: Import quotas are another instrument used to check free trade. Import quotas refer to the maximum quantities of goods which may be permitted to be imported during any period of time. They are also referred to as quantitative restrictions on imports. Quotas are more effective method of reducing trade than tariffs. A given commodity may be imported in a relatively large quantity despite high tariffs but low quotas totally stop the imports of a commodity beyond the fixed quota of the commodity. Since international negotiations to reduce trade barriers have tended to focus on tariffs, the various countries have resorted to non-tariff barriers to free trade. We discuss below the effects of tariffs and quotas. Effects of a Tariff: Let us now examine the economic effects of tariffs used as a trade barrier to protect domestic industries. We use partial equilibrium approach represented by supply and demand analysis to examine the effects of tariffs. Let us take a product, say computer, in which India has a comparative disadvantage. In Fig we have drawn domestic demand and supply curve Dd and Sd respectively of computers in India. In the absence of foreign trade, domestic price OPd is determined at which

26 OQ quantity of computers is demanded and sold. Assume now that the Indian economy is now opened to trade with USA which has a comparative advantage in the production of computers. Suppose OPw represents the world price at which USA sells computers. We assume that when the Indian economy is opened to trade, it can import computers from the USA at this world price OPw. In other words, free trade price is OPw. It will be seen from Fig that at free trade OPw, the domestic demand (or consumption) for computers is OH and the domestic producers are supplying ON quantity. Thus, with free trade out of OH quantity of consumption of computers, domestic production is ON. The quantity NH of computers is being imported. Consumption Effect: Now suppose that in order to protect domestic computer industry India imposes a tariff of Pw Pt per computer. As a result price of computer in India will rise to OPt. The imposition of tariff and consequently rise in the price of computers in India will have a variety of effects. First, as shall be seen from Fig that at a higher price OPt, the consumption of computers in India will decline to OL computers as the higher price causes buyers of computers to move up

27 the demand curve Dd. This is a consumption effect of the tariff. It follows that the Indian consumers of computers have been badly hurt by the imposition of tariff on computers. As a result of tariff, they pay PwPt more per computer which they now buy at the higher price. Besides, tariff induces them to buy fewer computers with the result that they reallocate a part of their expenditure to less desired substitute products. Production Effect: Second, tariff benefits Indian producers of computers as they will now be able to sell their computers at a higher price OPt instead of free trade price OPw. Further, at a higher price OPt, they will produce and supply more computers by moving up the domestic supply curve Sd. It will be seen from Fig that at price OPt, domestic producers of computers raises domestic production and quantity supplied from ON to OM. This is the production effect of tariff. It should be further noted that the increase in domestic production of computers by NM implies that some scarce resources will be bid away from other presumably more efficient industries. Trade Effect: Third, as a result of imposition of tariff by India, American producers will be hurt. It may be noted that American producers would not get the higher price OPt as the higher price is due to tariff which will be obtained by the Indian Government. For American producers price of computers will remain at OPw. Since due to rise in price to OPt, domestic production increases to OM and domestic consumption falls to OL, the imports of computers fall from NH to ML. This is trade effect of tariff. Revenue Effect: Now, the important effect which is to be examined is whether economic well- being of the nation will increase as a result of imposition of tariff. The answer is in the negative. Of course, the Indian Government will gain from tariff equal to the revenue it collects from tariff.

28 With rise in price by Pw Pt per computer and the import of computers reduced to ML, (or ab) the total revenue of the Government from tariff will be equal to the shaded area abgc. This is the revenue effect of tariff. This revenue from tariff obtained by the Government is essentially a transfer of income from the consumers to government and does not represent any net change in the nation s well being. The result is that government gains a portion of what consumers lose. But the effects of tariffs go beyond the basis of partial equilibrium analysis of demand and supply. The imposition of tariff on computers will reduce export earnings of American computer industry-the industry in which it has a comparative advantage. Because of lower exports of computers, the production of computers will be reduced in the USA. This will cause the resources to be shifted from relatively more efficient computer industry to relatively inefficient industries of the USA in which it has a comparative disadvantage. Thus tariffs cause misallocation of resources. To conclude in the words of Professors McConnel and Brue, specialisation and unfettered world trade based on comparative advantage would lead to the efficient use of world resources and an expansion of the world s real output. The purpose and effect of protective tariffs are to reduce world trade. Therefore, aside from their specific effects upon consumers, foreign and domestic producers, tariffs diminish the world s real output. Effects of Quotas: Quotas are quantitative restrictions on the quantity or value of a commodity to be imported in a country during a period. Since quota limits the imports of a commodity, it reduces supply of a commodity in a country as compared to the case with a free trade. Like tariffs, quotas raise the prices of imported goods and encourage domestic production of those goods. But in case of quotas, the government does not collect any revenue. Quotas may be imposed against imports from all countries or used against the imports of only a few countries. Economic effects of quota are graphically shown in Fig where DM and SM are domestic demand and supply curves of a commodity respectively. In the absence of trade, price of the commodity in the country is PA. Suppose the world price of the product is PW.

29 Under free trade, at price Pw of the commodity the domestic producers of country will produce OQ1 quantity but as domestic demand of the product at price Pw is OQ3 the quantity Q1 Q3 represents the imports at the world price Pw. Now assume that the Government imposes a quota and fixes the quantity of the product equal to Q1Q2 to be imported. With this the total supply of the product in the domestic market will be away from the domestic supply SM equal to the distance Q1Q2. Incorporating the quota equal to Q1Q2 we draw a new supply curve SM+ Quota, which lies to the left of the free-trade supply curve SM. It will be seen from Fig that interaction of the supply curve (SM + Quota) with the domestic demand curve DM determines price Pd which is higher than the world price Pw. It will be seen from Fig that difference AB between demand and domestic supply at price Pd is exactly equal to the fixed quota of Q1Q2 quantity of imports. It is thus dear that, like tariffs, fixation of quota has served to limit trade and raise price. It will therefore have same effects as we have explained in case of tariff. It may however be noted that, unlike tariff, in case of quota Government would not collect any revenue.

30 Case for Free Trade: The following arguments have been given in defense of free trade: 1. Gains in Output and Well-being from Specialization: The case for free trade is fundamentally based on the gain in output and well-being a country obtains from specializing in the production of those goods in which it is relatively more efficient and therefore export a part of them and in exchange gets those goods from other countries in production of which they are comparatively more efficient. Specialization and trading in this way would achieve a more efficient allocation of resources and a higher level of output and well-being. To quote Prof. Haberler, International division of labour and international trade which enable every country to specialise and to export those things which it can produce cheaper in exchange for what others can provide at a lower cost, have been and still are one of the basic factors promoting well-being and increasing national income of every participating country. 2. Gains from Economies of Scale: An important gain from trade is that it enables the trading countries to benefit from the economies of scale. If a country does not trade with others, its firms will produce goods to meet the domestic demand for a product. If domestic demand for a product is small, each of them will produce at a higher cost since they would not be able to enjoy the benefits of the economies of large scale production. Accordingly, the production of goods will be inefficient. Trade allows a country to export goods with the result that level of output of goods in a country will exceed domestic demand within a country. Thus trade expands the market for goods and enables the producers to take advantage of the economies of scale. Adam Smith was the first economist who pointed out that specialisation was limited by the size of the market.

31 Trade makes it possible for the producers to move beyond domestic market into international market and therefore makes it worthwhile to specialize and produce on a large scale and thereby to lower cost per unit. For example, in a small country such as Ceylon domestic demand would not be sufficient to produce efficiently large luxury cars on a large scale at a lower cost. Their production on a large scale at lower cost requires wider international market for sale of luxury cars. 3. Long-Run Dynamic Gains: Free trade also leads to dynamic gains being obtained from trade. Dynamic gains from trade refer to its stimulation of economic growth. Dennis Robertson described foreign trade as an engine of growth. The stimulation of growth through foreign trade are apparent from the rapid growth of such economies such as Japan, Taiwan, South Korea, Singapore, Hong Kong and China. Free trade promotes economic growth through: (1) Raising the rate of saving and investment; (2) Import of capital goods, and (3) Transfer of technology. (i) Raising rate of saving and investment: Increase in national product or real national income of a country obtained through trade above the level that prevails in autarky leads to a higher level of saving. The higher level of saving ensures a higher rate of investment and capital formation which stimulates growth. Hence if trade raises the rate of saving, it also promotes economic growth. The higher rate of saving makes it easier for the developing countries to break the vicious circle of poverty and to take off into self-sustained growth.

32 (ii) Import of capital goods: Besides trade permits a country to import capital goods in exchange for exports of consumer goods or surplus raw materials, and thereby accelerates industrial growth. Imports of capital goods adds to the capital stock in a country and raises its productive capacity more than it would have been possible without trade. Free trade also often enables a country to borrow from other countries to finance import of capital goods. (iii) Transfer of technology: If different countries worked in isolation the new technology developed in one country would remain confined locally. Through trade technological progress tends to feed on each other. A technology discovered by one is improved by another and so technology goes on being improved successively. Imagine if every country had to invent a wheel, a steam engine, electricity operating in an isolated manner, how slow would have been the progress in technology. The trade increases international diffusion of technology and in this way transfer of technology from the developed countries to the developing countries have been possible. In the modern times technology developed in one country by a firm is licensed to firms in other countries. Through this process, technology is transferred from country to country. In the absence of trade between countries such transfer of technology would not take place and as a result economic growth would be slower. 4. Promotes Competition and Prevents Monopoly: The case for free trade also rests on the fact that it promotes competition and prevents the emergence of monopolies in the domestic economy. In the absence of trade and therefore without facing any competition from foreign firms, domestic firms tend to become inefficient which causes rise in cost per unit of output and therefore higher prices of goods. When trade is free, increased competition by foreign firms forces domestic firms to adopt measures to increase their efficiency and make efforts to reduce cost by employing lowest-cost

33 production techniques. Free trade also compels them to be innovative and to improve the quality of their products. Further, free trade provides consumers a wide range of products from which to choose. The increase in efficiency and the adoption of improved technology not only lowers prices of products but also contributes to economic growth. 5. Political Gains from Free Trade: Free trade increases well-being or standard of living of the trading countries and this mutual welfare gains from trade make different nations economically dependent on each other. The economic interdependence raises the likelihood of reduced hostility between countries. Economic interdependence provides powerful incentives for peaceful solution of disputes. Trade between economically interdependent countries increases the potential losses from war and thus reduces the likelihood of armed conflict. Despite the above gains from free trade, countries have put up various barriers to free trade flows. The important barriers to free trade are: (1) The imposition of tariffs (i.e., duties on imports of goods), (2) The fixation of import quotas, (3) The licensing of imports. The reasons for these trade barriers are that different nations want to protect their domestic industries, to increase employment opportunities, to improve their balance of payments and to achieve other goals. We therefore discuss below the case for protection and then in a later section will examine the impact of trade barriers, especially tariffs on welfare and growth.

34 Case for Protection: Despite gains from free trade, many arguments have been given against free trade and in favour of protection. By protection we mean in order to safeguard the domestic industries from lowpriced imports some barriers against import of foreign goods are imposed. Some arguments given in defence of protection are irrational and invalid, whereas some are valid. We critically examine below various arguments given in favour of protection (i.e., against free foreign trade). Nationalism: First argument for protection has been that nationalistic feeling or patriotism requires that people of a country should buy products of their domestic industries rather than foreign products. In the USA there has been a campaign Be American, buy American appealing people to buy American goods instead of imported foreign products. Similarly, in India recent campaign of Swadeshi appeals to the patriotic feeling of the Indian people that we should protect our indigenous industries and impose barriers on imports of foreign goods or provide subsidies to our industries. However, this argument is misplaced and invalid. Those policy makers who yield to such arguments deny the people of a country the gains from trade such as rise in productive efficiency and greater well-being, stimulus to growth through higher capital formation and spread of superior technology. Thus restrictions imposed on trade in the name of nationalism or swadeshi are actually contrary to our national interests because they promote inefficiency and prevents rapid economic growth. Employment Argument: An important argument for protection is that it will lead to increase in domestic employment or at least preserves present domestic employment. It is often believed that imports of goods from abroad reduce domestic employment. Therefore, if instead of imports we produce those goods at home, employment in the country will increase. Besides, as prices of imported goods are lower, the domestic producers would not be

35 able to compete with them and may be competed out of the market. This will destroy even present jobs in the domestic industries. It is therefore concluded that protection of domestic industries will lead to their expansion and therefore employment in them will increase. In our view employment argument for protection is not logical and valid. This argument ignores the adverse effects of protection on our industries. An important economic principle is that exports must pay for imports. If imports are restricted by imposing barriers, the exports cannot remain unaffected. For example, many raw materials and capital goods are imported to be used in industries which export goods. If imports are restricted, exports will therefore fall. This will lead to the decline in employment in export industries which will offset the increase in employment in the importsubstituting industries. Further, when you restrict imports to protect domestic industries so that they should expand, other countries are likely to retaliate and will impose restrictions on our exports which are imported by them. This too will reduce exports and cause reduction in employment in export industries. Thus net effect on employment of restricting imports for providing protection to domestic industries may not be positive. Infant Industry Argument: A powerful argument given in support of protection, especially in the context of developing countries is infant industries should be provided protection from the competition of low-priced imports of the mature and well-established industries of the developed industrialized countries. Shortly after American Revolution, Alexander Hamilton argued that British industrial supremacy was due to its early start over American infant industries. He pointed out that these infant American industries required temporary protection for some time so that they should grow and achieve production efficiency and economies of scale before they could successfully compete with low-cost British goods. He thus argued that temporary protection of infant American industries was necessary for industrial development of America.

36 Similarly, the infant industry argument has been advanced for protecting infant industries of the developing countries from competition of the low-cost firms of the industrialized developed countries. Given some time, these infant industries will grow and will be able to benefit from the economies of scale and learn the techniques necessary to lower their cost of production. As a result, over a period of time their cost per unit will go down and will therefore be in a position to compete with the foreign imports. Therefore, for some time they should be protected otherwise they would be destroyed by foreign competition. However, there are some lacuna in infant industry argument. First, it is assumed that protected infant industries will make efforts to lower cost when provided protection. However, actual experience shows that it is more likely that protected industries lose incentives to become efficient and lower cost. It is said once an infant, always an infant. Secondly, even if an industry makes efforts to improve productivity and lower cost per unit when it is provided protection, it has been assumed in the argument that the Government is the best judge as to which industries will prove to be capable of competing low-priced foreign goods. It has been asserted in defence of free trade that selection of industries which will acquire competitive strength can be done better by private market mechanism. It is pointed out that when opening up the economy to foreign competition the domestic industries would try to increase their efficiency. As a result, only those industries will survive which are efficient and produce at a lower cost. Therefore, it is argued that it is better if the domestic industries are left to foreign competition and in this way they will have incentives to improve productivity to escape from losses. Only those domestic industries will survive and operate which are efficient and produce at a low cost per unit. Indian Automobile industry is a shining example of an industry not making any efforts to become efficient even after given protection for more than three decades. Before the setting-up of Maruti Udyog with Japanese collaboration, Indian car industry was fully protected by heavy duties on imports of cars.

37 The two domestic firms producing Ambassador and Fiat cars did not make any efforts to improve their efficiency, nor did they bring out any better models of their cars. It is only after 1991 that following the policy of liberalisation that new foreign firms such as Daewoo of South Korea, General Motors have come in India and producing new models and at relatively low prices. Even Maruti is now trying to improve its efficiency further and brought out new models of Maruti such as Zen, Esteem. However, it may be noted that in developing countries the Government is in a better position to protect certain industries such as steel, cement which lead to an expansion of the infrastructure of the developing economies. This is because these industries create external economies and the private firms will not be compensated for creating these external benefits. Anti-dumping Argument: The other important argument for protection is that foreign producers compete unfairly by dumping the goods in another country. Dumping is a form of price discrimination when producers of a country sell goods in another country at lower prices than those charged at home. Of course, consumers in a country in which foreign goods are dumped are beneficiaries, the industries of that country suffer as they are unable to compete with the dumped goods. Besides, there is more harmful predatory dumping which implies that foreign firms try to sell goods in other countries even below cost to establish a worldwide monopoly by driving competitors out of the market. Once the local industries are competed out, they raise prices to obtain monopoly profits. There is a lot of evidence that firms of USA and Japan often indulge in dumping of their goods in other countries to eliminate competition. But, in our view, instead of providing protection to domestic industries through tariffs or non-tariffs barriers, it will be a better policy to enact laws against dumping. Dumping should be prohibited by law declaring it illegal. In India such a law has been enacted but is not being properly implemented.

38 Correcting Balance of Payments Deficit: Correcting deficit in balance of payments is also mentioned as justification for imposing tariffs to restrict imports or fixing of quotas of imports. This appears to be a valid argument for providing protection. However, in our view the solution for fundamental disequilibrium in the balance of payments lies in the adoption of suitable adjustment in exchange rate, appropriate fiscal and monetary policies to lower domestic prices so as to encourage exports. The deficit in balance of payments can be reduced by ensuring rapid growth in exports of a country. Redistribution Income: Case for protection has also been built up on the ground that it can be used for making desirable redistribution of income from one section of society to another. Protection makes some people better off, while others worse off. By providing protection to domestic producers their profits can be raised at the expense of consumers who suffer a loss in consumer surplus as protection denies them consumption of low-priced imported goods. That is, protection redistributes income in favour of domestic producers. Sometimes protection causes transfer of income from some factors to the others. For example, Heckscher-Ohlin Model of international trade shows that trade benefits the abundant factor and harms the scarce factor. It is therefore scarce factor that demands protection by the Government against imports so that its income may not decrease. This implies that the workers, the owners of labour, and capitalists tend to take opposite views with regard to protection. This is however not confirmed by empirical evidence. In some countries one of the objectives of economic policy is to redistribute income from the rich to the poor. This can be done by imposing high tariffs on imports of goods considered to be luxury items and levying tariffs on exports of those goods which are considered as necessities. Higher import tariffs on luxuries will reduce the incomes of the rich as they would pay taxes to the Government. Similarly, higher taxes on exports of necessities ensure greater supplies of them in the domestic market which would lower their domestic prices and benefit the poor.

39 It may however be noted that direct taxes such as income tax are considered better methods of redistributing income among various sections of a society than the commercial policy. This is because as we shall see below import tariffs levied for protecting industries cause down-weight loss of welfare which are avoided under the direct tax system.

40 TRADE BARRIERS Trade barriers are restrictions imposed on movement of goods between countries. Trade barriers are imposed not only on imports but also on exports. The trade barriers can be broadly divided into two broad groups: (a) Tariff Barriers, and (b) Non-tariff Barriers. TARIFF BARRIERS Tariff is a customs duty or a tax on products that move across borders. The most important of tariff barriers is the customs duty imposed by the importing country. A tax may also be imposed by the exporting country on its exports. However, governments rarely impose tariff on exports, because, countries want to sell as much as possible to other countries. The main important tariff barriers are as follows: 1. Specific Duty: Specific duty is based on the physical characteristics of goods. When a fixed sum of money, keeping in view the weight or measurement of a commodity, is levied as tariff, it is known as specific duty. For instance, a fixed sum of import duty may be levied on the import of every barrel of oil, irrespective of quality and value. It discourages cheap imports. Specific duties are easy to administer as they do not involve the problem of determining the value of imported goods. However, a specific duty cannot be levied on certain articles like works of art. For instance, a painting cannot be taxed on the basis of its weight and size. 2. Ad valorem Duty: These duties are imposed according to value. When a fixed percent of value of a commodity is added as a tariff it is known as ad valorem duty. It ignores the consideration of weight, size or volume of commodity. The imposition of ad valorem duty is more justified in case of those goods whose values cannot be determined on the basis of their physical and chemical characteristics, such as costly works of art, rare manuscripts, etc. In practice, this type of duty is mostly levied on majority of items. 3. Combined or Compound Duty: It is a combination of the specific duty and ad valorem duty on a single product. For instance, there can be a combined duty when 10% of value

41 (ad valorem) and Re 1/- on every meter of cloth is charged as duty. Thus, in this case, both duties are charged together. 4. Sliding Scale Duty: The import duties which vary with the prices of commodities are called sliding scale duties. Historically, these duties are confined to agricultural products, as their prices frequently vary, mostly due to natural factors. These are also called as seasonal duties. 5. Countervailing Duty: It is imposed on certain imports where products are subsidised by exporting governments. As a result of government subsidy, imports become more cheaper than domestic goods. To nullify the effect of subsidy, this duty is imposed in addition to normal duties. 6. Revenue Tariff: A tariff which is designed to provide revenue to the home government is called revenue tariff. Generally, a tariff is imposed with a view of earning revenue by imposing duty on consumer goods, particularly, on luxury goods whose demand from the rich is inelastic. 7. Anti-dumping Duty: At times, exporters attempt to capture foreign markets by selling goods at rock-bottom prices, such practice is called dumping. As a result of dumping, domestic industries find it difficult to compete with imported goods. To offset antidumping effects, duties are levied in addition to normal duties. 8. Protective Tariff: In order to protect domestic industries from stiff competition of imported goods, protective tariff is levied on imports. Normally, a very high duty is imposed, so as to either discourage imports or to make the imports more expensive as that of domestic products. Note: Tariffs can be also levied on the basis of international relations. This includes single column duty, double column duty and triple column duty. NON-TARIFF BARRIERS A non tariff barrier is any barrier other than a tariff, that raises an obstacle to free flow of goods in overseas markets. Non-tariff barriers, do not affect the price of the imported goods, but only the quantity of imports. Some of the important non-tariff barriers are as follows:

42 1. Quota System: Under this system, a country may fix in advance, the limit of import quantity of a commodity that would be permitted for import from various countries during a given period. The quota system can be divided into the following categories: a. Tariff/Customs Quota b. Unilateral Quota c. Bilateral Quota d. Multilateral Quota 2. Tariff/Customs Quota: Certain specified quantity of imports is allowed at duty free or at a reduced rate of import duty. Additional imports beyond the specified quantity are permitted only at increased rate of duty. A tariff quota, therefore, combines the features of a tariff and an import quota. 3. Unilateral Quota: The total import quantity is fixed without prior consultations with the exporting countries. 4. Bilateral Quota: In this case, quotas are fixed after negotiations between the quota fixing importing country and the exporting country. 5. Multilateral Quota: A group of countries can come together and fix quotas for exports as well as imports for each country. 6. Product Standards: Most developed countries impose product standards for imported items. If the imported items do not conform to established standards, the imports are not allowed. For instance, the pharmaceutical products must conform to pharmacopoeia standards. 7. Domestic Content Requirements: Governments impose domestic content requirements to boost domestic production. For instance, in the US bailout package (to bailout General Motors and other organisations), the US Govt. introduced Buy American Clause which means the US firms that receive bailout package must purchase domestic content rather than import from elsewhere. 8. Product Labelling: Certain nations insist on specific labeling of the products. For instance, the European Union insists on product labeling in major languages spoken in EU. Such formalities create problems for exporters. 9. Packaging Requirements: Certain nations insist on particular type of packaging materials. For instance, EU insists on recyclable packing materials, otherwise, the imported goods may be rejected.

43 10. Consular Formalities: A number of importing countries demand that the shipping documents should include consular invoice certified by their consulate stationed in the exporting country. 11. State Trading: In some countries like India, certain items are imported or exported only through canalising agencies like MMTC. Individual importers or exporters are not allowed to import or export canalised items directly on their own. 12. Preferential Arrangements: Some nations form trading groups for preferential arrangements in respect of trade amongst themselves. Imports from member countries are given preferences, whereas, those from other countries are subject to various tariffs and other regulations. 13. Foreign Exchange Regulations: The importer has to ensure that adequate foreign exchange is available for import of goods by obtaining a clearance from exchange control authorities prior to the concluding of contract with the supplier. 14. Other Non-Tariff Barriers: There are a number of other non tariff barriers such as health and safety regulations, technical formalities, environmental regulations, embargoes, etc.

44 Exchange Rate Mechanisms ER mechanisms There are two types of ER mechanisms: Floating ER no intervention by governments or central banks Fixed ER officials strive to keep the ER fixed (or pegged) even if the rate that they choose is not the equilibrium rate. Government Policies toward ER a. Clean Float floating exchange rate with no government participation in the market b. Managed Float or Dirty Float - floating exchange rate with government influence/participation in the market c. Fixed Exchange Rate The exchange rate is fixed at some par value, although there is some small degree of flexibility (bands set around par value) 1. Floating (Flexible) Exchange Rates No Government Interference Market Forces dictate equilibrium exchange rates Value of a nation s currency allowed to float down or up End of the 1990 s these are the norm 2. Fixed Exchange Rates Predominant exchange rate system in the world for most of 20thcentury (1900 s 1970s) In a fixed exchange rate system, the value of a nation s currency is fixed (pegged) to a fixed amount of a commodity or to another currency Commodity usually Gold (Gold Standard); Currency US$ Commodity Based Fixed Exchange Rates 3 rules when fixing exchange rates to a commodity Fix the value of the currency unit in terms of gold (fixed exchange rate) Keep the supply of domestic money fixed in some constant proportion of the gold supply

45 Countries must be willing to exchange gold for their own currency Fixed Exchange Rate Mechanisms Under a fixed exchange rate, national Supply and Demand for currency may vary, but the nominal exchange rate does not Monetary authorities ensure that the rate does not change Typically, there are bands set above/below the par value that allow for some small fluctuation in the exchange rate Governments must act to counter and appreciation Fixed ER Maintenance Governments must act to counter and appreciation/depreciation of their currency Typically this is done by buying/selling foreign currency in the foreign exchange markets Ex. If the $ is appreciating, the US will buy FC (sell $) release $ into the market increase the US money supply If the $ is depreciating, sell FC (buy $) decrease the US money supply Exchange Rate Maintenance In addition to activity in the Foreign exchange markets, a government can defend an exchange rate by: Exchange Controls Tariffs/Quotas Changing Domestic Interest Rates Monetary/Fiscal Policy Switch to a floating ER Adjustable and Crawling Pegs The par value of a fixed exchange rate can be changed- it is nothing permanent Adjustable Peg a fixed exchange rate that can be periodically devalued or revalued if need be

46 Competitive Devaluations Crawling Peg a fixed exchange rate in which regular (frequent?) periodic adjustments Fixed vs. Flexible ER Benefits of a fixed ER o Reduce uncertainty associated with ER fluctuations o Helps limit inflationary pressures? o Benefits Benefits of a flexible ER o Help increase nation s growth o Liberate macroeconomic policy from maintaining ER- let monetary policy influence domestic economy and not just maintain ER Factors that Affect Foreign Exchange Rates Foreign Exchange rate (ForEx rate) is one of the most important means through which a country s relative level of economic health is determined. A country's foreign exchange rate provides a window to its economic stability, which is why it is constantly watched and analyzed. If you are thinking of sending or receiving money from overseas, you need to keep a keen eye on the currency exchange rates. The exchange rate is defined as "the rate at which one country's currency may be converted into another." It may fluctuate daily with the changing market forces of supply and demand of currencies from one country to another. For these reasons; when sending or receiving money internationally, it is important to understand what determines exchange rates.

47 1. Inflation Rates Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation rate than another's will see an appreciation in the value of its currency. The prices of goods and services increase at a slower rate where the inflation is low. A country with a consistently lower inflation rate exhibits a rising currency value while a country with higher inflation typically sees depreciation in its currency and is usually accompanied by higher interest rates 2. Interest Rates Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest rates, and inflation are all correlated. Increases in interest rates cause a country's currency to appreciate