International Economic and Policy

International Economic and Policy
Author

2015, Author
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Published by: Amity Directorate of Distance & Online Education, Noida
Contents
Chapter 1:
International Economics: An Introduction
Chapter 2:
Modern Theories on International Trade
17
Chapter 3:
Trade and Development
42
Chapter 4:
Equilibrium in International Trade
82
Chapter 5:
International Monetary System
114
Chapter 1: International Economics: An Introduction

Objectives
After studying this chapter, you should be able to understand:
1.
Meaning of international economics and international trade
2.
Bases of international trade
3.
Theories of international trade
4.
Absolute and comparative cost advantages theories
Introduction
International economics, which emerged as a 'specialist' field of economics long ago, has developed in depth and width over
time due to a lot of theoretical, empirical and descriptive contributions. International economics has enjoyed a long,
continuous and rich development over the past two centuries, with contributions from some of the world's most distinguished
economists, from Adam Smith to David Ricardo, John Stuart Mill, Alfred Marshall, John Maynard Keynes and Paul
Samuelson. International Economics as a matter of fact encloses the basic principles pertaining to International Trade and
Finance. In this introductory unit, an attempt is made to analyze the meaning, nature and scope of international economics
and also to discuss the concept of international trade.
1.1 Concepts and Scope

International economics deals with the economic interdependence among countries and includes the effects of such
interdependence and the factors which affect it. In other words, international economics deals with those international forces
which influence the domestic economic conditions as well as those which shape the economic relationship between countries,
world economic integration and transition.
In the words of Sodersten and Geoffrey Reed, Even if most people are agreed that international economic relations are of great
importance for most countries, it does not necessarily follow that international economics should be studied as a subject independent of
other branches of economics.
Further elaborating and interpreting the views of Sodersten and Reed, international economics may be defined specifically in
the following words International Economics is that branch of Economics which deals with International Trade and International
Finance. International Economics may also be defined as a sub-branch of economic theory that deals with the discussion of the
principles related to international trade and finance.
According to Dominick Salvatore, International Economics deals with the economic and financial interdependence among nations. It
analyzes the flow of goods, services payments and monies between a nation and the rest of the world, the policies directed at regulating
these flows and their effect on the nation's welfare.
1.1.1 International Economics Theoretical Considerations

The theoretical part tries to go beyond the phenomenon to seek general principles and logical frameworks which can serve as
a guide to the understanding of actual events (so as, possibly, to influence them through policy interventions). Like any
economic theory, it uses for this purpose of abstractions and models, often expressed in mathematical form. The theoretical
part can be further divided into pure and monetary theory, each containing aspects of both positive and normative economics,
although these aspects are strictly intertwined in our discipline.
The theoretical part of international economics may be divided into pure theory of international trade and international
monetary economics.
The pure theory of international trade, which has a micro-economic nature, covers a very wide area.
The pure theory encompasses mainly the following:

1.
The bases or causes of trade and the pattern of trade.
2.
Effect of trade on production, consumption and distribution of income.
3.
Effect of trade on relative factor prices and product prices.
4.
Gains from trade and distribution of the gains.
5.
Effect of trade barriers on trade, factor and product prices and income distribution.
6.
Effect of trade on economic growth and vice versa.
The international monetary theory, which is of a macroeconomic nature; deals with matters pertaining to balance of payments
and international monetary system. It covers areas such as causes and methods of correcting balance of payments
disequilibria, exchange rate determination, international liquidity, relationship between balance of payments position and
other macroeconomic variables etc.
1.1.2 International Economics Descriptive Considerations

The descriptive part is concerned with the description or international economic transactions just as they happen and of the
institutional environment in which they take place. This covers international trade flow of goods and services, flow of
international financial and other resources, international organizations like IMF, World Bank, Regional Development Banks,
WTO, UNCTAD, etc. International Economic Agreements (including trade blocs) and so on. International trade is only one,
though an important part of international economics.
Business strategies, particularly of the large corporations, such as multinational investments, production sharing and global
sourcing, joint venturing and other alliances etc. have been increasingly fostering world economic integration and
transnationalisation. These forces will gather more momentum in the future. However, the literature on international
economics does not appear to be giving due importance to the role of business strategies in shaping the world economic
transition.
Subject Matter of International Economics

The subject matter of International Economics comprises of the study of the following:
1.
International Trade: This deals with the basis of international trade and the gains from trade.
2.
International Trade Policy: International Trade Policy examines the reasons for and the effects of trade restrictions and
the concept of new protectionism.
3.
The Balance of Payments: The balance of payments measures a nation's total receipts from and the total payments to the
rest of the world.
4.
Foreign Exchange markets: Foreign Exchange markets are the institutional framework for the exchange of one national
currency for others.
5.
Open Economy Macroeconomics: Open Economy Macroeconomics deals with the mechanisms of adjustment in balance of
payments disequilibria (deficits and surpluses).
More importantly, it analyzes the relationship between the internal and external sectors of the economy of a nation and how
they are interrelated or interdependent with the rest of the world economy under different international monetary systems.
International trade theory and policies are the micro-economic aspects of international economics because they deal with
individual nations treated as single units and with the (relative) price of individual commodities. On the other hand, since the
balance of payments deals with total receipts and payments, as well as with adjustment and other economic policies that affect
the level of national income and the general price of the nation as a whole, they represent the macroeconomic aspects of
international economics. These are often referred to as Open Economy Macroeconomics or International Finance.
International economic relations differ from inter-regional economic relations (i.e., the economic relations among different
parts of the same nation), thus requiring somewhat different tools of analysis and justifying international economics as a
distinct branch of economics. That is, nations usually impose some restrictions on the flow of goods, services and factors across
their borders, but not internally. In addition, international flows are to some extent hampered by differences in language,
customs and laws. Furthermore, international flows of goods and services and resources give rise to payments and receipts in
foreign currencies, which change in value over time.
1.1.3 Nature and Scope of International Economics

The scope of the subject is broad. The need for development of this distinct branch of economics was justified by a number of
important factors. Economic activities between countries are made different from those within the countries by the fact that
factors of production are generally less mobile between countries than within the country. In fact, international trade theories
have been based on the traditional assumption that factors of production are perfectly mobile within the country and
completely immobile between countries. Simultaneously, it is assumed that goods are perfectly mobile both within and
between countries but for government restrictions in some cases. Indeed, the impact of different types of government
restrictions on trade, production, consumption and income distribution is an important area of study in international
economics.
1.1.4 Components of International Economics

These days, the subject matter of International Economics comprises a large number of segments which, in turn, can be
divided into several parts. It is obvious that the coverage of topics and arrangement and depth of their analysis would depend
upon the purpose of the study. Broadly speaking, however, international economics covers the following main components.
Pure Theory of Trade: It tries to explain the reasons for international trade in goods and services, determination of the
composition, direction and volume of trade; determination of the terms of trade between exports and imports of a country;
determination of rate of exchange and changes in it; concepts and issues relating to balance of trade and balance of payments,
as also the concepts of their equilibrium and disequilibrium.
Policy Issues: This portion of international economics covers a wide area of relevant questions and a choice of associated
policy alternatives. Examples include (a) free trade vs. protection, (b) methods of regulating trade, capital and technology
flows, (c) use of taxation, subsidies and dumping; (d) exchange control and convertibility, (e) issues relating to foreign aid,
external borrowings and direct foreign investment, (f) alternative measures of correcting balance of payments disequilibrium
and the like.
International Cartels and Trade Blocs, etc: Opening up of international trade and economic flows is accompanied by attempts,
with varying degrees of success, of economic integration in the form of international cartels, customs unions, monetary unions,
trade blocs, economic unions and so on. The operations of multinational corporations are also pushing the entire world
economy into a new pattern. The subject of international economics should cover these dimensions of international economic
relations as well.
International Financial and Trade Regulatory Institutions: After the Second World War, a number of international financial
and trade-regulatory institutions have come into existence. They deeply influence international economic transactions and
relations and, for this reason, their study should be considered a part of international economics in India and the world. For
Indian students and others interested in the Indian economy, a study of Indian economy vis--vis the rest of the world should
form an integral part of the subject matter of international economics. Such a study helps in formulating an appropriate policy
framework for accelerating our economic growth, reducing poverty and unemployment and enhancing our economic welfare.
1.2 International Trade

In ordinary language, trade refers to the sale-purchase of goods. The broader meaning of trade, however, is meant to include
all those activities as a result of which goods produced in a society are distributed for the purpose of consumption. In other
words, trade comprises all human activities which regulate goods from their production to distribution. Trade is normally
discussed as inter-regional trade and international trade.
1.2.1 Meaning of Inter-regional and International Trade

The trade of a company can be divided in two parts:
1.
Inter-regional Trade: It refers to the trade which is carried out in different places and regions of the same country. It is
also called domestic trade. Trade between Haryana and Punjab or Uttarakhand and Bihar is an example of inter-regional
trade.
2.
International Trade: It is a trade between two or more than two countries. Trade between India and U.K. is called
international or foreign trade. The goods consigned from India to U.K. will be known as India's exports. On the other
hand, goods coming from U.K. to India will be called India's imports.
1.2.2 Definitions of International Trade

A few definitions are as under:
1.
"International Trade is a trade between nations."- Anatol Murad
2.
"International Trade consists of transactions between residents of different countries." - Wasserman and Haltman
3.
"International Trade is simply the extension of the trade beyond the boundaries of a nation." - Ellsworth
4.
"International Trade means in plain English trade between nations."- Edgeworth
International trade takes place on account of many reasons such as:

z
Human wants and countries' resources do not totally coincide. Hence, there tends to be interdependence on a large scale.
Factors endowments in different countries differ.
Technological advancement of different countries differs. Thus, some countries are better placed in one kind of
production and some others superior in some other kind of production.
Labour and entrepreneurial skills differ in different countries.
Factors of production are highly immobile between countries.
In short, international trade is the outcome of territorial division of labour and specialization in the countries of the world.
1.2.3 Salient Features of International Trade

The following are the distinguishing features of international trade:
z
Immobility of Factors: The degree of immobility of factors like labour and capital is generally greater between countries
than within a country. Immigration laws, citizenship, qualifications, etc. often restrict the international mobility of labour.
International capital flows are prohibited or severely limited by different governments. Consequently, the economic
significance of such immobility of factors tends to equality within but not between countries. For instance, wages may be
equal in Mumbai and Pune but not in Mumbai and London. According to Harrod, it, thus, follows that domestic trade
consists largely of exchange of goods between producers who enjoy similar standards of life, whereas international trade
consists of exchange of goods between producers enjoying widely differing standards. Evidently, the principles which
determine the course and nature of internal and international trade are bound to be different in some respects at least.
In this context, it may be pointed out that the price of a commodity in the country where it is produced tends to equal its
cost of production. The reason is that if in an industry the price is higher than its cost, resources will flow into it from
other industries, output will increase and the price will fall until it is equal to the cost of production. Conversely,
resources will flow out of the industry, output will decline, and the price will go up and ultimately equal its cost of
production.
But, as among different countries, resources are comparatively immobile; hence, there is no automatic influence
equalizing price and costs. Therefore, there may be permanent difference between the cost of production of a commodity
in one country and the price obtained in a different country for it. For instance, the price of tea in India must, in the long
run, be equal to its cost of production in India. But in the U.K., the price of Indian tea may be permanently higher than its
cost of production in India. In this way, international trade differs from home trade.
z
Heterogeneous Markets: In the international economy, world markets lack homogeneity on account of differences in
climate, language, preferences, habit, customs, weights and measures, etc. The behaviour of international buyers in each
case would, therefore, be different.
Different National Groups: International trade takes place between differently cohered groups. The socio-economic
environment differs greatly among different nations.
Different Political Units: International trade is a phenomenon which occurs among different political units.
Different National Policies and Government Intervention: Economic and political policies differ from one country to
another. Policies pertaining to trade, commerce, export and import, taxation, etc., also differ widely among countries
though they are more or less uniform within the country. Tariff policy, import quota system, subsidies and other controls
adopted by governments interfere with the course of normal trade between one country and another.
Different Currencies: Another notable feature of international trade is that it involves the use of different types of
currencies. So, each country has its own policy in regard to exchange rates and foreign exchange.
Check Your Progress 1

State whether the following statements are true or false:
1.
International Economics can be defined as a sub-branch of economic theory that deals with the discussion of the
principles related to international trade and finance.
2.
Pure theory and International monetary theory are both the same.
3.
International flows of goods and services and resources give rise to payments and receipts in foreign currencies,
which change in value over time.
4.
The degree of immobility of factors like labour and capital is generally lesser between countries than within a
country.
1.3 Basis of International Trade

The basic foundations of international trade are as under:
1.
International Specialization: One of the basic foundations of international trade is international specialization. It means
that different countries of the world specialize in the production of those goods in whose production they possess special
resources. International specialization is the result of division of labour. According to Prof. Harrod, ordinarily exchange is
the necessary consequence of division of labour. When division of labour crosses national boundaries, there arises foreign
trade. International trade, therefore, is an inevitable result of division of labour.
2.
Non-availability of a Specific Factor: Every country does not possess all kinds of resources. Some resources may be
available in some countries while other countries may be in possession of other resources. For instance, the USA lacks the
soil and climate to produce tea and Japan has no iron mines. They have to import these goods. Likewise India has to
import tin, as the same is not available here.
3.
Difference in Costs: One of the significant causes of international trade is the difference in costs of different goods in
different countries. Such a difference may be of two kinds:
(i)
Absolute Cost Difference: It means that a country can produce a commodity at an absolutely cheaper cost than the other
country. According to the eminent economist Adam Smith, the main basis of international trade is the difference in
absolute costs.
(ii) Comparative Cost Difference: It means that a country can produce all goods at a lower cost than the other country, yet
the cost of producing some goods is comparatively less than all other goods. According to Ricardo the main cause of
international trade is the comparative difference in costs.
4.
Product Differentiation: It is often observed that, a country does import a commodity that she herself can produce. For
instance, India produces cloth on a large scale and also exports it; nevertheless she imports different varieties of cloths,
such as saris made in Japan and other countries. It is to enable the Indians to consume larger varieties of goods.
1.4 Theories of International Trade

1.4.1 Classical Theories
Theory of Mercantilism (1500-1700)
Mercantilism became popular in the late seventeenth and early eighteenth centuries in Western Europe and was based on the
notion that governments (not individuals who were deemed untrustworthy) should become involved in the transfer of goods
between nations in order to increase the wealth of each national entity. Wealth was defined, however, as an accumulation of
precious metals, especially gold.
Consequently, the aim of the government was to facilitate and support all exports while limiting imports, which was
accomplished through the conduct of trade by government monopolies and intervention in the market through the
subsidisation of domestic exporting industries and the allocation of trading rights.
The concept of mercantilism incorporates two fallacies. The first is the incorrect belief that old or precious metals have intrinsic
value, when actually they cannot be used for either production or consumption. The second fallacy is that the theory of
mercantilism ignores the concept of production efficiency through specialisation.
Neomercantilism corrected the first fallacy by looking at the overall favourable or unfavourable balance of trade in all
commodities, that is, nations attempted to have a positive balance of trade in all goods produced so that all exports exceeded
imports. The second fallacy, a disregard for the concept of efficient production, was addressed in subsequent theories, notably
the classical theory of trade, which rests on the doctrine of comparative advantage.
Adam Smith Theory (1800)

Being influenced by individualism around the beginning of the nineteenth century and by the industrial revolution, Adam
Smith emphasised the importance of individual freedom. He believed that if the individual was permitted to pursue his or her
own interest without interference from the state, he or she would promote the well-being of all by the invisible hand. In his
famous book The Wealth of Nations (published in 1776), Adam Smith put forward the theory that international trade would
occur in situations where nations had absolute advantages over rival states, i.e. they could produce, with a given amount of
labour and capital, larger outputs of certain items than any other country. The flaw in this argument is that it fails to explain
why countries with an absolute disadvantage in all their products (i.e. countries which produce less of everything made
within the country, using a given amount of labour and capital, than other nations) still engage in international trade. A
possible resolution of this question was suggested by the eminent economist, David Ricardo, who, in 1817, alleged that trade
among nations resulted from differences in the comparative advantages of countries in the production of various items, not
differences in absolute advantage. Ricardo assumed that the cost of producing any good depended only on the amount of
labour used in its production, and that firms and workers could not move freely between nations (a reasonable assumption for
the early 1800s).
Classical Economic Theory

This theory was based on the economic theory of free trade and enterprise that was evolving at the time. In 1776, in The Wealth
of Nations, Adam Smith rejected as foolish the concept of gold being synonymous with wealth. Instead, Smith insisted that
nations benefited the most when they acquired, through trade, those goods they could not produce efficiently and produced
only those goods that they could manufacture with maximum efficiency. The crux of the argument was that costs of
production should dictate what should be produced by each nation or trading partner.
Under this concept of absolute advantage, a nation would only produce those goods that made the best use of its available
natural and acquired resources and its climatic advantages. Some examples of acquired resources are available pools of
appropriately trained and skilled labour, capital resources, technological advances, or even a tradition of entrepreneurship.
Classical theory holds that expanding the labour pool leads to decline in the accumulation of capital per worker, lower worker
productivity and lower incomes per person, eventually, causing stagnation or economic decline. Naturally, this theory was
proven incorrect by numerous scientific and technological discoveries, which provided for greater efficiencies in production
and greater returns on inputs of land, capital and labour. It was also knocked awry by the growing acceptance of birth control
as a means of limiting population size.
Factor Endowment Theory

The Eli Heckscher and Bertil Ohlin theory of factor endowment addressed the question of the basis of cost differentials in the
production of trading nations. They posited that each country allocates its production according to the relative proportions of
all its production factor endowments land, labour and capital on a basic level, and, on a more complex level, such factors
as management and technological skills, specialised production facilities, and established distribution networks.
Thus, the range of products made or grown for export would depend on the relative availability of different factors in each
country. For example, agricultural production or cattle grazing would be emphasised in such countries as Canada and
Australia, which are generously endowed with land. Conversely, in small land mass countries with high populations, export
products would centre on labour-intensive articles. Similarly, rich nations might centre their export base on capital-intensive
production.
Economist Paul Samuelson extended the factor endowment theory to look at the effect of trade upon national welfare and the
prices of production factors. Samuelson posited that the effect of free trade among nations would be to increase overall welfare
by equalising not only the prices of the goods exchanged in trade, but also of all involved factors. Thus, according to his
theory, the returns generated by use of the factors would be the same in all countries.
In 1933, drawing upon the work of Eli Heckscher, Bertil Ohlin took the Ricardo model a significant step further by linking the
source of a countrys comparative advantage to the endowment of its factors of production. This theory, known as the
Heckscher-Ohlin model of international trade (or simply, the H-O model) is probably the most widely accepted form of the
comparative advantage theory today.
The H-O model focused on two assumptions (1) Goods differ in how much they use certain types of factors of production
that is, different goods have different factor intensities; for instance, the manufacture of textiles is labour intensive, while the
manufacture of semiconductors is capital intensive; (2) Countries differ with respect to their factor endowments; for instance,
one might reasonably argue that India has an abundant supply of labour relative to capital, while the reverse is true of the US.
Further, H-O assumed (as Ricardo did) that markets are perfectly competitive and factors are perfectly mobile, but it relaxed
the assumption of constant returns to scale in order to allow for decreasing returns to scale. Putting these assumptions
together, the main proposition of the H-O model is the following: A country exports those goods that use intensively its
relatively abundant factor of production. That is, countries export those goods that they are best suited to produce, given their
factor endowments.
Apart from these classical theories, there are two more theories, absolute and comparative cost advantage theories that we will
discuss in the next section.
1.4.2 Modern Trade Theories

Strategic Trade Theory
In the last two decades, a new set of models has come into being, using he perspectives of game theory and theories of
industrial organisation. While there is no one overarching model, this broad collection of theories and ideas has come to be
known as strategic trade theories. Most of the models of strategic trade are motivated by the attempt to relax (and explore
systematically the implications of) the seemingly restrictive assumptions of the Ricardian and H-O models, such as those
relating to perfectly competitive markets, constant or decreasing returns to scale, product homogeneity, per factor mobility, no
externalities or spillover effects, and so forth. In the process of doing so, a fresh new set of insights relating to international
trade and trade policy has emerged.
The essence of almost all the new models of trade is the recognition that industries are characterised by any or all of the
following features: scale, economies (both dynamic and static), product differentiation, imperfect competition, externalities
and spillover and, in cases, irreversible investments. Some of the main insights from this literature are as follows:
1.
Increasing returns to scale provide a justification for trade for reasons other than comparative advantage, since firms will
have the incentive to produce and export in order to lower costs by attaining greater scale economies; an example of a
industry where this is an important issue is the commercial airframes industry.
2.
Product differentiation can result in intra industry trade, since, within the same industry, the same product can have
different brand identities; for example, the US will export certain types of automobiles (Ford Escort) and it will import
other types of automobiles (BMWs).
3.
Imperfect competition creates rents, and trade policy could shift rents from the foreign country to the home country. For
example, the imposition of quotas will increase domestic prices and thus can create rents for foreign producers; the home
country government may try to counterbalance it with a subsidy to domestic producers, so as to put price pressure on
foreign producers.
4.
Externalities and spillover effects (particularly in innovation and R & D) may sometimes provide a justification for
industry protection for reasons other than industry infancy or national security. For instance, if process innovations in
commodity chip production can create spillovers in the manufacture of specialised chips, then the government may have
an incentive to protect the manufacture of commodity chips.
5.
Irreversible investments induce an asymmetry between entry and exit costs and can, therefore, lead to hysteretic
responses to price or quantity shifts. For instance, firms in the US earth-moving equipment industry (for example,
Caterpillar Tractor Company) lost substantial market share in the early 1980, when the US dollar appreciated 35% in real
terms against the Japanese yen. Yet firms could not exit markets because the costs of re-entry (for example, rebuilding
distribution networks) would be prohibitive. Thus, they had to stay on in many markets despite the fact that they were
incurring losses.
Modern Investment Theory

Other theories explain investing overseas by firms as a response to the availability of opportunities not shared by their
competitors, that is, they take advantage of imperfections in markets and only enter foreign spheres of production when their
comparative advantages outweigh the costs of going overseas. These advantages may be production, brand awareness,
product identification, economies of scale, or access to favourable capital markets. These firms may make horizontal
investments, producing the same goods abroad as they do at home, or they may make vertical investments, in order to take
advantage of sources of supplies or inputs.
Going a step further, some believe that firms within an oligopoly enter foreign markets merely as a competitive response to
the actions of an industry leader and to equalise relative advantages. Oligopolies are those market situations in which there
are few sellers of a product that is usually mass merchandised. Two examples are the automobile and steel industries. In these
situations no firm can profit by cutting prices because competitors quickly respond in kind. Consequently, prices for
oligopolistic products are practically identical, and are set through industry agreement (either openly or tacitly).
Thus, firms within an oligopoly must be keenly aware of the actions, market reach, and activities of their competitors. Unless
their response to the actions of competitors is following the leader, they will yield precious competitive edges to their
competitors. Therefore, it follows that when a market leader in an oligopoly establishes a foreign production facility abroad, its
competitors rush to follow suit.
Thus, the impetus for a firm to go abroad may come from a wish to expand for internal reasons to use existing competitive
advantages in additional spheres of operations, to take advantage of technology, or to use raw materials available in other
locations. Alternatively, the motive might arise from external forces such as competitive actions, customer requests or
government incentives. The final determinant, however, is based in a cost benefit analysis. The firm will move abroad if it can
use its own particular advantages to provide benefits that outweigh the costs of exporting or production abroad and provide a
profit.
International Product Life Cycle Theory

The international product life cycle theory puts forth a different explanation for the fundamental motivations for trade
between and among nations. It relies primarily on the traditional marketing theory regarding the development progress and
life span of products in markets. This theory looks at the potential export possibilities of a product in four discrete stages in its
life cycle. In the first stage, innovation, a new product is manufactured in the domestic arena of the innovating country and
sold primarily in that domestic market. Any overseas sales are generally achieved through exports to other markets, often
those of industrial countries. In this stage, the company generally has little competition in its markets abroad.
In the second stage the growth of the product sales tend to increase. Unfortunately, so does competition as other firms
enter the arena and the product becomes increasingly standardised. At this point, the firm begins some production abroad to
maximise the service of foreign markets and to meet the activity of the competition.
As the product enters the third stage, maturity, exports from the home country decrease because of increased production in
overseas locations. Foreign manufacturing facilities are put in place to counter increasing competition and to maximise profits
from higher sales levels in foreign markets. At this point, price becomes a crucial determinant of competitiveness.
Consequently, minimising costs becomes an important objective of the manufacturing firm. Production also frequently shifts
from being within foreign industrial markets to less costly lesser-developed countries to take advantage of cheaper production
factors, especially low labour costs. At this point, the innovator country may even decide to discontinue all domestic
production, produce only in third world countries, and re-export the product back to the home country and to other markets.
In the final stage of the product life cycle, the product enters a period of decline. This decline is often because new competitors
have achieved levels of production high enough to affect scale economies in the production that are equivalent to those of the
original manufacturing country.
The international product life cycle theory has been found to hold primarily for such products as consumer durables, synthetic
fabrics and electronic equipment, that is, those products that have long lives in terms of the time span from innovation to
eventual high consumer demand. The theory does not hold for products with a rapid time span of innovation, development
and obsolescence.
The theory holds less often these days because of the growth of multinational global enterprises that often introduce products
simultaneously in several markets of the world. Similarly, multinational firms no longer necessarily first introduce a product
at home. Instead, they might launch an innovation from a foreign source in the domestic markets to test production methods
and the market itself, without incurring the high initial production costs of the domestic environment.
1.5 Absolute and Comparative Cost Advantages Theories

The theory of relative advantage deals with the trade of goods and commodities. It is based on the promise that a nation gains
by trading with other nations in those goods in which it has an advantage over the other nations in terms of cost of
production. This advantage in terms of cost of production could be absolute or comparative.
1.5.1 Theory of Absolute Cost Advantage

In 1976, Adam Smith propounded the theory of absolute cost advantage to combat against the theory of mercantilism.
The concept of absolute cost advantage states that when goods can be produced more cheaply in one country than in another,
the first is said to have an absolute cost advantage over the other country. It would be in the interest of both these countries to
specialise in the production of the commodity, in which it has an absolute cost advantage and trade. This way the productivity
of both nations increases and thereby both nations stand to gain. Thus while India can produce tea more cheaply than Great
Britain and the latter can produce engineering goods more cheaply than India, it would be in the interest of both countries to
concentrate in the production of the goods in which they have absolute cost advantage and then to trade. Of course the cost
advantage in production must be greater than the cost of transportation incurred in moving the goods.
Figure 1.1: Absolute Advantage of Trade
Suppose that USA can produce wheat, but not cloth more cheaply than the rest of the world, as follows: 50 bushels of wheat or
25 yards of cloth or any combination of wheat and cloth in between. In the rest of the world, one unit of inputs can produce 40
bushels of wheat or 100 yards of cloth, or any combination in between. From Figure 1.1 it is clear that trade allows both
countries to consume at C, out beyond the confines of wheat they can produce themselves. Instead of producing and
consuming at points like S0, each country specialises producing at S1. By trading away some of its special product for the one it
no longer produces, each is at a better point than S0.

Fill in the blanks:
1.
. wrote the book Wealth of Nations, wherein he mentioned about the invisible hand.
2.
As per the ..Advantage Theory, the country should produce wheat if it is the best thing it can do.
3.
The final stage in the product life cycle is the stage of .
4.
As per principle of . advantage, country should export a commodity that can be produced at a
lower cost than can other nations.
1.5.2 Theory of Comparative Cost Advantage

David Ricardo developed the important concept of comparative advantage in considering a nations relative production
efficiencies as they apply to international trade. In Ricardos view, the exporting country should look at the relative efficiencies
of production for both commodities and make only those goods it could produce most efficiently.
Suppose, for example, in our illustration, that Greece developed an efficient manufacturing capacity so that martini glasses
could be produced by machine rather than being hand-blown. In fact, since the development of the productive capacity and
capital plants which were newer than those in Sweden, Greece could produce 100 crates of martini glasses using only 200
resource units as opposed to the 300 units required by Sweden. Thus, Greeces comparative costs would fall below that of
10
Sweden for both products and its comparative advantage vis--vis those products would be higher. Therefore, the resource
units required to produce olives and glasses would now be:
Country
Olives (500 crates)
Martini Glasses (100 crates)
Sweden
100 units
200 units
Greece
600 units
300 units
Logically, Greece should be the producer of both olives and martini glasses, and Swedens capital and labour used in making
these happy-hour supplies should be directed to Greece, so that maximum production efficiencies are achieved. Neither
capital nor labour is entirely mobile, however, so each country should specialise Greece in olives at 100 resources units per
500 crates and Sweden in glass production at 300 resource units per 100 crates. Greece is still better off at maximising its
efficiencies in olive production. By doing so, it produces twice as many goods for export with the same amount of resources
than if it allocated production level.
While Swedens production costs for glasses are still higher than those of Greece at 300 units, the resources of Sweden are
better allocated to this production than to expensive olive growing. In this way, Sweden minimises its inefficiencies and
Greece maximises its efficiencies. The point is not that a country should produce all the goods it can more cheaply, but only
those it can make cheapest. Such trading activity leads to maximum resource efficiency.
The concepts of absolute advantage and comparative advantage were used in a subsequent theory developed by John Stuart
Mill who looked at the question of determining the value of export goods and developed the concept of terms of trade. Under
this concept, export value is determined according to how much of a domestic commodity each country must exchange to
obtain an equivalent amount of an imported commodity. Thus, the value of the product to be obtained in the exchange was
stated in terms of the amount of products produced domestically that would be given up in exchange. For example, Swedens
terms with Greece would be exporting of 100 crates of glasses for an equivalent 500 crates of olives.
Weaknesses
While the work of Smith, Ricardo and Mill went far in describing the flow of trade between nations, classical theory was not
without its flaws. For example, the theory incorrectly assumed.
z
The existence of perfect knowledge regarding international markets and opportunities.
Full mobility of labour and production factors throughout each country.
Full labour employment within each country.
The theory also assumed that each country has, as its objective, full production efficiency. It neglected such other motives as
traditional employment and production history, self-sufficiency or political objectives.
In addition, the theory is overly simplistic in that it deals only with two commodities and two countries. In reality, given the
full range of production by many countries and interplay of many motives and factors, the trade situation is actually an
ongoing dynamic process in which there is interplay of forces and products.
The largest area of weakness in classical theory is that while all resource units used in production were considered, the only
costs considered by classical economists were those associated with labour. The theorists did not account for other resources
used in the production of commodities or manufactured goods for export, such as transportation costs, the use of land and
capital. This failing was addressed by subsequent trade theorists, who, in modern theory, include all factors of production in
looking at theories of comparative advantage.
11
Case Study
Core Complexities
Raj Abrader Singh, the 55-year-old CEO of the ` 353 crore Bharat Synthetics, was taken aback at the tone of the letter he
had just received from his creditors. Expressing concern at the lack of seriousness in initiating a turnaround strategy,
and the inordinate delays in the repayment of loans, it said that Singh should now make way for a new CEO. In the
considered view of the consortium of lenders, it said, only a professional manager can steer Bharat Synthetics towards
growth. The news was worrisome. Clearly, the letter was a vote of no confidence in Singhs ability to lead the 35-yearold company in a highly competitive market place.
Damn liberalisation! swore Singh. Why did it have to rock my coy world? The economy had opened up all right,
but, to his dismay, it had left Bharat Synthetics in a limbo. Or had it? Perhaps I did not read the signals right, he said
to himself. After all, economic liberalisation had also created a world of opportunities that many entrepreneurs had
grabbed quickly. He wondered if he had done anything wrong by refraining from diversification. Recalling the time,
only four years ago, when Bharat Synthetics was perceived as a good investment opportunity, Singh was troubled at the
way the tide had changed.
Later, at a luncheon meeting with Abhinav Paul, 54, executive director of the management consultancy firm, Quotient,
Singh ruminated. It does not make any sense, he told Paul, who was a childhood friend. I have been practising for
years all that management consultants have been preaching Core competence. No unrelated diversification. I was
doing well without these fancy buzzwords. I have stuck to man-made fibres throughout my career. Why, then, am I in
this mess? And look at my competitors. They did everything that went against present business wisdom. They
diversified into unrelated areas one of them even set up a cement plant without giving a damn about core
competence. Another ventured into financial services and hoteliering. Still, they seem to prosper.
Interesting, said Paul. You know, although we have never discussed business, I have been tracking Bharat
Synthetics progress. Its predicament is typical of what has been happening to many commodity businesses since the
economy opened up. Costs, you must understand, are driven by two factors: economies of scale and technology. Bharat
Synthetics products are out-priced and no longer competitive. I am aware that after recording profits of ` 34 crore in
1994-95, Bharat Synthetics today has accumulated losses of ` 27 crore, and is unable to service its total debt of ` 60 crore.
You have a big crisis on hand. But we could find a way out of the mess. Why did you think of man-made fibres in the
first place? Did you have any expertise?
We took the plunge into rayon filament yarn simply because we had a licence to make the product, said Singh. In
those days, if you remember, the choice of business was determined by official approvals not market needs. You
needed a licence to be competitive. Of course, being a cellulose derivative, rayon was a perfect substitute for cotton. So
its manufacture made good business sense. It was also a sellers market. We could sell everything we produced. So we
set up a plant in 1963 at Surat, to make rayon yarn. Profits posed no problem, since pricing was done on a cost-plus
basis.
I was also keen on improving the quality of our products. So, in 1966, we collaborated with a Japanese company. We
also began trading in finer deniers of rayon filament yarn, which are used in the manufacture of chiffon and georgette. A
decade later, we commissioned a nylon filament yarn plant in collaboration with an Italian company. Simultaneously,
we went into the manufacture of polyester filament yarn (PFY). And, in 1984, we started making nylon cord which is
consumed by the tyre industry in collaboration with a Japanese firm. Today, we have four product categories: rayon
yarn, which has a capacity of 4,500 tonnes per annum (tpa); nylon yarn (2500 tpa); nylon cord (4000 tpa); and PFY (15000
tpa). And we have been operating at full capacity for years.
Frankly, those capacities look minuscule, said Paul, in relation to global scales of 100,000 plus tpa. And India is
gradually becoming a global market. In fact, you are incurring losses despite optimum capacity utilisation. This is a clear
indication of poor economies of scale. Was there any synergy among the four products? No, replied Singh. It was
the availability of a licence that influenced the choice of products. Each product line is characterised by its own value
Contd
12
chain. Except rayon, all others are derived from naphtha. So, a common feedstock was the only link between the
products. Which meant that synergy lay in backward integration up to the feedstock.
You mentioned poor economies of scale, continued Singh. That, precisely, is the root of our problems. The
government did not permit large capacities when we started because of apprehensions of creating monopolies.
Capacities and market shares were fragmented across small players. There are 30 players in the industry today. Scale did
not matter for decades because we had large tariff barriers. The import duty on PFY, for instance, was 150 per cent. But
with liberalisation, the duty has fallen to 32 per cent today. I dont see any reason why a customer should buy from
Bharat Synthetics.
But why didnt you augment capacity even after the licence-permit era ended? asked Paul. After all, most of your
competitors have gone in for capacities over 50,000 tpa. For instance, Vimoline Industries has not only set up a 200,000
tpa capacity, it has also integrated backwards, right up to the primary feedstock.
A valid point, conceded Singh. You know, Bharat Synthetics was doing well till the mid-1990s, with operating
margins of up to 40 per cent. We were declaring dividends of between 20 and 25 per cent for years, and Bharat
Synthetics carried a premium. Our credibility with bankers was high. We rode the textile boom all through the 1980s.
We thought the good times would last. We were in no mood to see the flip side.
The classic trap of success, said Paul.
On hindsight. Yes, said Singh. It was only in 1995 when profits began to decline that we thought of expanding
polyester capacity. Paradoxically, it triggered off a spiral from which we have not recovered as yet. Since the primary
market was languishing, we decided on a rights issue of ` 70 crore in mid-1995 to fund capacity expansion in PFY, and
backward integration into polyester chips. But the rights issue flopped. All major shareholders, including our
collaborators, renounced their entitlements. The trouble was that we had already taken a bridge loan of ` 40 crore from
financial institutions. As the original promoter, I was forced to subscribe to more than 80 per cent of the issue, increasing
my stake from 12 to 34 per cent. Unfortunately, the proceeds of the issue were frozen following a court order. Unsure of
getting their money back, the institutions had taken the matter to court. Sooner than we realised, we got into working
capital problems. And while servicing the debt, our business priorities went haywire. One example: although we
imported the plant and machinery, it could not be commissioned for two years for lack of funds.
It is a typical trap that most companies get into, said Paul. I have seen how companies get trapped when cash flows
go haywire. The choice of the product is decided by the availability of working capital. You end up making something
that costs less to produce but is not the most profitable product. You are compelled to source cheaper raw materials,
affecting quality and revenues. Exigency becomes all. I dont know if you have also been facing that situation at Bharat
Synthetics.
That is just the paradox at Bharat Synthetics, said Singh. But the fact is that, despite a range of businesses, were a
small player in each of them. And none of these businesses is sustainable in the long run because of scale and
technology. Take nylon tyre cord. It does not have a future because most tyre manufacturers are now switching to
radials that do not use nylon cord. As far as polyester is concerned, there is a glut in India. And our scale is not large
enough to warrant a full-fledged business unit. Nylon is threatened by a substitute: polypropylene fibre yarn. And
although rayon is the only substitute for cotton, the rate of growth in demand has been a measly 4 per cent per annum.
Unfortunately, there are simply no buyers around.
The threat is obvious: technology is changing the rules of the game. Without large-scale economies, you are extremely
vulnerable. Your immediate priority is to prevent bleeding. Do you have an action plan? asked Paul. On the
operations front, yes, replied Singh. It centres on diversifying the client base and enlarging the end uses of our
products. We have developed and successfully test-marketed several types of industrial products. Flame-retardant
polyester, in particular, has a big demand. Bharat Synthetics has also developed adhesive-activated polyester industrial
yarn, which is used in rubberised goods. We are also making fancy yarn by combining various types of filament yarns.
All these products have improved our cash flow substantially.
Contd
13
To cut costs, we are recycling solid waste from the nylon tyre cord and the polyester plants to produce chips and
industrial yarn. But none of these initiatives can solve the fundamental problem. The Return on Capital Employed
(ROCE) in our business is a measly 3 per cent. There are two redeeming features, though. We have fixed assets worth
` 130 crore. And we have a locational advantage. Surat has one of the largest concentrations of power looms, and one of
the largest segments of synthetic yarn users. We are close to the customer.
Close to the customer, repeated Paul. That is interesting. How about the long-term? Well, there are several
options, said Singh. In order to generate some quick resources, we will be selling off some unproductive assets like
our corporate office in Mumbai. We are also negotiating with some firms for the sale of some of our existing businesses.
In fact, that is what the consortium of lenders has proposed. Of course, once we clear our debt, newer options will open
up. One option: forward integration, from polyester into textiles and finished products. Another: a joint venture with
our technology partner to produce and market polyester yarn. We are also open to the idea of entering into non-textilerelated businesses like chemicals and engineering. Bharat Synthetics is also considering a proposal to become a contract
manufacturer for a larger player like Vimoline, which is already operating at full capacity.
It is noteworthy that the ROCE is less than the average cost of fresh capital, continued Singh. So, we might be better
off selling the business and investing in risk-free financial instruments than in remaining in a business which does not
have inherent long-term strengths.
You spoke of Bharat Synthetics being close to the customer, said Paul. There could be a clue there. You also spoke
earlier about how you stuck to what you believed was your core competence. Tell me, what do you understand by core
competence? Core competence, said Singh, is a process by which you have an edge over the competitor, and which
you do well, along with the customer, to create superior value. Bharat Synthetics strength is product quality and
customer loyalty. Most power looms in Surat preferred to deal with us than with our competitors. Liberalisation
changed those equations. We are no longer cost competitive.
Frankly, said Paul, I dont think you have a clear understanding of the concept of core competence. India is
acknowledged to be one of the few countries in the world possessing a natural advantage in processing cotton and
cellulose derivatives. That was a start up advantage. But did you build on it? Did you make any attempt to identify the
skills that could set you apart from competition? You accessed newer technologies, but did you leverage them fully? Did
you strengthen your locational advantages? Did you ever find out where the Indian synthetics market was heading?
You have been in the synthetics business for 35 years. How could you not anticipate its future? If you had done that
exercise, you would not be in this situation today.
Questions
1.
Is there hope for Bharat Synthetics? Are its problems a result of circumstances alone? Or is it all its own doing? Do
its business portfolio and product range need a fresh look?
2.
What is the impact of Bharat Synthetics products in relation to theory of comparative advantage?
Source: International Marketing: 3rd Edition, P K Vasudeva, Excel Books
1.6 Let us Sum up

z
International economics deals with the economic interdependence among countries and includes the effects of such
interdependence and the factors which affect it.
Business strategies, particularly of the large corporations, such as multinational investments, production sharing and
global sourcing, joint venturing and other alliances etc. have been increasingly fostering world economic integration and
transnationalisation.
International trade theories have been based on the traditional assumption that factors of production are perfectly mobile
within the country and completely immobile between countries.
International specialization, non availability of factors, difference in costs and product differentiation are bases of
international trade.
14
Some of the popular theories of international trade are: Classical theories- Theory of Mercantilism, Adam Smiths Theory,
Classical Economic Theory, and Factor Endowment Theory, and Modern theories- Strategic Trade Theory, Modern
Investment Theory and International Product Lifecycle Theory.
More meaningful are relative production costs, which determine whether trade should take place and what items to
export or import. According to Ricardos Principle of relative (or comparative) advantage, a country may be better than
another country in producing many products but should only produce what it produces the best.
The Ricardian Model of Comparative Cost is based only on production. Manufacturing centres can move from the
developed to the developing countries, which have low labour cost.
1.7 Student Activity

Find out more about Adam Smith and his book, The Wealth of Nations.
1.8 Keywords
International economics: It is concerned with the effects upon economic activity of international differences in productive
resources and consumer preferences and the institutions that affect them.
International trade: Exchange of capital, goods, and services across international borders or territories.
International trade policy: A governmental policy governing trade with third countries.
Balance of payments: A system of recording all of a country's economic transactions with the rest of the world over a period of
one year.
Open economy: An economy in which there are economic activities between domestic community and outside, e.g. people,
including businesses, can trade in goods and services with other people and businesses in the international community, and
flow of funds as investment across the border.
Absolute Cost Difference: It means that a country can produce a commodity at an absolutely cheaper cost than the other
country.
Comparative Cost Difference: It means that a country can produce all goods at a lower cost than the other country, yet the cost
of producing some goods is comparatively less than all other good.
1.9 Review Questions

1.
What do you think should constitute the subject matter of International Economics?
2.
Distinguish between inter-regional and international trade.
3.
'International Trade is only a special case of inter-regional trade'. Do you agree with this view of Ohlin? Give arguments
in support of your answer.
4.
Explain the basis of international trade.
5.
What do you understand by the term "International Economics"? Differentiate it from "international trade".
6.
Contrast absolute and comparative cost advantage theories.
7.
Discuss the Modern Investment theory and International Product Life Cycle theory.
15
Check Your Progress: Model Answers

CYP 1
1.
True
2.
False
3.
True
4.
False
CYP 2
1.
Adam Smith
2.
Relative
3.
Downfall
4.
Absolute
1.10 Further Readings

Kumar, Raj, International Economics, Second Edition, Excel Books, 2011
Sodersten, BO and Reed, Geoffrey, International Economics, Third Edition, Macmillan Press Ltd, 1994
Salvatore, Dominick, International Economics, Eighth edition, Chapter 1
Krugman, Paul R. and Obsfeld, Maurice, International Economics, Theory and policy, 5th Edition, Addison Wesley, Indian
Reprint, 2000, Part 1
16
Chapter 2: Modern Theories on International Trade

Objectives
1.
The Heckscher-Ohlin model
2.
Samuelson models
3.
The points of difference between modern theories and classical theories
4.
Terms of trade
Introduction
The Modern Theory of International Trade was propounded by the Swedish economist Heckscher in an article published in
1919. It was further improved upon by his student Bertil Ohlin in a research paper published in 1924 and later in his book
International and Inter-regional Trade published in 1933. This theory does not contradict Comparative Cost Theory of
International Trade, rather supports it. According to Comparative Cost Theory, international trade takes place because of
difference in comparative costs. But it throws little light on the factors accounting for the difference in comparative costs. On
the contrary, modern theory of international trade reveals the causes responsible for difference in comparative costs that
account for the international trade.
2.1 Heckscher-Ohlin Model

According to this theory, there is difference in factor endowments among different countries of the world. For instance, certain
countries have comparatively large supply of labour while in others the supply of capital is relatively large. Because of
difference in factor endowments, there is difference in the prices of the factors. Difference in the prices of the factors depends
on their relative scarcity or abundance. Owing to difference in the prices of the factors, there is difference in the costs of the
goods. Hence this theory states that the main cause of difference in comparative costs is the difference in factor endowment.
Thus, international trade takes place because of diversity in factor endowments and hence difference in prices. Each country
will export that commodity in the production of which such factor is used whose supply is relatively abundant and price is
relatively cheaper. On the other hand, it will import that commodity in the production of which that factor is used whose
supply is relatively scarce and price is relatively dearer. According to this theory, conditions of supply alone determine the
pattern of international trade. BO Sodersten, writes that some countries have much capital, others have much labour. The theory
now says that countries that are rich in capital will export capital intensive goods and countries that have much labour will export labour
intensive goods!
2.1.1 Definitions
In the words of Salvatore, The Heckscher-Ohlin Theory states that difference in relative factor endowments and factor prices between
nations is the most important cause of trade. This theory predicts that each nation will export the commodity in the production of which a
great deal of relatively abundant and cheap factor is used and import the commodity in the production of which a great deal of its relatively
scarce and expensive factor is used. The theory also predicts that trade will lead to the reduction in the difference in factor prices between
nations.
According to Ohlin, The immediate cause of inter-regional trade is always that goods can be bought cheaper in terms of money than
they can be produced at home and here is the case of international trade.
17
2.1.2 Assumptions of the Theory

Assumptions of this theory are:
1.
This theory relates to two countries, two commodities and two factors. It is, therefore, called 2 x 2 x 2 model.
2.
There is same production function for each commodity in two countries.
3.
Factors are mobile within the country but immobile between two countries.
4.
There is perfect competition in all markets. As a result (a) all factors are fully employed (b) factors get their reward in
accordance with their marginal productivity (c) prices of the commodities are equal to their marginal productivity.
5.
No restriction is imposed on the exchange of goods, i.e., free trade exists between two countries.
6.
Consumers tastes and preferences are identical in the two countries.
7.
Technique of production employed in both countries is the same.
8.
There is lack of transport costs.
9.
Factor endowments are different in both countries.
10. Goods can be classified on the basis of factor intensity, such as capital intensive goods and labour intensive goods etc.
11. Production function of all goods is homogeneous of the first degree. It means that output will be doubled if all factors of
production are doubled.
2.1.3 Explanation of the Theory

According to Ohlin International trade is but a special case of inter-regional trade. Different regions have different factor
endowments, that is, some regions have abundance of labour but scarcity of capital while other regions have abundance of
capital but scarcity of labour. Different goods have different production functions, that is, factors are combined in different
proportions to produce different commodities. Some goods are produced by employing relatively large proportion of labour
and relatively small proportion of capital. Still other goods are produced by employing relatively small proportion of labour
and relatively large proportion of capital. In this way, each region is suitable for the production of those goods for whose
production it has relatively abundant supply of the required factors. A region is not suitable for the production of those goods
for whose production it has relatively scarce or zero supply of the essential factors. Hence different regions have different
capacity to produce different commodities. Difference in factor endowments is, therefore, the main cause of international trade
along with inter-regional trade.
According to Ohlin, The immediate cause of inter-regional trade is always that goods can be bought cheaper in terms of money than
they can be produced at home and here is the case of international trade. Heckscher in his article, The effect of Foreign Trade on the
Distribution of Income published in 1919 had supported the classical theory of comparative costs and maintained that
international trade took place because of differences in comparative costs. But classical theory did not explain why there was
difference in comparative costs. Answering to this question, Heckscher cites the following causes for difference in comparative
costs:
1.
Difference in Factor Endowments
2.
Difference in Factor Intensities.
According to the Heckscher-Ohlin Theory of International Trade, the immediate cause of international trade is the difference
in relative commodity prices. The cause of difference in the relative prices of the goods is the difference in the amount of factor
endowments, like capital and labour, between the two countries. As a result, there is difference in the relative demand and
supply of factors. These differences cause difference in the prices of the factors. It is due to difference in factor prices that
difference in the relative prices of the commodities takes place and it is this difference that constitutes the main cause of
international trade. Goods which require scarce factors on a large-scale are imported, because their domestic prices are high.
On the contrary, goods which require abundant factors on a large scale are exported, as their domestic prices are low.
18
For instance, if capital is abundant in the US, it will be relatively cheap. Hence, the US will export those goods which are
capital intensive. On the contrary, if labour is abundant in India, it will be relatively cheap. Hence, India will export those
goods which are labour intensive.
2.1.4 Concept of Relative Factor Endowment

Abundance or scarcity of factors in the Heckscher-Ohlin theory has been explained on the basis of two criteria: (i) Price
Criterion of Relative Factor Endowment, and (ii) Physical Criterion of Relative Factor Endowment. We shall explain
Heckscher-Ohlin theory on the basis of these two criteria.
Price Criterion of Relative Factor Endowment

Price criterion of factor endowment means that a country, where capital is relatively cheap and labour relatively dear, will be
called a capital abundant country, even if the quantity of capital in that country is relatively less. On the contrary, if capital is
relatively dear and labour relatively cheap, such a country will be called a capital scarce country, even if the quantity of capital
in such a country is relatively more. In other words, the criterion of factor abundance or factor scarcity is not the quantum of
the factor but its price.
On the basis of price criterion, international trade theory can be explained with the help of an example.
Diagrammatic Explanation: Let us take the US and India as two trading countries. It is assumed that the US is a capitalintensive country and India is a labour intensive country. So that capital is cheaper in the US in relation to labour; and labour
is cheaper in India in relation to capital. This can be expressed in terms of the following equation:
US
PK
PL
India
PK
PL
<
Here, PK: price of capital; PL: price of labour.

Both the countries are producing watches and shirts. While the production of watches is capital intensive, the production of
shirts is labour intensive. According to the Heckscher-Ohlin theory, India should specialise in the production of shirts and the
US should specialise in the production of watches. This is illustrated in Figure 2.1.
Figure 2.1: Price Criterion on Relative Factor Endowment
Y
Capital
A
S
W
C
H
F
Z
Z1
W (100 Watches)
E0
T
O N
N1
S (100 Shirts)
T
Labour
19
In this figure, labour is shown on the X-axis, and capital is shown on the Y-axis. WW is isoquant showing production of 100
watches, and SS, is the isoquant showing production of 100 shirts.
AB and CD are Isocost** lines for the US. These are parallel straight lines, which means their slope is same and, (since slope
shows price ratio) these isocost lines are showing the same price ratio.
These isocost lines are inclined towards OY-axis, showing that in the US, capital is cheaper in relation to labour.
Likewise ZT and Z1T1 are isocost lines for India. These are inclined toward OX-axis, showing that, in India, labour is cheaper
in relation to capital. These lines are also parallel. So that these are showing the same price ratio.
OZ
Thus,
OT
OZ1
OT1
Isoquants WW and SS are intersecting each other only at point E. This implies that there is no reversal of factor intensity. Or
that in both the US and India, production of watches is capital intensive, and production of shirts is labour intensive. This
conclusion is based on the assumption of the Heckscher-Ohlin theory that both in the US and India, production function of
watches or of shirts is similar.
The diagram shows that, in case of US, isocost line CD and iso product curve WW for watches are tangent at point H. So that,
for the US, Production Cost for 100 Watches = OF Capital + ON Labour.
As regards the production of shirts, we find isocost line AB and iso product curve SS are tangent at point J. So that for the US,
Production Cost of 100 shirts = OF Capital + ON1 Labour.
In the US, capital cost of production of watches or of shirts is equal to OF, but labour cost of shirts is ON1. While labour cost of
watches is ON.
Implying that labour cost of shirts is more by NN1 (ON1 ON = NN1) units of labour.
Thus, the US can produce watches at relative lesser cost, compared to the production of shirts.
In case of India, isocost line ZT and iso product curve WW for watches are tangent at point R.
So that, for India
Product Cost of 100 Watches = ON Capital + OX Labour
Likewise isocost line Z1T1 and iso product curve SS for shirts are tangent at point EI. So, that, Product Cost of 100 Shirts = OT
Capital + OX Labour.
Thus, in India, labour cost of watches and shirts = OX but capital cost of shirts is less than the capital cost of watches by NT
capital (ON - OT = NT). This suggests that India can produce shirts at lesser cost compared to watches. So that India should
specialise in the production of shirts and export the same.
It is thus, suggested that because capital is relatively cheaper in the US and because labour is relatively cheaper in India, the
US should specialise in the production of capital intensive goods i.e., watches and India should specialise in the production of
labour-intensive goods i.e., shirts. The US will export watches to India, while India will export shirts to the US.
Physical Criterion of Relative Factor Endowment

Physical criterion of factor abundance or scarcity means that if in a country capital ratio is greater than labour as against
another country, then it will be called a capital intensive country. Likewise, if in a country, labour ratio is greater than capital
as against another country, then it will be called a labour intensive country. In other words, basis of this criterion is the
physical quantity of the factors. On the basis of this criterion, international trade can be explained with the help of the
following example.
20
Example: According to Heckscher-Ohlin whether two countries, say the US and India, are capital intensive or labour intensive
depends on the fulfillment of the following condition:
Ku Ki
>
Lu Li
(Here Ku = Quantity of Capital in US; Lu = Quantity of Labour in US; Ki = Quantity of Capital in India; Li = Quantity of Labour
in India)
The US will produce capital intensive and India, labour intensive goods. It is illustrated in Figure 2.2, UU1 is the production
possibility curve of the US and II1 is the production possibility curve of India.
Figure 2.2: Physical Criterion of Relative Factor Endowment
P1
Watches
R
U
P2
E
I
F
U 1 I1
P1
P2
Shirts
Labour intensive production i.e., shirts is shown on the OX-axis and capital intensive production, i.e., watches is shown on the
OY-axis. If both the countries produce both the goods in the same ratio, then they will produce along OR-ray. The US will
produce at point E of its production possibility curve UU1 and India will produce at point F of its production possibility curve
II1. It is evident from this figure that at point E, the slope of production possibility curve of the US is steeper and at point F
while the slope of production possibility curve of India is flatter. It is clear from the fact that P1P1 price line of the US is steeper
than P2P2 price line of India. It proves that watches are cheaper in the US and shirts are cheaper in India. The US should
produce more of capital intensive goods viz. watches. It may, however, be noted that the above analysis does not clarify
whether the US will export watches and India shirts. Answer to this question depends on the demand for these goods. If the
domestic demand of the US for watches is less than the supply, then alone it will export watches, otherwise not. Likewise,
India too will export shirts only if domestic demand for shirts is less than the supply.
2.1.5 Factor Price Equality and International Trade

According to modern theory, international trade is responsible for bringing about equality in the factor prices of the countries
concerned. Supposing, there is, trade between two countries, namely India and the US. Because of abundant supply of labour
wage-rate in India will be low and as such labour intensive goods will be produced. On the other hand, because of abundant
supply of capital, interest-rate in the US will be low and as a result, capital intensive goods will be produced. In this way, India
will export labour intensive goods to the US and the US will export capital intensive goods to India. As India will export more
and more of labour intensive goods, demand for labour will go on increasing and hence wages will also go on rising. Likewise,
as India will import more and more of capital intensive goods, demand for capital in India will go on decreasing and hence the
price of capital, i.e., rate of interest will go on falling. Similarly, capital will become expensive and labour cheap in the US.
Ultimately, a stage will come when rising wages in India will become equal to falling wages in the US. It can, therefore, be said
that prices of the factors in India and the US will become equal owing to international trade.
21
2.1.6 Main Implications of Heckscher-Ohlin Theory

The discussion of Heckscher-Ohlin theory of international trade reveals the following main points of implications:
1.
Ohlin has highlighted in his theory The Principle of Mutual Interdependence.
2.
The basis of international trade between two countries is The Difference in Factor Endowments.
3.
The causes of difference in comparative costs are due to Difference in Factor-Endowments.
4.
International Trade is a Special Case of Inter-regional Trade.
5.
According to Ohlins theory International Trade promotes Factor price Equalization in the long run in the Trading
Countries.
2.2 Samuelson Models

Paul Samuelson is considered by many to be the founder of neoclassical economics. In welfare economics he helped to
establish the criteria for deciding whether an action will improve welfare; these criteria came to be known as the LindahlBowen-Samuelson condition. Samuelson is predominantly acknowledged for his public finance theory on determining the
optimal allocation of resources in the presence of both public goods and private goods. Finally, Samuelson has influenced
international economics through two important theories of international trade: the Balassa-Samuelson effect (consumer price
levels are systematically higher in wealthier countries than in poor countries) and the Hecksher-Ohlin model (a General
equilibrium mathematical model of the macro economy in international trade), in which the Stolper-Samuelson theorem (a
basic theorem in trade theory which describes a relation between the relative prices of output goods and relative factor
rewards) is utilized.
2.2.1 Balassa-Samuelson Effect

It has become conventional wisdom in economics that richer countries tend to have higher overall costs of living than poorer
countries. Typically this is measured in terms of the real exchange rate, which compares the consumer price indexes of two
countries converted to a common currency using the nominal exchange rate. This empirical observation has been referred to as
the Penn effect, after the Penn World Tables data used to measure it, or alternatively as the Balassa-Samuelson effect, after the
economists who wrote about the observation and endeavored to explain it. One important implication of this observation is
that it indicates a systematic deviation from the theory of purchasing power parity, which is a building block in exchange rate
theory. It indicates that there is a role for economic fundamentals such as relative income levels in explaining long-run real
exchange rate behavior.
Although numerous theories have been proposed over time to explain this systematic relationship between the real exchange
rate and income levels, by far the most influential is that proposed in 1964 in two separate papers by Bela Balassa and Paul A.
Samuelson. The theory is based on the divergence of productivity levels in a world of traded and non-traded goods,
explaining that rich countries specialize in and produce goods that are characterized by higher productivity and that are easily
traded internationally. (Because this basic idea is also found in an earlier book by Roy F. Harrod in 1933, the theory is
sometimes referred to as the Harrod-Balassa- Samuelson effect. This entry will follow the convention of referring to the
empirical observation and the theoretical explanation jointly as the Balassa- Samuelson effect.)
Many early empirical studies failed to find statistical support for the connection between relative prices and income levels. It
was even more difficult to find statistical evidence of a linkage to the underlying causal factors that the Balassa-Samuelson
hypothesis said should be at work, such as between exchange rates and relative productivity levels (see Officer 1982). It
appears, however, that the strength of the Balassa-Samuelson effect has grown steadily over time. Recent statistical studies of
the second half of the 20th century find that for a large sample of countries the relationship between relative national price
levels and income levels became positive as well as statistically significant only in the 1960s, thus validating the BalassaSamuelson hypothesis (for instance, see Bergin, Glick, and Taylor 2006). It may not be a coincidence that Balassa and
Samuelson began writing on the subject at this time. Further, the correlation between these two variables appears to have
quadrupled over the half-century since then, and it is very strongly significant statistically in current data.
22
The Theory of Balassa-Samuelson

How exactly are positive correlations between national price levels and income levels related to the Balassa-Samuelson effect?
There is a specific way of explaining these correlations, based on differences in productivity levels across countries and goods.
Here is a simple version of the theory with an intuitive example to follow.
Consider two countries, home and foreign, where foreign variables are denoted with an asterisk (*). Let there be two goods
produced in these countries, where one good (t) can be traded internationally, and the other is a non-traded good (n).
Traditional, albeit imprecise, examples of this distinction would be manufactured goods as traded and services as non-traded.
For simplicity, suppose these goods are produced competitively in each country, using only labor as an input, with wages W
and W* in each country. Denote the labor productivity in each sector as AT and AN at home, and AT and AN in the foreign
country.
If one assumes that trade is costless for the traded good, its price will be equalized in the two countries. Conveniently, this also
pins down the relative wage levels in the two countries, since WAT = PT = P*T = W* A*T. The wage levels, in turn, pin down
the non-traded goods prices with WAN = PN and W*A*N = P*N. Now construct a simple consumer price index, say, where the
share of expenditure on non-traded goods in consumption is constant at the value y in both countries. Then the relationship
between the price levels of the two countries is given by:
This equation predicts that a country will have a higher overall price level if it is highly productive in traded goods, relative to
its own non-traded goods, and relative to the traded goods of the foreign country. If one country is richer than the other, this
higher income level can be due to higher productivity in the non-traded goods, the traded goods, or some combination of the
two. The theory says that the larger the role of productivity growth specifically in the traded sector, the more likely it will be
that high relative income levels will be associated with high relative price levels. On the other hand, if a country is richer due
to higher productivity in the non-traded sector, or high productivity equally over both sectors, then the model will not predict
that the rich country will have a higher overall price level.
As an intuitive and commonly invoked example of the Balassa-Samuelson effect at work, suppose that the home country is
rich because it is very good at producing a manufactured good like automobiles, but it has no productivity advantage relative
to the foreign country in terms of a non-traded service like haircuts. The high productivity of home workers in the auto
industry affords them a high wage. But it also requires that the wage be high for haircuts, or else no worker would be willing
to provide this service, preferring instead to work in the auto industry. Given that a haircut requires the same amount of labor
time in each country, but the wage rate paid to the haircutter is higher at home, it is clear that the price of haircuts will be
higher at home. Since the purchase price of autos is the same across countries due to arbitrage through trade, the higher price
of haircuts makes the overall cost of living higher in the home country.
Implications and Assessment of the Theory

The Balassa-Samuelson theory is used regularly by economists and policymakers to interpret a range of applied issues. Note
that a straightforward extension of the theory from levels to changes would imply that countries with faster growth rates in
the traded sector would have real exchange rates that are appreciating over time. For example, it predicts that China or other
rapidly developing countries might expect pressure for their real exchange rates to appreciate as a natural counterpart to their
rapid growth in productivity. Similarly, the theory predicts that if new accession countries joining the European Monetary
Union experience a period of accelerated growth as they catch up to richer European countries, they likewise should expect
pressure for real appreciation. Since a monetary union effectively implies that the exchange rate is fixed, this pressure should
be expressed in this case as a higher inflation rate for countries with higher growth rates. The principle remains the same:
higher rates of growth are associated with a rise in the relative cost of living.
The prevalence of the theory behind the Balassa-Samuelson effect in economics owes much to its elegant explanation of the
basic price-income relationship. But it has received criticism for the assumptions needed to derive it. There is evidence that
productivity gains, especially recently, are not limited to manufactured goods, but that the wealth of relatively rich countries is
23
in part attributable to significant productivity gains in many services, such as information technology and retail. Furthermore,
it also appears to be true that many services, especially information services, are becoming more tradable due to new
telecommunications technologies. As changes in technology and transportation costs lead to significant changes in the volume
of trade and even the types of goods and services that are most traded, it is not entirely clear what the future holds for the
Balassa-Samuelson effect.
2.2.2 Stolper Samuelson Theorem

The Stolper-Samuelson theorem is a remarkable theorem: it says that in a world with two goods and two factors of production,
where specialization remains incomplete (plus a few more technical assumptions); one of the two factorsthe one that is
"scarce"must end up worse off as a result of opening up to international trade. Not in relative terms, but in absolute terms.
But the theorem is also quite limited in its applicability. It applies only to a case with two goods and two factors that is why its
real world relevance is always in question.
But there is a version of the theorem that is remarkably general and powerful. It says that regardless of the number of goods
and factors, at least one factor of production must experience a decline in real income from trade as long as trade induces the
relative price of some domestically produced good(s) to fall (and as long as the productivity benefits from trade are restricted
to the traditional, inter-sectoral allocative efficiency improvements, about which more later). All that this result requires is a
very mild assumption, namely that goods be produced with varying factor intensities (i.e., use different combination of
factors). The stark implication is that someone will lose, even if the nation as a whole becomes richer.
Case Study
BPO: Bane or Boon for Indian Companies?
Several MNCs are increasingly unbundling or vertical disintegrating their activities. Put in simple language, they have
begun outsourcing (also called business process outsourcing) activities formerly performed in-house and concentrating
their energies on a few functions. Outsourcing involves withdrawing from certain stages/activities and relaying on
outside vendors to supply the needed products, support services, or functional activities.
Take Infosys, its 250 engineers develop IT applications for BO/FA (Bank of America). Elsewhere, Infosys staffers process
home loans for green point mortgage of Novato, California. At Wipro, five radiologists interpret 30 CT scans a day for
Massachusetts General Hospital. 2500 college educated men and women are buzzing at midnight at Wipro Spectramind
at Delhi. They are busy processing claims for a major US insurance company and providing help-desk support for a big
US Internet service providerall at a cost up to 60 percent lower than in the US. Seven Wipro Spectramind staff with
Ph.Ds in molecular biology sifts through scientific research for western pharmaceutical companies.
Another activist in SPO is Evalueserve, headquartered in Bermuda and having main operations near Delhi. It also has a
US subsidiary based in New York and a marketing office in Australia to cover the European market. As Alok Aggarwal
(co-founder and chairman) says, his company supplies a range of value-added services to clients that include a dozen
Fortune 500 companies and seven global consulting firms, besides market research and venture capital firms. Much of its
work involves dealing with CEOs, CFOs, CTOs, CIOs, and other so -called C-Level executives.
Evalueserve provides services like patent writing, evaluation and assessment of their commercialization potential for
law firms and entrepreneurs. Its market research services are aimed at top-rung financial service firms, to which it
provides analysis of investment opportunities and business plans. Another major offering is multilingual services.
Evalueserve trains and qualifies employees to communicate in Chinese, Spanish, German, Japanese and Italian, among
other languages. That skill set has opened market opportunities in Europe and elsewhere, especially with global
corporations.
ICICI InfoTech Services in Edison, New Jersey, is another BPO services provider that is offering marketing software
products and diversifying into markets outside the US. The firm has been promoted by $2-billion ICICI Bank, a large
financial institution in Mumbai that is listed on the New York Stock Exchange.
Contd
24
In its first year after setting up shop in March 1999, ICICI InfoTech spent $33 million acquiring two information
technology services firms in New Jersey-Object Experts and Ivory Consulting-and Command Systems in Connecticut.
These acquisitions were to help ICICI InfoTech hit the ground in the US with a ready book of contracts. But it soon
found US companies increasingly outsourcing their requirements to offshore locations, instead of hiring foreign
employees to work onsite at their offices. The company found other native modes for growth. It has started marketing its
products in banking, insurance and enterprise resource planning among others. It has earmarked $10 million for its next
US market offensive, which would go towards R & D and back-end infrastructure support, and creating new versions of
its products to comply with US market requirements. It also has a joint venture-Semantik Solutions GmbH in Berlin,
Germany with the Fraunhofer Institute for Software and Systems Engineering, which is based in Berlin and Dortmund,
Germany. Fraunhofer is a leading institute in applied research and development with 200 experts in software
engineering and evolutionary information.
A relatively late entrant to the US market, ICICI Infotech started out with plain vanilla IT services, including operating
call centers. As the market for traditional IT services started weakening around mid-2000, ICICI Infotech repositioned
itself as a Solutions firm offering both products and services. Today, it offers bundled packages of products and
services in corporate and retail banking and insurance, among other areas. The new offerings include data center and
disaster recovery management and value chain management services.
ICICI Infotechs expansion into new overseas markets has paid off. Its $50 million revenue for its latest financial year
ending March 2003 has the US operations generating some $15 million, while the Middle East and Far East markets
brought in another $9 million. It now boasts more than 700 customers in 30 countries, including Dow Jones, GlaxoSmithkline, Panasonic and American Insurance Group. The outsourcing industry is indeed growing from strength.
Though technical support and financial services have dominated Indias outsourcing industry, newer fields are
emerging which are expected to boost the industry many times over.
Outsourcing of human resource services or HR BPO is emerging as big opportunity for Indian BPOs with global market
in this segment estimated at $40-60 billion per annum. HR SPO comes to about 33 percent of the outsourcing revenue
and India has immense potential as more than 80 percent of Fortune 1000 companies discuss offshore BPO as a way to
cut costs and increase productivity.
Another potential area is ITES/SPO industry. According to a NASSCOM survey, the global ITES/SPO industry was
valued at around $773 billion during 2002 and it is expected to grow at a compounded annual growth rate of nine
percent during the period 2002-06. NASSCOM lists the major indicators of the high growth potential of ITES/SPO
industry in India as the following. During 2003-04, The ITES/BPO segment is estimated to have achieved a 54 percent
growth in revenues as compared to the previous year. ITES exports accounted for $3.6 billion in revenues, up from $2.5
billion in 2002-03. The ITES-BPO segment also proved to be a major opportunity for job-seekers, creating employment
for around 74,400 additional personnel in India during 2003-04. The number of Indians working for this sector jumped
to 245,500 by March 2004. By the year 2008, the segment is expected to employ over 1.1 million Indians, according to
studies conducted by NASSCOM and McKinsey & Co. Market research shows that in terms of job creation, the ITESBPO industry is growing at over 50 per cent.
Legal outsourcing sector is another area India can look for. Legal transcription involves conversion of interviews with
clients or witnesses by lawyers into documents which can be presented in courts. It is no different from any other
transcription work carried out in India. The bottom-line here is again cheap service. There is a strong reason why India
can prove to be a big legal outsourcing industry. India, like the US, is a common-law jurisdiction rooted in the British
legal tradition. Indian legal training is conducted solely in English. Appellate and Supreme Court proceedings in India
take place exclusively in English. Indian legal opinions are written exclusively in English. Due to the time zone
differences, night time in the US is daytime in India which means that clients get 24 hour attention, and some projects
can be completed overnight. Small and mid-sized business offices can solve staff problems as the outsourced lawyers
from India take on the time-consuming labour intensive legal research and writing projects. Large law firms also can
solve problems of overstaffing by using the on-call lawyers.
Research firms such as Forrester Research; predict that by 2015, more than 489,000 US lawyer jobs, nearly eight percent
of the field, will shift abroad. Many more new avenues are opening up for BPO services providers. Patent writing and
Contd
25
evaluation services markets are set to boom. Some 200,000 patent applications are written in the western world annually,
making for a market size of between $ 5 billion and $ 7 billion. Outsourcing patent writing service could significantly
lower the cost of each patent application, now anywhere between $12,000 and $15,000 apiece-which would help expand
the market.
Off shoring of equity research is another major growth area. Translation services are also becoming a big Indian plus.
India produces some 3,000 graduates in German each year, which is more than that in Switzerland.
Though going is good, the Indian BPO services providers cannot afford to be complacent. Philippines, Mexico and
Hungary are emerging as potential offshore locations. Likely competitor is Russia, although the absence of English
speaking people there holds the country back. But the dark horse could be South Africa and even China. BPO is based
on sound economic reasons.
Outsourcing helps gain cost advantage. If an activity can be performed better or more cheaply by an outside supplier,
why not outsource it? Many PC makers, for example, have shifted from in-house assembly to utilizing contract
assemblers to make their PCs. CISCO outsourcers all productions and assembly of its routers and switching equipment
to contract manufactures that operate 37 factories, all linked via the Internet.
Secondly, the activity (outsourced) is not crucial to the firms ability to gain sustainable competitive advantage and
wont hollow out its core competence, capabilities, or technical know-how. Outsourcing of maintenance services, data
processing, accounting, and other administrative support activities to companies specializing in these services has
become common place. Thirdly, outsourcing reduces the companys risk exposure to changing technology and/or
changing buyer preferences.
Fourthly, BPO streamlines company operations in ways that improve organizational flexibility, cut cycle time, speedup
decision-making and reduce coordination costs. Finally, outsourcing allows a company to concentrate on its core
business and do what it does best. Are Indian companies listening? If they listen, BPO is a boon to them and not a bane.
Question
Which of the theories of international trade can help Indian services providers gain competitive edge over their
competitors?
Source: The Economic Times, February 02, 2003, and The Hindu, June 05, 2006.
2.3 Modern Theories vs. Classical Theories

Ohlins Theory does not contradict classical theory rather it is a clear and modified version of it.
Superiority of this theory is evident from the following points:
1.
The basis of classical theory is the difference of comparative costs in different countries. The basis of modern theory is to
explain the causes of differences in comparative costs.
2.
Classical theory treats labour alone as the most important factor of production, while Ohlin treats both labour and capital
as important factors of production.
3.
Classical theory is based on labour theory of value, which is unrealistic. Ohlins theory is based on cost of money, which is
more realistic.
4.
Classical theory treats international trade as quite distinct from domestic trade. According to Ohlin, international trade is
only a special case of inter-regional trade. It is a more realistic approach.
5.
Classical theory is a theory of partial equilibrium because it studies labour theory of value alone, but Ohlin has based his
theory on general equilibrium of value.
6.
Ohlins theory is superior to classical theory as according to it the main basis of international trade is the difference in
factor endowments. Classical theory made no mention of it.
26
7.
Classical theory only studies comparative costs of the goods concerned whereas Ohlin has taken into consideration the
relative prices of the factors which influence the comparative costs of the goods. It is a more realistic situation.
8.
Classical theory is based on the difference between production functions, whereas Ohlin has acknowledged the equality
of production function.
9.
Classical theory describes the advantage of trade between two countries. It is mainly a welfare theory. Modern theory
refers to the basis of international trade. It is a realistic theory.
10. Modern theory takes into account the space factor of international trade, whereas classical theory ignores it.
11. According to Ohlins theory, it is classified that prices of goods and factors tend to equality due to international trade. The
classical theory is vague in this respect.

1.
As per the Heckscher-Ohlin theory, difference in the prices of the factors depends on their relative scarcity or
abundance.
2.
Heckscher-Ohlin theory assumes that there is a different production function for each commodity in two
countries.
3.
If in a country, capital is relatively dear and labour relatively cheap, such a country will be called a capital scarce
country, even if the quantity of capital in such a country is relatively more.
4.
As per Balassa-Samuelson, if one assumes that trade is costless for the traded good, its price will be equalized in
the two countries.
5.
Modern theory is based on the difference between production functions, whereas Classical theory has
acknowledged the equality of production function.
2.4 Terms of Trade: Concept and Measures

The concept of Terms of Trade is one of the most significant concepts used in the theory of international economics. It is a
quantitative measure of the rate at which a country's exports and imports are exchanged against each other.
The terms of trade receive considerable attention in the discussion of international economic problems at least for two reasons
(i) the gains from trade depend upon the terms of trade, (ii) the Third World countries feel that their products have suffered a
secular deterioration in their terms of trade as a result of which there has been an unjust transfer of income from the poor to
the rich countries who have improved their terms of trade at the expense of the poor countries.
Meaning of Terms of Trade

The terms of trade refer to the rate at which the goods of one country exchange for the goods of another country. It is a
measure of the purchasing power of exports of a country in terms of its imports, and is expressed as the relation between
export prices and import prices of its goods. When the export prices of a country rise relatively to its import prices, its terms of
trade are said to have improved. The country gains from trade because it can have a larger quantity of imports in exchange for
a given quantity of exports. On the other hand, when its import prices rise relatively to its export prices, its terms of trade are
said to have worsened. The country's gain from trade is reduced because it can have a smaller quantity of imports in exchange
for a given quantity of exports than before.
27
2.4.1 Types of Terms of Trade

There are several concepts of terms of trade, and the major ones are listed below:
Gross Barter Terms of Trade

The distinction between "gross" and "net" barter terms of trade was introduced by Taussig in 1927. Symbolically, we can
express gross barter terms as follows:
G=
Mq
100
Xq
Where, Mq stands for the import quantity index, Xq for export quantity index and G for gross barter terms. We multiply the
whole expression Mq/Xq by 100 in order to get rid of the decimal, and there is no other significance to this number. Let us
illustrate the concept with some concrete examples.
The quantity index of imports and exports for the base year, say 2003 will always be equal to 100. The base year will serve as
the benchmark period with which we can measure changes in the gross barter terms of trade in any given subsequent year-say
2004, 2005, 2006, etc. Let us look at the following hypothetical sets:
Gross Barter Terms of Trade Index
2003 base year:
G=
100
100 = 100 (base year)
100
2004
G=
120
100 = 120 (improvement year)
100
2005
G=
120
100 = 100 (no change)
120
2006
G=
100
100 = 83.33 (det erioration)
120
For 2004, the import quantity index is up from 100 to 120 and the export quantity is the same. This means that in 2004, we
export the same quantity as in 2003, but we import more in 2004 than in 2003. In other words, the purchasing power of exports
has gone up in 2004 compared to the base year 2003. There has been, therefore, a 20-percentage point improvement in the
gross barter terms of trade in 2004 as compared to the year 2003. In 2005, compared with the base year 2003, however, there
has been no change in gross barter terms because both the import and the export quantity index numbers have gone up from
100 to 120 between these two periods. The gross barter terms of trade index are 100, both for 2003 and 2005. In 2006, as
compared to the base year 2003, there has been deterioration in gross barter terms. The import quantity index is constant at 100
both for 2006 and the base year 2003, but the export quantity index for 2006 is 120 as against the base period index of 100. This
means that in 2006 we import the same quantity as in 2003 but we are paying more for these imports as indicated by the
increase in the export quantity index (from 100 in 2003 to 120 in 2006). Put simply, what it means is that we are forced to
export more to import the same quantity in 2006 as compared to the year 2003.
In brief, an increase in the import quantity index (the numerator value) tends to improve gross barter terms; while an increase
in the export quantity indexed (the denominator value) would tend to worsen the gross barter terms of trade. The concept of
terms of trade used in the theory of reciprocal demand and offer curves, or in the neo-classical comparative advantages
analysis, is in this gross barter terms of trade sense. This concept has its own merits, but it is not the commonly used
expression of the terms of trade concept in today's world.
28
Net Barter or Commodity Terms of Trade

This is the most commonly (almost universally) used expression for the terms of trade changes in the contemporary world.
The gross barter terms concept uses quantity index for imports and exports, whereas the net barter or commodity terms
concept makes use of the price index for imports and exports. Herein lies the distinction between gross and net barter terms of
trade. Symbolically, the net barter terms of trade can be written as follows:
N=
Xp
100
Mp
Where, Xp and Mp stand for price index numbers of exports and imports, respectively, and N stands for net barter or
commodity terms. As in the previous case, the expression is multiplied by 100 only to get rid of the decimal.
The price index of imports and exports for the base year (say 2003) will always be equal to 100. We express commodity terms
changes in subsequent years always with reference to the base year index. Take a look at the following hypothetical set of
commodity price index numbers of imports and exports.
Commodity Terms of Trade Index
2003
N=
100
100 = 100 (base year)
100
2004
N=
120
100 = 120 (improvement year)
100
2005
N=
100
100 = 83.33 (det erioration)
120
2006
N=
120
100 = 100 (no change)
120
2007
N=
96
100 = 120 (base year)
80
2008
N=
126
100 = 90 (det erioration)
140
In 2004, there is an improvement in commodity terms by 20 percentage points, because we buy our imports at the same price
(as in 2003) but sell our exports at a higher price (20% higher than in 2003). In 2004, there is deterioration in commodity terms,
because we sell our exports at the same price (as in 2003) but buy our imports at a higher price. In 2006, however, there has
been 'an increase in both the export price index and the import price index by the same percentage point (viz. 20%) which
leaves the terms of trade unchanged. In 2007 there has been a decrease in both import and export price index, and in 2008,
there has been an increase in both index numbers in such a way that commodity terms have turned, "favourable" in 2007 but
"unfavourable' in 2008 (as compared to the base year 2003). The simple rule is that if there is an increase in our selling price
(export price index) there will be an improvement in commodity terms, and if there is an increase in our buying price (import
price index) there will be an unfavourable movement in commodity terms of trade.
There is a general belief that improvement in commodity terms would mean an improvement in the economic welfare of the
country. Because when the export prices go up we sell our goods at a higher price, and when import prices go down, we will
be able to buy foreign goods at a lower price. In either case, commodity terms improve and the country is better off in terms of
economic welfare. From this one comes to the conclusion that maximization of commodity terms of trade would mean
maximization of economic welfare of a country. But, Haberler has, however, argued that the terms of trade should be
optimized rather than maximized because the economic welfare of a country will be maximized not when the commodity
terms are maximized but when they are optimized. Let us pursue this point and, see what Haberler's argument means.
29
What is important to a country, from the welfare viewpoint, is not how high the export prices are but how high the export
earnings are. If we are able to sell our export goods at a very high price, (thereby improving commodity terms) it could mean
that foreigners buy less of our export goods. In this case, we end up with reduced export earnings and thereby reduced
economic welfare. What we cannot afford to ignore, is the elasticity of demand for our export goods. Just as the optimum price
of a monopolist the price which maximizes monopoly profits is not the highest price which the monopolist would be able
to charge, the optimum terms of trade which maximize welfare is not the highest price of exports which a country could
possibly obtain. Take for instance, the following two situations: i.e., elasticity of demand for export goods and elasticity of
demand for import goods.
Elasticity of Demand for Export Goods
Figure 2.3: Elasticity of Demand for Export Goods
From the Figure 2.3 (a) and (b) it can be seen that the export demand curve is very elastic in Figure 2.3 (a) and is very inelastic
in case of Figure 2.3 (b).
An increase in export price from OA to OA1 in Figure 2.3 (a) will lead to a substantial fall in export volume from OQ to OP. As
a result, the export earnings after the export price increases (OA1DP) are far less than the export earnings before (OABQ). In
such a situation, though the commodity terms have improved, export earnings have gone down thus reducing the welfare of
the country. In spite of a substantial increase in export prices from OA to OA1 in Figure 2.3 (b) there is only a marginal
decrease in the export quantities (OQ to OP) such that the export earnings after the export price increases (OA1DP) are
substantially higher than before i.e., OABQ.
Therefore, we can say that the elasticity of exports play an important role in deciding whether the welfare of the country would go up as a
result of an increase in export prices. It is essential to study the effect of export price increases on the volume of exports because
we are interested in maximizing export earnings rather than export prices.
Elasticity of Demand for Import Goods
The import demand curve is highly inelastic in Figure 2.4 (a) and highly elastic in Figure 2.4 (b).
Figure 2.4: Elasticity of Demand for Import Goods
30
In Figure 2.4 (a), a substantial drop in import price from OA' to OA leads only to small increase in the level of imports. OA
leads only to a small increase in the level of imports (from OP to OQ) such that the import spending after the import price
decrease (OABQ) are considerably less than before i.e., OA'DP. In this case, an improvement in commodity terms brought
about a fall in import prices has led to a reduction in import spending and hence an increase in the welfare of the country.
In Figure 2.4 (b) on the other hand, a small drop in import prices from OA' to OA has resulted in a substantial increase in the
level of imports (from OP to OQ) such that the import spending after the import price decrease (OABQ) are substantially more
than before (OA'DP). In this situation, the commodity terms have improved due to a fall in import prices but the economic
welfare of the country has gone down because of the increase in import spending.
Income Terms of Trade

Dorrance has improved upon the concept of the net barter terms of trade by formulating the concept of income terms of a
trade. This index takes into account the volume of exports of a country and its export and import prices (the net barter terms of
trade). It shows a country's changing import capacity in relation to changes in its exports. Thus, the income terms of trade are
the net barter terms of trade of a country multiplied by its export volume index. It can be expressed as:
Ty = Tc . Qx =
PxQx Index of export prices Export quality

=
Pm
Index of import prices
Where, Ty is the income terms of trade, Tc the commodity terms of trade and Qx the export volume index.
A rise in the index of income terms of trade implies that a country can import more goods in exchange for its exports.
A country's income terms of trade may improve but its commodity terms of trade may deteriorate. Taking the import prices to
be constant, if export prices fall there will be an increase in the sales and value of exports. Thus, while the income terms of
trade might have improved, the commodity terms of trade might have deteriorated.
The income terms of trade are called the capacity to import in the long run, the total value of exports of a country must equal
its total value of imports: i.e., PxQx = PmQm or Px. Qx/Pm = Qm. Thus Px.Qx/Pm determines Qm which is the total volume
that a country can import. The capacity to import of a country may increase if other things remain the same (i) the price of
exports (Px) rises, or (ii) the price of imports (Pm) falls, or (iii) the volume of its exports (Qx) rises. Thus, the concept of the
income terms of trade is of much practical value for developing countries having low capacity to import.
Limitations
But the index of income terms of trade fails to measure precisely the gain or loss from international trade. When the capacity to
import of a country increases, it simply means that it is also exporting more than before. In fact, exports include the real
resources of a country, which can be used domestically to improve the living standards of its people.
Moreover, the income of trade index is related to the export-based capacity to import and not to the total capacity to import of
a country, which also includes its foreign exchange receipts. For example, if the income terms of trade index of a country have
deteriorated but its foreign exchange receipts have raised its capacity to import its trade has actually increased, even though
the index shows deterioration. That is why; the concept of the commodity terms of trade is usually used in preference to the
income terms of trade concept for measuring the gain from international trade.
Single Factoral Terms of Trade

The concept of commodity terms of trade does not take account of productivity changes in export industries. Professor Viner
has developed the concept of single factoral terms of trade which allows changes in the domestic export sector. It is calculated
by multiplying the commodity terms of trade index by an index of productivity changes in domestic export industries. It can
be expressed as:
Ts = Tc . Fx =
Px . Fx
Pm
31
Where Ts is the single factoral terms of trade, Tc is the commodity terms of trade, and Fx is the productivity index of export
industries.
It shows that a country's factoral terms of trade improve as productivity improves in its export industries. If the productivity
of a country's exports industries increases, its factoral terms of trade may improve even though its commodity terms of trade
may deteriorate. For example, the prices of its exports may fall relatively to its import prices as a result of increase in the
productivity of the export industries of a country. The commodity terms of trade will deteriorate, but its factoral terms of trade
will show an improvement.
Limitations
This index is not free from certain limitations. It is difficult to obtain the necessary data to compute a productivity index.
Further, the single factoral terms of trade do not take into account the potential domestic cost of production of import
industries in the other country. To overcome this weakness, Viner formulated the double factoral terms of trade.
Double Factoral Terms of Trade

The double factoral terms of trade take into account productivity change both in the domestic export sector and the foreign
export sector producing the country's imports. The index measuring the double factoral terms of trade can be expressed as:
Tc . Fx Px . Fx
=
Fm
Pm Fm
Px
Tc =
Pm
Td =
Where Td is the double factoral terms of trade, Px/Pm is the commodity terms of trade Fx is the import productivity index,
and Fm is the import productivity index.
It helps in measuring the change in the rate of exchange of a country as a result of the change in the productive efficiency of
domestic factors manufacturing exports and that of foreign factors manufacturing imports for that country. A rise in the index
of double factoral terms of trade of a country means that the productive efficiency of the factors producing exports has
increased relatively to the factors producing imports in the other country.
Limitations
In practice, however, it is possible to calculate an index of double factoral terms of trade of a country. Professor Devons made
some calculations of changes in the single factoral terms of trade of England between 1948-53. But it has not been possible to
construct a double factoral terms of trade index of any country because it involves measuring and comparing productivity
changes in the import industries of the other country with that of the domestic export industries.
Moreover, the important thing is the quantity of commodities that can be imported with a given quantity of exports rather
than the quantity of productive factors required in a foreign country to produce its imports.
Again, if there are constant returns to scale in manufacturing and no transport costs are involved; there is no difference
between the double factoral terms of trade and the commodity terms of trade of a country.
According to Kindleberger, the single factoral terms of trade is a much more relevant concept than the double factoral. We are
interested in what our factor can command in goods, not what our factor services can command in the services of foreign
factors. Related to productivity abroad moreover, is a question of the quality of the goods imported.
Real Cost Terms of Trade

Viner has also developed a terms of trade index to measure the real gain from international trade. He calls it the real cost terms
of trade index. This index is calculated by multiplying the single factoral terms of trade with the reciprocal of an index of the
amount of disutility per unit of productive resources used in producing export commodities. It can be expressed as:
32
Tr = Ts . Rx =
Ts =
Px Fx . Rx
Pm
Px . Fx
Pm
Where Tr is the real cost terms of trade, Ts is the single factoral terms of trade and Rx is the index of the amount of disutility
per unit of productive resources used in producing export commodities.
A favourable real cost terms of trade index (Tr) shows that the amount of imports received is greater in terms of the real cost
involved in producing export commodities. But this index fails to measure the real cost involved in the form of goods
produced for export which could be used for domestic consumption to pay for imports. To overcome this problem, Viner
develops the index of utility terms of trade.
Utility Terms of Trade

The utility terms of trade index measures "changes in the disutility of producing a unit of exports and changes in the relative
satisfactions yielded by imports, and the domestic products foregone as the result of export production." In other words, it is an index of
the relative utility of imports and domestic commodities foregone to produce exports. The utility terms of trade index is
calculated by multiplying the real cost terms of trade index with an index of the relative average utility of imports and of
domestic commodities foregone. If we denote the average utility by U and the domestic commodities whose consumption is
foregone to use resources for export production by a, then,
U=
Um1 Um0
/
Ua1 Ua0
Where, u is the index of relative utility of imports and domestically foregone commodities. Thus, the utility terms of trade
index can be expressed as:
Tu = Tr . u =
Px . Fx . Rx . u
Pm
Since the real terms of trade index and utility terms of trade index involve the measurement of disutility in terms of pain,
irksomeness and sacrifice, they are elusive concepts. As a matter of fact, it is not possible to measure disutility (for utility) in
concrete terms.
Hence like the single and double fact oral terms of trade concepts, the concepts of real and utility terms of trade are of little
practical use. They are only of academic interest. That is why the concepts of the commodity terms of trade and of income
terms of trade have been used in measuring the gains from international trade in developed as well as developing countries.
2.4.2 Factors Affecting Terms of Trade

The terms of trade of a country are influenced by a number of factors, which are discussed as under:
Effect of Changes in Demand

Equilibrium Terms of Trade
The following diagram illustrates the determination of the equilibrium terms of trade with the help of offer curves. In the
Figure 2.5, OP represents the offer curve of Country A which specializes in the production of commodity X and OQ represents
the offer curve of Country B which specializes in the production of commodity Y. OT represents the equilibrium terms of trade
and E represents the equilibrium point. When the terms of trade is OT, Country A would be willing to offer OX of X for OY of
Y and Country B would be willing to offer OY of Y for OX of X. Hence, E emerges as the point of equilibrium, OT being the
equilibrium terms of trade.
33
Figure 2.5: Offer Curves and Terms of Trade
Suppose the terms of trade have changed from OT to OT1. This shift of the terms of trade curve towards the right implies that
commodity X has become cheaper in terms of Y. At the new terms of trade, i.e., OT1, Country B would demand OX2 of X, but
Country A would be willing to supply only OX1 of X. Thus, at OT1 terms of trade, there is an excess demand for X equivalent
to X1X2. This excess demand would tend to drive the price of X upwards. As the price of X increases, its supply would also
tend to increase. These changes would have the effect of re-establishing the equilibrium terms of trade.
Effect of Demand on Terms of Trade
A change in demand for a commodity would cause a change in the equilibrium terms of trade. In the Figure 2.6 assume that
OT is the original terms of trade and E the corresponding equilibrium point, established by OP, the offer curve of Country A
producing, X and OQ, the offer curve of Country B producing, Y. Now, suppose that the demand for X increases in Country A,
causing an increase in its price. This increase in price will shift the offer curve of Country A towards the left implying that now
Country A will have to be offered more Y to make it part with any given amount of X.
Figure 2.6: Effect of Change in Demand on Terms of Trade
Suppose that as a result of the change in demand for X and the concomitant increase in price, the offer curve of Country A
shifts from OP to OP1. Then E1 will emerge as the new equilibrium point and OT1 the corresponding equilibrium terms of
trade.
It is clear from the Figure 2.6 that the shift in Country A's offer curve to the left has caused a decline in the volume of
international trade. This is natural because as the domestic demand for X increased in Country A, the amount of X now
34
available and offered for an export has also reduced. As exports pay for imports, lower exports of X would also mean lower
imports of Y.
Effect of Changes in Supply on Terms of Trade

Suppose, due to an advance in technology, the output of X increases in Country A. Ceteris Paribus, this increase in the supply
of X will cause a fall in its price and a shift in the offer curve of Country A towards the right as shown in the Figure 2.7.
This shift in the offer curve from OP to OP1 implies that now Country A is willing to offer a larger quantity of X than before,
for any given amount of Y. E is the new equilibrium point and OT the corresponding equilibrium terms of trade.
This change in the terms of trade need not result in a loss to Country A because if the increase in the supply of X is caused by a
technology advance, it could reduce the cost of production of X. It could be even possible that at the new exchange ratio,
though unfavourable compared to the original one, Country A is gaining more now for the sacrifice involved in producing
any given amount of X.
Figure 2.7: Effects of Changes in Supply on Terms of Trade
Figure 2.7 shows that the increase in the supply of X and the fall in its price lead to an expansion of international trade. This is
natural because at the lower price of X, Country B would demand more X and Country B would demand and import by
exporting more Y.
Changes in Technology
Technological changes also affect the terms of trade of a country. The effect of technological changes on terms of trade is
illustrated in Figure 2.8. Suppose there is change in technology in USA. Before technological change, the terms of trade
between USA and France are settled at point M on the OT ray where USA exports EM of linen for OE of France's cloth. With
technological change, USA's new offer curve is OG1 which cuts the terms of trade line OT at M1. At this point, USA would like
to export less linen E1M1 and import less cloth OE1 than France wants to exchange at the terms of trade OT. So USA's terms of
trade improve when its new offer curve OG1 cuts Frances unchanged offer curve OD at M2 where the new terms of trade are
settled on the line OT1. At M2, USA is better off because it exports less linen for more of France's cloth i.e., E2M2 > OE2. Its
terms of trade have improved with technological change.
35
Figure 2.8: Effect of Change in Technology on Terms of Trade
Changes in Tastes
Changes in tastes of people of a country also influence its terms of trade with another country: Suppose France's tastes shift
from USA's linen to its own cloth. In this situation, France would export less cloth to USA and its demand for USA's linen
would also fall. Thus France's terms of trade would improve. On the contrary, a change in France's taste for USA's linen would
increase its demand and hence the terms of trade would deteriorate for France. The first case of an improvement in the terms
of trade of France is depicted in Figure 2.9. When France's tastes change from USA's linen to its own cloth, its offer curve shifts
up to OD1 and intersects USA's unchanged offer curve OC at M1. As a result, France exports only OE1 of cloth in exchange for
E1M1of USA's linen. Obviously, France's terms of trade have improved for now it exchanges less cloth (OE1) for more linen of
USA (E1M1) i.e., OE1 < E1M1.
Figure 2.9: Effect of Change in Taste on Terms of Trade
Economic Growth
Economic growth is another important factor, which affects the terms of trade. The raising of a country's national product or
income over time is called economic growth. Given the tastes and technology in a country, an increase in its productive
capacity may favourably or unfavourably affect the terms of trade. This is illustrated in the Figure 2.10 in terms of the
production possibility curves and the community indifference curves of a country which experiences economic growth. D1D1
is the production possibility curve of France before growth where the slope T1T1 shows its terms of trade. Before growth, it is
36
producing at M1 and consuming at C1 on the community indifference curve CI1. Thus France is exporting H1M1 of cloth and
importing H1C1 of linen from USA. When growth takes place, the production possibility curve D1D1 shifts outward to D2D2.
The new terms of trade after growth, as represented by the slope of the line T2T2, show an improvement when production
takes place at point M2 on the production possibility curve D2D2 and consumption at point C2 of the community indifference
curve CI2. As a result of the improvement in France's terms of trade, it exports less cloth to USA in exchange for more linen
than in the pre-growth situation. It exports H2C2, which is less than H1M1 and imports H2M2 that is greater than H1C1.
Figure 2.10: Effect of Economic Growth
Tariff
In the Figure 2.11, OP is France's offer curve of linen and OE USA's offer curve of cloth before the imposition of tariff. The
slope of ON is the terms of trade.
Supposing USA imposes some tariff (import duty) on its imports of France's linen. As such, traders in USA would have to give
to the government an amount of their import purchases equivalent to the import duty. USAs offer curve then shifts upwards
to OE1. It can be seen that before tariff was imposed, USA was willing to offer (export) OC of its cloth in exchange for NC of
import of linen. But when the tariff (import duty) was imposed, she will be willing to offer OB of cloth in exchange for a larger
amount of imports N1B plus amount equal to import duty, say N1G, i.e., NG of linen. Therefore, OE shifts to OE1. Now, the
terms of trade change as indicated by the slope of ON1. Since the line of terms of trade (ON) moves away from the tariff
imposing country towards the opposite side (as ON1), the terms of trade for the imposing country improve.
Figure 2.11: Effect of Tariff on Terms of Trade
37
It should be noted that a tariff can improve the terms of trade only when the offer curve of the opposite country is not
perfectly elastic and it (the opposite country) does not retaliate by imposing a tariff on its imports from the country concerned.
In the case of retaliation, however, the final effect of tariffs on the terms of trade depends upon the relative size of tariffs. But
the volume of trade of both the countries will decline as a result of rising prices of import under retaliation, consequent to
tariff imposition, so both the countries will lose.

Fill in the blanks:
1.
Terms of trade is a measure of the .. of exports of a country in terms of its imports, and is
expressed as the relation between export prices and import prices of its goods.
2.
is the most commonly used expression for the terms of trade changes in the
contemporary world.
3.
The play an important role in deciding whether the welfare of the country would go
up as a result of an increase in export prices.
4.
The income terms of trade are called the capacity to import in the run -the total value of exports of a
country must equal its total value of imports.
5.
terms of trade index measures changes in the disutility of producing a unit of exports and
changes in the relative satisfactions yielded by imports, and the domestic products foregone as the result of
export production.
An Impact of Devaluation on Terms of Trade

The effects of devaluation on the terms of trade have been much debated among economists. According to Prof. Machlup,
"Devaluation is supposed to improve the balance of trade. A reduction in the physical volume of imports in relation to the physical volume
of exports constitutes an adverse change in the gross barter terms of trade."
The devaluation will be successful only if the gross barter terms become adverse. Prof. Robertson favours the use of the
concept of the commodity terms of trade to assess the effects of devaluation. To him, if this concept is used, devaluation will
lead to rise in the prices of imports and fall in the prices of exports in foreign currency and hence deteriorate the commodity
terms of trade. Prof. Hirch suggests that the right procedure should be to study price movements in exports and imports in the
same currency in order to assess the true effects of devaluation. Both export and import prices normally rise in the home
currency and fall in the foreign currency. The commodity terms of trade will deteriorate only when export prices fall more
than import prices in terms of domestic currency. In reality, the elasticities of demand and supply for exports and imports of a
devaluing country determine deterioration or improvement in its terms of trade. If both the foreign demand for exports and
home demand for imports are highly elastic and supplies both to home exports and foreign imports are highly elastic to price
movements, devaluation leads to an improvement in the commodity terms of trade. This is explained in Figure 2.12 (A) & (B).
Figure 2.12: Effect of Devaluation on Trade
38
Suppose the English pound is devalued in relation to the French franc and the price movements before and after devaluation
are taken in pound. The present devaluation price of OQ exports is OPE and that of OM imports is OP1. The post-devaluation
export price rises to PE when the demand curve shifts upward as DE and the import price rises to OPI with the shifting of the
supply curve to the left as SI'. A comparison of Figure 2.12 (A) and (B) reveals that the export price has risen more than the
import price PE PE'>PI PI' and that while exports have risen from OQ to OQ1; imports have fallen from OM to OM1. Hence it
is proved that the terms of trade have improved for England after devaluation.
2.5 Let us Sum up

According to the Heckscher-Ohlin theory, there is difference in factor endowments among different countries of the world. For
instance, certain countries have comparatively large supply of labour while in others the supply of capital is relatively large.
Because of difference in factor endowments, there is difference in the prices of the factors.
Different regions have different factor endowments, that is, some regions have abundance of labour but scarcity of capital
while other regions have abundance of capital but scarcity of labour. Different goods have different production functions, that
is, factors are combined in different proportions to produce different commodities.
Some goods are produced by employing relatively large proportion of labour and relatively small proportion of capital. Still
other goods are produced by employing relatively small proportion of labour and relatively large proportion of capital. In this
way, each region is suitable for the production of those goods for whose production it has relatively abundant supply of the
required factors.
Abundance or scarcity of factors in the Heckscher-Ohlin theory has been explained on the basis of two criteria: (i) Price
Criterion of Relative Factor Endowment, and (ii) Physical Criterion of Relative Factor Endowment.
Samuelson has influenced international economics through two important theories of international trade: the BalassaSamuelson effect (consumer price levels are systematically higher in wealthier countries than in poor countries) and the
Hecksher-Ohlin model (a General equilibrium mathematical model of the macro economy in international trade), in which the
Stolper-Samuelson theorem (a basic theorem in trade theory which describes a relation between the relative prices of output
goods and relative factor rewards) is utilized.
The basis of classical theory is the difference of comparative costs in different countries. The basis of modern theory is to
explain the causes of differences in comparative costs.
The terms of trade refer to the rate at which the goods of one country exchange for the goods of another country. It is a
measure of the purchasing power of exports of a country in terms of its imports, and is expressed as the relation between
export prices and import prices of its goods.
There are several concepts of terms of trade, and the major ones are: Gross Barter Terms of Trade, Net Barter or Commodity
Terms of Trade, Income Terms of Trade, Single Factorial Terms of Trade, Double Factorial Terms of Trade, Real Cost Terms of
Trade and Utility Terms of Trade.
Factors that affect terms of trade are changes in demand, changes in supply, changes in technology, change in taste, economic
growth and tariff.

Imagine two countries that each produces 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 modern theory of trade, what can both the
countries do? Examine diagrammatically.
39
2.7 Keywords
Devaluation of terms of trade: A reduction in the physical volume of imports in relation to the physical volume of exports
constitutes an adverse change in the gross barter terms of trade.
Elasticity of demand for imports: Normally the price elasticity of demand for imports of a country, either for a single industry
or for the aggregate of all imports.
Equilibrium terms of trade: The terms of trade at which the country's excess supply of each good to the world market equals
the world market's excess demand.
Isocost line: It shows all combinations of inputs which cost the same total amount.
Isoquant: The locus of input combinations that yield the same output level.
Real cost terms of trade: It attempts to measure the gain from international trade in utility terms.
Relative scarcity: It means that we do not have enough resources to satisfy all our wants and needs.
Terms of trade: Refers to the rate at which the goods of one country exchange for the goods of another country.

1.
Explain the Modern Theory of International Trade. How does it differ from comparative advantage theory?
2.
Explain critically the Heckscher-Ohlin theory of International Trade.
3.
The difference of factor endowments among the nations is the basis of international trade. Explain.
4.
Contrast modern and classical theories of international trade.
5.
Distinguish between Gross Barter Terms of Trade and Barter Terms of Trade or Income Terms of Trade and Net Barter
Terms of Trade.
6.
Discuss the factors that determine the terms of trade.
7.
What are different kinds of terms of trade? Which of these concepts is most helpful in indicating 'gains from trade'? Why?
8.
Describe single factoral and double factoral terms of trade. Highlight their merits and demerits.
9.
Write a brief note on income terms of trade of a country and their relevance for a developing economy.
10. What is meant by equilibrium terms of trade? Discuss alternative interpretations of this concept.

CYP 1
1.
True
2.
False
3.
True
4.
True
5.
False
CYP 2
1.
Purchasing power
2.
Net barter/commodity
40
3.
Elasticity of exports
4.
Long
5.
Utility

Kumar, Raj, International Economics, Excel Books, New Delhi, 2011
Sodersten, BO, International Economics, Macmillan, London, 1972, p 105.
Salvatore, Dominick, International Economics, John Wiley and Sons, New York, 2001, p. 146.
Ohlin, Bertil, Interregional and International Trade, Harvard University Press, Cambridge, 1957, p. 49.
41
Chapter 3: Trade and Development

Objectives
1.
The concept of gains from trade
2.
How trade can act as a substitute for growth
3.
Theory of immiserising growth
4.
The concept of free trade vis--vis protectionism
5.
The types of trade barriers
6.
The working of trade blocks
Introduction
Trade is a key factor in development of any economy. A successful use of trade can add to a country's development.
According to mercantilists and classical economists, international trade promotes economic welfare through division of labour
and specialization. As a result of it, all countries of the world stand to gain. On account of international trade based on the
principle of comparative costs and consequent specialization and division of labour, the gain that the trading countries enjoy is
called gain from international trade. Mill, Marshall, Samuelson, Kemp and Haberler and many other economists have also
highlighted mention of the gains from international trade. Endorsing the viewpoint of the classical economists, these
economists have also stated that countries participating in international trade produce and exchange goods on the basis of
division of labour and specialization and thereby maximize their economic gain.
In the words of Horn and Gomez, "International trade renders benefit to all participating nations and injury to none."
3.1 Gains from Trade

The gain from international trade refers to that advantage which different countries participating in international trade enjoy
as a result of specialization and division of labour.
Definitions
z
In the words of Sodersten, "Gains from trade means increase in welfare to the world economy as a whole or to an individual
country depending on the view point, as a result of engaging in international trade. The gains originate in two sources, which are the
possibility of exchange and the possibility of increased specialization."
According to the Dictionary of Modern Economics, "The surplus production arising out of international division of labour
represents gains from trade and it is distributed among trading partners according to agreed rates of exchange for goods."
In the words of R.F. Harrod, "A country gains by foreign trade if and when the traders find that there exists abroad, a ratio of
prices very different from that to which they are accustomed at home. They buy what to them seems cheap and sell at what to them
seem good prices. The bigger gap between what to them seems low points and high points and the more important the articles affected
the greater will the gain from trade lie.
In the words of Adam Smith, "The gains on account of the advantages of division of labour and specialization at both national and
international level are called gains from trade."
It is evident from above that gains from international trade are expressed in the form of larger production. As a consequence
of these gains, different countries make optimum use of their resources and thus maximize their production, extend the size of
market and increase their national income.
42
International trade gives rise to many economic advantages, which may also be termed as gains from trade, which are as
under:
z
International trade makes international division of labour possible. Consequently, there is optimum, distribution of world
resources. The same can be put to efficient use.
There will be increase in the total production of the world.
There is increase in the volume and value of the goods traded among the countries.
International trade enables each country to secure variety of consumer goods in large quantity.
It promotes the welfare of each country and adds to the prosperity of the world.
3.1.1 Sources of Gains from Trade

The main sources of gains from trade are as under:
1.
Division of Labour: It is clear from Ricardo's theory of comparative costs that when different countries of the world
specialize in the production of those goods in which they enjoy greater comparative advantage or they have least
comparative disadvantage, then all the trading countries will stand to gain. Thus one of the main sources of gain from
trade is division of labour on the basis of comparative costs.
2.
International Specialization: Another main source of gain from international trade is specialization based on the
comparative cost advantage. It makes possible large-scale production, which in its turn yields internal and external
economies. These economies give rise to gains from trade.
3.
Wide Extent of Market: Scale of production increases as a result of wide extent of the market. Scope of division of labour
and specialization widens. Consequently, cost of production falls and so also the price of the commodity. It also
constitutes gain from the international trade.
3.1.2 Kinds of Gains from Trade

Gains from international trade are of two types:
1.
Static Gains
It includes the following:
(a) Maximization of Production: As a result of international trade, total production in the country increases. Higher
production takes place due to specialization and division of labour. Every country exports those items, which this
country can produce at cheaper costs. In the words of Ricardo, "Gains from trade arise simply on account of cost saving
which takes place due to import of goods in place of their domestic production."
(b) Increase in Welfare: Since production due to specialization and division of labour increases international trade,
consumption too increases which leads to increase in welfare of the people. Ricardo again says that, "growth of
international trade is immensely contributed in raising quantity of goods and total profits."
(c) Increase in National Income: As a result of international trade production increases through specialization and division
of labour. The rise in production leads to increase in national income of the country and finally, rate of economic
growth of the economy appreciates.
2.
Dynamic Gains
Following are the main dynamic gains of international trade.
(a) International trade leads to the efficient use of resources.
(b) International trade widens the size of market, which is essential for rapid economic development.
(c) International trade promotes savings and capital accumulation.
43
(d) International trade also creates positive educational effect as it facilitates in the generation of new ideas, new
techniques, competitive and managerial skills.
(e) International trade promotes healthy competition and checking of monopolies. International trade, thus, checks the
operation of inefficient monopolies.
(f)
International trade also promotes other activities such as growth of infrastructure, power generation and other basic
economic and tertiary activities.
3.1.3 Nature of Gains from International Trade

Gains from international trade are automatic as traders enter into trade only if it is profitable. It is evident from the following
statements:
z
In the words of Adam Smith, "between whatever places foreign trade is carried on, all of them drive two distinct benefits from it. It
carries out that surplus part of the production of their land and labour for which there is no demand among them and brings back in
return of it something for which there is demand."
In the words of Ricardo, "Saving in cost under free trade, resulting from obtaining the imported commodities in exchange for
exports, instead of by domestic production, not only demonstrates the existence of gain but also measures the extent of gain."
According to Jacob Viner, "Free trade, therefore, always makes more commodities available and unless it resulted in an impairment
of the distribution of the real income substantial enough to offset increase in quantity of goods available, free trade always operates to
increase national real income."
The nature of gains from international trade can further be classified in two cases:
1.
Gains from Trade under Partial Equilibrium: Gains from trade under partial equilibrium analysis can be explained in
Figure 3.1 with the help of Marshall's D & S curves.
Figure 3.1: Gains from Trade under Partial Equilibrium
In Figure 3.1 there are two parts. One part shows the D & S curves of country A and another part shows the D & S curves
of country B. In the absence of trade, both the countries have different domestic price levels i.e., P & P'. This causes origin
of trade. Let international trade price settled is P1, at which country A imports MN and B country exports M'N'. It is
evident that in country A, price increases and in country B price falls. Hence, the producers of country A gain the gross
profit of PQNP1 whereas the consumers suffer loss equal to PQMP1. The net benefit of the country is MNQ.
44
In country B, gains to consumers are P'Q1M'N' and loss to consumers is equal to the area N' P1P' Q1. So, that the net gain
is M' N' Q1.
2.
Gains from Trade under General Equilibrium: Modern economists explain gains from trade not on the basis of competitive
cost analysis but on the basis of general equilibrium analysis. Prof. Samuelson* restated the gains from trade in 1962. The
Figure 3.2 is drawn on the basis of following assumptions:
(i)
Country in question is small and cannot affect the terms of trade.
(ii) Internal value of the product differs from the external value.
AUB is consumption possibility frontier and PDQ is production possibility curve. Every point on CPF is outside PPC.
Hence it is evident that the society will obtain more goods through trade. The same conclusion was drawn by Haberler on
the basis of opportunity costs.
Figure 3.2: Gains from Trade under General Equilibrium
If the country in question is larger, it can affect the terms of trade of the country. In this case consumption possibility
frontier will be of the shape shown by EVU and it is also called as Baldwin Envelope as is shown in Figure 3.3. It is
derived by superimposing the Marshall's offer curves upon the production possibility curves.
Consumption possibility frontier is still above the production possibility curve. Hence it is possible to improve society's
production by ideal transfer of goods. To conclude it can be said that:
1.
If there is perfect competition, it is possible to maximize world production by the ideal transfer and free trade.
2.
Similarly by ideal transfer and free trade, maximum utility limit for every individual can be attained.
45
Figure 3.3: Baldwin Envelope
3.1.4 Measurements of Gain from International Trade

The gains from international trade are measurable. Prof. Jacob Viner says that the classical economists had adopted three
methods of measuring the gains from international trade.
1.
Measurement of increased real income by comparative cost theory.
2.
Increase in the level of National income.
3.
Improvement in terms of trade.
However, with the introduction of J.S. Mill's theory of Reciprocal Demand, the most frequently used method of measuring
gains from trade is the terms of trade method.
Hence, in order to measure gains from trade, three approaches are used:
1.
Ricardo's Approach
2.
J. S. Mills Approach
3.
Modern Approach or Samuelson's Approach
Ricardo's Approach
According to Ricardo, a country would export those goods in which its comparative cost of production is less. This is proved
in an example and diagram.
India: 15 units of cotton or 20 units of wheat

Pakistan: 10 units of cotton or 10 units of wheat
(i)
If in every country only two units of the factor are used, the product would be as under:
India: 15 units of cotton + 20 units of wheat

Pakistan: 10 units of cotton + 10 units of wheat
46
(ii)
1.
Without specialization, if both the countries produce both the commodities, the total production in the two countries
would be as under:
India + Pakistan = 25 units of cotton + 30 units of wheat
(25C + 30W)
2.
(iii)
If there is specialization on the basis of comparative cost theory, in India specializing in the production of cotton, total
production would be:
India = 25 units of wheat
Pakistan = 20 units of cotton
India + Pakistan = 40 units of wheat + 20 units of cotton
(iv)
Comparing situations (ii) and (iii), reveals that due to specialization in the two countries, production of wheat increases by
10 units whereas there is loss of 5 units of cotton. Hence the net result is:
Net Result = +10 units W 5 units C

(v)
From situation (i) it is revealed that 10 units of wheat in India is equal to 7.5 units of cotton and in Pakistan it is equal to 10
units of cotton i.e.,
10 W = 7.5 C or 10 W = 10 C
So the net result is:
+ 7.5 C 5 C
or
10 C 5 C
i.e., + 2.5 C or + 5 Cotton

Thus, specialization results in net gain of 2.5 or 5 units of cotton which is distributed between the two countries.
The gain that a country enjoys by pursuing trade according to this theory is illustrated by the following Figure 3.4.
Figure 3.4: Gains from Trade
In Figure 3.4, X-commodity is shown on OX-axis and Y-commodity on OY-axis. Suppose, in case of trade, AB is the production
possibility curve that indicates different combinations of X-commodity and Y-commodity produced by the given number of
labour. Point 'E' on AB curve indicates equilibrium position of the country. After entering into trade, the production possibility
47
curve shifts and assumes the shape of BC curve. Slope of BC curve indicates international price ratio of the country. Suppose
this country is in equilibrium at point 'F' on AB1 curve. If this country produces a combination of X-commodity and
Y-commodity as shown by point 'F', it will have to increase the number of labourers to such an extent that domestic
production possibility curve shifts from AB to A1B1. Thus the amount of gain from the trade will be measured by BB1/OB.
Criticism
The main points of criticism of gain from international trade occurred as a result of comparative cost or Ricardo's theory are as
under:
z
According to later economists, Ricardo has unnecessarily exaggerated the gain from international trade. Ricardo's theory
does not apply to those countries which cannot produce the imported goods or can produce the same only at higher cost.
Mill feels that Ricardo's theory does explain the reason why international trade takes place but it does not explain the
quantum of gain and how the same is distributed among different countries.
Mill's Approach
J .S. Mill analyzed the gain as well as the distribution of the gain from international trade in terms of his theory of reciprocal
demand. According to Mill, it is the reciprocal demand that determines terms of trade which, in turn, determines the
distribution of gains from trade of each country. The term 'terms of trade' refers to the barter terms of trade between the two
countries, i.e., the ratio of the quantity of imports for a given quantity of exports of a country.
To take an example, in country A, 2 units of labour produce 10 units of X and 10 units of Y, while in country B the same labour
produces 6X and 8Y. The domestic exchange ratio (or domestic terms of trade) in country A is lX = 1Y, and in country B, 1X =
1.33Y. This means that one unit of X can be exchanged with one unit of Y in country A or 1.33 units of Y in country B. Thus, the
terms of trade between the two countries will lie between 1X or 1Y or 1.33 Y.
Figure 3.5: MarshallEdgeworth offer Curves and Distribution of Gains from Trade
Y
Commodity
Q
R
T
A
E
S
O
K
X-Commodity
However, the actual exchange ratio will depend upon the reciprocal demand, i.e., "the relative strength and elasticity of
demand of the two trading countries for each other's product in terms of their own product." If A's demand for commodity Y
is more intense (inelastic), then the terms of trade will be nearer 1X= 1Y. The terms of trade will move in favour of B and
against country A. B will gain more and A less. On the other hand, if A's demand for commodity Y is less intense (more
elastic), then the terms of trade will be nearer 1X= 1.33 Y. The terms of trade will move in favour of A and against B. A will
gain more, and B less.
The distribution of gains from trade is explained K in terms of the Marshall-Edgeworth offers curves in Figure 3.5. OA is the
offer curve of country A, and OB of country B. OP and OQ are the domestic constant cost ratios of producing X and Y in
country A and B respectively. These rays are, in fact, the limits within which the terms of trade between the two countries lie.
48
However, the actual terms of trade are settled at E the point of intersection of OA and OB. The line OT represents the
equilibrium terms of trade at E.
The cost ratio within country A is KS units of Y and OK units of X. But it gets KE units of Y through trade. SE units of Y is,
therefore, its gain. The cost ratio within country B is KR units of Y and OK units of X. But it imports OK units of X from
country A in exchange for only KE units of Y. ER units of Y is its gain. Thus, both countries gain by entering into trade.
Haberler's Proof of the Gains of Trade

Haberler has specified the gains of trade in a given diagram. In Figure 3.6 AA is the production possibility curve. Before trade
H is the equilibrium point showing the state of production and consumption. The slope of the tangent DD at H shows the
price ratio before trade. After international trade price ratio is shown by PP line which is tangent at point T on the PPC. Point T
represents production equilibrium point and H' represents competition equilibrium point. At H' country exports H'L quantity
of X and import LT quantity of Y commodity.
Figure 3.6: Gains from Trade - Haberler's Approach
On the basis of community IC it has been clarified that point H1 is superior to H as at H1 higher indifference curve is tangent at
H1 than at H. Hence these are gains from international trade. It should however, be clarified that since Haberler was not in
favour of using community indifference curves, point H1 can prove to be superior to H if H1 is above and to the right of H. In
this case at H1 international trade causes rise in the quantity of both X and Y goods. This is nothing but gain from trade.
Modern Approach (Samuelson's Approach)

In modern trade theory, the gains from international trade are clearly differentiated between the gains from exchange and the
gains from specialization. The analysis is explained in terms of the general equilibrium of a closed economy by taking demand
and supply. It is characterized by the tangency of a community indifference curve with the transformation curve, and the
equality of the marginal rates of substitution between commodities in consumption and production with the domestic terms of
trade or commodity price ratio. "The introduction of international trade permits the realization of a gain from exchange and gain from
specialization. When equilibrium is established and these gains are maximized, the new marginal rate of transformation in production and
the new marginal rate of substitution in consumption are equal to the international price ratio or terms of trade." Thus, both producers
and consumers gain from international trade by producing and consuming more than the pre-trade level.
Figure 3.7 explains the gains from international trade. AB is the transformation curve representing the supply side and IC0 is
the community indifference curve representing the demand side of an economy. The closed economy (no trade) equilibrium is
shown by point E where the AB and IC0 curves are tangent to each other and both equal the domestic terms of trade or
commodity price ratio (line) PP.
49
With the introduction of international (or free) trade the international price ratio (terms of trade) will be different from the
domestic price ratio (terms of trade). It is shown as P1 and is steeper than the domestic price ratio P. It means that the price of
commodity X has increased in relation to commodity Y in the world market. At the international price line P1, the consumers
move to point C on a higher community indifference curve CI1 from point E on the IC0 curve. This movement from E to C
measures the gain from exchange or consumption gain with no change in production.
Figure 3.7: Gains from Trade - Samuelson's Approach
Since the price of X has increased in the world market, producers increase its production and decrease that of Y. This leads to
movement along the transformation curve from point E to E1 where the international price line P2 is tangent to the AB curve.
In other words, at E1 the marginal rate of transformation of production equals the international price ratio. The new world
terms of trade ratio P2 is the same as PI because it is parallel to P1. At E1 the country exports E1Z of X in exchange for ZC1
imports of Y.
As a result of increased specialization in the production of X, there is shift in consumption from point C on the IC1 curve to
point C1 on the IC2 curve, where consumers consume larger quantities of both X and Y. This movement from C to C1 measures
the gain from specialization in production or production gain. At C1, the marginal rate of substitution and the international
price ratio are equal. Hence the gains from international trade are maximized at points E1 and C1 because the marginal rate of
transformation in production and the marginal rate of substitution in consumption are equal to the international price ratio P2.
The total gain from free trade is the sum of the consumption and production gains and is shown as improvement in welfare
from IC0 to IC2.
3.1.5 The Gains from Trade and the Income Distribution

Income distribution from the gains from international trade mostly depends on the terms of trade. The terms of trade refer to
the rate at which one commodity of a country is exchanged for another commodity of the other country. This refers to the
barter terms of trade which J. S. Mill used to determine the gains as well as distribution of gains from international trade. The
country which has favourable terms of trade will gain more from the international trade and the gains will add more to the
GNP of the country. Thus, higher the GNP higher is the possibility of favourable income distribution (other things being
equal). On the contrary, the country which has unfavourable terms to trade it will get less gain from the international trade
and thereby its GNP win rise in a lesser quantity. Thus, if GNP is lesser, the income distribution will also be lesser. Thus,
underdeveloped countries, due to unfavourable terms of trade, will not be benefited more from the gains of the trade as
compared to the advanced countries.
It is a known fact that trade makes a country as a whole better off. But it need not necessarily make every citizen better off. To
deal with the problem, the box diagram and a production possibility curve will be used.
50
Figure 3.8: Gains from Trade and Income Distribution
RR the production-possibility curve of Figure 3.8 (b) is derived from the box diagram presented in the figure (a). Before trade
the country produces and consumes at point S' on its production-possibility curve.
Relative commodity prices before trade are given by the line P0P0, tangential to the production -possibility curve at S'. The
point on the contract curve in the box diagram that corresponds to S' to S.
With the introduction of trade the new terms of trade are given by the line P1P1. As good B now becomes more expensive, the
country produces more of good B, that is, it moves to point T1 on its production-possibility curve, where P1P1 is tangential to
the production possibility curve. By moving to T2, the country obviously becomes better off by trading.
The Implication of Trade on Factor Prices: For this, the points S and T on the contract curve are to be compared. It is easily
seen that at point T the methods of production are more labour-intensive in both industries than they are at S. This implies
wages are lower and returns to capital are higher at T than at S. Thus, the income distribution has moved against labour in
favour of the owners of capital.
From this, it follows that the owners of capital gain from free trade - not the wage earners in general. So a policy of free trade
will have to be accompanied by measures of redistribution of income in order to make everyone better off.
But even if the capital-owners are not willing to compensate those who suffer - trade will still be advantageous for the society
as a whole. This situation can be analyzed as follows: the labourers will be unwilling to leave the industry A in order to move
to industry B. But because the price line will become S'S" (which is parallel to P1P1), it would produce at point S' but consume
at S" - which lies to the right of the indifference curve II. This shift in the level of consumption will make the country surely
better off than before. This shows that restricted trade is better than no trade. But restricted trade is potentially less
advantageous than free trade.
3.1.6 Factors Affecting Gains from Trade

The following factors influence the gains from international trade:
1.
Difference in Cost Ratios: In the opinion of Harrod, gains from international trade depend on the difference in
comparative cost ratios of trading countries. More the difference in the cost ratios of two countries, more are the gains
from the international trade. According to Harrod, when trade is expanded for the sake of gains, then a situation arises where
cost ratio of one country becomes equal to the other. A country should expand or contract production of different goods up to the limit
where the cost ratio of that country is equal to the cost ratio of the foreign country.
2.
Production Capacity of the Country: Production capacity of the country also influences gains from international trade. If
the production capacity of a country increases, it will benefit the other country, because it will make the terms of trade
more favourable for the other country. On the contrary, if the production capacity of the country decreases then through
the medium of unfavourable terms of trade the other country will suffer loss. With increase in the production capacity of a
country, the other country enjoys favourable terms of trade because costs and price in the former country go down. As a
result, there is expansion of trade that benefits the other country.
3.
Terms of Trade: Gains from trade are also influenced by terms of trade. Terms of trade refer to the rate at which the goods
of one country are exchanged for the goods of another country. Terms of trade express the relationship between export
51
prices and import prices. Improvement in terms of trade of a country means that the country will gain from the trade. On
the contrary, unfavourable terms of trade are indicative of less gain from trade.
4.
Reciprocal Demand: According to Mill, reciprocal demand also influences gain from trade. If the demand of a country for
the production of another country is inelastic, terms of trade will be unfavourable to it, or it will gain less from trade. On
the contrary, if its demand is elastic, terms of trade will be favourable to it, or it will gain more from trade. According to
Taussig, that country gains from the trade most, demand for whose goods is more in foreign countries and whose own
demand for foreign goods is less. Elasticity of supply also influences terms of trade. If the supply of goods exported from
a country is elastic, the terms of trade will be favourable to it or it will gain more from trade. On the contrary, if the
country imports such goods as have inelastic supply abroad, then also the terms of trade will be favourable to it or that it
will gain more from trade. Under contrary conditions, gain from trade will be less.
5.
Size of the Country: Smaller countries gain more from international trade than the bigger ones. The reason being that
smaller countries can specialize in the production of a commodity without making any change in its exchange ratio in the
world market. On the contrary, if a large country will specialize in the production of a commodity, then the supply of that
commodity will increase very much. Consequently, the price of the commodity concerned will fall sharply and gain from
trade will accordingly be less.
6.
Facilities for Trade: Facilities of trade also affect gain from trade. If facilities of trade are large, for example, low transport
costs, then there will be no difficulty in the sale of the goods and gain from trade will increase. Efficient salesmanship also
adds to gain from trade.
7.
Volume of Trade: Gain from trade is also influenced by volume of trade. Larger the volume of trade greater will be the
gain from trade. Mill is of the opinion that if a country produces a commodity on a large scale because of its large demand
abroad, then by exporting this commodity alone, it would be able to earn enough to pay for all its imports. In this way, the
country stands to gain from the trade.
8.
Transport Cost: Gain from international trade is also influenced by transport cost. Fall in transport cost results in the
expansion of scope of international trade and gain from international trade also increases. On the contrary, with rise in
transport cost, scope of international trade is restricted and gains from international trade declines.
In short, every country makes a constant effort to increase its gains from international trade. Gain from trade is the result of
specialization and division of labour.

1.
Gains from trade are a result of specialization and division of labour.
2.
Since production due to specialization and division of labour increases international trade, consumption too
increases which leads to increase in welfare of the people.
3.
According to Ricardo, it is the reciprocal demand that determines terms of trade which, in turn, determines the
distribution of gains from trade of each country.
4.
In modern trade theory, the gains from international trade are clearly differentiated between the gains from
exchange and the gains from specialization.
3.2 Trade as a Substitute for Growth

Although the level and rate of economic development depend primarily on internal conditions in developing nations, most
economists today believe that international trade can contribute significantly to the development process. This was not always
the case. Until the 1980s, a sizable and influential minority of economists strongly believed that international trade and the
functioning of the present international economic system hindered rather than facilitated exports earnings for development
through secularly declining terms of trade and widely fluctuating exports earnings for developing nations.
52
These economists contended that standard international trade theory based on comparative advantage was completely
irrelevant for developing nations and the development process. Therefore, they advocated industrialization through imports
substitutions and generally placing less reliance on international trade by developing nations. They also advocated reform of
the present international economic system to make it more responsive to the special needs of developing countries.
In the present scenario, when environmental issues are gaining prominence in the growth process of the developed nations as
well as in development process of the developing nations of the world, the concept of sustainable development in place of
simple economic development or growth needs to be discussed. Sustainable development takes care of the environmental
aspects.
In this section, relations between economic development and international trade is discussed in two parts:
3.2.1 International Trade and Economic DevelopmentTraditional View

Traditionally, there has been a difference of opinion among the economists whether international trade is an engine of growth
or it is an obstacle to development.
Prof. Haberler has categorized two types of benefits from international trade as under:
Direct Benefits
z
Trade Helps in Breaking Vicious Circle of Poverty: Underdeveloped countries are characterized by a vicious circle of
poverty. In other words, low income accounts for deficiency of demand and lack of demand account for low supply and
low supply in its turn, accounts for low income. Trade enables underdeveloped countries to produce more of those goods
in which they enjoy greater comparative advantage. Consequently, production, income and employment in these
countries increase leading to increase in demand. This increased demand is partially met by domestic production and
partially by foreign imports. In this, exports and imports of goods help break the vicious circle of poverty and accelerate
the rate of economic development.
Inducement to Invest: The rate of economic development is very slow in underdeveloped countries on account of low
demand, lack of technology improvement and shortage of social overhead cost. Investment is encouraged under the
impact of international trade and shortage of social overhead costs. New export industries are set up. New industries are
installed with the help of foreign technical know-how or in collaboration with foreign companies. With the help of foreign
capital and technology, necessary infrastructure like roads, railways, power, irrigation facilities etc. is created to promote
economic development. As a result of all this, the expected profitability of the entrepreneurs increases and they are
induced to invest more. Because of increase in investment, the rate of capital formation accelerates which in turn leads to
increase in the rate of economic development.
Expansion of Market: Most of the production of underdeveloped countries comprises of primary goods like rubber, tea,
coffee or minerals products. The size of the market for primary goods and minerals products in these countries is very
narrow. Whatever little industrial production is there, it has a limited market low income and hence low capacity to
spend. With the development of trade, goods produced by these countries will rise, extent of the market and income of
the people will increase. Wide extent of the market stimulates production on large scale and countries enjoy many internal
and external economies.
Efficient Use of Means of Production: According to Prof. J.S. Mill, another direct advantage of foreign trade is that it adds
to the efficiency of production. In underdeveloped economies, agriculture is backward and subsistence farming is the
rule. With the development of trade, use of latest and improved techniques of production becomes possible in agriculture
and industrial fields. All this promotes efficiency of means of production and its commercialization become possible.
Similarly, many new industries come into being and some of them are meant for the production of export goods only. Efficient
use of petroleum resources in Arab countries becomes possible only on account of trade. As a result, these countries have
become among the richest in the world.
53
Indirect Benefits
z
Import of Capital Goods and Exports of Primary Goods: Another advantage of foreign trade for the economic
development of underdeveloped countries is that these countries can industrialize themselves by obtaining raw material
from industrially developed countries. In return, they can export primary goods and mineral resources produced in their
countries and thus solve the problem of balance of payments. The result is that underdeveloped countries increase the
pace of their economic development by setting up directly productive activities.
Basis of Import of Foreign Capital: It is on account of foreign trade that underdeveloped countries find a basis for the
import of foreign capital. Volume of foreign capital depends on the volume of foreign trade. Greater the volume of trade
greater will be the ability of the market and thus, enable them to borrow large foreign capital at comparatively low rate of
interest for their economic development.
According to J.S. Mill, foreign capital that does not allow increased production to be exclusively dependent to the thrift of
the natives, may not improve real condition of the population. Yet it presents an important example before them and fills
their minds with new ideas, new desires and ambitions and gives them food for thought for the future. It breaks the series
of orthodox concepts and notions.
Foreign capital not only helps in increasing output, income and employment but it also proves helpful in balancing the
balance of payments and in stabilizing prices.
Important Education Effects: Underdeveloped countries are short of efficient engineers, capable managers and competent
technical experts etc. On account of trade, there is expansion of technical education and training in the countries. There is
an increase in the efficiency and scientific knowledge of the people.
In the words of G. Harberler, "Foreign trade is the means and vehicle for the dissemination of technical knowledge, the
transmission of ideas, for the importation of know-how, skills, managerial talents and entrepreneurship." Underdeveloped
countries get an opportunity to learn from the achievements and failures of the developed countries. Through foreign
trade, underdeveloped countries can acquire technical know-how, new inventions and efficient management from
developed countries and can adopt the same to their factor endowment so as to accelerate growth rate. In the words of J.S.
Mill, "It is possible that the citizens of a country may be lethargic, self-contended or underdeveloped and neutral towards their ends
and do not utilize their capabilities fully. International trade is certain to remove these obstacles and deficiencies and become the basis
of Industrial Revolution."
Healthy Competition: Foreign trade gives birth to healthy competition in the country. It improves production efficiency.
Cost of production goes down and the entire population stands to gain. On account of healthy competition, inefficient
monopolies cannot exploit the people. All this has a favourable effect on the economic development of the country.
In short, in the words of Prof. Hicks, "Foreign trade accelerates the rate of economic development of underdeveloped countries.
They get opportunities for improved technique". There is expansion in the size of market. Domestic and foreign goods are
easily available. Income, output and employment of the company increase. The basic factor behind the progress of such
countries as Singapore, the Arab countries, Brazil, Malaysia, Japan, Korea, Taiwan, Hong Kong etc. is foreign trade.
3.2.2 International Trade and Sustainable Development Modern View

In recent years, economists have put forward a new concept of economic development known as sustainable development.
This concept of sustainable development was propounded for the first time in 1987 by the World Commission on Environment
and Development in the Brundtland Report titled 'Our Common Future'.
According to World Development Report, 2003, "Sustainable development is that process of development which meets the needs of the
present generation without compromising the ability of the future generation to meet their own needs".
Nobel Laureate Robert Solow defined "Sustainability as making sure the next generation is as well off as the current generation and
ensuring that this continues for all time."
In short, sustainable development is that process which fulfills the needs of the present generation without causing any harm
to the ability of the future generations to meet their own needs.
54
The ability to meet the needs of the people depends on three types of capital: (i) Natural capital (natural resources, clean air,
clean water, etc.) (ii) Physical capital (machines, tools, capital equipments, etc.), and (iii) Human capital (education and
technical advancement). Thus, sustainable development means that we pass on the future generation at least as much capital
(natural + physical + human) as we have, so that they have no less a chance than us to be happy.
The question arises, why should we protect the interests of future generations? It is because of the reason that in the past, the
benefits of development have been exaggerated while the cost of development (in particular the cost of environmental loss)
has been ignored. It is, therefore, argued that these costs must be considered when development projects are decided upon.
And in view of the fact that some depletion of natural resources does take place, efforts should be made to preserve natural
capital. The strongest argument for protecting the environment is the need to guarantee the future generations' opportunities
similar to the ones previous generations have enjoyed. This guarantees the foundation of sustainable development. Apart from
natural capital, sustainable development should also protect the human capital and physical capital so that the future
generations do get at least as much as the present generation has inherited from the past. All this involves such a management
of resources that, while we satisfy the present needs, we enhance the quality of these resources. Thus, it is evident that
sustainable development is pro-people, pro-jobs and pro-nature.
Characteristics of Sustainable Development

The main characteristic features of sustainable development are:
1.
Efficient Use of Natural Resources: Sustainable development does not mean that natural resources should not be used at
all. It simply means that natural resources and environment should be used in such an efficient manner so as to achieve
long-term net gains of increase in income and employment, abolition of poverty, improvement in standard of living, etc.
2.
No Increase in Pollution: Sustainable development discards those activities which, in order to maintain existing high
standard of living, prove detrimental to natural resources and environment. Therefore, one should desist from
undertaking such activities which may increase pollution and decrease quality of life for the future generation.
3.
No Reduction in the Quality of Life of the Future Generation: Sustainable development aims at making use of natural
resources and environment for raising the existing standard of living in such a way so as not to bring down the quality of
life of future generations.
4.
Does Not Delimit the Concept of Development: Sustainable development does not delimit concept of economic
development. Its objective is that natural resources and environment be used in such a manner as to maintain not only the
present but also the future rate of economic development.
5.
Distributional Equity: The concept of sustainable development lays emphasis on distributional equity namely intergenerational and intra-generational equity i.e., within the same generation.
6.
Preservation of Three Types of Capital: Sustainable development emphasizes the preservation of human capital
(education and technical advance), physical capital (machines, tools etc.) and natural capital (i.e., natural resources, clean
air, clean water etc.).
Importance or Need of Sustainable Development

Any serious attempt at reducing poverty requires sustained economic growth in order to increase productivity and income in
developing countries. But there is more to development than just economic growth. World Development Report 2003
suggests that ensuring sustained development requires attention not just to economic growth but also to environmental and
social issues. Unless the transformation of society and management of environment are addressed integrally along with
economic growth, growth itself will be jeopardized over the longer term.
The importance and need for sustainable development is mainly due to the following reasons:
z
Poverty Declining but still a Challenge: There has been a significant drop in poverty since 1990; there has been decline in
the number of poor people in China and India. But countries in Africa, East Asia and South Asia accounted for two thirds
of the world's very poor people. Sustainable development strategy is needed to eliminate poverty in these countries.
55
Inequality Widening: The average income in the richest 20 countries is 37 times that in the poorest 20. The ratio has
doubled in the last 40 years mainly because of lack of growth in poorest countries. Similar inequalities are found within
many other countries. Reduction in inequality requires sustainable development.
Air Pollution: Cities in the developing countries have unhealthy levels of air pollution. At the global level the biosphere
capacity to absorb carbon dioxide without altering temperature has been reduced. It is because of heavy reliance on fossil
fuels for energy. Greenhouse gas emissions will also continue to grow unless serious efforts are made for sustainable
development. In the last 50 years, excess nitrogen mainly from fertilizers and human sewage has begun to overpower
the global nitrogen cycle. It has adversely affected soil fertility and water in lakes and rivers.
Fresh Water Increasingly Scarce: Fresh water consumption is rising rapidly, but its availability in some parts of the world
has become scarce. Thus, better conservation and allocation of water is very important. It requires sustainable
development.
Conflicts-Devastating: In the 1990's, 46 countries were involved in conflicts, primarily civil. This included more than half
of the poorest countries (17 out of 33). These conflicts have high costs destroying post-development gains and leaving a
legacy of damaged assets and mistrust that impeded future growth.
Degradation of Soil: Nearly 20 lakh hectares of land have been degraded since 1950; some areas face sharp losses in
productivity. This necessitates sustainable development as only then soil conservation would be possible.
Forests Being Destroyed: Deforestation is proceeding at a significant rate. One-fifth of tropical forests have been cleared
since 1960. According to FAO, deforestation has caused loss of 20 crore hectares between 1980 and 1995. Deforestation in
developing countries has several causes, including, conversion of forests to large scale ranching and plantations and the
expansion of subsistence farming. Deforestation leads to the necessity of sustainable development.
Biodiversity Disappearing: Through a series of local extinction, the range of many plants and animals have been reduced
to that found at the beginning of the century. One-third of world bio-diversity is threatened with complete loss in the
event of natural calamity or further human encroachment.
According to World Development Report "None of these social and environmental patterns is consistent with sustained growth
in an interdependent world over the long-term, given the social and environmental stress caused by past development strategies, the
goal of raising human welfare worldwide must be pursued that a development process - that does better poverty eliminating, growth
path that integrates social and environmental concerns in pursuing the goal of sustained developments and well-being."
Thus, in addition to the above, the following points highlight the importance of sustainable development: (i) It will raise the
standard of living of the existing generation; (ii) It will check that no harm is caused to the living standard of the future
generations, (iii) It will also protect the people against pollution, thus improving their quality of life and health; (iv) It will also
help in conserving the environment for the present and future generations.
But to make sustainable development a reality, efforts should be made in the following directions: (i) There should be restraint
on wasteful luxurious consumption pattern; (ii) Efforts should be made to invent environment and employment-friendly
appropriate technology; and (iii) Fast growing population should be effectively checked especially in developing countries.
Indicators of Sustainable Development

After discussing the conditions of sustainable development, we can go a step further by asking what the indicators of
sustainability are. By now, it is clear that sustainability refers to both ecological and economic attributes. Therefore, the
corresponding sustainability indicators will also have to account for both of them. A large number of product and service
specific and people related indicators could be developed.
Sustainable development links present development with future development. But here the main question arises is that how
can we say whether sustainability is achieved or not? How can we sanction the play, policies, programmes and projects within
the context of sustainability? What should be the indicators of sustainability? Many dynamic mathematical/statistical models
tinkling with environmental economics and socio-economic changes have developed for measuring sustainability. But these
models are very complex, confused and full of difficulties, from operational practical point of view. Simplicity, practicality,
56
reality and easiness are required for sustainability of the development process. Fortunately, some learned economists and
experts have tried to represent such type of indicators.
These experts are: Daly and Cobb (1989), EI Serafy (1989), Clarke (1991), Mathews and Tunstall (1991), Goodland, R. et al.
(1991), Homeberg (1991), Dalal Claton (1992), etc. Considering the various views of these experts, the following are the main
indicators of sustainability.
1.
Total Production Growth Rate is one of the significant indicators of sustainability. This represents the success or failure
story of working machinery of the economy as a whole. GDP is the basic and very important criteria of development. The
growth rate of GDP depends on the growth rate of total production of commodities and services. The total production
growth rate depends upon, capital formation, the marginal efficiency of capital, infrastructural facilities, resource use
planning, etc. Higher economic growth rate is essential for economic and social welfare of present and future generations.
Higher growth rate in total production reduces the unemployment and poverty, which is directly connected with the
reduction in the environment damage caused by poverty.
2.
Population should be controlled in the context of environment. Overpopulation overexploits the natural resources which
make it difficult to achieve sustainability. It is true that labour is very important factor of production. It is also true that
human beings are ultimately responsible for the present pollution problems. In this context population control is required.
Optimum size of population is essential for optimum use of resources for the welfare of present and future generations.
The present overpopulation is harmful to future generations. Overpopulation is one of the major causes of environmental
degradation in India. Because poverty, overpopulation and environmental degradation are interrelated with each other.
3.
The Availability of Fresh and pure Air for present as well as future generations is one of the significant indicators for the
sustainability. Because pure air is life supporting for human beings and other creatures.
Due to rapid industrial and urban development, the level of air pollution is continuously increasing day-by-day.
Automobiles and industries emit pollutants in the air. Many gases mix in the air. These include carbon dioxide, carbon
monoxide, sulphur oxide, sulphur dioxide, etc. This air pollution resulted in the greenhouse effects and acid rains causing
many health problems. This would also eliminate the sustainability of the development process.
4.
Water Supply and its uses are directly related to the sustainability. Water is a key factor in production and consumption
process. Water is required for domestic, agricultural, industrial and many other uses. Unfortunately, even after 58 years of
independence our people are not getting safe and fresh drinking water. Crores of rural and urban people cover long
distances daily for obtaining drinking water. The use of water is excessive and faster than its renewable capacity. Wells
are dug thousands of meters deep for obtaining water. Overuse of water in an inefficient manner has already created a
water crisis for present generation, and then what would be the fate of future generations? Water should be easily
available in pure and safe form to the countrymen, because it is very essential for the very existence of life.
5.
Energy is the key factor in the whole process. There are specific impacts of the changes in the trends of demand and
supply of energy on sustainable development. In this context, energy intensity is very important in total output. It can be
measured by Energy/ GNP ratio. Lower Energy/GNP ratio reflects higher sustainability. There are two types of sources
of energy exhaustible sources and renewable sources. Renewable sources are very important in energy generation.
Higher the ratio of renewable energy, greater is the sustainable development.
There should be lower use of renewable energy than the rate of its regeneration for sustainability. But if the rate of use of
renewable resources is higher than the rate of regeneration of energy by renewable resources, then shorter will be the
sustainability.
6.
Human Resources Development is also very significant achieving sustainable economic development. Because here,
human beings are treated as a capital/human capital. Human capital is very essential in transforming the process of
economic development. Human quality or human upgradation is required in the development process. Human Resource
Development can be identified as an indicator of sustainable development. Efficient, capable and skilled human resource
serves as foundation not only for the present but also future generation. Education and training, nutritional standards,
research and development, health, standard of living, etc. are very essential as the same constitute main indicators of
57
Human Resource Development index. More than 0.8 HRD index as considered as high and less than 0.5 is to be
considered poor. For the last many years, the World Bank and UNDP give topmost priority to the HRD index.
An illustrative list of sustainable indicators is given in the table below:
Table 3.1: Sustainable Development Indicators
Issues
Pressure
Impact
Sustainable Development
Indicators of
environmental pressure
Indicators of societal
responses
Indicators of
environmental conditions
1.
Climate
Change
Emissions of Carbon
monoxide
Energy Intensity
Atmospheric concentration
of greenhouse gases,
global mean temperature
2.
Urban
Environmental
quality
Auto, transportation,
Industrialization
Minor and Major

morbidity
Concentration of sulphur
dioxide, Nitrogen
particulates in selected
cities.
3.
Biological
diversityand
landscape
Land use changes
Protected areas as
percentages of total
area
Threatened or extinct
species as percentage of
known species
4.
Waste
Municipal, industrial,
nuclear hazardous waste
Expenditure on
collection and
treatment, waste
recycling rates (paper
and gases)
Not applicable
5.
Water
Resources
Intensity of use of water

resource
Short duration morbidity
Depletion of surface and

ground water
6.
Forest
Resources
Intensity of use of forest

resource
Soil erosion, floods
Area, volume and

distribution of forests
7.
Fish resources
Fish extraction rates
Decline in fish catches
Bio diversity changes,

extinction of species
8.
Soil
degradation
and erosion
Deforestation, intensive
use of chemical fertilizers
Water logging, salinity

changes, floods
Decline in land productivity
Is there a Conflict between Trade and Environment?

Proponents of free trade note that it is not a direct source of environmental damage. For example, if chemicals were no longer
traded internationally, and sold only locally, their production will still generate water pollution. Similarly, if trade in cars were
eliminated and cars were only sold locally, they would still generate air pollution when driven. However international trade
can affect the environment indirectly because it influences overall levels of production and consumption, as well as their
composition.
Some experts maintain that freer trades add to the quality of the environment. As freer trade raises the countries' incomes,
people tend to increase their demand for a clean environment, demanding more stringent regulations. This encourages firms
to shift toward cleaner production techniques, thus reducing emissions. Moreover, people may shift their preferences toward
more environmentally friendly goods, which causes the share of pollution intensive goods in output to fall, thus reducing
emissions.
To the extent that domestic producers lose competitiveness because of stringent environmental regulations, what might be
done? Government could provide subsidies to domestic producers to offset production cost disadvantages caused by
environmental regulations. However, subsidies must be financed by higher taxes and may not be in the national interest.
International differences in the cost of environmental regulations could also be neutralized through tariffs (taxes) applied to
imports of goods produced by polluting industries overseas. Such a policy, however could invite tariff retaliation by foreign
governments.
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3.3 Theory of Immiserising Growth

This concept was first introduced by Professor Jagdish Bhagwati. Immiserising growth refers to that situation where all
increases in a country's export commodities lead to such deterioration in its terms of trade that there is a net decline in its
export earnings and social welfare.
It has been observed from above that, given the demand schedules of goods X and Y and other assumptions like competitive
markets, a relative reduction in the cost of production; of labour-intensive commodity X in labour-abundant Z lead to a fall in
the product price ratio (Px/Py). It means to say that there is deterioration in terms of trade (TT) of Z.
The following conditions must be satisfied for a country to experience immersing growth.
1.
Its growth should be characterized by a more than proportionate increase in the production of its export commodity.
2.
The supply of its export commodity should be price-inelastic so that it is willing to export more even at reduced price.
3.
The share of its export commodity in the total supply in international markets should be large enough to depress its
international price. This condition applies irrespective of whether the country in question is "large" or "small" or whether
it is rich or poor. What matters is its share in the total world exports, and the relevant elasticities of supply and demand
for its export Ii' commodity.
The demand for this commodity by the importing countries should be price inelastic so that with an increase in the volume of
exports, there is a net decline in the export earnings of the exporting country.
Before trade, the exporting country must already be heavily engaged in trade, so that the decline in its welfare on account of
deterioration in its terms of trade results in 'losses' that are more than the addition to its gains from additional trade.
It is seen that developing countries are more prone to suffering from deterioration in terms of trade with an expansion in their
exports. This is because a major portion of their exports comprises mainly of minerals and other primary products, which tend
to have inelastic demand in the developed countries. In addition, the developed countries have been able to create synthetic
substitutes for a number of these products.
Diagrammatic Representation
The possibility of immersing growth is diagrammatically represented in Figure 3.9. AB is the PPC of Country Z with
production equilibrium at P, the product-price ratio (or terms of trade, Px/Py) equal the slope of the line TT'. With trade,
Country Z moves to E on indifference curve I2.
Figure 3.9: Immiserising Growth of Labour Intensive Country Z
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Now, let there be an increase in the factor endowment of L, which means an increase in the maximum possible output of
labour-intensive commodity X. Consequently, its PPC moves out to the new position A'B'. At the same time, let the terms of
trade deteriorate for commodity X and equal the slope of T1T1'. The production equilibrium of Z moves to P1, and after-trade
equilibrium to E1, which is at a lower indifference curve number I1. Since, in this case, economic growth pushes Z to a lower
consumption level, it is termed immiserising growth.
3.4 Free Trade vs. Protection

Regarding trade policy to be followed by a country, there has been a good deal of discussion among the economists. There are
supporters and critics of free trade and Protection policy. What constitutes an optimum international trade policy for an
economy? Unanimity continues to elude us on this front. The protagonists put forward arguments and counter arguments.
While determining the accurate trade policy for the country, the recent WTO regime has to be taken into consideration which
aims at removing trade restrictions.
Historical study reveals that till the end of Second World War, classical economics enjoyed a long spell of popularity. Free
trade was claimed to be an ideal and indisputable long-term policy for subserving both national and collective interests.
However, the picture changed in the post-war period. Theories of economic growth and welfare gained prominence. Models
of economic growth and welfare were extended to cover the fields of international trade as well. Since the introduction of
economic reforms and the policy of liberalization, once again a free trade regime is being supported by the W.T.O. The details
of the two trade policies are given as under:
3.4.1 Free Trade Policy

Free trade policy refers to a trade policy without any tariffs, quantitative restrictions and other devices obstructing the
movement of goods between countries.
Definitions
z
According to Prof. Jagdish Bhagwati, "Absence of tariffs, quotas, exchange restrictions, taxes and subsidies on production, factor
use and consumption."
According to Prof. Lipsey, "A world of free trade would be one with no tariffs and no restrictions of any kind on importing or
exporting. In such a world, a country would import all those commodities that it could buy from abroad at a delivered price lower than
the cost of producing them at home."
However, it must be noted that even in case of free trade import duties can be levied but the purpose is simply to earn revenue
and not to protect the domestic product. In fact, the policy of free trade is subject to the following qualifications, which may be
termed as legitimate exceptions.
1.
Customs Duties: Presence of customs duties and their periodic revision do not imply a restriction on free trade so long as
these duties are levied for the purpose of raising only public revenue and have no policy objective of influencing the
working of demand and supply forces in the external sector of the country. These duties are similar to the indirect taxes
levied by the government on domestic production, consumption, storage, transport, sale, purchase etc., without the
intention of influencing the market activities. Such indirect taxes are considered legitimate levies by the authorities even
in a laissez-faire economy, because the state has to collect resources for its own maintenance and for provision of other
essential services like defence, law and order and so on. In the same way, the presence of customs duties does not come
into conflict with the policy of free trade so long as they are not levied with the objective of influencing market
transactions.
Thus, while duties have a legitimate place in free trade, subsidies are ruled out. It is because, by their very nature,
subsidies are meant to protect and assist certain industries and products.
2.
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Legitimate Restrictions: It is admitted that some legitimate restrictions can co-exist with the regime of free trade. These
restrictions are justified by the fact that the state is the guardian of the economic, social, political and other interests of the
community, and is expected to take appropriate steps to do its duty. They include:
(a) Protection of health and moral standards of the society,

(b) Prevention of environmental degradation and erosion of natural resources,
(c) Ensuring adequate defence of the country,
(d) Ensuring self sufficiency in politically sensitive products, and so on.
3.
Market Imperfections: The case for free trade is based on the assumption that free market mechanism has no ill-effects.
Factually, however, this is not so, and this necessitates government intervention including the regulation of external trade.
These days, for example, most markets economies are characterized by a variety of imperfections and rigidities.
Monopolistic competition, product differentiation, and selling campaigns are some of the salient features of developed
economies. Instances of tacit agreements between suppliers are also quite frequent. A developed market economy spends
a substantial proportion of its productive resources on advertisement and other selling expenses which burden the
consumers and distort their preferences.
Case for Free Trade

Classical economists were the staunch protagonists of free trade policy which is nothing but an extension of the case for
laissez-faire, competitive markets and division of labour. It also makes use of the other conventional assumptions of classical
economics.
Thus, for example, it is implicitly assumed that distribution of income in a free trade economy satisfies the criteria of
distributive justice, and that, for this reason, the demand pattern in it conforms to the true needs and aspirations of the society.
In other words, by allocating its productive resources in conformity with the pattern of market-demand, such an economy
maximizes its social welfare. It is also implicitly assumed that the adjustment process faced by such an economy is always a
short-lived and self-correcting one, so that it does not face a persistent problem of unemployment, or instability of incomes
and prices. It further assumes that the free-trading economies are compatible with each other and that they are sufficiently
flexible and have competitive markets. It is, thus, evident that the case for free trade rests on some very stringent assumptions
including (i) Given productive resources, and (ii) given technology etc. Its case collapses if these assumptions are not satisfied.
Arguments for free trade can be formulated and advanced in several alternative ways but the main theme is the same.
Arguments for Free Trade

1.
Efficiency Argument: Free trade allows trading countries to specialize in the production of those items in which they are
respectively most efficient. This, in turn, reduces the resource cost of production to its lowest possible level. For that
reason, it may also be termed the efficiency argument.
As a result of this, there takes place international specialization which has the effect of increasing the scale of production.
Though classical economics proceeds on the assumption of constant returns to scale and therefore, does not take into
account the possibility of economies of scale, incorporating them in our discussion does not violate the basic tenets of free
trade. It only presents itself as an additional source of increased output and thus strengthens the case for international
specialization and free trade.
2.
Gains from Trade: Gains from trade to the trading countries depend upon several factors, including the volume of trade
and the difference between domestic cost of production and international prices. It follows that, other things being equal,
gains to the trading countries would increase under free trade. This is because free trade provides maximum opportunity
for international specialization and reduction in production costs.
3.
Creates Incentives: Free trade, by opening up markets and increasing demand, provides an incentive for producers to go
in for improved techniques of production. This causes an all-round decline in production costs and addition to output. To
the extent trade is restricted, these incentives are also curbed.
4.
Growth of Technology: Free trade allows easier flow of technical know-how. This also helps free-trading countries in
accelerating their rate of economic growth.
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5.
Optimum Allocation of Resources: This is another dimension the efficiency argument. The theory of free trade assumes
that in each free-trading country, demand pattern in the market represents true needs and aspirations of the society.
Given this and other assumptions such as the flexibility of the trading economies, allocation of resources, in all the trading
countries put together, has a basic tendency to conform to the needs and aspirations of their societies taken as a whole.
The logical reasoning is given as under:
The production pattern in free competitive economies follows the demand pattern expressed in the market. This is
because producers produce goods with the aim of maximizing their profit incomes (at least in the long run). Since
goods with stronger demand tend to be more profitable to produce, it follows that the investment and production
patterns of the economy also tend to be in conformity with the demand pattern expressed in the market. The
productive resources are also allocated accordingly.
However, what is questionable is the claim that the demand pattern in the market represents true needs and
aspirations of the society. It is noteworthy that demand pattern depends upon the incomes and preferences of the
buyers.
It is evident that the demand pattern would reflect true needs and aspirations of the society only if the distribution of
national income between members of the society is in accordance with their relative needs. This, however, is not the case
in a market economy.
In a market economy, factors of production are in private ownership and incomes of individuals and households depend
upon their ownership of factors of production and the rates at which they are paid for in the market. However, the
ownership of factors of production is not based upon relative needs of the members of the society. Also, an individual (or
a household) can own several productive resources and in different quantities. More particularly, non-wage earners have
higher incomes than wage earners. They have higher capacity to save and can further add to their non-wage sources of
income. Thus, the net result is two-fold: (a) distribution of income is not on the basis of relative needs of the members of
society, and (b) inequalities of income and wealth keep increasing with the passage of time.
6.
Helpful in Preventing Monopolies: Free trade, like free markets, prevents monopolies with all the attendant benefits. If we
agree with the traditional wisdom that competitive markets are superior to monopolistic ones, then this is a major
advantage of free trade. However, these days, critics claim that free markets are not able to prevent the emergence of
monopolies.
7.
Preventing Vested Interests: Free trade helps in preventing the emergence of vested interests. As such, it provides a better
scope for the authorities to formulate and implement welfare-oriented measures. (The reader should recall the earlier
argument that the effects of welfare-oriented measures would be felt in the external sector of the economy as well).
8.
Improving Standard of Living: As human beings; we are always eager to improve our living standards. International
trade feeds this urge through the demonstration effect. In addition, free trade has the advantage that it also provides
better opportunities to satisfy this urge.
Case against Free Trade

The policy of free trade, with all its advantages noted above, was abandoned after the Great Depression of 1929 by the
countries of the world. There are certain theoretical and practical difficulties in following free trade policy:
1.
Market Failures and Laissez-faire: These days, it is widely acknowledged that market mechanism often yields results
which are sub-optimal from the point of view of the society as a whole. These include, for example, cyclical fluctuations
and vulnerability to disturbances originating from rest of the world.
2.
No Guarantee of High Economic Growth: Free trade does not ensure a high enough rate of economic growth for a freetrading country. This problem is particularly serious for an underdeveloped country suffering from certain, inherent
disadvantages like scarcity of capital. The case against free trade is further strengthened when we note the fact that
economic growth is accompanied by changes in the stock, composition and allocation of productive resources of an
economy.
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3.
Opposed to Distributive Justice: We have seen above that left to itself, a free market mechanism does not ensure
distributive justice. For that, a comprehensive policy (inclusive of a trade policy) has to be formulated.
4.
Discriminatory Policy: Irrespective of what may be claimed by the advocates of free trade, market mechanism is never
non-discriminatory. It tends to favour some economies and some enterprises against others. Economies of scale, product
differentiation and other factors turn into an interplay of monopolistic forces and strengthen this phenomenon.
Consequently, the smaller enterprises run the risk of being wiped out. It is noteworthy that currently by and large; we are
passing through an era of corporate capitalism with increased odds against native entrepreneurs in developing countries
like India with heavy dependence upon cottage and small scale industries and suffering from scarcity of capital and
infrastructure.
In contrast, the developed economies are in a better position to protect their industries even when they face genuine
competition from labour-intensive products of developing countries. They are also better able to dump their products
below cost without much notice and/or opposition. As a result, unless the underdeveloped countries are able to defend
themselves, they run the risk of remaining underdeveloped forever.
5.
Reconstruction of Economies: Developed countries have reached a stage of self-sustaining growth. In contrast, for
reaching that stage, developing countries have to depend upon large scale import of modern technology. Factually,
however, the seller firms of the developed countries try to export only outdated and obsolete technology to the
developing countries. This prevents the latter from offering quality products at competitive prices in international
markets, and enables developed countries to derive longer lifecycles from their outdated products (which are,
nevertheless, still a novelty for developing countries).
6.
Adverse Elasticities: There is a general tendency for the exports of underdeveloped countries to have a high elasticity of
demand and a low elasticity of supply. In contrast, their imports tend to have a high elasticity of supply and a low
elasticity of demand. Therefore, terms of trade tend to move against these countries, forcing them to adopt corrective
measures through trade restrictions.
7.
Not Suitable for Weak Financial System: A developed and efficient financial system is a prerequisite for the health and
strength of a modern economy. However, financial systems of most developing countries are weak and inefficient. By
implication, they need additional safeguards for protecting themselves from disturbances originating in developed
economies.
8.
Adverse Impact on Trade Volume: Developed countries trade far more between themselves than with developing ones. By
implication, developing countries should devise measures to promote trade amongst them. Hence the trade volume of
developed countries would be affected.
3.4.2 Protection
Protection, as against the term free trade, stands for a considered policy of regulating external trade. It is a policy whereby
domestic industries are to be protected from foreign competition. The aim is to impose restrictions on the imports of lowpriced products in order to encourage domestic industries producing high priced products. The domestic industries may be
protected by imposing import duties which raise the price of foreign goods by more than the price of domestic goods. The
domestic industries may also be protected by quotas or other non-tariff restrictions which turn imports of cheaper foreign
goods impossible. Otherwise, the domestic industries may be paid subsidies to enable them to complete with cheap foreign
goods.
Case for Protection

In recent decades, economic theory has intensified its attention to the issues of economic and institutional rigidities, market
distortions and distributive injustice. Attention has also been focused on the interrelationship between domestic and external
sectors of an economy. The result of these investigations is a greater acceptance of the need for import restrictions and export
promotion. As an example, we may mention the fact that there was a phase during which an export-led strategy of growth
was strongly advocated by international institutions like the World Bank. In the preceding paragraphs, we have also noted the
absence of a level playing field between trading economies and the ability of bigger economies to grab a larger share of gains
63
from trade. The suggested implication of all this investigative research and model-building is that the developing countries
should not be bogged down by the philosophical idealism of free trade. They should be ready to discard and replace it with a
judiciously framed policy of trade regulation. The popular arguments advanced in favour of protection should be viewed in
the context of this underlying theme.
For developing countries, the case for protection rests on safeguarding their national interests; for developed countries, it rests
on their ability and willingness to exploit the opportunities. The argument in favour of protection can be discussed in two
parts: (A) Economic arguments (B) Non-economic arguments.
Econom ic Argum e nts
1.
Terms of Trade: It is claimed that use of tariffs and other trade restrictions improves the terms of trade of a country.
However, a number of factors may prevent this favourable outcome including the following:
(i)
The demand and supply elasticities of the tradeable goods have to be "appropriate" for the terms of trade to improve.
A small country has hardly any ability to affect world prices and its own terms of trade.
(ii) With an improvement in terms of trade, volume of trade may decrease to such an extent that any benefit of improved
terms of trade is lost.
(iii) Trade restrictions may invite retaliatory action by other countries. A retaliation by large countries can be all the more
damaging.
2.
Bargaining Strength: It is often argued that a country can use its protectionist policy as a bargaining point for obtaining
trade concessions from its trading partners. This argument is reasonably valid where the exporting country has some kind
of a natural monopoly. Actually, however, such monopolies usually do not last forever because of the development of
their substitutes. In addition, like all such arguments, the argument of "bargaining strength" also suffers from some
limitations including the following:
(i)
The countries with which the country in question is trading should have something to offer in exchange which means
that they must also be following a protectionist policy.
(ii) An underdeveloped country suffers from an inherent weakness vis--vis the developed ones and cannot use
protectionist measures as an effective bargaining tool.
(iii) Protectionist measures, particularly by a developing country, are prone to invite retaliation by others.
3.
Anti-Dumping Argument: It is considered a legitimate right of a country to protect itself from dumping by another
country. Protection is advocated against the practice of dumping. Dumping is selling a product in a foreign market at a
lower price than in the home market, after taking into transport and other costs of transfer. The foreign market, thus, is
flooded with the low-priced commodities as a result of which, the import competing firms are ruined. To protect such
firms, a high tariff is justified. This will raise the price of the product in the importing country so that the threat of
dumping is removed.
4.
Diversification Argument: These days, a modern economy is expected to pursue a long-term goal of diversification and a
multi-sectoral structure. It is believed that such a policy helps an economy in achieving balanced development and
inherent strength. Its capacity to restructure itself helps it in improving its terms of trade. It is better placed to reap the
benefits of external economies.
It is quite certain to say that a well-executed policy of protection can accelerate the process of achieving this goal.
5.
Self-sufficiency/Self Reliance: This objective is closely connected with that of diversification of the economy.
A protectionist policy is considered to be an effective (and frequently an essential) device for achieving this objective.
Though closely related, the twin concepts of self-sufficiency and self-reliance are distinct from each other. Self-sufficiency
in an item means its adequate production within the domestic economy and thereby eliminating the need for its import.
In the extreme situation of complete self-sufficiency, all imports to a country come to an end, converting it into a "closed
economy". In contrast, a country is self-reliant when it can pay for all its normally required imports out of its export
earnings.
64
6.
Infant Industry Argument: It is one of the oldest and most popular arguments in favour of protection and was first
advanced by economists like Alexander Hamilton (1790) and Fredrich List (1882). It recognizes the hurdles that a freetrading country faces in promoting and strengthening an industry for which it has a potential; and advocates that a policy
of protection may be adopted for exploiting this potential. The infant industry argument for protection is shown in figure.
Let the PPC of a small country is BA.
The production of commodity X of industry A is on the horizontal axis and the production of commodity Y of industry B
on the vertical axis. The production possibility curve of the country is BA. Under free trade, the country produces at C where
the international terms of trade line Q1Q1 is tangent to the production possibility curve BA. When it enters into trade, it
moves from C to C1 where it imports and consumes more of commodity X. In order to protect its industry, the country
introduces a prohibitive tariff on the imports of the commodity X so that the domestic terms of trade are represented by
the line QQ. This line is tangent to the production possibility curve BA at D. Now the country produces and consumes
commodity X at point D. But it consumes fewer goods under protection because point D is below point D under free
trade. Thus, protection lowers the country's welfare as the consumer moves to lower indifference curve ISO. Hence there
is a less in community Welfare. This however in a short run situation.
In the long run, however, protection increases the production of commodity X when industry B experiences increasing
returns so that the production possibility curve BA shifts outward to BA1. The country can now restart free trade.
Assuming that the same international terms of trade prevail as before protection, draw a line Q2Q2 parallel to Q1Q1 which
is tangent to the production possibility curve BA1 at E. Now the country produces and consumes more of commodity X at
E than before protection at D. By entering into trade, it can move to point E1 which represents a higher level of social
welfare than at point D. People consume more of commodity Y at E1 than at D by protecting an infant industry for some
time and then reverting to free trade. Thus infant industry needs protection till it is able to face foreign competition.
Figure 3.10: Infant Industry Argument for Protection
The infant industry argument for protection has also been rejected by economists on the basis of the following arguments:
(i)
It is difficult to select genuine infant industries.
(ii) Protection once given is difficult to be withdrawn. Hence, it promotes inefficiency.

(iii) It leads to monopoly profit. Hence the owners of such industries use political influence to continue with the
protection regime.
(iv) The argument that infant industries lead to internal and external economies is not acceptable Haberler says it is
always vogue and doubtful argument of the protagonists of infant industry.
Concluding Remarks: The infant industry argument is normally applicable to LDCs which have potential to grow in
specific industries. These industries need support to face foreign competition in the initial stages. Hence protection in
justified. The logic is explained in Figure 3.11 OPW in the world price of good x in which LDC has potential but in the
65
beginning the cost in LDC in OPL which is higher than OPW. Hence there is need to protect this industry and import duty
equal to PW-PL can be imposed. As a result, cost would fall and at E the protection is to be withdrawn.
Figure 3.11: Infant Industry Argument in LDCs
7.
Foreign Direct Investment: The theory of free trade is based on the assumption that factors of production do not move
from one country to the other. However, with the phenomenon of direct foreign investment, all this has changed.
Producers, in search for reducing costs, are looking for opportunities to shift their production centres to low-cost areas
and closer to consumer markets. Therefore, when a country imposes import restrictions and import costs go up, the
exporters of other countries start exploring the possibility and advantages of shifting their production centres to the
protected markets. This helps the host country in accelerating its growth rate. Moreover, direct foreign investment has the
advantage that the risk of failure is borne by the foreign investors and they also bring in the latest technology and work
culture with them.
Non- e conom ic Argum e nts

Protection is also advocated on certain non-economic grounds.
1.
Defence Argument: From the standpoint of national defence, each country should be self-sufficient as far as possible. It
should avoid too close a dependence upon other countries, even if such avoidance involves an economic loss. If a country
is dependent on another country for the supply of certain essential articles and war goods, it becomes politically weaker
and in times of war, the economy will be strangled if supply is stopped.
2.
Patriotism Argument: Protection is essential to rouse and satisfy the patriotism of the people. It is the duty of every citizen
to prefer homemade (swadeshi) goods to foreign goods. As such, homemade goods should be available in the right
quantity and quality. This is not possible without a strong base of home industries being developed with the aid of
protection.
3.
Preservation Argument: Protection has been advocated in some countries for the purpose of preserving certain classes of
the population or certain occupations. This argument was particularly applied to agricultural duties, to the preservation
of an agricultural community or farming industry of the country for political and social reasons. It has been argued that
tariff duties should preserve the peasant class as it is the backbone of the society. European countries also faced the
situation of falling prices of import of cheap, foodgrains from Australia, Canada, etc. When agriculturists' interest began
to suffer, these countries imposed a tariff duty on the import of foodgrains. In England, for instance, "Corn Laws"
imposed tariffs in 1819 on wheat to maintain the price levels reached during the Napoleonic wars, and to prevent the
collapse of grain production and save the peasantry.
Conclusion: In spite of most countries advocating the benefits of free trade, international trade flow is still suffering from
practices like dumping, imposition of countervailing duties and "safeguard" measures. WTO provides a forum for challenging
violation of WTO agreements.
66
Table 3.2: A Case Violation of Free Trade Norms: Protection and Disputes
Year
Antidumping
Countervailing
Safeguards
Initiative
Measures
Disputes,
New Requests for
consultations
Initiative
Measures
Initiative
Measures
1995
159
118
10
19
23
1996
224
84
42
1997
243
124
16
46
1998
254
162
25
11
44
1999
356
18
41
14
14
14
31
2000
281
234
17
19
24
21
30
2001
330
163
27
12
30
20
27
Source: U.N. World Economic and Social Survey, 2002.

Note: It is evident that there is a time lag between the initiation of an investigation and the final decision.
Case against Protection

Case against protection may be summarized in the term "government failures". We have earlier noted the phenomenon of
"market failures", that is, inability of the market forces to deliver optimum social welfare. Thus, for example, a "free" market
mechanism is not necessarily free and competitive. It may suffer from monopoly elements, unfair competition, dumping, and
other malpractices: Growing inequalities of income and wealth are common features of a market economy.
Correspondingly, there is no guarantee that a policy of trade regulation and control will increase social welfare. This is
because, in this case, the policy decisions are necessarily arbitrary. Critics claim that the damage inflicted by government
failures is far greater than that inflicted by market failures. Moreover, market failures are relatively harder to identify, while
government failures are easier to spot.
1.
Self-sufficiency vs. Self-reliance: The case for protection primarily rests on its possible contribution to self-reliance rather
than to self-sufficiency. It is only in certain specific items relating to defence, energy, and health care etc., that a country
should really have a long-term policy of self-sufficiency (or complete import substitution).
However, there is a practical risk that the authorities may make a mistake in the selection of the items for import
substitution. When that happens, the home country ends up having a misallocation of its productive resources.
2.
Discrimination: It is impossible for a country to formulate a policy under which all sectors of the economy and all sections
of the society are equally protected. By its very nature, the policy of protection is discriminatory. This adds to the
problems of equity and welfare within the society.
3.
Vested Interests: Under a policy of trade regulation, vested interests tend to emerge and entrench themselves. This, in
turn, leads to misallocation of productive resources, and inefficient and burdensome industries. A protected economy is
thus handicapped in acquiring competitive strength.
4.
Choice of Industries: Choosing those industries which need to be protected is a highly difficult task because it should
correspond to the economy's potential and not to its current position. The risk is that the industries chosen for protection
may have inadequate developmental potential for the economy as a whole. Actually, a proper choice of the industries to
be protected rests on estimates of the relevant social and private costs and benefits a very difficult task indeed.
5.
Administrative Cost: A policy of protection requires the creation and maintenance of appropriate administrative
machinery and entails a resource cost as well. In addition, if the administrative machinery suffers from inefficiency,
delays, obstructive legal provisions, cumbersome procedures or other weakness, the entire economy suffers from its allpervasive ill-effects.
6.
Dual Economy: Depending upon the nature of hurdles faced by a developing economy, a policy of protection may result
in the creation of only absence of protection, there will be a costly competition faced by countries having dear labour
67
economy from those having cheap labour. The product of high wage labour of these countries will be undersold by the
"pauper labour' countries. Thus, in the advanced countries where the people enjoy high real wages, it is often felt that
their standard of living will be undermined if cheap goods are imported from low wage countries. Hence, to protect a
country's high standard of living and maintain its high wages, tariffs become essential to rule out competition from
"pauper labour" countries.

Fill in the blanks:
1.
. is that process which fulfills the needs of the present generation without causing any
harm to the ability of the future generations to meet their own needs.
2.
The concept of immiserising growth has been given by .
3.
refers to a trade policy without any tariffs, quantitative restrictions and other devices
obstructing the movement of goods between countries.
4.
The case for protection primarily rests on its possible contribution to self-reliance rather than on
3.5 Trade Barriers

Every country has to regulate its own international trade mainly due to the following specific reasons: (i) improving its
balance of trade and balance of payments position. Most of the developing countries face balance of payments problem and,
therefore, they struggle hard to maintain the balance in their imports and exports; (ii) protecting its own industries against
competition in the international market or in domestic markets from foreign products; and (iii) exploiting its manpower and
natural resources to the maximum extent possible so that the countrys economic development may proceed at a faster pace. In
order to attain these objectives, almost every country imposes certain restrictions on its international trade, i.e., imports and
exports. These restrictions may be called trade barriers. Trade barriers may be (i) tariff barriers and (ii) non-tariff or protective
barriers.
3.5.1 Tariffs
Tariffs have been one of the classical methods of regulating international trade. They may be referred to as taxes levied on
imports. They aim at restricting the inward flow of goods from other countries to protect the countrys own industries by
making the goods costlier in that country. Sometimes the duty on a product is so steep that it does not become worthwhile to
import it. In addition, the duties so imposed provide a substantial source of revenue to the importing country. In India,
customs duty forms a significant part of total revenue and, therefore, is an important element in preparing the budget. Some
countries use this method of imposing tariffs and customs to balance their balance of trade. A nation may also use this method
to influence the political and economic policies of other countries. It may impose tariffs on certain imports from a particular
country as a protest against tariffs imposed by that country on its goods.
In order to ensure that the system of imposing custom duties is not discriminatory, a multilateral association, comprising a
number of countries of the world, has been formed to help formulate trade policies of the member countries. This association
is popularly known as General Agreement on Tariff and Trade (GATT) and its main objective is to reduce duties and other
import levies systematically through mutual negotiations. It ensures that every member country enjoys a status of Most
Favoured Nation (MFN) and a member country must charge the tariffs and customs duties at the lowest rate unless otherwise
settled bilaterally.
Kinds of Tariffs
Tariffs may be classified according to (i) the purpose of taxes, and (ii) how they are levied.
1.
68
As far as the purpose of taxes is concerned, tariffs may be classified into two categories (a) revenue tariff and (b) protective
tariff.
(a) Revenue Tariffs are basically intended to raise government revenue without intending to protect any industry of the
country. It is levied at a fairly low rate and does not obstruct the free flow of imports.
(b) Protective Tariffs, on the other hand, aim at protecting the domestic industries and are generally levied at a very high
rate and, therefore, obstruct the free flow of imports. Its main purpose is not to increase revenue but to provide a
safeguard to the domestic industries against foreign competition in the local market.
Tariffs, sometimes, are levied to discriminate between countries, e.g., tariffs are imposed on certain goods having certain
specifications, which are imported, from a particular country.
2.
On the basis of how tariffs are computed, tariffs may be put into two categories (a) specific tariffs and (b) ad valorem
tariffs.
(a) Specific Duties or Tariffs are imposed on the basis of per unit of any identifiable characteristics of merchandise such as
per unit of weight, volume, length, number or any other unit of quality of goods. The duty schedules so specified
must specify the rate of duty as well as the determining factor such as weight, number, etc. and the basis of arriving
at determining factor such as gross weight, net weight or fair weight, etc.
(b) Ad valorem Tariffs are based on the value of imports and are charged in the form of a specific percentage of the value
of goods. The schedule should specify how the value of the imported goods would be arrived at. Most of the
countries follow the practice of charging tariffs on the basis of c.i.f. cost of a product or f.o.b. cost mentioned in the
invoice. As tariffs, under this method, are levied on c.i.f. or f.o.b. prices, sometimes unethical practices of under
invoicing are adopted whereby the custom revenue is affected. In order to eliminate such malpractices, some
countries adopt a fair value (given in the schedule) or the current domestic value of the goods as the basis for the
computation of customs duty.
3.
O th e r Tariffs: In order to protect the domestic industries against competitions, some other tariffs are also imposed.
Among them, two are important (a) Anti-dumping duty and (b) Counteracting duties.
(a) Anti-dumping duty: Very often, exporters from developed countries are eager to sell their products in foreign markets
with a view to capture a large market, at a very low price not proportionate to their cost of production. This attempt
to introduce their products in a large quantity into foreign market at a very low price, even lower than cost, is called
dumping. This naturally will adversely affect the domestic industries. The government of the importing country,
therefore, imposes customs duty on such goods at a very high rate to counteract this unfair competition. This duty is
known as anti-dumping duty. Such duties are charged in addition to the normal customs duty on the product. This
additional charge would cover at least the difference between the export price and the normal price or market price in
the exporting country.
(b) Counteracting duties: These are similar to the anti dumping duties and are charged on goods imported from countries
where the manufacturer exporter is paid, directly or indirectly, a subsidy as an incentive for export. The amount of
duty normally does not exceed the estimated amount of subsidy.
3.5.2 Non-tariff Barriers

Over the last few years, GATT has been endeavouring to achieve a reduced and rationalised tariff structure for trade among
its member countries. As per terms of GATT, every member country will accord MFN treatment to all other member countries
while importing goods from them. At the same time, importing countries are also concerned with the development of their
own industries and trade. They will have to protect them against unfair competition with a view to giving the domestic
industry a fair chance for survival. To meet the challenges, more and more countries are adopting non-tariff measures to
regulate their imports. Such measures may be called non-tariff barriers. Some of these non-tariff measures are:
1.
Quantitative (QR) restrictions, quotas and licensing procedures: Under quantitative restrictions, the maximum quantity
of different commodities, which would be allowed to be imported over a period of time from various countries, is fixed in
advance. The quantity allowed to be imported or quota fixed normally depends upon the relations of the two countries
and the need of the importing country. There is, therefore, no effect of price level changes in foreign or domestic markets
and the government is in a position to restrict the imports to a desired level. Quotas are very often combined with
69
licensing system to regulate the flow of imports over the quota period as also to allocate them between various importers
and supplying countries. Under this system, a licence or a permit is to be obtained from the government to import the
goods specifying the quantity and the country from which to import, before concluding the contract with the supplier.
2.
Foreign exchange restrictions: Exchange control measures have been widely used by a number of developing countries in
the post-war period to regulate their imports and to keep the balance of payments in controllable limits. Under this
system, the importer must be sure that adequate foreign exchange would be made available to him for the import of
goods by obtaining a clearance from the exchange control authorities of the country before concluding the contract with
the supplier.
3.
Technical and administrative regulations: Another measure to regulate imports is the imposition of certain standards of
technical production, technical specifications, etc. to which an importing commodity must conform. Such types of
technical restrictions are impressed in case of pharmaceutical products, etc. and the importing commodities must satisfy
them before their import is permitted. Besides technical restrictions, administrative restrictions such as adherence to
certain documentary procedure are adopted to regulate imports. These technical and administrative measures impede the
free flow of trade to a large extent.
4.
Consular formalities: A number of countries demand that shipping documents must accompany the consular documents
such as certificate of origin, certified invoices, import certificates, etc. Sometimes, it is also insisted that such documents
should be drawn in the language of importing countries. In case the documentation is faulty or not drawn in the language
of importing country, heavy penalties are imposed. Fees charged for such documentation are quite heavy.
5.
State trading: In most socialistic countries, foreign trade, i.e., import and export transactions, are exclusively handled or
canalised by certain state agencies. Separate state agencies are set up for each class of products. These agencies carry on
international trade strictly according to the government policies. A few other countries of the world follow state trading in
a restricted sense to achieve certain desired results especially where bulk imports are needed and the government wants
to maintain price stability. India is a good example where state trading is followed in a restricted sense. Some articles, as
decided by the government, are imported only through the State Trading Corporation (STC). Likewise, exports of raw
materials such as iron ore, mica, etc. are canalised only through Minerals and Metals Trading Corporation (MMTC).
6.
Preferential arrangements: With due evolvement of the multilateral trading system, a few member countries agree to a
small advantageous group for their mutual benefit. The member countries of the group negotiate and arrive at a
settlement of preferential tariff rate to carry on trade amongst them. These rates are much lower than ordinary tariff rates
and applicable only to the member nations of the small group. Such types of preferential arrangements are outside the
purview of the GATT. Some of the small groups are EEC, ASEAN, LAFTA, etc.
3.6 Trade Blocks

Economic integration experiments have a long history dating back to the last decade of the nineteenth century. One of the
earliest attempts of economic integration was the free trade attempted by Norway and Sweden in the nineteenth century.
Although this effort failed, a number of economic arrangements survived at that time.
Economic integration gained great popularity in the second half of the twentieth century.
The first wave of regional integration included the creation of European Community (EC) in 1957, European Free Trade Area
(EFTA) in 1960 and Latin American Free Trade Area (LAFTA) in 1960. A World Bank Policy Research Report on Trade Blocks
observes that during the last decade of the last century, the move to regionalism has become a headlong rush. At the
beginning of 1994, there were 121 regional agreements notified to the GATT/WTO. In contrast, as many as 149 trade
agreements were registered by the year 2008 and the trend has not weakened till now. However, we will concentrate on
NAFTA, ECM and ASEAN.
3.6.1 North American Free Trade Agreement (NAFTA)

NAFTA went into effect in 1994. The United States signed its FTA with Israel in the mid-1980, followed by FTA (Free Trade
Agreement) with Canada in 1988. This agreement passed the way for Mexico, Canada & US to form NAFTA.
70
Features of NAFTA
The NAFTA seeks to eliminate all the tariffs on products moving among the three countries and end other barriers to services
and investment capital within NAFTA. NAFTA covers the following areas:
z
Market Access: Tariff and non-tariff barriers, rules of origin, governmental procurement.
Trade Rules: Safeguards, subsidies, countervailing and antidumping duties, health and safety standards.
Investment: Establishes investment rules governing minority interests, portfolio investments, seal properly and majority
owned or controlled investment from the NAFTA countries.
Intellectual Properly: To provide adequate and efficient protection and enforcement of intellectual property rights, while
ensuring that enforcement measures do not themselves become barriers to legitimate trade.
Dispute Settlement: Provides a dispute settlement process that will be followed instead of countries taking unilateral
action against an offended party.
NAFTA's Benefits for Mexico and Canada

NAFTA's benefits for Mexico are proportionally much greater than for the US and Canada because Mexico is integrated with
economies many times larger than its own. Eliminating trade barriers would presumably lead to increase in the production of
goods and services for which Mexico has comparative advantage. Mexico's gain comes largely at the expense of other low
wage countries such as Taiwan and Korea. The production of low wage and low-skilled goods has increased such as
production fruits, vegetables, processed foods, sugar and glass. With FTA with the US, Mexico has divested the flow of money
and technology that previously moved to low-cost Asia and Eastern Europe.
Moreover, rising investment spending in Mexico has increased incomes, employment, national output and foreign exchange
earnings. NAFTA has resulted in a rise of 3 to 10% in national output of Mexico.
Canada's benefits from NAFTA were mostly in the form of safeguards, maintenance of its status in international trade, no less
of its current free trade preferences in the US market and equal access to Mexico's market. Since there is a small amount of
Canada-Mexico trade, the gains are relatively small in the short run.
Another benefit of NAFTA for Canada is economies of large-scale production. The bilateral free trade with US has provided
Canadian companies an opportunity, as the elimination of US trade restrictions results in a shift in export demand which will
further result in economies of large-scale production, thus permitting Canadian firms to adopt more competitive price policies.
NAFTA's Benefits and Costs for the US

The NAFTA has benefited the US economy overall by expanding trade opportunities, reducing prices, increasing competition
and enhancing the ability of US firms to attain economies of large scale production. The additional benefit of NAFTA for US,
new rules that give trade benefits only to product with high percentage of North American made parts which would make it
unprofitable for Japanese and European multinational to assemble finished products in Mexico from foreign made parts. That
meant increased investment in US manufacturing facilities by foreigners, creating jobs for US workers.
NAFTA's Trade and Employment Effects

The effect of NAFTA on the US economy has been relatively small. These effects have included increases in overall US income
and increases in US trade with Mexico. The period of 1994 to 1998 the flow of US imports from Canada was estimated to have
increased by $1.074 billion because of NAFTA, with $690 billion of that trade expansion representing trade creation and $384
billion representing diversion imports that previously came into the United States from other lower cost countries but now
come from Canada the higher cost producers. NAFTA has resulted in greater creation than trade diversion for the US, thus,
improving its welfare. However, NAFTA is estimated to have a significant excess of trade diversion over trade creation in the
cases of Canadian imports from Mexico and Mexican imports from Canada.
71
Is NAFTA an Optimum Currency Area?

According to the theory of optimum currency areas, the greater the linkage between countries, the more suitable it is for them
to adopt a single official currency. One such linkage is the economic integration (among the three NAFTA members). Canada
and Mexico rank as first and second, respectively, largest trading partners of United States in terms of trade turnover.
Another linkage is the similarly of economic structure among the three NAFTA members. Canada's advanced industrial
economy resembles that of the United States. Mexico, however, is a growing economy that is aspiring to maintain economic
and financial stability with a much lower average real income per capita and significant higher inflation and interest rates as
compared with those of Canada and United States.
The value of peso relative to the US dollar is quite volatile; although the peso has been more stable against the Canadian dollar
other problems endured by Mexico are high levels of external debt, balance of payments deficits and weak financial markets.
If Mexico adopted the dollar, its central bank would be unable to use monetary policy to impact production and employment
in the face of economic shocks, which might further weaken its economy. However, adopting the dollar offers Mexico several
advantages, including achievement of long-term credibility in Mexican financial markets, long-term monetary stability and
reduced interest rates resulting reduced inflation to the levels of the US.
Canada has expressed dissatisfaction concerning the adoption of the US dollar as their official currency. There is no added
benefit of credibility to monetary and fiscal discipline. Since Canada, like the US, is already committed to achieving low
inflation, low interest rates and low level of debt relative to gross domestic products. Hence Canadian participation in any
North American currency area is less strong on political grounds than economically.
Impact of NAFTA
NAFTA has achieved substantial trade liberalization. The trade between the US and Canada and the US and the Mexico is
substantial and has been rising fast. The two-way trading relationship between the US and Canada is the target in the world.
The American companies have been immediately benefited by shifting production to Mexico where labour is substantially
cheap as compared to US.
Table 3.3: Trade Effects of NAFTA Trade Creation and Trade Diversion
Trade Flow
U.S. import from Canada
Trade Expansion
Trade Diversion
Creation
$1074186
$689997
$384189
U.S. import from Mexico
334912
50138
284774
Canadian import from US
63656
25212
38444
Canadian import from Mexico
167264
163943
3321
Mexican import from US
77687
27651
50036
Mexican import from Canada
28001
27099
902
These have been divergent views on the potential benefits and harmful effects of NAFTA and its members. The foreign
investment in Mexico has risen substantially since the Agreement.
Impact of NAFTA had only a drawback, which is job loss in the US.
72
Case Study
NAFTA Wal-Marts Success in Mexico
Comercial Mexicana S.A. (Comerci), one of Mexico's largest retail chains, is faced with a serious dilemma. Since WalMart's aggressive entry into the Mexican retail market, Comerci has found it increasingly difficult to remain competitive.
Wal-Mart's strong operating presence and low prices since NAFTA's lifting of tariffs have put pressure on Comerci, and
now management must determine if Comerci's recent participation with the purchasing consortium Sinergia will be
sufficient to compete against Wal-Mart. What has caused this intense competitive pressure on Comerci, and what is
likely to be its future?
Prior to 1990, Wal-Mart had never made moves to enter Mexico or any country other than the United States. Once, WalMart started growing in Mexico, management created the Wal-Mart International Division in 1993. The company has
expanded internationally to nine countries through new-store construction and acquisitions. It now operates in
Argentina, Brazil, Canada, China, Germany, Korea, Mexico, Puerto Rico, and the United Kingdom. It also possesses a
37.8 percent owning interest in Seiyu, Ltd., a leading Japanese retailer, and has announced plans to explore
opportunities in the Russian and Indian markets. Wal-Mart's operations in Canada began in 1994 with the acquisition of
122 Woolco stores. It now has over 235 stores and 6 Sam's Clubs and has strong partnerships with Canadian suppliers.
Although successful in countries like Mexico and Canada, where it has become the largest retailer, it has yet to prove
itself in Germany and Argentina. It is learning from its past mistakes, and it is now adapting much better to local
cultures and learning from partnerships formed in each country.
Wal-Mart's Competitive Advantage
Much of Wal-Mart's international success comes from the tested practices the U.S. division bases its success on. WalMart is known for the slogan "Every Day Low Prices." It has expanded that internally to "Every Day Low Costs" to
inspire employees to spend company money wisely and work hard to lower costs. Because of its sheer size and volume
of purchases, Wal-Mart can negotiate with suppliers to drop prices to agreeable levels. It also works closely with
suppliers on inventory levels using an advanced information system that informs suppliers when purchases have been
made and when Wal-Mart will be ordering more merchandise. Suppliers can then plan production runs more accurately, thus reducing production costs, which are passed on to Wal-Mart and eventually the consumer.
Wal-Mart also has a unique distribution system that reduces expenses. It builds super warehouses in central locations
that receive the majority of merchandise sold in Wal-Mart stores. It then transports the merchandise to the various
stores, using its company-owned fleet or a partner. The central distribution center helps Wal-Mart negotiate lower prices
with its suppliers because of the large purchasing volumes. These strategies have resulted in great success for Wal-Mart.
In 2001, it passed General Electric and ExxonMobil to become the largest company in the world, with sales of $217.8
million. It has the largest private-sector workforce, with 1.3 million people in 3,300 facilities throughout the world. And
it even uses the second most powerful computer in the world-behind the Pentagon's-to run its logistics.
Wal-Mart in Mexico
In Mexico, Wal-Mart operates 671 units, including Sam's Clubs, Bodegas (discount stores), Wal-Mart Supercenters,
Superamas (grocery stores), Suburbias (apparel stores), and VIPS restaurants. Wal-Mart encountered some difficulties
with its opening in Mexico prior to the passage of NAFTA. One of the biggest challenges it faced was import charges on
many of the goods sold in its stores, thus preventing Wal-Mart from being able to offer its "Every Day Low Prices."
Unsure of local demand, Wal-Mart stocked its shelves with things like ice skates, fishing tackle, and riding lawnmowersall unpopular items in Mexico. Rather than informing headquarters that they wouldn't need those items, local managers
heavily discounted the items, only to have the automatic inventory system reorder the products when the first batch
sold. Wal-Mart also encountered logistics problems due to poor roads and the scarcity of delivery trucks. Yet another
problem was the culture clashes between the Arkansas executives and the local Mexican managers. Some of these
problems were solved by trial and error, but the emergence of the North American Free Trade Agreement in 1994 helped
solve most of the problems. Among other things, NAFTA reduced tariffs on American goods sold to Mexico from 10
percent to 3 percent. Prior to NAFTA, Wal-Mart was not much of a threat to companies like Comerci, Gigante, and
Contd
73
Soriana, Mexico's top retailers. But once the agreement was signed, the barriers fell and Wal-Mart was on a level playing
field with its competitors-all it needed to become number one.
NAFTA encouraged Mexico to improve its transportation infrastructure, thus helping to solve Wal-Mart's logistical
problems. The signing of NAFTA also opened the gates wider to foreign investment in Mexico. Wal-Mart was paying
huge import fees on goods shipped to Mexico from areas U.K., Europe and Asia. Foreign companies knew that if they
built manufacturing plants in Mexico, they could keep costs low with Mexican labor but Ship to NAFTA's free trade
zone-Mexico, the United States, or Canada. As companies began to build manufacturing plants in Mexico, Wal-Mart
could buy these products without paying the high import tariffs. An example of this tactic is Sony's flat-screen television
line, Wega. Sam's Clubs in Mexico imported Wega TVs from Japan with a 23 percent import tariff plus huge shipping
costs, resulting in a $1,600 sales price at Sam's Club. In 1999, Sony built a manufacturing plant in Mexico, thus allowing
Sam's Club to purchase the Wegas without import tariffs; this tactic also yields much lower shipping fees. Sam's Clubs
passed on the savings to customers-with a sales price of only $600.
The benefits of NAFTA, like lower tariffs and improved infrastructure, helped not only Wal-Mart but also its
competitors, like Comerci. But Wal-Mart used the advantages of NAFTA better than anyone else. Rather than pocketing
the differences the lower tariffs made, Wal-Mart reduced its prices. In 1999, it closed one of its Supercenters for a day to
discount up to 6,000 items by 14 percent. Comerci and others have combated Wal-Mart's tactics by lowering their own
prices, but on many items, they can't get the prices as low. Wal-Mart's negotiating power with its suppliers is large
enough that it can get the better deal. Also, most of Mexico's retailers priced goods differently. They were used to
putting certain items on sale or deep discount, a strategy known as "high and low," rather than lowering all prices. They
have been trying to adjust their pricing structure to match Wal-Mart's, but they are still frustrated with the continued
cost cutting of Wal-Mart. Competitors and certain suppliers are so angry that they have gone to Mexico's Federal
Competition Commission (known in Mexico as CoFeCo) with complaints of unfair pricing practices.
Formation of Sinergia
Unable to compete with Wal-Mart under the new conditions, Comerci has been faced with extinction. Wal-Mart is the
largest retailer in Mexico and owns about 55 percent of the market share in Mexico's supermarket sector, with $11.7
billion in sales and $585 million in profit in the country during 2004. In contrast, Comerci realized only $3.1 billion in
sales and $93 million in net profit and has seen its market share drop to 15 percent.
Fear over the giant retailer's predominance and over its unexplained withdrawal from the Mexican National Association
of Department Stores (ANTAD) in 2004 prompted Comerci to band with two other struggling homegrown supermarket
chains, Soriana and Gigante, to form a purchasing consortium that would allow them to negotiate better bulk prices
from suppliers. As a representative body with no assets, Sinergia's purchases are currently limited to only local
suppliers, and its future is still uncertain.
Should Sinergia fail to improve the situation, Comerci could still look for possible foreign buyers, like France's
Carrefour, or it could duplicate the efforts of its Sinergia partner Soriana which is attempting, with some notable success,
to differentiate itself from Wal-Mart by offering products and a store atmosphere that appeal more to Mexicans' middleclass aspirations. The government may give Comerci a break if it rules against Wal-Mart's aggressive pricing but as one
analyst put it, "We do not believe the CFC will end up penalizing Wal-Mart for exercising its purchasing power in an
attempt to get the best deals available in the marketplace, which is the goal of every retailer in the world, especially
when these savings are ultimately passed on to consumers. One thing is certain, however- Comerci cannot afford to sit
still.
Questions
1.
How has the implementation of NAFTA affected Wal-Marts success in Mexico?
2.
How much of Wal-Marts success is due to NAFTA, and how much is due to Wal-Marts inherent competitive
strategy? In other words, could any other U.S. retailer have the same success in Mexico post-NAFTA, or is Wal-Mart
a special case?
Contd
74
3.
What has Comerci done in its attempt to remain competitive? What are the advantages and challenges of such a
strategy, and how effective do you think it will be?
4.
What else do you think Comercial Mexicana S.A. should do, given the competitive position of Wal-Mart?
5.
Which strategies were responsible for Wal-Marts competitive edge and its global success?
Source: Adapted from John D. Daniels, Lee H. Radebaugh & Daniel P. Sullivan, International Business, 11th ed., Pearson Education,
p.278-281.
3.6.2 European Common Market (ECM)

The European Union (EU), then known as the European Economic Community was created by the treaty of Rome in 1957. IT is
also known as Common Market in Europe. The EU initially consisted of six nations: Belgium, France, Italy, Luxembourg, the
Netherlands and West Germany. By 1973 the UK, Ireland and Denmark had joined the trade bloc. Greece becomes 10th
members in 1981 and the entry of Spain and Portugal in 1987, raised the membership to 12 nations. In 1995, Austria, Finland
and Sweden were admitted into the EU.
The Treaty of Rome required every member country to:
1.
Eliminate tariffs, quota and other barriers on intra-community.
2.
Devise common internal tariff on their import on rest of the world.
3.
Allow the free movement of factors of production within the community.
4.
Harmonise their taxation and monetary policies and social security policies.
5.
Adopt common policy on agriculture, transport and completion in industry.
Trade creation was pronounced in machinery, transportation equipment, chemicals and fuels where as trade diversion was
apparent in agricultural commodities and raw materials. The trade creation was significant in the year 1970 from 10% to 30%
of total EU imports of manufactured goods. EU realized dynamic benefits from integration in the form of additional
competition and investment and also economies of scale. For example, Netherlands and Belgium realized economies of scale
by producing both for the domestic market and for export.
Convergence Criteria of EMU

The Maastricht Treaty, signed in 1991, set 2002 as the target date for the formation of the European Monetary Union (EMU)
with a single currency known as the euro.
When the Maastricht treaty was signed, economic conditions in the various EU members differed. So the first thing the
Europeans had to do was align their economic and monetary policies. This effort, called convergence has led to a high degree
of uniformity in terms of price inflation, money supply growth and other key economic factors. The specific convergence
criteria as mandated by the Maastricht Treaty are as follows:
1.
Price Stability: Inflation in each prospective member is supposed to be no more than 1.5% above the average of inflation
rates in the three countries with lowest inflation rates.
2.
Low Long Term Interest Rates: Long-term interest rates are to be no more than 2% above the average interest rate in those
countries.
3.
Stable Exchange Rates: The exchange rate is supposed to have been kept within the target bands of the monetary union
with no devaluation for at least two years prior to joining the monetary union.
4.
Sound Public Finance: One fiscal criterion is that the budget deficit in a prospective member should be at most 3% of
GDP; the other is that the outstanding amount of government debt should be no more than 60% of a year's GDP.
75
In 1999, 11 of the EU's 15 members fulfilled the economic tests as mandated by the Maastricht treaty and became the funding
members of the European Monetary Union (EMU). These countries included Belgium, Germany, Spain France, Ireland, Italy,
Netherlands, Austria, Portugal and Finland. In 2001, Greece became the 12th country to join the EMU. Only Britain, Sweden
and Denmark had not participated in EMU. Prior to EMU, Europe's monetary policy was mainly determined by the German
Bundesbank.
Agricultural Policy and EU

Besides providing for free trade in industrial goods among its members, the EU has abolished restrictions on agricultural
products traded internally. A Common Agricultural Policy has replaced the agricultural stabilization policies of individual
member nations, which differed widely before the formation of the EU. A substantial element of the common agricultural
policy has been the support of prices received by the farmers for their produce. Schemes of deficiency payments, output
controls and direct income payments have been used for this purpose. In addition, the common agricultural policy has
supported the EU farm prices through a system of variable levies, which applies tariffs to agricultural imports entering the EU.
Exports of any surplus quantities of EU produce have been assured through the adoption of export subsidies.
Problems in EU's Price-support Programmes

One problem confronting the EU's price-support programmes is that agricultural efficiencies differ among EU members.
German farmers being high cost producers have got high support prices to maintain their existence, as comparison to that of
French farmers.
The common agricultural policy has, thus, encouraged inefficient farm production by EU farmers and has restricted food
imports from more efficient non-member producers. Such trade diversion has been a welfare decreasing effect of the EU:
1.
The impact of a system of variable levies: The impact of price-support-programmes is discussed on two basis-system of
variable levies and system of export subsidies. The EU's policy of ensuring a high level of income for its farmers has been
costly. High support price led to high internal production and low consumption. So the huge surpluses need to be
purchased by EU to depend support price which is sold in world market at prices less than costs.
In Figure 3.12 (a) S and D represent the EUs supply and demand schedules for wheat and that the world price of wheat
equals the price of P1 ($3.50) per bushel. Assume that the EU wishes to guarantee its high cost farmers a price of P2 ($4.50)
per bushel. This price cannot be sustained as long as imported wheat is allowed to enter EU at the free market price of P1
($3.50) per bushel. Suppose to validate the support price, the EU initiates a variable levy. EU farmers are permitted to
produce 5 million bushels of wheat as opposed to the 3 million bushels that would be produced under free trade and at
the same time EU imports total 2 million bushels instead of 6 million bushel. Due to increased production overseas, the
world price of wheat falls to price of P ($2.50) per bushel.
Variable levy is determined by the difference between the lowest price of the world market and the support price. This
results in EU's production and imports being unchanged. The import tariff would increase to $2 per bushel. The variable
import levy tends to be more restrictive than a fixed tariff. It discourages foreign procedures from absorbing part of the
tariff and cutting prices to maintain export sales. It also discourages the foreign producers from subsidizing their exports
in order to penetrate domestic markets.
76
Figure 3.12 (a): The Operation of a System of Variable Levies
2.
Impact of a system of Export Subsidy: The EU has also used a system of export subsidies to ensure that any surplus
agricultural output will be sold overseas. The higher price supports of the common agricultural policy have given EU
farmers the incentive to increase production, often in surplus quantities. The EU pays its producers export subsidies so
they can sell surplus produce abroad at the low price but still receive the higher, international price because the world
price of agricultural commodities has generally been below the EU price.
Figure 3.12(b): The Operation of a System of Export Subsidies
In Figure 3.12(b) above, let the price of wheat be P1 per bushel. Suppose that improving technologies result in a shift in the
EU supply schedule from S to S1. At the internal support price, P2, EU production exceeds EU consumption by 2 million
bushels. To facilitate the export of this surplus output, the EU provides its producers an export subsidy of say, $1 per
bushel. EU wheat would be exported at a price of P1 ($3.50), and EU producers would receive a price (including the
subsidy) of P2 ($4.50). The export subsidies are characterized by a sliding scale. Should the world price of wheat fall to P
($2.50), the support price P2 ($4.50) would be maintained through the imposition of a $2 export subsidy.
77

1.
Tariffs may be referred to as taxes levied on imports.
2.
Counteracting duties are similar to the anti dumping duties and are charged on goods imported from countries
where the manufacturer exporter is paid, directly or indirectly, a subsidy as an incentive for export.
3.
Preferential arrangements are always under the purview of GATT.
4.
USA, Canada, Mexico and Brazil are the four prominent members of NAFTA.
3.6.3 ASEAN
The Association of South East Asian Nations (ASEAN) was formed by the Bangkok declaration 1967 by five countries, viz.,
Indonesia, Malaysia, the Philippines, Singapore and Thailand with a view to accelerate economic progress. The region
accounts the highest share of the world's natural rubber, palm oil and tin. It is also an important producer of sugar, coffee,
timber, petroleum, nickel, bauxite, tungsten and coal.
The ASEAN free trade area was created in 1992 by the six nations mentioned above. Between 1995 and 1999 Vietnam, Laos
PDR, Myanmar and Cambodia acceded to AFTA taking the membership to ten.
AFTA reduced intra-regional tariffs or Common Effective Preferential Tariffs (CEPT) rates to a range of 0-5%. The agreement
now also calls for elimination of all customs duties by 2010. AFTA includes preferential liberalization of services and
investments, harmonization to tariff nomenclature, intellectual property cooperation, and harmonization of products
standards and mutual recognition of conformity. Under AFTA, ASEAN's established members have cut tariff on most goods
traded within the region to between 0-5 percent.
Despite the realization of AFTA the share of intra-regional trade has not increased significantly. There are a number of reasons
for this:
z
Within ASEAN 66% of the tariff lines have the same CEPT rates.
Many products with strong potential for intra-regional, trade are also politically sensitive and have had their
liberalization delayed by a number of members.
The 10 nations of ASEAN will form an economic community by 2020. This unified market would have about 500 million
people and estimated annual sales totalling US $720 billion.
3.7 Let us Sum up

Gains from trade means increase in welfare to the world economy as a whole or to an individual country depending on the
view point, as a result of engaging in international trade. The gains originate in two sources, which are the possibility of
exchange and the possibility of increased specialization.
Sources of gains from trade include division of labour, international specialization and wide extent of market. There are two
kinds of gains from trade: static gains and dynamic gains. In order to measure gains from trade, three approaches can be used:
Ricardos approach, JS Mills approach and Samuelsons approach.
Although the level and rate of economic development depend primarily on internal conditions in developing nations, most
economists today believe that international trade can contribute significantly to the development process. Trade helps in
breaking the vicious circle of poverty, acts as an inducement to invest, helps in market expansion and efficient use of means of
production.
In recent years, economists have put forward a new concept of economic development known as sustainable development.
This concept of sustainable development was propounded for the first time in 1987 by the World Commission on Environment
and Development in the Brundtland Report titled 'Our Common Future'. According to World Development Report, 2003,
78
"Sustainable development is that process of development which meets the needs of the present generation without
compromising the ability of the future generation to meet their own needs".
Immiserising growth refers to that situation where all increases in a country's export commodities lead to such deterioration in
its terms of trade that there is a net decline in its export earnings and social welfare.
Free trade policy refers to a trade policy without any tariffs, quantitative restrictions and other devices obstructing the
movement of goods between countries. Classical economists were the staunch protagonists of free trade policy which is
nothing but an extension of the case for laissez-faire, competitive markets and division of labour. It also makes use of the other
conventional assumptions of classical economics.
Protection, as against the term free trade, stands for a considered policy of regulating external trade. It is a policy whereby
domestic industries are to be protected from foreign competition. The aim is to impose restrictions on the imports of lowpriced products in order to encourage domestic industries producing high priced products.
Tariffs have been one of the classical methods of regulating international trade. They may be referred to as taxes levied on
imports. They aim at restricting the inward flow of goods from other countries to protect the countrys own industries by
making the goods costlier in that country.
Importing countries are also concerned with the development of their own industries and trade. They will have to protect
them against unfair competition with a view to giving the domestic industry a fair chance for survival. To meet the challenges,
more and more countries are adopting non-tariff measures to regulate their imports.
Economic integration experiments have a long history dating back to the last decade of the nineteenth century. One of the
earliest attempts of economic integration was the free trade attempted by Norway and Sweden in the nineteenth century.
NAFTA went into effect in 1994. The United States signed its FTA with Israel in the mid-1980, followed by FTA (Free Trade
Agreement) with Canada in 1988. This agreement passed the way for Mexico, Canada & US to form NAFTA.
The European Union (EU), then known as the European Economic Community was created by the treaty of Rome in 1957. IT is
also known as Common Market in Europe.
The Association of South East Asian Nations (ASEAN) was formed by the Bangkok declaration 1967 by five countries, viz.,
Indonesia, Malaysia, the Philippines, Singapore and Thailand with a view to accelerate economic progress. The region
accounts the highest share of the world's natural rubber, palm oil and tin. It is also an important producer of sugar, coffee,
timber, petroleum, nickel, bauxite, tungsten and coal.

1.
Prepare a report on: SAARC and its prominence.
2.
Include headings such as history, members, role of each member, benefits, meetings, etc.
3.9 Keywords
Gains from trade: The surplus production arising out of international division of labour represents gains from trade and it is
distributed among trading partners according to agreed rates of exchange for goods.
Partial equilibrium: A type of economic equilibrium, where the clearance on the market of some specific goods is obtained
independently from prices and quantities demanded and supplied in other markets.
General equilibrium: Market situation where demand and supply requirements of all decision makers (buyers and sellers)
have been satisfied without creating surpluses or shortages.
Reciprocal demand: The concept that, in international trade, it is not just supply and demand that interact, but demand and demand.
Sustainable development: It is that process of development which meets the needs of the present generation without
compromising the ability of the future generation to meet their own needs.
79
Immiserising growth: It refers to that situation where all increases in a country's export commodities lead to such deterioration
in its terms of trade that there is a net decline in its export earnings and social welfare.
Free trade policy: It refers to a trade policy without any tariffs, quantitative restrictions and other devices obstructing the
movement of goods between countries.
Tariffs: Taxes levied on imports.
Non-tariff barriers: Any measure other than high import duties (tariffs) employed to restrict imports.
Trade block: A type of intergovernmental agreement, often part of a regional intergovernmental organization, where regional
barriers to trade (tariffs and non-tariff barriers) are reduced or eliminated among the participating states.

1.
What do you mean by gains from international trade? What are the types of gains?
2.
Explain the nature of gains from international trade. Explain the factors affecting gains from trade.
3.
Discuss the classical and modern theory of the measurement of gains from trade.
4.
Foreign trade is the engine of economic growth". Discuss the statement so as to bring out its importance for developing
countries.
5.
Define sustainable development. Discuss the indicators of sustainable development.
6.
Define tariffs. What are the various types of tariffs?
7.
What are the non-tariff barriers to international trade?
8.
Explain the theory of Immiserising Growth with the help of a figure.
9.
Define the concepts of 'free trade' and 'protection', with qualifying exemptions, if any.
10. "An underdeveloped country is doomed to remain backward unless it resorts to protectionism". Discuss.
11. Distinguish between the terms self-sufficiency and self-reliance. Which of the two is preferable and why?
12. Write short notes on: NAFTA, ECM and ASEAN.

CYP 1
1.
True
2.
True
3.
False
4.
True
CYP 2
1.
Sustainable development
2.
Prof. Jagdish Bhagwati
3.
Free trade policy
4.
Self sufficiency
80
CYP 3
1.
True
2.
True
3.
False
4.
False

Kumar, Raj, International Economics, Excel Books, New Delhi.
Kindleberger, Charles P., International Economics, D. B. Taraporevala and Sons, Mumbai.
Theberge, James, D., (Ed.), Economics of Trade and Development, Wiley, New York.
Viner, Jacob, Studies in the Theory of International Trade, George Allen and Unwin Ltd., London.
81
Chapter 4: Equilibrium in International Trade

Objectives
1.
Difference between balance of trade and balance of payments
2.
The disequilibrium in balance of payments and measures to correct it
3.
Adjustments for disequilibrium in balance of payments
4.
Exchange rate determination theories
5.
Difference between fixed rate and floating rate system
Introduction
Equilibrium is the state of balance. This unit deals with the equilibrium in international trade. To understand this equilibrium
we need to analyse the balance of payments and exchange rate system.
To arrive at the exact state of international trade position, it is essential to understand the two concepts of Balance of Trade and
Balance of Payments. Balance of Payments is a wider term than Balance of Trade because it is the balance of payments which
reveals the true picture of international transactions of a country.
Among the factors that make international economics a distinct subject is the existence of different national monetary units of
account. In the United States, prices and money are measured in terms of the dollar. The peso represents Mexico's unit of
account whereas franc signifies the units of account of France.
A typical international transaction requires two distinct purchases. First, the foreign currency is bought; second the foreign
currency is used to facilitate international transaction. For example, before Indian importers can purchase commodities from,
say US exporters, they must first purchase dollars to meet their international obligation. Some institutional arrangements are
required that provide an efficient mechanism whereby monetary claims can be settled with a minimum of inconvenience to
both parties. Such a mechanism exists in the form of the foreign exchange market.
4.1 Balance of Trade

Balance of Trade refers to the balance of difference between the value of total imports and export of visible material goods.
According to Benham, "Balance of Trade of a country is the relation over a period between the values of her exports and the values of her
imports." A proper record of all material goods which are exported and imported is kept at the ports, so they are called visible
items. Balance of trade may be of three types:
1.
Favourable or Surplus Balance of Trade: A country may have favourable or surplus balance of trade when the total value
of the goods exported by it is more than the total value of the goods imported by it. (Exports> Imports)
2.
Unfavourable or Deficit Balance of Trade: A country may have unfavourable or deficit balance of trade when the total
value of the goods imported by it is more than the total value of the goods exported by it. (Imports > Exports.)
3.
Balanced Balance of Trade: A country may have balanced balance of trade when the total value of the goods exported by
it is equal to the total value of the goods imported by it. (Exports = Imports)
82
4.2 Balance of Payments

Global companies plan or venture not only on national markets, but also venture globally and view themselves as a global.
The balance of payments of a country is a systematic record of all its economic transactions with the outside world in a given
year. It is a statistical record of the character and dimensions of the country's economic relationships with the rest of the world.
Balance of Payments includes three types of items:
1.
Visible Items which are physical goods that are recorded at the ports.
2.
Invisible Items which include services and these are not recorded at the ports.
3.
Capital Transfers which are related to the receipts and payments of capital.
If the total receipts from foreigners on the credit side exceed the total payments to foreigners on the debit side, the balance of
payments is said to be favourable. On the other hand, if the total payments to foreigners exceed the total receipts from
foreigners, the balance of payments is unfavourable.
Definitions
1.
According to Benham, "Balance of payments of a country is a record of all economic transactions over a period with the rest of the
world."
2.
According to Kindleberger, "the balance of payments of a country is systematic record of all economic transactions between its
residents and residents of foreign countries."
3.
According to James O. Ingram, "the balance of payments is a summery record of all economic transactions between all residents of
one country and the rest of the world during a given period of time."
4.
According to P.T. Ellsworth, "balance of payments is an annual summary statement of all the transactions between the residents of
one country and the rest of the world."
5.
According to Walter Krause, "balance of payments is a summary of all economic transactions between the residents of a country
and the residents of the rest of the world during a certain period usually a year."
Features of Balance of Payments

Main features of balance of payments are as under:
1.
Balance of payments is a systematic, record of receipts and payments of a country with other countries.
2.
It is a statement of account pertaining to a given period of time, usually, one year.
3.
It includes all the three items, i.e., visible, invisible and capital transfers. Hence it is comprehensive.
4.
Receipts and payments are recorded on the basis of the double entry system.
5.
From the point of view of accounting, double entry system keeps automatically debit and credit sides of the accounts in
balance.
6.
Whenever there is difference in actual total receipts and payments, need is felt for necessary adjustment.
7.
Balance of payments includes receipts and payments of all items, government and non-government.
4.2.1 Difference between Balance of Trade and Balance of Payments

Following are the main differences between Balance of Trade and Balance of Payments:
1.
Balance of Payments is a broad term. It includes balance of trade. The latter is relatively a narrow concept. It is a part of
balance of payments.
83
2.
Balance of Trade includes imports and exports of goods alone i.e., visible items. On the contrary, the balance of payments
includes all kinds of items; that is imports and exports of goods, services and capital. In other words, it includes visible as
well as invisible items. In brief, balance of trade is a part of balance of payments.
3.
Balance of trade of a country can be favourable or unfavourable but balance of payment always balances.
4.
Deficit of balance of trade can be met by balance of payments but deficit of balance of payments cannot be met by balance
of trade.
5.
From the point of view of economic analysis, balance of payments is more significant than balance of trade. Every country
takes into account items of balance of payments while formulating its foreign trade policy. If the liabilities (payments) of a
country to other countries are large, it will have great impact on its national income, employment etc.
4.2.2 Importance of Balance of Payments

From economic point of view, balance of payments for a country is most important. It is evident from the following facts:
1.
Guide to Economic Conditions and Direction: Balance of payments is indicative of the economic situation of a country.
Countries having always a favourable balance of payments are considered to be economically sound. On the other hand,
countries suffering from chronic adverse balance of payments are treated economically sick and unhealthy.
2.
Indicator of Economic Changes: Changes taking place in the economy at different periods of time can best be reflected in
its balance of payments position.
3.
Indicator of Foreign Dependency: Balance of payments is an indicator of the extent to which a country is dependent on
other countries.
4.
Knowledge of Foreign Receipts and Payments: A country's total receipts and payments are known from its balance of
payments.
5.
Knowledge of Foreign Investment: Again, it is balance of payments that tells us about the amount of income earned by the
foreigners on their investment in the country. Likewise, the amount of income earned by the country on its investment
abroad.
6.
Indicator of Foreign Trade: Study of balance of payments tells us about the state of foreign trade of a country. A country
formulates its foreign trade policy on the basis of this knowledge.
7.
Basis of Economic Policy and Planning: Balance of payments makes an important contribution to the formulation of
national planning and economic policy. The government of India is introducing fundamental and structural changes in
economic policy due to the state of its balance of payments position.
8.
Helpful for International Financial Organisations: It is on the basis of balance of payments position that international
financial institutions determine the amount of financial assistance to be given to a country, as IMF has done in case of
India.
4.2.3 Composition or Structure of Balance of Payments

The balance of payments account of a country is constructed on the principle of double-entry bookkeeping. Each transaction is
entered on the credit and debit side of the balance sheet. But balance of payments accounting differs from business accounting
in one respect. In business accounting, debits are shown on the left side and credits on the right side of the balance sheet. But
in balance of payments accounting, the practice is to show credits on the left side and debits on the right side of the balance
sheet.
When a payment is received from a foreign country, it is a credit transaction while payment to a foreign country is a debit
transaction. The principal items shown on the credit side are exports of goods and services, transfer receipts in the form of
gifts, grants, etc. from foreigners, borrowings from abroad, investments by foreigners in the country, and official sale of
reserve assets including gold to foreign countries and international agencies. The principal items on the debit side include
imports of goods and services, transfer payments to foreigners as gifts, grants, etc., lending to foreign countries, investments
84
by residents to foreign countries, and official purchase of reserve assets or gold from foreign countries and international
agencies.
These credit and debit items are shown vertically in the balance of payments account of a country according to the principle of
double-entry bookkeeping. Horizontally, they are divided into three categories: the current account, the capital account, and
the official settlements account or the official reserve assets account.
The balance of payments account of a country is constructed in Table 4.1.
Table 4.1: Balance of Payments Account
Credit (+) (Receipts)
Debits (-) (Payments)
1. Current Account
Exports
Imports
(a) Goods
(a) Goods
(b) Services
(b) Services
(c) Transfer Payments
(c) Transfer Payments
2. Capital Account
(a) Borrowing From Foreign Countries
(a) Lending to Foreign Countries
(b) Direct Investment by Foreign Countries
(b) Direct Investment in Foreign Countries
3. Official Settlement Account

(a) Increase in Foreign Official Holdings
Errors and Omissions
(a) Increase in Official Reserve of Gold and

Foreign Currencies
Current Account
The current account of a country consists of all transactions relating to trade in goods and services and unilateral (or
unrequited) transfers. Service transactions include costs of travel and transportation, insurance, income and payments of
foreign investments, etc. Transfer payments relate to gifts, foreign aid, pensions, private remittances, charitable donations etc.,
received from foreign individuals and governments to foreigners.
In the current account, visible exports and imports are the most important items. The difference between exports and imports
of a country is its balance of visible trade or merchandise trade or simply balance of trade. If visible exports exceed visible
imports, the balance of trade is favorable. In the opposite case when imports exceed exports, it is unfavourable.
The invisible items along with the visible items determine the actual current account position. If exports of goods and services
exceed imports of goods and services, the balance of payments is said to be favourable. In the opposite case, it is unfavourable.
In the current account, the exports of goods and services and the receipts of transfer payments (unrequited receipts) are
entered as credits (+) because they represent receipts from foreigners. On the other hand, the imports of goods and services
and grant of transfer payments to foreigners are entered as debits (-) because they represent payments to foreigners. The net
value of these visible and invisible trade balances is the balance on current account.
Items of Current Account
The following items are mainly included under current account:
1.
Export and Import of Visible Items: Import and export of visible material goods and precious metals. In other words, all
goods included in balance of trade are the main items of current account.
2.
Invisible Items: Import and export of visible goods, i.e., different kinds of services are also included in current account.
Main invisible items (services) are:
(i)
Expenditure of Travellers: One of the main visible items of balance of payments is travels. These travellings many be
of any kind and on any account for instance, these may be in connection with business, education, health,
conventions or pleasure trip, etc. The country visited to, for in these travels constitute exports and the country from
which the visitors originate, for it these travels constitute imports.
85
(ii)
Services of Experts: Every country avails mostly the services of foreign experts like doctors, engineers, soldiers, etc.
and also puts the services of its experts at the disposal of other countries. The services received from abroad are like
imports and the services rendered to foreign countries are like exports.
(iii)
Transport: Movement of goods from one country to the other is another invisible item influencing balance of
payments on current account. Use of domestic transport by the foreigners amounts to exports and use of foreign
transport by the natives amounts to imports.
(iv)
Services Rendered by Commercial Undertakings: Commercial undertakings like shipping companies, insurance
companies, banks, etc. belonging to a given country or different countries, exchange their services among different
countries. Exchange of such services is included in current account.
(v)
Investment Income: Interest, rent, dividend and profit also form invisible items of balance of payments. When a
country obtains income from its investments abroad it is recorded under the head 'receipts'. On the other hand,
when foreign investors earn income from the country where they made investment, and then it is recorded under
the head 'payments'.
(vi)
Governmental Transactions: Each government establishes its embassies, offices a high commissioners and other
missions abroad and spends a lot on their maintenance. Such expenditure is treated as 'payments'. Besides
subscriptions etc. made to international institutions are also included in this category.
(vii) Donations and Gifts: Donations and gifts etc. received from abroad are included under 'receipts' and donation and
gifts etc. given to other countries are included under 'payments'.
(viii) Miscellaneous: These include such invisible items as commission, advertisement, rent, patent fees, royalties,
membership fees etc. The amount received from abroad on this count constitutes credit item and the amount paid to
other countries in this respect constitute debit items.
Capital Account
The capital account of a country consists of its transactions in financial assets in the form of short-term and long-term lendings
and borrowings, and private and official investments. In other words, the capital account shows international flow of loans
and investments, and represents a change in the country's foreign assets and liabilities. Long-term capital transactions relate to
international capital movements with maturity of one year or more and include direct investments like building of a foreign
plant, portfolio investment like the purchase of foreign bonds and stocks, and international loans. On the other hand, shortterm international capital transactions are for a period ranging between three months and less than one year.
There are two types of transactions in the capital account private and government. Private transactions include all types of
investment: direct, portfolio and short-term. Government transactions consist of loans to and from foreign official agencies.
In the capital account, borrowings from foreign countries and direct investment by foreign countries represent capital inflows.
They are positive items or credits because these are receipts from foreigners. On the other hand, lending to foreign countries
and direct investments in foreign countries represent capital outflows. They are negative items or debits because they are
payments to foreigners. The net value of the balances of short-term and long-term direct and portfolio investments is the
balance on capital account.
Items of Capital Account
Capital Account of Balance of Payments is related to financial transactions. It includes all types of short period and long period
capital transfers including gold transactions. The following are the items of capital account.
Main items of capital account are as follows:
1.
Private Loans: Foreign loans received by the private sector are counted as 'credit item' and repayment of these loans is
counted as 'debit item'.
2.
Movement of Banking Capital: Besides central bank, inflow of banking capital is counted as 'credit item' and outflow as
'debit item'.
86
3.
Official Capital Transactions: Loans received by the public sector from abroad or International Monetary Fund
constitutes "credit items" and loans repaid "debit items".
4.
Reserves and Monetary Gold: Foreign currency assets of the government, gold reserves of the central bank, SDR of IMF
and similar capital transactions, etc. are included under credit items and all kinds of payments under "debit items".
5.
Gold Movement: When the central bank of a country buys gold from abroad, it makes payment to foreign sellers. It is
reflected under "debit items". On the contrary, when it sells gold it is reflected under "credit items".
The Official Settlements Account

The official settlements account or official reserve assets account are, in fact, a part of the capital account. But the U.K. and U.S.
balance of payments accounts show it as a separate account. "The official settlements account measures the change in nation's
liquidity and non-liquid liabilities to foreign official holders and the change in a nation's official reserve assets during the year. The official
reserve assets of a country include its gold stock, holding of its convertible foreign currencies and SDRs, and its net position in the IMF."
It shows transactions in a country's net official reserve assets.
Errors and Omissions: Errors and omissions is a balancing item so that total credits and debits of the three accounts must be
equal in accordance with the principles of double entry bookkeeping so that the balance of payments of a country always
balances in the accounting sense.
4.2.4 Balance of Payments are always Balanced

Generally, it is believed that in the context of international transactions, balance of payments of a country remain always
balanced. It is so because, under double entry system, receipts and payments, known as assets and liabilities are always equal.
When we say that balance of payments is always balanced, why then do we say that balance of payments in a country is in
deficit or surplus. This can be answered by discussing the balance of payments in two senses:
1.
Balance of Payments in Accounting Sense: In the accounting sense, balance of payments of a country always balances
because of payments accounts are prepared on the basis of double entry system. Under the system, the receipts side is
always equal to the payments side. Thus, from this point of view, balance of payments always balances.
2.
Balance of Payments in Operational Sense: From the practical point of view, it is not necessary that balance of payments
may always be balanced. It may turn out to be unbalanced. In the operational sense, balance of payments is also called
economic balance. When current account is in deficit or surplus, then the balance is restored with the help of capital
account. In other words, deficit of current account is balanced with the help of surplus of capital account and the surplus
of current account is used to meet the deficit of capital account. In this way, balance of payments is balanced through
transfers of current account and capital account.
In the process of foreign trade, it is not necessary that the balance of payments of a country should be balanced with each and
every country separately. It is neither necessary nor does it happen in practical life. In actual practice, India's balance of
payments may be favourable with England and unfavourable with the U.S.A. but, in totality, it must be balanced with all the
countries in a given period of time.
It can, thus, be concluded that the overall balance of payments are always balanced. It can be further clarified with the help of
Table 4.2.
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Table 4.2: Statement of Balance of Payments

Items
Receipts
Payments
Balance
I Current A/C
Visible items
1. Import and exports of goods invisible items
2. Services
3. Investment Income
4. One Sided receipts
Total
II Capital Account
5. Long-term Loans
6. Short-term Loans
7. Gold Flows
400
200
200
400
600
400
100
300
-200
-200
100
100
1200
1400
-200
400
200
200
300
150
150
100
50
50
2000
2000
In the form of equations:
Balance of Trade
XM+S+E+U+C+G=0
Current Account
Capital Account
X = Export of goods.
M = Import of goods.
S = Net services exported or export of services-import of services.
E = Net foreign investment income or income from foreign investment foreign income from investment.
U= Net one sided receipts or one sided receipts-one sided payments.
C = Net capital follows or short and long-term foreign loans long-term and short-term loans to foreigners.
G = Net gold sales or sale of gold-purchase of gold.
The Balance of Payments statement in Table 4.2 shows that there is deficit in current account to the tune of as ` 200 crores
which is met by the excess in the capital account. Hence it is evident that balance of payments is always balanced. The
question arises, in what respect, balance of payments can be in disequilibrium? The above table shows that inflow of capital
into the country is ` 800 crores whereas out flow of capital is ` 600. So ` 200 crores is excess capital inflow which would
compensate the deficit in current account. The disequilibrium in balance of payments, thus, refers to the deficit in current
account.
4.3 Disequilibrium in BOP

A disequilibrium in the balance of payments of a country may be either a deficit or a surplus. A deficit or surplus in balance of
payments of a country appears when its autonomous receipts do not match its autonomous payments. If autonomous credit
receipts exceed autonomous debit payments, there is a surplus in the balance of payments and the disequilibrium is said to be
favourable. On the other hand, if autonomous debit payments exceed autonomous credit receipts, there is a deficit in the
balance of payments and the disequilibrium is said to be unfavourable or adverse.
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In the words of Kindleberger, "When we talk of disequilibrium in balance of payments, we refer not to overall balance of payments.
Rather, we refer to balance of payments in current account".
There can be three positions regarding balance of payments disequilibrium:
Balanced Balance of Payments

When total receipts of a country or exports (visible and invisible) are equal to its total payments or imports (visible and
invisible) then its balance of payments is in balance.
B/PB = R P = 0
B/PB = Balanced Balance of Payments. R=Receipts or Exports
P = Payments or Imports.
Favourable Balance of Payments

When, in order to balance the receipts and payments, a country receives gold from abroad or it has to give short-term loans,
then its receipts are more than payments and balance of payments turn favourable.
B/PF = R P > 0
Unfavourable Balance of Payments
Balance of payments is unfavourable when to balance its receipts and payments, a country has either to surrender its gold or
indulge in short-term borrowing from abroad.
B/PU = R P < 0
Balance of payments of a country is, thus, unfavourable, when its receipts are less than payments.
4.3.1 Kinds of Disequilibrium in Balance of Payments

Various kinds of disequilibrium in balance of payments may be given as under:
According to Duration
According to time duration, balance of payments can be two types:
1.
Short-term or Temporary Disequilibrium: Short-term factors account for temporary disequilibrium in balance of
payments. For instance, when crops are washed away by floods in certain regions of India and to make good the loss the
country is forced to import foodgrains on a large-scale while her exports remain constant, then the balance of payments
will turn unfavourable. This sort of disequilibrium is called temporary or short-term disequilibrium.
2.
Long-Period or Secular Disequilibrium: When an economy undergoes intensive changes, it causes secular or long-term
disequilibrium in the balance of payments.
According to Causes
According to causes, balance of payments can be three types:
1.
Cyclical Disequilibrium: Disequilibrium caused by trade cycles is called cyclical disequilibrium. Terms of trade and
growth of trade undergo a change as a result of trade cycles. Consequently, balance of payments is influenced. Cyclical
disequilibrium can be corrected by import-export adjustment.
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2.
Structural Disequilibrium: When structural changes take place in some sectors of the economy, then they affect importexport trade of the country resulting into structural disequilibrium.
3.
Fundamental Disequilibrium: When a country suffers chronic disequilibrium in its balance of payments, then according to
the International Monetary Fund, it will be called fundamental disequilibrium.
4.3.2 Causes of Disequilibrium in Balance of Payments

There are many factors that may lead to balance of payments deficit or surplus. These causes of disequilibrium in balance of
payments are discussed as under:
Economic Causes
The following economic causes lead to balance of payments disequilibrium:
1.
Stage of Economic Development: A country's balance of payments also depends on its stage of economic development. If
a country is developing, it will have a deficit in its balance of payments because it imports raw materials, machinery,
capital equipment, and services associated with the development process and exports primary products. The country has
to pay more for costly imports and gets less for its cheap exports. This leads to disequilibrium in its balance of payments.
2.
Price Changes: Inflation or deflation is another cause or disequilibrium in the balance of payments. If there is inflation in
the country, prices of exports increase. As a result, exports fall. At the same time, the demand for imports increases. Thus
increase in export prices leading to decline in exports and rise in imports results in advance balance of payments.
3.
Cyclical Fluctuations: Cyclical fluctuations in business activity also lead to BOP disequilibrium. Where there is
depression in a country, volumes of both exports and imports fall drastically in relation to other countries. But the fall in
exports may be more than that of imports due to decline in domestic production. Therefore, there is an adverse BOP
situation. On the other hand when there is boom in a country in relation to other countries, both exports and imports may
increase. But there can be either a surplus or deficit in BOP situation depending upon whether the country exports more
than imports or imports more than exports. In both the cases, there will be disequilibrium in BOP.
4.
Changes in Foreign Exchange Rates: Changes in foreign exchange rate in the form of overvaluation or undervaluation of
foreign currency lead to BOP disequilibrium. When the value of currency is higher in relation to other currencies, it is said
to be overvalued. Opposite is the case of an undervalued currency. Overvaluation of the domestic currency makes foreign
goods cheaper and exports dearer in foreign countries. As a result, the country imports more and exports less of goods.
There is also outflow of capital. This leads to unfavourable BOP. On the contrary, undervaluation of the currency makes
BOP favourable for the country by encouraging exports and inflow of capital and reducing imports.
5.
Dynamic Changes: The following dynamic changes may cause balance of payments disequilibrium:
(a) Changes in consumer's tastes within the country or abroad which reduce the country's exports and increase in
imports.
(b) Continuous fall in the country's foreign exchange reserves due to supply in elasticities of exports and excessive
demand for foreign goods and services.
(c) Low competitive strength in world markets which adversely affect exports.
6.
Structural Changes: Structural changes bring about disequilibrium in balance of payments over the long-run. The
following factors are responsible for the structural changes:
(a) Technological changes in methods of production of products in domestic industries or industries of other countries.
They lead to changes in costs, prices and quality of products.
(b) Import restrictions of all kinds bring about disequilibrium in balance of payments.
(c) Deficit in balance of payments also arises; when a country suffers from deficiency of resources, which it is required to
import from other countries.
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(d) Disequilibrium in balance of payments may also be caused by changes in the supply or direction of long-term capital
flows. More and regular flow of long-term capital may lead to balance of payments surplus, while an irregular and
short supply of capital brings balance of payments deficit.
7.
Capital Movements: Borrowings and lendings or movements of capital by countries also result in disequilibrium in
balance of payments. A country that gives loans and grants on a large scale to other countries has a deficit in its balance of
payments on capital account. If it is also importing more, as is the case with the USA, it will have chronic deficit. On the
other hand, a developing country borrowing large funds from other countries and international institutions may have a
favourable balance of payments. But such a possibility is remote because these countries usually import huge quantities of
food, raw materials, capital goods, etc. and export primary products. Such borrowings simply help in reducing balance of
payments deficit.
8.
Population Explosion: Aggregate consumption demand in underdeveloped countries increases due to rapid increase in
population. Consequently export surplus falls down. When total export earnings fall, balance of payments become
adverse.
9.
Demonstration Effect: Nurkse is of the opinion that people of underdeveloped countries try to imitate the consumption
pattern of the people of developed countries. On account of this demonstration effect, their imports: increase to a large
extent and cause disequilibrium in balance of payments.
Political Factors
In addition to economic factors, there are political factors also accounting for disequilibrium in balance of payments. The main
political factors are:
1.
Political Instability: Political instability of the country may also have an adverse affect on the balance of payments of a
country.
2.
International Relation: International relations of a country may be cordial, hostile or full of tension. These may have
either a favourable or unfavourable effect of the balance of payments of a country.
3.
Partition or Unification of country: Partition or unification of a country may have an unfavourable or favourable effects
on the balance of payments of a country. India and Pakistan, disintegrated USSR and divided Yugoslavia are the instances
of partitioned economies whereas Germany is an example of an unified economy.
4.
Expansion of Embassies: Expansion of embassies abroad and large expenditure on their maintenance tantamount to
imports and so turn the balance of payments of a country unfavourable.
Natural Factors
The natural conditions of a country are another cause of disequilibrium in balance of payments. Disequilibrium in balance of
payments can also occur in the event of war or fear of war with some other country. The fear of war may be because the
country may be surrounded by enemy countries.
4.3.3 Consequences or Effects of Unfavourable Balance of Payments

Continuously adverse balance of payments leads to the following consequences:
1.
Pace of economic development of the country slows down.
2.
Foreign dependence sometimes assumes the form of political dependence.
3.
Economic dependence of the country on foreign countries increases.
4.
It lowers the international economic credibility of the country.
5.
Country's economy is subjected to exploitation.
6.
Foreign exchange reserves of the country are depleted.
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7.
Reserves of gold and other precious metals go down as the same flow out of the country.
8.
Foreign interference in country's economic, social and political spheres goes on increasing.
4.3.4 Measures to Correct Adverse Balance of Payments

Adverse balance of payments of a country for a long period is always harmful for that country's sustained economic
development. Hence it is essential to bring back the equilibrium. Classical economists were of the opinion that the adjustment
is brought about automatically through price and income changes. However, no nation can afford to wait for the automatic
adjustment. Rather, certain policy measures are immediately taken for the necessary correction. The measures that are
generally taken may be classified in two parts.
Monetary Measures
The following monetary measures are generally taken for the correction of adverse balance of payments:
1.
Deflation: Deflation refers to that monetary policy under which the volume of currency in the country is reduced, so that
prices and monetary income of the people are brought down. The central bank of the country contracts the volume of
credit in the economy by raising the bank rate, open market operation and other quantitative and qualitative methods of
credit control. All these measures bring down the prices and monetary income of the people. Fall in domestic prices
stimulates exports and reduction in money income of the people discourages imports. Thus, adverse balance of payment
is corrected.
2.
Adjustment through Exchange Depreciation (Price Effect): Under flexible exchange rates, the disequilibrium in the balance
of payments is automatically solved by the forces of demand and supply for foreign exchange. An exchange rate is the
price of currency which is determined, like any other commodity, by demand and supply. This is automatically achieved
by depreciation of a country's currency in case of deficit in its balance of payments. Depreciation of a currency means that
its relative value decreases. Depreciation has the effect of encouraging exports and discouraging imports. When exchange
depreciation takes place, foreign prices are translated into domestic prices. Suppose the dollar depreciates in relation to
the rupee. It means that the price of dollar falls in relation to the rupee in the foreign exchange market. This leads to the
lowering of the prices of U.S. exports in India and raising of the prices of Indian imports in the U.S. When import prices
are higher in the U.S., the Americans will purchase less goods from the Indians. On the other hand, lower prices of U.S.
exports will increase exports and diminish imports, thereby bringing equilibrium in the balance of payments.
3.
Exchange Controls: To correct disequilibrium in the balance of payments, the government also adopts direct controls
which aim at limiting the volume of imports. The government restricts the import of undesirable or unimportant items by
levying heavy import duties, fixation of quotas, etc. At the same time, it may allow imports of essential goods duty-free or
at lower import duties, or fix liberal import quotas for them. For instance, the government may allow free entry of capital
goods, but impose heavy import duties on luxuries. Import quotas are also fixed and the importers are required to take
licenses from the authorities in order to import certain essential commodities in fixed quantities. In these ways, imports
are reduced in order to correct an adverse balance of payments. The government also imposes exchange controls.
Exchange controls have a dual purpose. They restrict imports and also control and regulate the foreign exchange. With
reduction in imports and control of foreign exchange, visible and invisible imports are reduced. Consequently, an adverse
balance of payment is corrected.
4.
Adjustment through Capital Movements: A country can use capital imports to correct a deficit in its balance of payments.
A deficit can be financed by capital inflows. When capital is perfectly mobile within countries, a small rise in the domestic
rate of interest brings a large inflow of capital. The balance of payments is said to be in equilibrium when the domestic
interest rate equals the world rate. If the domestic interest rate is higher than the world rate, there will be capital inflows
and the balance of payments deficit is corrected.
5.
Devaluation or Expenditure Switching Policy: Devaluation raises the domestic price of imports and reduces the foreign
price of exports of a country devaluing its currency in relation to the currency of another country. Devaluation is referred
to as expenditure switching policy because it switches expenditure from imported to domestic goods and services. When
a country devalues its currency, the price of foreign currency increases which makes imports clearer and exports cheaper.
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This causes expenditures to be switched from foreign to domestic goods as the country's exports rise and the country
produces more to meet the domestic and foreign demand for goods with reduction imports. Consequently the balance of
payments deficit is eliminated. However it must be noted that devaluation is a conditional remedy. It is successful only if
price elasticity of demand for exports and imports is greater than one.
6.
External Debts: The government can also secure loans from abroad or international agencies correct its balance of
payments position. Foreign loans constitute a credit item and help the country correct its balance of payments.
Non-Monetary Measures
These measures are as follows:
1.
Stimulation of Exports and Import Substitutes: A deficit in the balance of payments can also be corrected by encouraging
exports. Exports can be encouraged by producing quality products, by reducing exports through increased production
and productivity, and by better marketing. They can also be increased by a policy of import substitution. It means that the
country produces those goods which it imports. In the beginning, imports are reduced but in the long run, exports of such
goods start. An increase in exports causes the national income to rise by many times through the operation of the foreign
trade multiplier. The foreign trade multiplier expresses the change in income caused by change in exports. Ultimately, the
deficit in the balance of payments is removed when exports rise faster than imports.
2.
Encouragement to Foreign Investment: Investment of foreign capital in the country constitutes a credit item and so has a
favourable effect on the balance of payments position. Foreign investment can be attracted by offering different kinds of
incentives and concessions.
3.
Attraction to Foreign Tourists: In order to attract tourists, the government has to develop recreation parks and
entertainment programmes. Foreign tourists bring along with them large amount of foreign currency which serves the
same purpose as exports.
4.
Expenditure-Reducing Policies: A deficit in the balance of payments implies an excess of expenditure over income. To
correct this, expenditure and income should be brought into equality. For this, expenditure-reducing monetary and fiscal
policies are used. A contractionary or tight monetary policy relates to cut in interest rates to reduce money supply and a
contractionary fiscal policy relates reduction in government expenditure and or increase in taxes. Thus, expenditurereducing policies reduce aggregate demand through higher taxes and interest rates, thereby reducing expenditure and
output. The reduction in expenditure and output in turn, reduces the domestic price level. This gives rise to switching of
expenditure from foreign to domestic goods. Consequently, the country's imports are reduced and the balance of
payments deficit is corrected.
5.
International Measures: Formation of new regional or international alliances or market organisations or participation in
the existing organisation can help reduce adverse balance of payments. SAARC, NAM, EEC, WTO, UNCTAD, etc. and the
examples of such alliances.
6.
Social Measures: Balance of payments can be corrected through the medium of social psychology. For instance,
awakening of swadeshi spirit had adversely affected the balance of payments of British India. Presently, import of petrol
and petroleum products is one of the major causes of adverse balance of payments of India. If social awareness is aroused
among the people to make economical use of petrol, it will have a salutary effect on the balance of payments. Similarly,
social psychology can also be made use of in other fields for correcting adverse balance of payments. For example, Lal
Bahadur Shastri, ex-Prime Minister of India, solved the food problem by exhorting the country men to forgo meals on
every Monday. Presently, if people do not ply their vehicles on any weekday, the problem of petrol can be solved.
7.
Political Measures: In order to correct an adverse balance of payments, some political measures can also be taken.
Political measures can be as under:
(a) Less Expenses on Embassies: This will save foreign exchange and help improve country's balance of payments.
(b) End of Political Alliances: Many independent sovereign countries make a political alliance to form one united country
on the basis of mutual agreement. The former USSR is an example in this respect. The disintegration of the USSR
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should serve a lesson to those countries which are still a victim of such political alliances, and they should become
independent sovereign states. As an independent entity, a country can take necessary measures to correct its adverse
(c) Political and Administrative Thriftiness: Economy should be exercised in political and administrative matters. All nonessential foreign trips should be banned and the foreign exchange, thus, saved be utilized to correct the adverse
(d) Participation of Non-Residents: Citizens of developing countries who reside in other developed countries are mostly
prosperous economically. If they are convinced to return to the country of their origin or are encouraged to
collaborate with indigenous firms and industries, they will bring in lot of foreign exchange that can be used to correct
adverse balance of payments.
(e) Changes in Basic Political Ideology: Changes in basic political ideologies like socialism, capitalism, nationalism etc. also
help correct an adverse balance of payments. Change-over from a socialistic pattern to a free market economy by the
USSR and other socialist countries, the present liberal industrial policy of India, are instances of changes in basic
political ideologies.

1.
A country may have balanced balance of trade when the total value of the goods exported by it is equal to the
total value of the goods imported by it.
2.
Balance of trade is a statement of account pertaining to a given period of time, usually, one year.
3.
A country's total receipts and payments are known from its balance of trade.
4.
Investment income is an invisible item in the balance of payments.
5.
Disequilibrium caused by trade cycles is called structural disequilibrium.
4.4 Adjustments for Equilibrium in BOP

Disequilibrium in balance of payments can be corrected through expenditure policies or through devaluation.
4.4.1 Balance of Payments Adjustment through Expenditure Policy

Disequilibrium in balance of payments can also be corrected by the expenditure policies which are of two types:
1.
Expenditure Reduction Policy: In order to reduce imports, the government should impose taxes so that overall
expenditure would fall. Fall in expenditure would mean the fall in imports.
2.
Expenditure Switching Policy: The government should adopt such a policy which encourages the people to switch their
expenditure from foreign goods and domestic goods. This can be possible by import restrictions and devaluation.
Policy of Exchange Control

In order to remove balance of payment deficit, the government can adopt the exchange control policy. In this all the exports
producers will have to deposit their foreign currencies under the Central Bank's control. The Bank will distribute the foreign
exchange on the basis of priority, which means it will not supply foreign exchange for unnecessary imports so that imports
would fall and balance of payments would be corrected.
Absorption Approach
Keynes suggested this approach to remove disequilibrium in balance of payments. The absorption approach was developed
by Sydney Alexander according to him, "The traditional micro approach was deficient as it overlooked the income effect of devaluation.
94
Devaluation can affect domestic consumption, investment and government spending. The absorption approach stresses precisely on that."
This approach is shown below:
Y = C + I + G + (X M)
X M = Y (C + I + G)
B= YA
(B is Balance of Payments and Y-A is the sum of C+I+G which is known as absorption)
B = Y A
It means changes in balance of payments are equal to excess of change in Y over absorption.
There are two possibilities in this approach
1.
If there is less than full employment: Then the balance of payments can be improved by increasing income over
absorption as is shown
Equilibrium condition would be
X+I=S+M
XI=SI
Given a fixed level of exports and a linear import function, X-M will slope downward. Given the fixed level of I and a
linear saving function, the line S-I will slope upward. These two curves will intersect at the point which would be the
point of equilibrium. In the Figure 4.1, equilibrium income is Y0 as X-M is equal to S-I at point E.
Figure 4.1: Balance of Payments Adjustment through Absorption ApproachState of Less than Full Employment Level
OB is balance of payments deficit. Now government should adopt such a policy that exports increase and imports fall so
that (X-M) shifts to right to (X-M)1. Now the balance of payments deficit is corrected with a rise in income from Y0 to Y1.
J.M. Keynes suggests the following action plan to correct deficit balance of payments. Absorption in the form of C, I,
government expenditure and net exports (X-M) should be increased. For this, the policy of devaluation should be adopted
that encourages exports and reduces imports.
2.
When there is state of full employment: If there is full employment, any improvement in balance of payments must be
secured through reduction in absorption:
in equilibrium
B = Y A
...1
at full employment
Y = O
Improvement in balance of payments = O DA i.e., absorption should be reduced.
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Figure 4.2: Balance of Payments Adjustment through Absorption ApproachState of Full Employment Level
In Figure 4.2, at full employment income Yf, balance of payments deficit is OB. Deflationary policy will cause an upward
shift in (S-I), which shifts to left. But this would reduce income level OY1. If then (X-M) line would shift to right to (X-M),
which means unemployment is removed and there may be surplus balance of payments OB1 at E1.
Thus the policies suggested above to check balance of payments disequilibrium, especially to check deficit balance of
payments, are to be adopted with great care as they involve different policy implications. The use of a particular policy
depends upon the circumstances in the economy.
4.4.2 Impact of Devaluation on Balance of Payments

Devaluation is a practice of reducing external value of domestic currency, thereby making our exports cheaper and imports
costlier, so that finally exports increase and imports fall. In this process adverse balance of payments stands corrected. Even
the advanced countries, including the USA, UK, France, Germany and Japan have resorted this measure.
The immediate effect of devaluation is an increase in exports and reduction in imports so that the B/P deficit in reduced or
completely eliminated. The achievement of B/P equilibrium through devaluation can be explained by the Figure 4.3.
Figure 4.3: Balance of Payments Adjustment through Devaluation
In Figure 4.3, (X-M) is the net exports or B/P function if changes inversely with income. (I-S) is the net investment function
which varies directly with the level of income. Initially equilibrium is determined at the intersection (X-M) & (I-S) at point E.
The equilibrium level of income is Y0 but there exists B/P deficit of the order of OB. Now devaluation of the home currency
will raise exports and reduce imports so that (X-M) will shift upward to (X-M)1 and (I-S) function remains the same. Hence
income increases from YO to Y1 and B/P deficit is completely removed.
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Devaluation, a monetary measure to correct an adverse balance of payments, however, is a conditional remedy. It is successful
only if the following conditions are satisfied.
1.
Prices of Exports Should Not Rise: A country can achieve its objective of balancing the balance of payments by means of
devaluation only if the prices of export goods do not increase. If prices of export goods rise, in the wake of devaluation,
the possibility of increase in exports becomes remote because export goods will no longer be cheap in the foreign
countries. Consequently, exports will not increase, nor an adverse balance of payments become favourable. It, therefore,
becomes incumbent on the government to adopt and strictly enforce price control policy in the country.
2.
Larger Production of Export Goods and Possibility of Import Substitution: Devaluation can be profitable if large quantity
of export goods is available. In other words, production in the country must be large. Besides, the country resorting to
devaluation should have bright prospects of import, substitution. If there is no possibility of import substitution, imports
will not fall even after devaluation. In that event, devaluation will not serve its purpose.
3.
International Cooperation: Devaluation can succeed if other countries of the world cooperate with the country resorting
to it. Other countries should not devalue their respective currencies nor should they increase import duties or impose
restrictions on the goods coming from the country that devalued its currency.
4.
Elasticity of Demand for Exports Should be Greater Than One: Demand for the exports of the country devaluing its
currency should be highly elastic in foreign countries. It implies that fall in the price of exported goods in terms of dollars
will be followed by more than proportionate increase in their demand. Consequently, devaluation will be marked by
exports of larger value. On the contrary, if the demand for exports is less elastic in foreign countries, devaluation will
result into smaller value of exports and devaluation will fail to achieve its objective. It can be explained in Figure 4.4
and 4.5.
Figure 4.4: Impact of Devaluation on Exports when Edx > 1
Value of exports after devaluation>

value of exports before devaluation.
(OP1E1Q1>OPEQ)
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Figure 4.5: Impact of Devaluation on Exports when Edx<1
Value of exports after devaluation<

value of exports before devaluation.
(OP1E1Q1<OPEQ)
Figure 4.4 shows DxDx as highly elastic demand for exports (Edx > l). After devaluation, demand for exports increases to
OQ1 and total export value is OP1El Q1. In this case, we find that the total export value OP1El Ql is larger than the total
expert value OPEQ before devaluation. It can therefore be concluded that if demand for exports is elastic, devaluation will
prove beneficial to the country concerned.
Figure 4.5 shows that DxDx is less elastic demand for exports (Edx < l). Inelastic demand curve DxDx shows that at OP
price, demand for exports will be OQ. The total value of exports will thus be OPEQ. After devaluation, Indian exports will
become cheaper in terms of dollars and their price will fall to OP. At the new price OP1 demand for exports increase to
OQl and total value of exports will be OP1E1Ql. Thus we find that the total value of OPl El Q1 after devaluation will be
smaller than the total export value OPEQ before devaluation. Consequently, devaluation will not achieve its objective.
5.
Elasticity of Demand for Imports should be Greater than One: Devaluation can correct adverse balance of payments only
if the demand for imports will be highly elastic. On account of devaluation, imports will become dearer and hence their
demand will contract considerably. It can be explained with the help of the following Figure 4.6 and 4.7.
Figure 4.6: Impact of Devaluation on Imports when Edm > 1
Value of imports after devaluation>

value of imports before devaluation
(OP1E1Q1<OPEQ)
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Figure 4.7: Impact of Devaluation on Imports when Edm<1
Value of imports after devaluation<

value of imports before devaluation
(OP1E1Q1>OPEQ)
Figure 4.6 shows that DMDM is more elastic demand for imports. PSM is the supply curve prior to devaluation. Prior to
devaluation, price of imported goods is OP and quantity of imports is OQ. Thus, the total value of imports is OQEP. After
devaluation, the price of imported goods will increase in terms of rupees in the same proportion as devaluation.
Hence, price of the imports will rise to OP1. Consequently, quantity of imports will fall to OQ1 as is evident from demand
curve DMDM and total value of imports will be equal to OP1E1Ql. Thus before devaluation, the total value of imports was
OPEQ and after devaluation the same is reduced to OP1E1Q1. In other words, the total value of imports after devaluation
will go down, because OP1E1Q1 is less than OPEQ. Hence, the devaluation is successful in reducing the total value of
imports when price elasticity of imports is greater than one (>1).
Figure 4.7 shows that demand for imports is less elastic (Edm <1). In this case, total demand of imports will come down to
OQ1 and total value of imports will be OP1E1Ql whereas before devaluation it was OPEQ. It is evident from the figure that
area of OP1E1Q1 is larger than, OPEQ, which means that total value of imports after devaluation will be more than before
devaluation. Thus, in the event of inelastic or less elastic demand for imports, the total value of imports will not fall and as
such, devaluation will not succeed in its objective.
6.
When Supply of Exports and that of Imports is Perfectly Inelastic (Ex+Em=0): In this case if the Country devalues, it will
still be possible for the devaluing country to improve her balance of payments, since the price of her exports in terms of
domestic currency rises by the full amount of devaluation and the price of her imports in terms of domestic currency fails
to rise. This situation results in the devaluing country receiving larger quantities of imports in exchange for the same
quantity of exports or receiving same flow of imports for a lesser quantity of exports. This is shown through Figure 4.8
and 4.9.
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Figure 4.8: Impact of Devaluation when Ex = 0
In Figure 4.8, the demand and supply of imports are measured along the horizontal scale and the price expressed in terms
of the home currency is measured along the vertical scale. We assume that India devalues her currency. Since the supply
of exports is perfectly inelastic, the price of exports in term of rupees will rise by the full extent of devaluation such that
the price rises from r0 to r1. In spite of a rise in domestic prices of exports, country's exports still remain unaffected. This
implies that the demand for Indian goods by the foreigners has actually undergone an increase reflected by a shift in the
demand function of exports from Dx to Dx1. The total payments received by India after devaluation are OX0S1r1 which
exceed the receipts before devaluation, i.e., OX0S0r0 by r0S0S1r1. The amount r0S0S1r1 represents the net gain due to
devaluation.
Figure 4.9: Perfectly Inelastic Supply of Imports
The supply of imports too being perfectly inelastic, as shown in Figure 4.9 the foreign exporters will have to reduce the
prices of their own products in their own currency with the intention of preventing the demand for their goods from
declining. The domestic prices of imports in India will, therefore, remain the same. As a result, the imports from other
countries will also remain unchanged at M0 and the total payments which India will have to make in exchange for her
imports remain equal to OM0S0r0 even after devaluation. Since the receipts have gone up by r0S0S1r1, in Figure 4.9 the net
gain due to devaluation in equal to r0S0S1r1.
Marshall-Lerner Conditions
The above analysis related to the effect of elasticities of demand and supply upon the balance of payments adjustment through
devaluation was too general. It is necessary to be more specific in order to predict the effects of devaluation upon the BOP
situation. In this connection, Marshall-Lerner Conditions can be used. The Marshall-Lerner Conditions can specify the
situations in which devaluation can successfully improve the balance of trade and payments. These conditions are mentioned
below:
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1.
If the sum of elasticities of demand for export and imports is greater than unity, devaluation will improve the balance of
payments (i.e., reduce deficit).
2.
If the sum of these elasticity coefficients is equal to unity, devaluation will leave the balance of trade or payments
unchanged.
3.
If the sum of these elasticity coefficients is less than unity, devaluation can cause the worsening of the balance of
payments (i.e., increase deficit).
The Marshall-Lerner conditions rest upon a fundamental assumption that the supply of export and imports is perfectly elastic.
In actual reality, elasticity of supply coefficients do not have the limiting value. In such situations, nothing can be said offhand
i.e., whether the payments position, consequent upon devaluation, will improve or get worsened. The net change in the
balance of payments due to a given change in the rate of foreign exchange has been expressed by L.A. Metzler through the
following equation:
(1 + e x + e m ) + e x e m ( x + m 1)
dB
= k x m
d
( x + e x )( m + e x )
dp and dB denote the change in foreign exchange rate and a change in the balance of payments respectively and k denotes the
devaluation of currency in terms of percentages.
x and m refer to the price elasticities of demand for exports and imports respectively.
ex and em refer to price elasticities of supply of exports and imports respectively.
We have studied above the two limiting cases. Metzler's comments about these cases are:
"If exports are produced under constant supply prices, as they are for many manufactured products, both ex and em are infinities, and
elasticity on the balance of payments becomes =1. The minimum requirement for stability in this case is, therefore, that the sum of the two
demand activities shall exceed unity. At the other extreme, where the supply of exports and imports is completely inelastic, as it is in the
short run for certain agriculture products, the elasticity of the balance of payments is always positive and has a value of unity, regardless of
the demand elasticities. Under such conditions, devaluation always improves a country's balance of payments, no matter how elastic the
demand for imports may be."
Between these two extremes, lower the coefficients of elasticities of demand for imports and exports, which are likely to be in
the short run, brighter are the chances of improving the balance of payments through devaluation. If the elasticities of supply
of exports and imports too are low, the balance of payments can be improved still more quickly.
Critical Remarks
Marshall-Lerner conditions/elasticity approach have been criticised on the following grounds:
1.
Unrealistic to assume perfectly elastic supply of exports and imports.
2.
Approach fails to consider the effect of devaluation upon capital movements.
3.
Unrealistic assumptions of full employment of resources, stable prices and incomes.
4.
This approach overlooks the income redistribution effect of devaluation.
As a matter of fact despite theoretical deficiencies in the elasticity approach and Marshall-Lerner conditions, it was found
empirically valid in the industrial countries.
4.5 Exchange Rate

The term "foreign exchange" means one or more foreign currencies. Correspondingly, the term "foreign exchange reserves" of a
country means funds held by it in the form of "foreign exchange".
There are different interpretations of the term foreign exchange, of which the following two are most important and common:
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1.
According to Dr. Paul Einzig, foreign exchange is the system or process of converting one national currency into another, and of
transferring money from one country to another.
2.
Secondly, the term foreign exchange is used to refer to foreign currencies. For example, the Foreign Exchange
Management Act (FEMA) defines, foreign exchange as foreign currency and includes all deposits, credits and balance payable in
any foreign currency and any drafts, traveller's cheques, letters of credits and bills of exchange drawn by banks, institutions or
persons outside India but payable in Indian currency.
The foreign exchange market refers to the organizational setting within which individuals, businesses, governments, and
banks buy and sell foreign currencies and other debt instruments. Only a small fraction of daily transactions in foreign
exchange actually involve trading of currency. Most foreign exchange transactions involve the transfer of bank deposits.
The foreign exchange market is by far the largest and most liquid market in the world. The estimated worldwide amount of
foreign exchange transactions is around $1.5 trillion a day. Individual trades of $200 million to $500 million are not
uncommon. Quoted prices change as often as 20 times a minute. It has been estimated that the world's most active exchange
rates can change up to 18,000 times during a single day.
Not all currencies are traded on foreign exchange markets. Currencies that are not traded are avoided for reasons ranging
from political instability to economic uncertainty. Sometimes a country's currency is not exchanged for the simple reason that
the country produces very few products of interest to other countries.
Three of the largest foreign exchange markets in the world are located in London, New York and Tokyo. Other major stock
exchanges are located at Paris and Zurich. Because foreign exchange dealers are in constant telephone and computer contact,
the market is very competitive.
The foreign exchange market opens on Monday morning which is still Sunday evening in New York. As the day progresses,
markets open in Tokyo, Frankfurt, London, Chicago, San Francisco, Mumbai and elsewhere. The foreign exchange market is a
round the clock operation.
4.5.1 Exchange Rate Theories

We are going to discuss two major theories proposed for exchange rate determination: Mint Parity Theory and Purchasing
Power Parity Theory.
Gold Standard Mint Parity Theory

Gold standard is a monetary system in which a country's government allows its currency unit to be freely converted into fixed
amounts of gold and vice versa. The exchange rate under the gold standard monetary system is determined by the economic
difference for an ounce of gold between two currencies. A nation on the gold-exchange standard is thus able to keep its
currency at parity with gold without having to maintain as large a gold reserve as is required under the gold standard.
The rate of exchange is determined by the demand and supply of foreign exchange. When the demand for foreign exchange is
exactly equal to its supply then the rate of exchange is said to be at par or there is said to be parity of exchange. But in actual
life, the demand for foreign exchange is seldom equal to its supply. Thus parity of exchange is a rare phenomenon. The actual
rate of exchange is either above or below the parity of exchange. It is very seldom that the actual rate of exchange coincides
with the parity of exchange.
The question now arises as to what extent can the actual rate of exchange rise or fall below the parity of exchange.
We can study the problem of the determination of the rate of exchange under four different types of situations:
1.
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When both the countries are either on gold standard or on the silver standard: To understand the determination of the
rate of exchange between the two countries on gold standard, we shall try to understand the meaning of the term 'mint
par of exchange'. The reason being that the rate of exchange between the two countries on the gold standard depends
upon the 'mint par of exchange'. The term 'mint par of exchange' means the mint rate at which the currencies of the two
countries can be exchanged with each other. Under the 'mint par exchange', the gold contents of the standard coins of the
two countries are evaluated and the rate of exchange between them is established. The 'mint par of exchange' in other
words, is that rate which establishes equality between the gold contents of the standard coins of the two countries. For
example, before the start of the First World War, the mint par of exchange between the UK and the USA was one pound
sterling equal to 4.866 dollars. What this implied was that one Pound Sterling contained in it much gold as was to be
found in 4.866 dollars. At that time, the Pound Sterling as well as the dollar was both made of gold or their values being
expressed in terms of gold. Thus, one American dollar contained in it 23.22 grains of fine gold while the pound sterling
had in it 113.0016 grains of fine gold. The mint par of exchange between the British pound and the American dollar was 1
pound sterling equal to 4.866 dollars.
But this did not mean that the actual rate of exchange between Britain and America was 1 pound sterling equal to 4.866
dollars. This was only the mint rate between these two countries. The actual rate of exchange could either be more or less
than the mint par of exchange. The actual rate of exchange between the two countries is determined by the balance of
payment. The rate of exchange keeps on changing time to time according to the favourableness or unfavourableness of the
balance of payments. But the changes in the rate of exchange takes place within two well defined limits. These limits are
known as the gold points - the upper gold point and the lower gold point.
The upper gold point is arrived at by adding the cost of transporting gold (from one country to another country) to the
existing mint par of exchange. There are no restrictions on the export of gold from the country on the gold standard.
Transporting gold from one country to another involves some expenditure or cost on the part of the exporter of gold.
Let us assume that the cost of transporting gold worth 1 pound from Britain to America is 0.020 cents. Now, if the
expenditure on the transport of gold is added to the mint parity the upper gold point would be: 4.866+0.020 = 4.886
dollars and the lower gold point would be: 4.866 - 0.020 = 4.846 dollars. Thus the rate of exchange between Britain and
America will keep on fluctuating between these two gold points. It shall neither rise above Pound1=4.886 dollars nor fall
below 1 pound = 4.846.
If the two countries impose restrictions on the import or export of gold, in that case, the rate of exchange may even cross
the gold points. For example, if America restricts the export of gold when its balance of payments is unfavourable, in such
a situation, the rate of exchange will exceed the upper gold point. The reason is that the demand for pounds will go on
increasing on account of imposition of restrictions on the export of gold from America. Hence the rate of exchange will
remain confined within the two gold points only if the two countries impose no restrictions of any kind on the import and
export of gold.
Hence our conclusion is that the rate of exchange between the two countries on the gold standard will remain within the
two gold points. This is shown in the following Figure 4.10.
Figure 4.10: Demand and Supply of Foreign Exchange
Mint Par of Exchange Approach: If at any time the rate of exchange crosses the gold points in any direction (upward or
downward), then in such a situation the disequilibrium in the balance of payments will soon be automatically corrected
through the import and export of gold. The rate of exchange shall one again be back to the limits fixed by the gold points.
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2.
When one country is on the gold standard while the other is on the silver standard: In such a situation, we shall have to
find out the quantity of fine gold contained in the standard coin of the country on gold standard. Along with that we have
to find out the total quantity of fine silver contained in the standard coin of the country on the silver standard. After that
we shall have to find out the gold value of the silver contents of the standard coin of that country. In actual practice, it is
not difficult to find out the gold value of the silver coins of the country on the silver standard, because the government of
that country invariably fixes under the law the gold value of the silver contents of its standard coin. Thus, by comparing
the gold values of the standard coins of the two countries we can easily arrive at the mint par of exchange between the
two countries. It becomes easier then to determine the rate of exchange between two countries after having found out the
mint parity of their currency units.
3.
When one country is on the gold standard and the other is on inconvertible paper currency: In such a situation the mint
parity between the two countries is determined by the quantity of gold which will be purchased by the currencies of the
two countries, taken individually. The gold value of the currency of the country on the gold standard is invariably
declared by the government. But the gold value of the currency of the country on invertible paper currency standard is
not fixed in terms of gold by the government of that country. The gold value of its currency keeps on changing from time
to time according to the situation prevalent in the market.
In earlier situations, the rate of exchange was governed by the gold points the upper as well as the lower gold points.
In other words, the fluctuations in the rate of exchange were confined to the limits set by the gold points. This, however, is
not possible in the present situation, the reason being that one country is on the gold standard while the other is on the
inconvertible paper currency.
The upper gold point or the gold export point can be fixed for the country on the gold standard. The reason is that the
export of gold from that country is permitted without any restrictions of any kind. Thus, the rate of exchange in the gold
standard country cannot rise above the upper gold point or the gold export point. Since the other country is on
inconvertible paper currency standard, it does not permit the export of gold to other countries on account of commercial
transactions. Consequently there is no lower limit (or the lower gold point) below which the rate of exchange cannot fall.
Thus, the changes in the rate of exchange of the country on the paper currency are governed by the demand and supply of
foreign currency.
Thus, it can be concluded that when one country is on the gold standard while the other is on inconvertible paper
currency standard, then the rate of exchange in the country on the gold standard cannot rise above the gold export point
but there is no lower limit below which it cannot fall.
4.
When both the countries are on inconvertible paper currency standard: The rate of exchange between two countries on
inconvertible paper currency standard is not governed by the gold points because the currencies of both the countries
have no link with any metal, gold or silver. As such, the rate of exchange between the two countries is determined by the
demand and supply of foreign exchange. The rate of exchange between the currencies of these is greatly influenced by
their purchasing power parity. If there are changes in the purchasing powers of currencies of the two countries, such
changes do influence the rate of exchange between them. Hence, it becomes necessary to estimate the purchasing powers
of the currencies of the two countries to determine the rate of exchange between them. In the short period, the rate of
exchange between these countries can either be less or more than the purchasing power parity.
But the rate of exchange has the tendency to coincide with the purchasing power parity in the long period.
Differences between determination of exchange rate under gold standard and paper currency standard:
z
The rate of exchange between two countries on the gold standard is determined by mint par of exchange. But the rate of
exchange between the two countries on inconvertible paper currency standard is determined by the purchasing power
parity of the currencies of the two currencies.
The rate of exchange between two countries on the gold standard is determined by the purchasing powers of their
currencies in terms of gold. But the rate of exchange between two countries on inconvertible paper currency standard is
determined by the purchasing powers of their currencies in terms of goods and services.
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The mint par of exchange between the two countries on the gold standard remains constant. But the purchasing power
parity between the two countries on inconvertible paper currency is subject to changes from time to time as a result of the
changes in the price levels of the two countries.
The change in the rate of exchange between the two countries on the gold standard remains confined to the gold points
whereas the rate of exchange between the two countries on inconvertible paper currency can rise above or fall below the
purchasing power parity.
Limitations
The mint parity theory suffers from some serious limitations even on analytical grounds. It projects an adjustment process
which is conceptually deficient and ignores some vital realities.
z
It is based on the assumption of a highly competitive market with elastic demands and supplies of traded items.
It ignores the fact of international capital flows which are in addition to and independent of trade flows. Such movements
can be in response to interest rate differences and investment opportunities and not motivated by small shifts in exchange
rate only. There is also the possibility of their becoming speculative in nature.
It also assumes complete flexibility of cost price structures of the trading economies as also the policy of laissez-faire on
the part of the authorities.
Mint parity theory is no longer applicable in the world of today. It retains its usefulness because it enables us to have an
insight into some of the fundamental forces at work in exchange markets.
Purchasing Power Parity Theory

According to the purchasing power parity theory, put forward by Gustav Cassel in the years following the First World War,
when the exchange rates are free to fluctuate, the rate of exchange between two currencies in the long run will be determined
by their respective purchasing powers. In the words of Cassel, "the rate of exchange between two currencies must stand essentially
on the quotient of the internal purchasing powers of these.
There are two versions of the PPP theory-absolute purchasing power parity theory and relative purchasing power parity
theory. According to the absolute purchasing power parity theory, the least complicated of the two, the bilateral exchange rate
is related to the differences in the level of prices between countries.
Absolute PPP: The absolute PPP theory is closely related to the law of one price which suggests that a product that is easily
and freely traded in a perfectly competitive global market should have the same price everywhere, once the prices at different
places are expressed in the same currency. The law of one price proposes that the price of the product measured in domestic
currency will be equated to the price of the product measured in the foreign currency through the current spot exchange rate.
Relative PPP: While absolute PPP theory is based on the absolute prices of goods in the two countries, the relative purchasing
power parity between two countries states that the percentage change in the bilateral exchange rate is equal to the difference in
the percentage change in the national price levels over any given period of time. In other words, while the absolute PPP is a
statement about absolute prices and exchange rate levels, the relative PPP is a statement about price and exchange rate
changes over time.
While the value of the unit of one currency in terms of another currency is determined at any particular time by the market
conditions of demand and supply, in the long run, that value is determined by the relative values of the two currencies as
indicated by their relative purchasing power over goods and services (in their respective countries). In other words, the rate of
exchange tends to rest at that point which expresses equality between the respective purchasing powers of the two currencies.
This point is called the purchasing power parity.
Effects of PPP Thus, according to the purchasing power parity (PPP) theory, the exchange rate between one currency and
another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent. For example, assume
that a particular bundle of goods in India costs ` 42.00 and the same in the US costs $1. Then the exchange rate will be in
equilibrium if the exchange rate is $1 = ` 42.00. Once the equilibrium is established, the market forces will operate to restore
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the equilibrium if there are some deviations. For example, if the exchange rate changes to $1 = ` 43.50 when the purchasing
powers of these currencies remain stable, dollar holders will convert dollars into rupees because, by doing so, they can save
` 1.50 when they purchase a commodity worth $1. This will increase the demand for the Indian currency and the supply of
dollars will increase in the foreign exchange market and eventually, the equilibrium rate of exchange will be re-established.
A change in the purchasing power of currencies will be reflected in their exchange rates. The index number of prices may be
made use of to determine the purchasing power parity. If there is a change in prices (i.e., the purchasing power of the
currencies), the new equilibrium rate of exchange can be found out by the following formula.
ER =
Er Pd
Pf
Where ER = Equilibrium exchange rate

Er = Exchange rate in the reference period
Pd = Domestic price index
Pf = Foreign country's price index
The purchasing power parity theory exposes some very important aspects of exchange rate determination.
1.
It indicates the relationship between the internal price levels and exchange rates.
2.
It explains the state of the trade of a country as well as the nature of its balance of payments at a particular time.
3.
Further, the theory is applicable, to some extent, to all sorts of monetary standards.
Comparison between Mint Par and Purchasing Power Parity Approach

Purchasing Power Parity Theory is better than Mint Par Theory because it is applicable to all type of monetary standards.
Besides, the foreign exchange rate fluctuations are not endless rather they are also kept within selling and floors. The
difference between the two approaches is that Purchasing Power Parity is moving par and the upper and lower limits are also
moving and not static. This is as evident from Figure 4.11.
Figure 4.11: Purchasing Power Parity Approach
LL Lower limit
UL Upper limit
PP Purchasing Power Parity (Moving Parity)
RE Market rate of exchange
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Although the PPP theory has certain strengths, it has a number of drawbacks too. The purchasing power parity theory is
subject to the following criticisms:
z
The theory makes use of the price index number to measure the changes in the equilibrium rate of exchange. Therefore,
the theory suffers from the various limitations of the price index number.
The composition of the national income varies in different countries and hence the types of goods and services included in
the index number may vary from country to country, rendering comparisons on the basis of such index numbers
unrealistic.
The quality of goods and services may vary from country to country. Comparison of prices without regard to the quality
is unrealistic.
The price index number may include the prices of products which are not internationally traded and hence the rate of
exchange calculated on the basis of such price indices cannot be realistic.
The theory is rendered further unrealistic by ignoring the cost of transportation in international trade.
Another very unrealistic assumption made by the theory is that international trade is free from all barriers.
The purchasing power parity theory ignores the effects of international capital movements on the foreign exchange
market. International capital movements may cause changes in the exchange rate. For example, if there is capital inflow to
India from the USA, the supply of the dollar and the demand for rupees increases in the foreign exchange market, causing
an appreciation in the value of the rupee and depreciation in the value of the dollar.
Another defect of the theory is that it ignores the impact of changes in the exchange rates on the prices. For example, if, as
a result of large capital inflows to India, Indian currency appreciates in terms of foreign currencies, Indian exports may
decline and as a result, the supply of goods in India may exceed the demand and may cause a fall in prices.
The theory does not explain the demand for the supply of foreign exchange. When the exchange rate is determined
largely by demand and supply conditions, any theory that does not pay adequate attention to these aspects proves to be
unsatisfactory.
The purchasing power parity theory starts with a given rate of exchange, but fails to explain how that particular rate of
exchange is arrived at. Thus, the theory only tells us how, with a given rate of exchange, changes in the purchasing
powers of two currencies affect the exchange rate.
The theory is based on the wrong assumption that the elasticity of demand for exports and imports is equal to unity i.e.,
this theory is valid only if the exports and imports change in the same proportion as the change in prices. But this is a very
rare occurrence.
No satisfactory explanation of short-term changes in exchange rates is provided by the theory.
The theory runs contrary to general experience. Critics point out that there has hardly been any case when the rate of
exchange between two currencies has been equivalent to the ratio of their purchasing powers.
Observers maintain that the applicability of the PPP theory is limited because exchange-rate movements are often caused
by news that, by its very nature, is unpredictable. Foreign-exchange rates have been seen to behave similarly in asset
markets (such as stock markets), which incorporate new information quickly and adjust their prices continuously.
However, purchasing power-parity calculations are based on commodity prices (such as the consumer price index), which
respond sluggishly to changing economic circumstances. To the extent that exchange rates respond quickly to new
information and commodity prices respond slowly, departures from the purchasing-power-parity theory will occur. Most
economists maintain that other factors are much more important than relative price levels for exchange-rate
determination in the short run.
107
4.5.2 Determinants of Exchange Rate

As in the case of any commodity, it is the market with its interplay of demand and supply of currencies that fixes the rates.
In the foreign exchange market the commodity is the foreign currency, i.e., the US dollar, Japanese yen, euro, Swiss francs,
pound sterling and a host of other currencies. The price of these currencies is called the exchange rate. The demand for and
supply of these currencies would determine the rate of exchange.
The importer of goods and services, people wanting to remit money abroad for whatever purpose, persons intending to travel
abroad and host of other people create a demand for a currency, which could be US dollars, pound sterling, etc. They need
these currencies since they have to make payment to overseas suppliers of goods and services. The supply is provided by
exporters, remittances by overseas Indians, etc., who have the concerned currency or would come in possession of the foreign
currency at a future date.
Demand and supply are not the only factors affecting exchange rate. Other factors affecting exchange rate determination are:
z
Balance of Payments: It is a record of the value of all transactions between residents of a country with outsiders. In other
words, it represents the demand for and supply of foreign exchange which will determine the value of the
currency/exchange rate. Exports both visible and invisible represent the supply side; imports both visible and invisible
create demand for the currency.
Inflation: This means rise in prices of the domestic commodities. With increase in price the exports may be affected, as it
will cease to be competitive. For example, if both India and the US experience 7% inflation, the rate of exchange will not
change. If on the other hand India has 15% inflation and the US has 5% inflation, then obviously the Indian rupee will
depreciate by 10% (that is 15-5).
Interest Rates: The interest rate has a great influence on short-term movement of capital. When the interest rate in a centre
rises it attracts funds from other centres. The result would be demand for those currency increases, hence it appreciates.
Money Supply: An increase in money supply in the country increases the supply of the currency in the foreign exchange
currency market and its value declines.
Political Factors: Political stability induces confidence in the investors and encourages capital inflows into the country.
This would strengthen the currency and would appreciate it. On the other hand, where the political situation is volatile,
there will be a flight of capital and the currency's value would decline and depreciate.
Market Sentiments: In the short-term, the exchange rate is affected mostly by the views of the market participants. If they
are buoyant about the market the currency will appreciate. For example, let us presume the market expects that the
balance of payment of India would be a deficit of ` 10,000 crores. But when the figures are released the deficit is larger, at
say ` 15,000 crores. This would immediately depress the rate of exchange of the rupee temporarily.
Technical Factors: Isolated large transactions can upset the market's ability to balance supply with demand for the
currency, which immediately results in the distortion of exchange rate. For example, whenever the big oil companies enter
the forex market for the purchase of US dollars for imports of oil into India, it depresses the value of rupee by
appreciating the value of the US dollar. Hence in order not to upset the market, US dollar is purchased right through the
month.
108

Fill in the blanks:
1.
In order to remove balance of payment deficit, the government can adopt the exchange . policy.
2.
The . refers to the organisational setting within which individuals, businesses, governments, and
banks buy and sell foreign currencies and other debt instruments.
3.
The exchange rate under the . monetary system is determined by the economic difference for an
ounce of gold between two currencies.
4.
The rate of exchange tends to rest at that point which expresses equality between the respective purchasing
powers of the two currencies. This is known as .
5.
. purchasing power parity between two countries states that the percentage change in the
bilateral exchange rate is equal to the difference in the percentage change in the national price levels over any
given period of time.
4.5.3 Fixed Rate vs. Floating Rate Systems

Most of the countries of the world would follow the floating rates of exchange. However, there are countries that follow fixed
rates of exchange too. When we refer to a fixed rate of exchange, we must understand that currencies today are no more based
on the gold standard. Thus, fixed rates mean maintaining the external value of a currency at a predetermined rate. When the
exchange rate differs from this level it is corrected through official intervention. The intervention in the markets helps in
correcting the excess demand or excess supply of a currency, thereby maintaining the fixed rate of exchange of the currency.
Floating rates or flexible rates refer to a system where the exchange rates are determined by the demand for and the supply of
foreign exchange in the market. The rates are free to fluctuate according to the changes in the demand and supply of the
currency concerned. Under floating rates, no par value of the currency is declared. Any disequilibrium in the balance of
payment position of the country is adjusted through changes in the exchange rate that take place automatically in the market.
Economists have always debated the issue of floating rates versus fixed rates with arguments for and against both the systems.
Both have their advantages and disadvantages.
Case for Fixed Exchange Rate

z
Promotion of International Trade: Stable exchange rates enable exporters and importers to know their receipts and
payment liability. This certainty helps in the promotion of international trade.
International Investments: International lenders are guided by a host of investment criteria, but the most important one is
the returns in terms of their home currency. Fixed rate of exchange ensures easy calculation of investment to be made and
the returns thereof. In this way, it encourages the flow of investments which are so very essential for development and
growth.
Inflation: Under the fixed exchange rate, inflation due to change in the rate is not possible, unlike in the flexible exchange
system.
Speculation: Stable exchange rates avoid the possibility of speculation.
Convenience: Traders and bankers favour a fixed exchange rate for its sheer convenience and safety. There is no sudden
movement to destabilize a commercial transaction.
Source of Economic Benefit: If rate of exchange is chosen by taking into account the relevant elasticities of demand and
supply of traded goods, it can be economical and beneficial.
109
Case for Floating Exchange Rate

z
Automatic Adjustment of Balance of Payments: Any deficit or surplus in the balance of payment would be automatically
reflected in the rate of exchange. There is no need for the authorities to take harsh steps to correct the balance of payment
position. The country in the long run would become competitive since it would take long-term measures to correct the
balance of payments disequilibrium.
Reserves: Since the rate is market-determined there is no need for the monetary authorities to hold reserves and bring in a
correction in the exchange rates. The market does it automatically.
Confidence: Any disequilibrium in the balance of payments is corrected automatically and immediately and thereby
prevents country from having persistent deficits. This inspires confidence of the international community.
Effectiveness of Monetary and Fiscal Policies: It increases effectiveness of monetary policy for domestic stability which
can be achieved with less forceful monetary and fiscal measures.
Thus, it can be observed that each of the systems has its own advantages and disadvantages. Neither system is good in its
extreme form. Most countries have adopted what is termed as a managed float, where exchange rates of major currencies are
floating subject to exchange control regulations to keep the exchange rate movement within limits.
Case Study
Exchange Rate Regime An Ever-changing Phenomenon
The expansion of world trade and commerce, and emergence of strong colonial powers, favored the adoption of gold
standard by economically strong countries of the world. To be on gold standard became a symbol of economic "strength
and stability. However, the system was not able to meet growing needs of liquidity generated by expanding domestic
economics and increasing world trade. Over time, it came under a great strain. During Inter- War period, an allpervasive global depression forced even some strong economies like the UK to go off gold standard. Some other
countries adopted the path of competitive exchange depreciation and multiple exchange rates. The ill-effects of this
chaotic situation were well recognized by all concerned.
At the end of the Second World War, leading countries of the world agreed to avoid such a chaotic situation by having
an orderly regime of fixed exchange rates which could be revised, if need, be, only occasionally and subject to certain
guidelines: IMF was given the overall responsibility of monitoring the entire system which came to be popularly known
as the Bretton Woods System.
However, the Bretton Woods System also could not cope with the dynamism and restructuring of the world economies
and collapsed in early 1970s. This yielded place to a long drawn phase of volatile exchange rates with varying degrees of
regulatory measures by the authorities. This phase, however, exhibited two overall trends:
1.
An increasing shift towards market-determined flexible (or free and floating) exchange rates; and
2.
Attempts towards forging regional monetary unions.
When Bretton Woods System collapsed in early 1970s, some European countries made successive attempts in forging
and improving an arrangement with the objective of stabilizing intra-European exchange rates while floating against
other currencies, particularly the US dollar. The system involves commitments of the member countries to the common
goal supported by various arrangements, such as, unlimited short-term credit facilities to each other by the central banks
of the member countries. Currently, there are several regional financial and monetary arrangements among developed
countries, none of them free from limitations. An excellent example of a successful monetary union is that of the
European Monetary Union which, having passed through several difficult phases, even succeeded in having a common
currency, Euro, by the end of 1990s.
Contd
110
Questions
1.
Why it is said that foreign exchange rate regime has been an ever changing phenomenon?
2.
Why did the system of gold standard collapse?
3.
What is Bretton Woods System? Why did this system collapse in early 1970s?
4.
What practice of foreign exchange management is adopted by European country after the failure of Bretton Wood's
system?
Source: Input from UNCTAD, UN Trade and Development Report, 2001.
4.6 Let us Sum up

Balance of Trade refers to the balance of difference between the value of total imports and export of visible material goods.
The Balance of Payments is a statistical account of the transactions between residents of one country and residents of the rest
of the world for a period of one year or fraction thereof.
BOP is divided into 3 accounts: capital account, current account and Official Settlement Account. The current account records
the net flow of goods, services and unilateral transfers; the capital account records the net flow of FDI in plant, equipment and
long-term, short-term portfolio (debt and equity) investment; and The Official Settlement Account measures changes in the
holdings of foreign currency, SDRs and gold by the central bank of a nation.
The BOP must always equal 0, i.e., balance since it is an accounting identity in a fixed exchange rate system.
When payments are larger than receipts in international transactions, it is called deficit balance of payments, but when receipts
are larger than payments, it is called surplus balance of payments.
Short-term disturbances like floods, crop failures, drought and so on may raise imports and reduce exports, and Increase in
income may lead to more imports and less exports lead to an imbalance in BOP.
Disequilibrium in balance of payments can be corrected through expenditure policies or through devaluation. Devaluation is a
practice of reducing external value of domestic currency, thereby making our exports cheaper and imports costlier, so that
finally exports increase and imports fall. In this process adverse balance of payments stands corrected.
The term "foreign exchange" means one or more foreign currencies. Correspondingly, the term "foreign exchange reserves" of
a country means funds held by it in the form of "foreign exchange".
Gold standard is a monetary system in which a country's government allows its currency unit to be freely converted into fixed
amounts of gold and vice versa. The exchange rate under the gold standard monetary system is determined by the economic
difference for an ounce of gold between two currencies.
The rate of exchange is determined by the demand and supply of foreign exchange. When the demand for foreign exchange is
exactly equal to its supply then the rate of exchange is said to be at par or there is said to be parity of exchange.
Purchasing-power parity theory is a theory which states that the exchange rate between one currency and another is in
equilibrium when their domestic purchasing powers at that rate of exchange are equivalent.
Fixed rates mean maintaining the external value of a currency at a predetermined rate. When the exchange rate differs from
this level it is corrected through official intervention. The intervention in the markets helps in correcting the excess demand or
excess supply of a currency, thereby maintaining the fixed rate of exchange of the currency.
Floating rates or flexible rates refer to a system where the exchange rates are determined by the demand for and the supply of
foreign exchange in the market.
111

Compare the items included in the Balance of Payments of India, China, USA, Brazil and Nigeria. After comparison, comment
on the international trade status of these countries.
4.8 Keywords
Balance of Payments: Record of all transactions made between one particular country and all other countries during
a specified period of time.
Devaluation: It means an official reduction in the external value of a currency vis--vis gold or other currencies.
Floating exchange Rate: A country's exchange rate regime where its currency is set by the foreign-exchange market through
supply and demand for that particular currency relative to other currencies.
Official Reserve Account: It measures the foreign currency and securities, held by the central bank and is used to balance the
payments from year to year.
Exchange rate: The value of one currency for the purpose of conversion to another.
Gold Standard: The system by which the value of a currency was defined in terms of gold, for which it could be exchanged.
Fixed exchange system: A country's exchange rate regime under which the government or central bank ties the official
exchange rate to another country's currency.
Floating rate system: A system in which currency exchange rate is determined by free market forces, rather than being fixed
by a government.

1.
What do you mean by Balance of Payments?
2.
Enumerate the principle items in the balance of payments of a country.
3.
"Balance of Payments always balances." Elucidate.
4.
Distinguish between balance of payments and balance of trade.
5.
What are the causes of an adverse balance of payments? Give suggestions to remove an unfavourable balance of payments?
6.
What is devaluation? Explain the impact of devaluation on balance of payments.
7.
If balance of payments is always balanced then why do we say that balance of payments is in disequilibrium?
8.
How is exchange rate determined under gold standard?
9.
Critically examine the Purchasing Power Parity Theory of exchange rate determination.
10. Contrast fixed rate and floating rate systems.

CYP 1
1.
True
2.
True
3.
False
4.
True
5.
False
112
CYP 2
1.
Control
2.
Exchange rate market
3.
Gold standard
4.
Purchasing Power Parity
5.
Relative

Carbaugh, Robert J., International Economics, Thomson Asia Pvt. Ltd., Singapore, 2004
Sodersten, BO and Reed, Geoffrey, International Economics, 3rd edition, Macmillan Press Ltd, London
113
Chapter 5: International Monetary System

Objectives
1.
The working of IMF and World Bank
2.
The causes of international debt crisis
3.
Significance and trends in FDI
4.
The concepts of international labour migration and technology transfer
Introduction
International monetary system refers to the rules and procedures by which different national currencies are exchanged for
each other in world trade. Such a system is necessary to define a common standard of value for the world's currencies. The
international monetary system is a topic that encompasses a wide range of issuesreserve currencies, exchange rates, capital
flows, and the global financial safety net, to name a few.
During the period of World War II (1939-1945), it was realized that economic development of all the countries of the world
was the only solution to attain stable peace and prosperity in the world. It was felt by the developed nations that poverty
anywhere is a threat to prosperity everywhere. As a result in the year 1944, a conference was held at Bretton Woods in the
USA which was attended by the representatives of 44 countries including India.
It was decided at the conference of Bretton Woods to set upon two financial institutions for the development of all countries of
the world. These two institutions were1.
International Monetary Fund (IMF)
2.
International Bank for Reconstruction and Development (IBRD) or the World Bank.
The logic behind setting up IMF was to stabilize exchange rates by facilitating the removal of temporary balance of payments
deficits. The objective of IBRD or World Bank was to reconstruct the war-ravaged economies and provide them the capital
necessary for the economic development of underdeveloped countries. The detailed analysis of these institutions is given as
under.
5.1 IMF and International Liquidity

A landmark in the history of world economic cooperation is the creation of International Monetary Fund, briefly called IMF.
The establishment of an International Monetary Fund was the outcome of a conference held at Bretton Woods (U.S.A.) in 1944.
The conference gave birth to the organisation IMF along with the IBRD.
The IMF came into existence in December 1945, and it announced its readiness to commence exchange transactions in March
1947. At present, the fund has 183 countries as its members. The main purposes for which the IMF was set up were to provide
exchange stability, temporary assistance to countries falling short of foreign exchange and international sponsoring of measure
for curing the fundamental causes of disequilibrium in balance of payments. The IMF is a pool of central bank reserves and
national currencies which are available to its members under certain conditions. It can be regarded as an extension of the
central bank reserves of the member countries.
5.1.1 Objectives of IMF

The main purposes of the Fund are:
z
114
Creation of International Monetary Co-operation: The first and foremost objective of the Fund is to promote international
monetary cooperation through a permanent institution.
Promotion of Balanced Growth of International Trade: The second important objective of the Fund is to facilitate the
expansion and balanced growth of international trade and to contribute thereby to the promotion and maintenance of
high levels of employment of the member countries.
Stability in Exchange Rate: It is also one of the main objectives of IMF. To promote exchange stability, to maintain orderly
exchange arrangements among members and to avoid competitive exchange depreciation.
Multilateral Payments Arrangement: The objective is to assist in the establishment of a multilateral system of payment in
respect of current transaction between members and in the elimination of foreign exchange restrictions which hamper the
growth of world trade.
To Correct Maladjustments in their Balance of Payments: The important objective is to provide confidence to members
by making the funds resources available to them under adequate safeguards. Thus, it provides them with the opportunity
to correct maladjustments in their balance of payments without resorting to measures destructive of national and
international prosperity. The IMF does not interfere in the internal economy of the member-countries in order to restore
equilibrium in their balance of payments.
To shorten the duration and lessen the degree of disequilibrium: The objective is to shorten the duration and lessen the
degree of disequilibrium in the international balance of payments of members.
Abolition of Exchange Restrictions: The Fund will try to remove all sorts of restrictions and controls on foreign exchange
imposed by the member countries.
Help in International Payments: The Fund will lend or sell to its member nations currencies of other countries. This
facilitates foreign exchange transactions among the members.
Aid to Member Countries during Emergency: The Fund aims at providing short-term monetary assistance to member
nations during emergency.
5.1.2 Membership
There are two types of members of the Fund:
1.
Original Members: All those countries whose representatives took part in Bretton Woods Conference and who agreed to
be the member of the Fund prior to 31st December, 1945, are called the original members of the Fund.
2.
Ordinary Members: All those who become its members subsequently are called ordinary members.
Any country can cease to be its member after giving a notice in writing to that effect. Fund can terminate the membership of
such a country as does not observe its rules. In 1947, the number of member-countries was 40; now there are 184 countries as
members.
Organization and Management

In order to manage the Fund, the following administrative boards have been set up:
1.
Board of Governors: It consists of one Governor and an Alternate Governor for each member country. It meets once a
year. It frames the policies of the Fund.
2.
Board of Directors: It conducts day-to-day affairs of the Fund. It consists of 21 directors, 7 of whom are permanent
directors and others temporary directors. Permanent directors belong to those countries that have the largest quotas in the
Fund. Currently, these countries are United States, Britain, France, Germany, Japan, Italy and Canada. 14 other directors
are elected by other member countries. India is one of the elected directors. The managing director may appoint 3 deputy
managing directors instead of one w.e.f. June 1994.
115
5.1.3 Capital Resources of the Fund

The capital resources of the Fund are subscribed by the various member-countries by way of their respective quotas. Each
member's quota is determined before its enrolment as a member.
These days, quota of each member is fixed in terms of SDRs. Each country has to give 25% of its quota amount in terms of
reserve assets, like SDRs or any other usable currency and 75% in terms of its own currency. A country's relations with the
Fund are determined by the amount of its quota. For example (a) voting powers of a member-country depends upon the
amount of its quota. Each country has 250 minimum votes. Besides, on each one lakh SDRs one vote is increased (b) the
maximum limit of the financial assistance from the fund by the member country to correct its balance of payments, depends
on the amount of its quota (c) share of a country in the allocation of SDRs depends on the amount of its quota. Changes in the
amount of quota of fund are made after every five years. In the beginning, total International Monetary Fund capital of the
fund was fixed at 880 crore dollars. The fund has made changes in the quotas of member-countries at different times. Quotas
of member-countries have been raised from time to time. In 2004, the fund raised the quota to 415.8 crore SDRs. Three things
are clear from the quota of a member country: (i) The share of a member country in the capital of the fund. (ii) The loan a
member-country can receive from the fund. (iii) The total number of votes that a member-country can cast. America has the
maximum quota. It constitutes 23% of the total capital of the fund.
In 2002, the fund has total holding of 228.1 billion dollars in the form of foreign exchange and SDRs from 153 membercountries.
5.1.4 Operational Strategy of the Fund

1.
Borrowing Strategy of the Fund: The Fund is an important financial institution besides performing regulatory and
consultative functions. The Fund's bulk financial resources come in the form of quota subscriptions from member
countries. Further, it can borrow from governments, Central Banks or private institutions of industrialized countries, the
Bank for International Settlements and even from OPEC countries, like Saudi Arabia.
General Agreements to Borrow (GAB): The Fund can borrow from its 11 industrialized members under GAB in order to
forestall or cope with an impairment of the international monetary system. The GAB remained in force from October 1962
to December 1998. At that time, its total borrowings were SDR 17 billion. Under the new arrangements of borrowing, the
developed countries have sanctioned $25 billion.
2.
Lending Strategy of the Fund: Under tranche policies, members may use the reserve tranche and the four credit tranches.
Three permanent facilities for specific purposes. The facility for compensatory financing of export fluctuations
(established in 1963 and liberalized in 1975 and 1979), the Buffer stock financing facility (established in 1969), and the
Extended Fund facility (established in 1974) and the structural adjustment facility (SAF) established in March, 1986 can
be accessed by the members. Lending by the Fund is made to members temporarily in disequilibrium in their balance of
payments on current accounts. If the currency of the member country falls below than its quota, the difference is called
reserve tranche. It can draw up to 25% on its reserve tranche automatically upon representation to the Fund for its balance
needs. The Fund does not charge any interest on such drawings. The borrowing is to be repaid by the borrowing country
within a period of 3 to 5 years.
3.
Credit Strategy of the Fund

(a) Credit Tranches: Further, a member country can draw up to 100% of balance quota in installments from credit
tranches. The borrowing member has to satisfy the Fund that the viable programme is being adopted to ensure
financial stability. It means the drawings from credit tranches are conditional. The Fund has gradually raised the limit
of borrowing by members to meet the severe balance of payment problems. Now a member can borrow up to 300% of
its new quotas on the total net use of the Fund's resources. Drawings made under CCFF, BSAF, SAF, STF and ESAF
are excluded from this limit of 300%.
(b) Other Credit Facilities: Several new credit facilities have been created by the Fund since 1960s. These credit facilities are
exclusive of borrowing made under credit tranches and these loans are available for a long period of time: These
credit facilities are:
116
Buffer Stock Financing Facility (BSFF): It was created in 1969. It was created for financing the commodity buffer
stock by member countries. A member can draw up to 30% of its quota under this head. The member has to
cooperate with the Fund in establishing prices of commodity within the country. Repurchases are made between
3 years and 5 years.
Extended Fund Facility (EFF): The facility was created in 1974. The credit under EFF is provided to meet their
balance of payments deficits. The amounts provided under EFF are larger than their quotas under normal credit
facilities. This facility is provided for a maximum period of 10 years. The amount of loan under EFF is allowed
up to 300% of member's quota. The sanction is based on performance criteria and drawings installments.
Supplementary Financing Facility (SFF): In 1977, another facility called SFF was created to provide
supplementary financing under extended or stand-by arrangements. The main purpose of it was to provide
Funds to member countries to meet serious balance of payments deficits which are large in relation to their
economies and their quotas. This facility was extended to low income developing member countries also. The
Fund established a Subsidy Account in 1980 to reduce the cost of borrowing under SFF to such low income
developing countries. Subsidy Account means an account through which Fund makes subsidy payment to
borrower countries.
Structural Adjustment Facility (SAF): It was established in March 1986. The main purpose of SAF was to provide
concessions to carry out medium term macroeconomic and structural adjustment programmes. The loans are
also granted to them to solve their balance of payments problems. The loans are made available to the poorer
countries on highly concessional terms. The rate of interest charged from them ranges between 0.5 to 1% and the
repayment period ranges between 5 to 10 years with a 5 year grace period. Disbursements are made on annual
basis and are linked to the approval of annual arrangements with members receiving equivalent to 15% of their
quota under the first, 20% under the second and 15% under the third annual arrangements. The SAF was created
with the resources of SDR 2.7 billion. The resources came mainly from repayments on loans from the Trust Fund.
Enhanced Structural Adjustment Facility (ESAF): The ESAF was created in December 1987 with SDR 6 billion of
resources. It was created to meet the medium-term financing needs of low income countries. The ESAF has same
objectives, eligibility and basic programmes as are of SAE. The only difference among both is of the amount of
assistance. The members can receive up to 100 percent of Quota over a 3 year programme period, with a
provision for up to 250% in exceptional circumstances. Disbursements under the ESAF are biannual instead of
annual.
Compensatory arid Contingency Financing Facility (CCFF): The CCFF was created in August 1988. The main
purpose of it was to provide timely compensation for temporary shortfalls or excesses in cereal import costs due
to factors beyond the control of the members. This facility was provided to a member to maintain the momentum
of Fund supported adjustment programmes. In 1990, the Fund introduced an important element temporarily up
to the end of 1991 to help members to come out of Gulf War Crisis. This was within 95% of quota for CCFF. It
was also decided to expand the coverage of CCFE. Now for the calculation of export shortfalls, workers'
remittances and travel receipts, shortfalls in other services such as receipts from pipelines, canals, shipping,
transportation, construction and insurance, etc., have also been included under compensatory financing.
Systematic Transformation Facility (STF): In April, 1993, STF was established with $6 billion to help Russia and
other Central Asian Republics to face balance of payments crisis.
Emergency Structural Adjustment Loans (ESAL): ESAL facility was established in early 1999 by the Fund to help
the Asian and Latin American countries which were suffering from financial crisis. The interest charged by the
Fund was 3% to 5% above the Fund's normal lending rates for short period.
Contingency Credit Line (CCL): In April 1999, CCL was created to protect fundamentally sound countries from
the contingency of financial crisis occurring in other countries. Those countries were considered eligible which
can finance medium-term BOP comfortably and enjoy financial stability and have strong debtor creditor
relations. No country has borrowed under this facility.
117
4.
Strategy Regarding Exchange Rates Policy: Members are under obligation to collaborate with the Fund and with others
members, as expressed in Article I of the Articles of Agreements, to assure orderly exchange arrangements and to
promote a stable system of exchange rates. The exchange rate policies are to be followed, as per the New Article IV of the
second amendment of the Articles, with its commitment to:
(a) Endeavour to direct its economic and financial policies toward the objective of fostering orderly economic growth
with reasonable price stability, with due regard to its circumstances;
(b) Seek to promote stability by fostering orderly underlying economic and financial conditions and a monetary system
that does not tend to produce erratic disruptions;
(c) Avoid manipulating exchange rate or the international monetary system in order to prevent effective balance of
payments adjustment or to gain an unfair competitive advantage over other members.
These three principles were given to oversee the compliance by each member of these obligations and to assure the
effective operation of the international monetary system. As per the Second Amendment these specific principles are
necessary to be adopted for the guidance of members regarding exchange rate policies.
These are enunciated as below:
(a) A member shall avoid manipulating exchange rates or the international monetary system in order to prevent effective
balance of payments adjustment or to gain an unfair competitive advantage over other members.
(b) A member should intervene in the exchange market if necessary to counter disorderly conditions which may be
characterized inter alia by disruptive short-term movements in the exchange value of its currency.
(c) Members should take into account in their intervention policies the interests of other member, including those of the
countries in whose currencies they intervene.
The original Fund Agreement provided that the par value of each member country was to be expressed in terms of gold of
certain weight and fineness or US dollars. The idea behind it was to create a system of stable exchange rate with orderly
cross rates. Later on, the Fund agreed to change in the exchange rates which did not exceed 1 per cent of the initial par
value. A further change of 1 per cent is allowed but with the permission of the Fund. These provisions were changed
from fixed exchange rates to flexible exchange rates in 1971. Now the Fund has no control over the exchange rate
adjustment policies of member countries. The member countries are not required to maintain and establish par values
with gold or dollar.
Any country can now change the par value of its currency by 10% after notifying the Fund. If a country was to make 20%
change in its par value, it must seek prior approval of the Fund. In such a case, the Fund has to communicate its decision
within 72 hours. In case of larger change than 20%, the Fund requires more time to take its decision. Such a decision is
taken by 2/3rd of the members. The Fund can also change, by a majority decision, par values of all countries by a given
proportion. If a member-country does not like this change, it must notify the Fund within 72 hours. A country can change
its par value only if it is faced with the problem of correcting "Fundamental disequilibrium" in its balance of payments
position.
5.
Other Facilities: The balance of payments, exchange rate problems and monetary and fiscal issues are the other issues on
which the IMF advises its member countries. The Fund has set up three departments to solve banking and fiscal problems
of member countries. These departments are:
(a) Central Banking Service Department: This department helps member countries with the services of its experts to
manage and run their central banks. These services are especially provided to developing countries for making
reforms in their banking system.
(b) Fiscal Affairs Department: This department is established to provide advice on fiscal matters of the member countries.
(c) IMF Institute: It conducts short-term training courses on the fiscal, monetary, banking and BOP policies for the
officers of the member countries.
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In addition to these, the Fund's research department publishes many reports in a year containing material relating to
different policy measures. The major publications are IMF Annual Report and IMF staff papers, Finance and Development
Journal, etc.
5.1.5 Main Functions of the Fund

From the above given brief account of the Fund, it can be seen that the Fund performs several major functions. The Fund deals
only with the central bank or the government of a country. It has no right to interfere with the economies of the membercountries. Main functions of the Fund are enumerated below. However, some of these functions are being modified:
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Determination of the Rate of Exchange by Every Country: When a country becomes member of the Fund, it has to declare
the par value of its currency in terms of dollar or gold. This facilitates multilateral convertibility of that currency.
Loan of Foreign Currency: If a country has an adverse balance of payments, the Fund gives foreign currency, required by
the said country, on loan at a fixed rate of exchange. It enables the country to discharge its foreign liability. Such loans are
of a short duration.
Restriction on Foreign Currency: The Fund buys and sells the currencies of the member-countries. Whenever a country
buys the currency of another country from the Fund, the latter makes it available by purchasing the same from the
country concerned, of which it constitutes the national currency. However, in anyone year a member-country can
purchase from the Fund foreign currency up to the maximum of 15% of its quota.
Bank of Central Banks: The Fund is called the bank of the central banks of different countries of the world. Just as a
central bank holds the cash reserves of the commercial banks of the country, the IMF also mobilizes resources of the
central banks of the member-countries.
Technical Assistance: The Fund also provides technical assistance to its member-countries. The Fund sends its experts on
deputation to member-countries to advise them on matters like exchange control, foreign payments, credit money, central
banking and economic policy etc. The Fund also publishes many technical journals and magazines.
Training: It also imparts short-term training courses to the representatives of member-countries. This training is imparted
to the senior officers of the central banks and finance departments. In 1975, a training centre was set up.
Facilities During Emergency: Although the IMF is opposed to any sort of controls either on foreign exchange or foreign
trade, yet member-countries have been given the right to resort to these controls during emergency in the hope that they
will lift it as early as the situation warranted.
It Serves as a Short-term Credit Institution: The Fund removes temporary difficulty of adverse BOP of any member
country. It is a second line of defense. It means that the member country will maintain its separate foreign exchange
reserves and the payments will be met out of these first and the balance will be given by Fund.
The Fund Provides a Mechanism for Improving Short-Term BOP Position: For this purpose, its rules provide for orderly
adjustment of exchange. A country can alter its rate of exchange when it feels that its rate of exchange is out of line with
its economy. But this alteration can be made after the due deliberations with the authorities of the Fund.
The Fund Provides Machinery for International Consultations: The Fund has provided the excellent opportunity to the
principal countries to sit together and reconcile their conflicting claims.
The Fund Promotes Exchange Stability by promoting orderly adjustments of exchange rates.
It provides the services of technical experts to member-countries to solve their balance of payments problem and other
related matters.
Thus, the Fund performs financial, supervisory and controlling functions.
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5.1.6 Special Drawing Rights (SDRs)

With effect from January 1, 1970, for increasing international liquidity IMF created a system of Special Drawing Rights (SDRs).
The SDRs are designed to supplement gold and the reserve currencies, viz. the pound and the dollar. The SDRs represent
entirely a new form of paper money which will serve as well as gold or dollar, and hence are called "Paper Gold". The value of
the SDR was initially defined as equivalent to 0.888671 grams of fine gold.
According to the system adopted w.e.f. January 1, 1989. The value of SDR is determined on the basis of the basket of five most widely
used currencies of member countries. These include the US Dollar, the British Pound, the French Franc, the German Mark and the
Japanese Yen. Till date, it is defined in terms of basket of these give currencies. Since 1991 the determination of value of SDR is
based according to the weightage of the currencies as under:
On March 14, 2008, US 1$ = SDR 1, SDR = 40.45
Features of SDR
Main features of SDR are as under:
1.
It has no backing of any fund. There is book entry only.
2.
IMF has opened a separate special account.
3.
It is a method of augmenting existing liquid funds and has resulted in increasing international liquidity.
4.
The number of shares a member-country holds in IMF, in the same proportion it has its share in SDR.
5.
SDR is used to meet unfavourable balance of payments as also to make up unexpected shortage of liquid funds. When an
exporting country advances its currency to importing country, SDRs of the said amount are credited into the account to
exporting country and debited to the account of importing country.
6.
Since January 1981, SDR is evaluated on the basis of basket of currencies of five nations. These five nations are the largest
exporters of the world. Since January 1, 1996 some changes have been effected in the weightage and value of one unit of
SDR, because there is a provision to effect change in weightage and value of SDR every five years. Whenever there is
change in the value of these currencies, there is corresponding change the value of one unit of SDR.
7.
The country which makes use of SDR, the volume of its reserve will go down and the country that provides foreign
exchange in lieu of SDR will find a rise in the accumulated of its SDRs. There is also provision of paying simple interest,
at the rate of 1.5%, on the quantum of SDRs of these countries.
Allocation of SDRs
The Fund allocates SDRs to participants in proportion to their quotas for various uses mentioned above. From 1970-72, initially
SDR $9.3 billion were created by the Fund. This holding continued till 1978. SDR $4 billion were raised in each of the years
1979, 1980 and 1981. As a result, the total holding of SDRs was $21.4 billion in 1981. Since 1981 no further allocation of SDRs
has been made by the Fund. At present, about 70% of SDRs are distributed among 26 rich countries and the remaining 30%
among developing countries. Consequent upon increase in the shares of member-countries of IMF in April 1998, the total
holding of SDR has gone up to 214 billion SDRs or 293 billion American dollars.
5.1.7 Evaluation of the Functioning of IMF

The IMF has been functioning for a long time. During this period it has achieved its objectives to a large extent and at the same
time its programmes have also been subjected to criticism.
Achievements
According to Halm, "Fund is like an International Reserve Bank". The Fund has performed the following significant functions to
attain its objectives:
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International Monetary Cooperation: One of the main objectives of the Fund was to present a forum where most of the
countries of the world may be able to solve their monetary problems by mutual cooperation. IMF has succeeded in
achieving this objective.
Reconstruction of European Countries: Because of the efforts of the Fund, rich countries like America gave liberal
economic assistance under Marshall Plan for the reconstruction of European countries. But for this Plan, war-devastated
European countries could not have been rehabilitated.
Multilateral Systems of Foreign Payments: At the time of the establishment of the Fund, almost all countries were
practising exchange control in one way or the other. There were many restrictions on foreign trade. The IMF has
succeeded in reducing the same and in establishing multilateral systems of foreign payments.
Increase in International Liquidity: Corresponding to increase in international trade, the Fund has succeeded in
increasing international liquidity. On the one hand, the Fund has increased its resources from 2920 cr. SDRs to 21,200 cr.,
SDRs; on the other it has created a new liquid asset in the form of SDR. As a result of it, international liquidity has
increased manifold.
Increase in International Trade: The Fund has succeeded in expanding the international trade and making it free from
restrictions to a large extent. It has rendered payments relating to international trade easy. By helping the countries
suffering from trade disequilibrium, it has promoted their trade. All this has resulted into expanding the value of world's
exports from 53 billion dollars in 1948 to more than 2,000 billion dollars at present.
Special Aid to Developing Countries: The Fund has done a special service to developing countries in finding a solution to
their problems. It has been actively helping them in correcting their unfavourable balance of payments and achieving
monetary stability. These countries have been receiving adequate assistance from the Fund in determining their monetary,
export-import and exchange policies. It has provided technical assistance to them besides imparting training to their
senior officers.
Helpful in Times of Difficulties: The Fund has come to the rescue of all member countries faced with economic crisis. On
account of hike in petrol prices many countries of the world experienced acute shortage of foreign exchange. In order to
ease this situation, it set up the Petrol Facility Fund.
Failures of the International Monetary Fund

The Fund has failed to achieve some of its objectives. Its chief failures are as under:
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Lack of Exchange Stability: The Fund has failed to achieve its main objective of exchange stability. It succeeded till 1971 in
maintaining Fixed Rate of Exchange. Thereafter, it became variable once again. Lack of stability in exchange rate has been
a major failure of the Fund.
Lack of Stability in the Price of Gold: Strenuous efforts were made by the Fund to bring stability in the price of gold but it
failed miserably. Up to 1971, the price of gold was kept stable at $35 per oz; but thereafter it could not remain stable and
rose to $1,500 per oz.
Inability to Remove Exchange Control: The Fund has failed to remove restrictions on foreign trade and control on foreign
exchange. Many countries of the world have resorted to policy of protection with greater vigour.
Rich Countries' Club: Critics say that the International Monetary Fund is a club of rich countries. It works at the behest of
rich countries like America, Britain etc. and helps their supporters. It pursues a policy of discrimination.
Charitable Institution: Other critics point out that it is a charitable institution whose main function is to provide the
resources of some rich countries to their supporter countries to enable them to correct disequilibrium in their balance of
payments. Such a help, instead of promoting their economic development, renders them more careless and increases their
foreign indebtedness.
No Solution of International Liquidity: The Fund is not a proper solution of international liquidity. Although the Fund
has considerably increased its permanent resources and helped in the creation of a new currency in the form of Special
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Drawing Right (SDRs), yet the problem of liquidity persists. Consequently, it will be difficult for the Fund to lend
resources to developing countries and help them tide over their balance of payments deficit.
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No Elimination of Multiple Exchange Rates: Another aim of the Fund was to eliminate multiple exchange rates but it has
not succeeded therein. Multiple exchange system refers to a system where in a country adopts different exchange rates for
different transactions. For instance in 1971, France had adopted two exchange rates, fixed exchange rate for genuine trade
transactions and flexible rate of exchange for speculative transactions.
Inability to Tackle the Monetary Crisis of August 1971: In the year 1971, a global monetary crisis triggered off when
America not only devalued its dollar but also stopped its convertibility into gold. The Fund failed to resolve this crisis.
Rather, due to this crisis the Fund had to bid good-bye to its objectives like the gold standard and fixed exchange rates. It
was the biggest failure of the Fund.
Discriminatory Policies: The major cause of criticism of the Fund is its discriminatory policies in favour of developed
countries and against the developing countries. The US and other developed countries dominated the Fund, although the
majority of its members are the developing countries. Generally, a rigid attitude regarding the grant of loans to
developing countries is adopted by the developed countries, especially by the United States.
It is evident from the above account that International Monetary Fund has largely failed to achieve its objectives. No wonder,
many countries are insisting on its re-organisation.
Future Directions
Prof. Anna Schwartz and Friedman have criticized the IMF for the global financial crisis and have pleaded for abolishing it.
Prof. Samuelson, on the other hand, has praised the working and achievements of IMF in his article Three Cheers for the IMF
published in 1997. Horst Kohler, the new Managing Director of the Fund himself admitted: "IMF is not a God that knows
everything". It means that there is a need to improve its' policies by the Fund.
The following measures for this purpose have been suggested at different economic forums:
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Contagion Effect: The IMF should make provision for giving financial help on concessional terms to those countries
which have a fear of contagious effect of the financial crisis of other countries.
Safety Net: The Fund should formulate a plan which acts as a safety net for countries during economic crisis.
Justifiable Global Trading System: The Fund should also establish a free global trading system which is proper and
justifiable towards developing countries.
Equitable Distribution of Voting Right: The voting rights should be equally distributed among participating countries.
For this purpose, the quota may be refixed.
Transparency: The loan practices should be changed by the Fund to increase transparency. For recovering the amount
quickly, the Fund should reduce the maturity period and in case of default, a penal interest rate should be charged.
Conditional Loans: The Fund should provide loans on such terms and conditions which make them able to increase their
internal resources and do self-financing for their economic programmes in the long run.
Macroeconomic Policies for Developed Countries: The IMF should formulate such macroeconomic policies for developed
countries that provide safety to the growth of world output and trade. They should act as highly effective safety net for
the global economy.
5.2 World Bank and International Economic Development

The International Bank for Reconstruction and Development (IBRD) popularly known as the World Bank owes its birth to the
deliberations of the United Nations Monetary and Financial Conference which met at Bretton Woods; New Hampshire. The
World Bank was established on 1 July 1944. The Headquarters of World Bank is in Washington D. C.
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The Second World War (1939-45) had completely dislocated the multilateral trade and had caused massive destruction of life
and property. While the need for promptly reconstructing the war damaged economies, it was also recognized that stable
world peace was threatened from the presence of great disparities in the standards of living between the developed and
underdeveloped countries. Thus, the World Bank was established.
5.2.1 Objectives of the World Bank

The main objectives of the World Bank are:
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Reconstruction and Development: The main objective of the bank was to reconstruct the war-devastated economies like
Britain, France and Holland etc. and to provide economic assistance to underdeveloped countries like India, Pakistan, Sri
Lanka, Burma etc.
Encouragement to Capital Investment: Another important objective of the Bank is to encourage private investors to invest
capital in underdeveloped countries, by means of guarantee of participation in loans and other investment made by
private investors and when private capital is not available on reasonable terms, to supplement private investment by
providing on suitable conditions finance for productive purposes out of its own capital, funds raised by it and its other
resources.
Encouragement to International Trade: The third objective of the Bank is to encourage international trade. It aims at
promoting long-range growth of international trade and maintenance of equilibrium in member's international balance of
payments, so that standard of living of the people of member-countries are raised.
Establishment of Peace Time Economy: The fourth objective of the Bank is to help the member-countries changeover from
war-time economy to peacetime economy.
Environmental Protection: Global environmental protection is also an objective of the Bank. To this end, the World Bank
gives substantial financial assistance to those underdeveloped countries which are engaged in the task of environmental
protection.
5.2.2 Membership of the World Bank and its Capital Structure

Any country that is a member of IMF is ipso facto a member of the Bank. The countries that accepted the membership of the
Fund on 31st December, 1945 were also treated the founder members of the World Bank. Countries becoming members of the
Bank subsequent to the above date had to secure 2/3rd votes of the then existing members of the Bank. At present, 184
countries are members of the Bank. A member can withdraw at any time its membership by giving a written notice. If a
country fails to observe the rules of the Bank, its membership can be terminated.
At the time of establishment, the authorized capital of the Bank was $1,000 crore divided into 1,00,000 shares of $1,00,000 each.
Every member-country had to pay 20% of his quota at the time of membership. Of it, 2% is in gold and the remaining 18% in
its own currency. The balance 80% of the capital subscription can be called by the Bank as and when required. The capital of
the World Bank has been increased from time to time with the concurrence of the member-countries. In the share of the capital
of the Bank, America has the first, Japan the second and India the eighth place. In the year, 2000, the capital of the Bank has
been further increased to $18,860 crore. The authorized capital of the Bank is $19,081 crore.
The member countries contribute their share capital to the Bank as follows:
1.
2% of the share in the form of gold and US dollars. The World Bank utilizes this amount freely for granting loans.
2.
18% of the share capital in the form of own currency. The amount is also used by Bank for granting loans.
3.
80% of the share capital is payable at the request of the Bank. This amount is not used by Bank for granting loans. But it
can use this amount in discharging its responsibilities.
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Management of the World Bank

Management of the World Bank vests in the following four committees:
1.
Board of Governors: Board of Governors represents the General Council of the Bank. Every member country appoints one
governor and one alternative governor for five years. No alternative governor can vote except in the absence of his
principal. Board of Governors selects from its members one president who presides over its annual meeting. The Board
meets normally once a year. This general meeting is convened along with the general meeting of the IMF in any member
country. Each governor has the voting power which is related to the financial contribution of the government which he
represents. Board decides the policy of the Bank.
The Board enjoys the following rights:
(a) Admission of new members,
(b) Termination of the membership,
(c) Change in the capital,
(d) Distribution of the income of the Bank,
(e) Agreement with international institutions and
(f)
Liquidation of the Bank.
2.
Board of Executive Directors: Board of Executive Directors consists of 22 members. Of these, 5 members have the largest
subscription. They are: America, Britain, Germany, France and Japan. The remaining are elected from among the other
members of the Bank, for a two-year term. Board of Executive Directors can appoint any person, who is not a member,
either of Board of Governors or Board of Executive Directors, its President. He is the chief officer of the Bank. He acts
according to the directions of the Board of Directors and is responsible to it. He appoints all other officers of the Bank.
Board of Executive Directors is responsible for day-to-day conduct of the Bank's operations.
3.
Advisory Council: It consists of minimum 7 members. Their appointment is made by Board of Executive Directors.
Members of this Council are expert on different subjects like banking, foreign trade, industry, labour, agriculture etc. It
meets once a year. The council tenders its advice on different issues to the Bank.
4.
Loan Committees: Whenever the member-countries apply for loans, the Board of Executive Directors appoint a Loan
Committee. This Committee scrutinizes loan applications and gives its report on the propriety of the loan.
5.2.3 Activities of the Bank

The fundamental aims underlying the World Bank's activities are:
1.
The Bank is not intended to provide the external financing required for all meritorious projects of reconstruction and
development (but) to provide a catalyst by which production may be generally stimulated and private investment
encouraged;
2.
The Bank should encourage necessary action by the member governments to ensure that the Bank's loans will actually
prove productive. The promotion of sound financial programmes, the removal of unnecessary barrier, and the regional
integration of production loans, where appropriate, are some of the fields in which the Bank may be able to exert a helpful
influence; and
3.
Bank must play an active rather than a passive role (and take advantage of its international cooperative character) to
initiate and develop plans to the end that the Bank's resources are used not only prudently from the standpoint of its
investors but wisely from the standpoint of the world.
The World Bank is primarily concerned to ensure that its loans make the greatest possible contribution to increase the
production, raising the living standards of people in the borrowing member country and opening opportunities for further
investment in the borrowing member-country.
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5.2.4 Operational Strategy of the Bank

This includes five main strategies:
1.
Funding Strategy of the Bank

(a) To make sure availability of funds in the market.
(b) To provide the funds at the lowest possible cost to the borrowers through appropriate currency mix when interest
rates are expected to rise.
(c) To control volatility in net income and overall loan changes.
(d) To provide an appropriate degree of maturity transformations between its lending and the borrowing. Maturity
transformation depicts the Bank's capacity to lend for longer period than to borrow.
2.
Borrowing Strategy of the Bank: Bank's main function is to lend the money to the needy members. For lending activities,
it needs money and therefore it has to borrow.
Sources: The Bank borrows from the following sources:
(a) The Bank borrows from international market both for long and short periods.
(b) The Bank also borrows under Currency Swap Agreements (CSA).
(c) The Bank also borrows under the Discount-Note Programme by two methods. First, it places bonds and notes
directly with its member countries. Second, it offers issues to investors and in public markets.
Two new borrowing instruments were evolved by the Bank. The first one is Central Bank Facility and the US dollar
dominated facility. The World Bank borrows from the Central Banks of the member countries. The second instrument is
Floating Hate Notes. The World Bank borrows from the commercial banks and other financial institutions with the help of
these instruments.
3.
Lending Strategy of the Bank: The Bank grants loans to members in anyone or more of the following ways:
(a) By participating or granting direct loans out of its own funds;
(b) By granting loans out of funds raised in the financial market of a member or otherwise borrowed by the Bank, and
(c) By guaranteeing in whole or part, loans made by private investors through the investment channels. The total
outstanding amount of the total direct and indirect loans made or guaranteed by the Bank is not to exceed 100% of its
total unimpaired subscribed capital, resources and surplus. Bank imposes following conditions in granting loans:
The Bank is satisfied that the borrower is unable to borrow under reasonable conditions in the prevailing market
conditions.
The project for which loan is required should be recommended by the competent authority in the form of a
written report after careful examination of the project.
The loan is required for productive purpose.
The borrower or guarantor has reasonable prospects of repaying loans and interest on loans.
If the project is located on the territory of the member but itself is not a borrower, then the member or its central
bank has to guarantee the repayment of loan, interest on loans and other charges on loan.
In 1991, the Executive Board of the Bank modified the repayment terms which include extension of repayment period
from 3 to 5 years for middle income countries and review of repayment terms for middle income countries within 3 years.
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4.
Facilitating Strategy of the Bank

The Bank provides the following facilities to member countries:
(a) Structural Adjustment Facility (SAF): In order to reduce their balance of payments deficit and maintaining or regaining
the economic growth of member countries, the World Bank has introduced SAF in 1985. These funds are used to
finance the general imports with a few agreed exceptions such as luxury and military imports. These funds are
released in two parts and in a series of up to five SAFs to a borrowing country. Generally, the bank imposes stiff
conditions for these. These are provided to support to programmes running from 5 to 7 years.
(b) Enhanced Structural Adjustment Facility (ESAF): In order to increase the availability of concessional resources to the
low income member countries, ESAF was established in December 1987. It provides new concessional resources of
SDR 6 billion which will be financed by special loans and contributions from developed and OPEC countries. The
purposes for advancing the amount is same, i.e., to reduce balance of payment deficits of borrowing member
countries and encourage growth. The interest rate charged by the Bank is 0.5% to be repaid in ten semi-annual
installments beginning after 5 years of disbursements.
(c) Special Action Programme (SAP): The Special Action Programme (SAP) has been started in 1983 to strengthen the
IBRD's ability to assist member countries in adjusting to the current economic environment.
It has three major elements:
(a) Provide lending for structural adjustment, policy changes, export-oriented production, full utilization of existing
capacity and maintenance of critical infrastructure.
(b) Provide advisory services regarding policies.
(c) Enlisting familiar efforts by other donors for speedily disbursing assistance.
5.
Training, Assistance and Cooperation Strategy of the Bank

In addition to lending activities, the Bank also undertakes the following activities:
(a) Training: In 1956, the Bank set up a staff college to provide training to senior officials of the member countries. This
Bank is known as Economic Development Institute (EDI). The Institute helps the officials in improving the
management of their economies and to increase the efficiency of their investment programmes. The EDI also
organizes seminars in Washington and in different regions of the world in cooperation with regional institutes.
(b) Technical Assistance: The World Bank also provides technical assistance to its member countries. This assistance
includes:
Engineering-related: It includes feasibility studies, engineering design and construction supervision;
Institution-related: It includes diagnostic policy and institutional studies, management support and training.
The primary way of providing technical assistance is through loans made for supervision, implementation and
engineering services, energy, power, transportation, water supply, etc. In 1975, the Bank created Project Preparation
Facility (PPF) for meeting gaps in project preparation and for institution building. The Bank also acts as executing
agency for project financed by the United Nations Development Programme (UNDP).
(c) Inter-Organisational Co-operation: The World Bank is also engaged in inter organisational cooperation. It is based on
formal agreement between itself and international organisations, such as, the cooperative programmes between itself
and FAO, UNESCO, WHO, GAIT, UNCTAD, UNEP (United Nation Environment Programmes), UNDP, UNIDO
(United Nations Industrial Development Organisation) ILO, African Development Bank, The Asian Development
Fund, the International Fund for Agriculture Development (IFAD), etc.
(d) Economic and Social Research: In 1983, the Bank established a Research Policy Council (RPC). It provides leadership in
the guidance, coordination, and evaluation of all bank research. The Bank's research staff undertakes research
activities of its own and also in collaboration with outside researchers.
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(e) Operations Evaluation: The Bank has set up the Operations Evaluation Department (OED) to help borrowers in the
post-evaluation of Bank-assisted projects. Members of borrowers' staff visit this Department for seeking help in the
preparation of project completion report.
(f)
Settlement of Investment Disputes: The Bank has set up the International Centre of Settlement of Investment Disputes
(ICSID) between states and nationals of other states. The Bank has successfully mediated in solving many
international investment disputes such as the River Water Dispute between India and Pakistan, and the Suez Canal
dispute between Egypt and the UK.
Note: All these activities are included in the functions of the World Bank. Besides these activities, main functions of the Bank
are cited below:
5.2.5 Functions of the World Bank

The Bank in collaboration with its associates like, (i) International Development Association (ii) International Finance
Corporation and (iii) Multinational Investment Guarantee Agency-MIGA performs diverse functions. Its main functions are as
under:
1.
To Advance Loans: Main function of the Bank is to advance loans to member countries or to private entrepreneurs on the
guarantee of their governments, for productive purposes. These loans are advanced through the medium of the central
bank of the country. World Bank gives loans for short and long periods. It mainly advances three kinds of loans:
(a) Direct Loans: It either gives loans out of its own Funds or itself borrows in the open market and gives the proceeds to
the member countries as loan.
(b) Guarantee Loans: It gives guarantee to the private investors and thus helps them to give loans to member countries.
(c) Joint Loans: The bank advances loans in collaboration with other commercial banks. The debtor country has to repay
the loan either in gold or in the currency of creditor country. The Bank collects progress reports on those projects of
the member countries for which loans are advanced to them. Between 1947 and 2000 the World Bank has sanctioned
loans amounting to $32,700 crore.
2.
Technical Assistance: The bank also provides technical assistance to member countries. This is of two kinds. One relates
to development plans and the other to the study of economies, their analysis and improvements. The Bank sends its
experts to member countries in order to provide them with technical assistance.
3.
Training: The Bank also arranges to impart training to the officials of the member-countries in matters relating to
planning, economic development, public finance and other economic activities. Many training programmes have been
initiated by the Bank for this purpose. In the year 1956, the Bank established Economic Development Institute for
imparting training.
4.
Co-ordinated Development Assistance: The Bank also co-ordinates assistance given to member-countries from various
sources and this makes developmental efforts effective. The first attempt in this direction was made in 1958 when Aid
India Club was founded. Now, such clubs have been founded for many countries.
5.
Settlement of International Disputes: The World Bank also acts as a mediator to settle international disputes. In 1960,
Indo-Pak River Water Dispute and Suez Canal Dispute could be settled only by the efforts of the World Bank.

1.
The IMF promotes international monetary cooperation through a permanent institution.
2.
Quota of each member of IMF is fixed in terms of SDRs.
3.
Any country can now change the par value of its currency by 20% after notifying the Fund.
4.
At board meeting of the World Bank, No alternative governor can vote except in the absence of his principal.
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5.2.6 Critical Evaluation of the Bank

In the history of over sixty years of its existence, the World Bank has achieved many successes in the fulfillment of its
objectives, although it had to meet failures in certain directions. The working of the World Bank can be evaluated as under:
Main Achievement of the World Bank

The World Bank has succeeded in following respects:
1.
Increase in Capital: The Bank has succeeded admirably in enlarging its capital. It has increased its share capital by about
80%. It has also added to its capital by selling securities. Accordingly, the Bank's power to advance loans has increased
tremendously.
2.
Due attention to Developed and Underdeveloped Countries: It has attended to the requirements of both developed and
underdeveloped countries with fairness and equity. Of the total loans advanced by the Bank about 70% loans have gone
to Asia, Africa and other underdeveloped countries for their economic development. In addition, the Bank has also given
large amounts as loans for the reconstruction of developed countries. In 1997, the World Bank established Poverty
Reduction and Economic Management (PREM) to eradicate poverty.
3.
Loans for Productive Purposes: The World Bank give loans only for productive purposes to the member-countries. The
Bank gives loans particularly for the development of electricity, power generation, transport etc. The reason being that for
the economic development of a country these facilities are a must. In the absence of these items of infrastructure, no
underdeveloped country can develop economically. However, these projects need huge capital investment.
Underdeveloped countries are short of capital. Hence, without the help of the World Bank they cannot go ahead with
their programmes of economic development satisfactorily. In the year 2000, the World Bank had given advances to the
tune of $1,530 crore to underdeveloped countries.
4.
Technical Assistance: The World Bank has provided technical assistance to almost all underdeveloped countries of the
world. Officials of many countries have received training from the institutions set up by the Bank. Consequently, the
planned development of these countries has become possible.
5.
Third Window of World: Loans given by the World Bank and International Development Association (IDA) were
inadequate. In order to make up this deficiency both these institutions jointly founded in 1975 a Third Window. This
window has been instrumental in providing loans on a large-scale to developing countries at low rate of interest. The
Window has made available loans to many countries like India, Pakistan, Sri Lanka, Ghana, Uganda etc.
6.
Coordination of the Lending Activities of the Lender Countries: The World Bank coordinates the lending activities of such
lender countries as lend to underdeveloped countries. The World Bank convenes their meetings and prompts them to
advance loans to different underdeveloped countries. Aid India Club or Indian Development was organized by the World
Bank for this very purpose.
7.
Settlement of Disputes among Nations: The World Bank has made successful attempts at settling mutual economic
disputes among nations. Indo-Pak Basin Water Dispute and the dispute between UK and United Arab Republic on the
nationalization of Suez Canal and compensation to shareholders could be settled only through the mediation of World
Bank.
8.
Fight Against Poverty: Through its loans, policy advice and technical assistance, the World Bank supports a broad range
of programs aimed at reducing poverty and improving living standards in the developing world. The global fight against
poverty is aimed at ensuring that people everywhere in this world have a chance for a better life for themselves and for
their children. Over the past generation, more progress has been made in reducing poverty and raising living standards
than during any other period in history.
9.
Establishment of Subsidiary Institutions: The World Bank has also established three subsidiary institutions, namely:
(a) International Finance Commission: It was set up in July 1956. Its objective is to encourage private enterprises of
member-countries.
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(b) International Development Association: It was founded in 1960 with the objective of providing loans to underdeveloped
countries at low rate of interest.
(c) Multinational Investment Guarantee Agency (MIGA): It was founded in 1988. It aims at encouraging private foreign
investment.
(d) Environment Protection: In recent years, the World Bank has undertaken many significant actions to protect world's
environment against pollution. The Bank has launched the World Environment Facility Scheme to protect
environment. Under this scheme, a provision exists to give grants to low per capita income countries.
In short, the World Bank has made a significant contribution to the reconstruction and economic development of the membercountries.
Failures of World Bank

The main failures of the World Bank are as under:
1.
Discriminating Behaviour: The treatment of the World Bank towards rich and poor countries has been discriminatory.
The Bank is more favourably inclined towards European countries. On the contrary, underdeveloped countries have
received comparatively less financial accommodation. Conditions of loan have also been harsh.
2.
Inadequate Financial Help: According to critics, the capital of the World Bank is not sufficient to meet the rising needs of
the member countries. The Bank provides very little financial assistance to the underdeveloped countries compared to
their requirements.
3.
High Rate of Interest and Commission: According to critics, rates of interest and commission of the World Bank have also
been very high. Underdeveloped countries experience the pinch of these exorbitant rates.
4.
Loans for Limited Objectives: The Bank gives loans only for limited objectives. Underdeveloped countries need loans for
all-round development. Their loans need not be tied to specific projects. They need such loans as can be utilized by them
according to their priorities.
5.
Defective Loan Policy: The Bank has a rigid loan policy. It takes a long time to receive a loan from it. The Bank lays more
stress on the repaying capacity of the borrowing country. It is not a proper policy from the point of view of
underdeveloped countries because their repaying capacity enhances only after making productive use of the borrowed
capital.
6.
Repayment of Loans in Foreign Currency: The condition of the Bank for repaying the loan in the same foreign currency in
which it was taken earlier is also hard to be fulfilled by the underdeveloped countries. Many a time, it becomes pretty
difficult for these countries to repay the loans in foreign currencies.
7.
Hard Conditionalities: The introduction of SAF and ESAF has put hard conditionalities for borrowing countries, like open
trade, reform in public budgeting and debt management, revision of price policies, better planning of public investment
and management of public enterprises. SAF releases second installment of loan only after a review of time-bound reform
programmes.
8.
Discriminatory: The Bank is also being criticized on the basis of discrimination adopted by it in its purpose-wise and
region-wise assistance towards developing countries. From 1990, the Bank has directed its lending policy in favour of
developing countries for the development of agriculture, rural development, transportation, communication, water
supply, sewerage, human resources development and environment, etc.
In short, despite the above shortcomings, the Bank has made a significant contribution in the development of all the countries
of the world. The Bank's overall performance must be judged not only on behalf of its lending activities, but also on behalf of
its success in providing technical assistance and much needed advice on various projects. The Bank also provides assistance to
the private sector in areas like finance, power, telecommunications, information technology, oil and gas, etc. in addition to
public sector. The Bank's greater emphasis is on development of human resources through education, population control,
health and nutrition and environment.
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Criticisms
Many decisions of the World Bank relating to India are criticised on various counts, like:
z
The Bank has made efforts to lower the significance of Indian planning after the Third Plan. It created certain situations
that resulted in diminishing the role of planning commission.
From its very inception, the World Bank has influenced the economic policies of India. Its objective has been to promote
foreign capital investment in India.
The World Bank has given more importance to the development of private than public sector.
It was at the Bank's instance that India devalued its Rupee in 1966 and 1949.
India's dependence on the World Bank has been increasing. India's economic policies must be in line with the World
Bank. It has adversely affected India's economic freedom.
The World Bank is largely responsible for the economic reforms introduced in 1991 in India. According to critics, these
reforms will benefit multinational companies only. Poor masses will not gain from it.
In a nut shell, the critical view is that the membership of the World Bank has endangered the economic freedom of countries
like India.
5.3 International Debt Problems, Issues and Initiatives

The debt crisis of the 1980s affected all the countries. The international financial markets were severally affected when a
number of developing countries found that they were unable to meet the payments amounting to several hundred billion
dollars to major banks around the world. As countries trade with each other, economies are integrated. The stagnant
economies in Europe and the United States had an adverse affect on many Less Developed Countries (LDC) economies. These
countries were highly dependent on their exports business on these two economies. In addition, due to the oil glut at that time,
the oil exporting LDCs were also generating less revenue.
The strengthening of the dollar during the early 1980s adversely affected the debt problems of the LDCs as most of the loans
provided to LDCs were denominated in US dollars.
The interest rates in 1981 were also at their peak, exceeding 20% in 1981. Infact the increased market interest rates, along with
the strengthening of the US dollar, resulted in the effective interest rates on previous loans to be 30% or more.
Thus the international debt crisis reflected a combination of external shocks including deterioration of terms of trade and a
sharp rise in US dollar interest rates and domestic imbalances such as large fiscal deficit and currency overvaluation.
In August 1982, Mexico announced that it was unable to pay its debt to international creditors. Brazil and Argentina also
found themselves in a similar situation. By the spring of 1983, several LDC Governments simultaneously announced their
inability to repay loans and entered into loan-rescheduling negotiations with the creditor banks. The negotiating power of
LDCs was enhanced because they had announced as a group, their inability to repay the loans. This forced the authorities to
search for long-term economic rescue plans that would ultimately help in recovery of the loan.
Negotiations between the commercial banks, LDCs and the IMF were held in 1983. In November 1983, the IMF funding bill
was passed to provide additional funding to those LDCs that could meet specified economic goals.
Baker Plan
The aim of the Baker plan was to strengthen the international debt strategy of the LDCs so as to make them more desirable
borrowers and restore their access to international capital markets.
However, the Baker Plan failed to achieve its objectives primarily because new lending from commercial banks did not
materialise. Although the debt strategy had placed emphasis on improved domestic policies in developing countries, an
improved external environment was acknowledged at the outset as necessary in order to provide the maneuver required for
growing out of debt. The terms of trade also deteriorated.
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Brady Plan
March 1989 saw new international debt strategy in the form of the Brady Plan. The key elements of the Brady Plan were:
1.
Adoption of sound economic policies with strong emphasis on measures to increase foreign and domestic investment and
repatriation of flight capital;
2.
Timely support from the IMF and World Bank for countries reform programmes, in part through financing for debt and
debt-service reducing transactions; and
3.
Active participation by commercial banks in providing financing support through the negotiation of debt and service
reduction and new lending, where needed. The Brady Plan consisted of debt reduction by permanent restructuring of
existing commercial debt at lower interest rates and/or writing off a portion of the existing debt. The resulting
restructured debt was to be exchanged for tradable fixed income securities known as Brady Bonds.
The major problem with the Brady Plan was that it required commercial banks to both make new loans as also write off the
existing loans. Money banks, however, used the Brady Plan as an opportunity to exit from the LDC debt market.
5.3.1 Asian Financial Crisis

With globalisation, there has been a consistent rise in cross-border investment and increased interdependency among the
various economies in the world. A crisis in one part, however small, is sure to have serious repercussions on other parts of the
globe. The Asian financial crisis began in July 1997 as a result of an exchange rate crisis in Thailand and spread almost
immediately to Malaysia, Indonesia, Philippines and Korea. The crisis adversely affected these countries and produced severe
downturns in real economic activity. Infact the South-east Asian economies were more acutely affected by the crisis than the
other countries in the region such as Hong Kong, China, Singapore and Taiwan (i.e. South Asian regions). The South Asian
countries experienced only a mild impact i.e. a slower economic growth and only a limited adverse effect from reduced
international competitiveness.
Figure 5.1: Merchandise Import and Export during the Asian Crisis
Source: http://www.wto.org/images/img_pr00/pr175b_e.gif
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The South-east Asian economies experienced currency and stock market depreciation and the world capital flows also reduced
as investors in the developed nations stayed away from the disturbance in South-east Asia. For example, capital inflow into
the South East Asian region was US $35 billion in the first half of 1997 which reduced dramatically in the second half of 1997 to
a capital outflow of US $50 billion. The Figure 5.1 shows the impact of crisis on import and export of major Asian countries.
Role of the International Monetary Fund (IMF)

The various crises have raised important issues on the role of the IMF in financing at the times of crisis. The fund has
specifically come into greater focus after the Asian crisis as the strategy adopted in Indonesia, Korea and Thailand came under
severe criticism. The basic issue is whether the IMF should act as the International Lender of Last Resort (ILOLR).
There are diverse views on this some feel that the IMF is ineffective and can lull nations into complacency by acting as the
self-appointed lender of last resort; however others feel that in the absence of IMF lending the crisis would become more deep
and frequent and impose higher burdens of adjustment on developing countries in the face of external shocks. Another
approach which has also found favour is the view that the IMF should be restructured into smaller institutions with three
separate entities/responsibilities a global information agency (rating the health and stability of countries economies), a
contingent global financing facility (providing contingent credit lines to countries meeting minimum standards of information)
and a global restructuring agency (providing conditional lending and advice on debt restructuring to crisis countries). Thus,
recent events including the Asian crisis have brought into greater focus, governance and management issues in the IMF.
The important point to be taken note of here is that the fund has been criticised for imposing uniform policies irrespective of
the nature of the crisis. In the recent episode of Asian crisis, the IMF suggested raising interest rates, which ultimately led to a
virtual collapse of the financial and corporate sector in the crisis countries. To come out of a crisis, countries need to undertake
both stabilisation and structural reform measures. Experience has also proved that it is only during a crisis that required
changes take place.
In the context of the changes and developments that have taken place in the last decade, countries will have to move fast to
adopt internationally accepted standard so that a crisis can be prevented. In addition, countries will need to adopt sound
macroeconomic policies so that the focus can be on crisis prevention and crisis management.
5.3.2 Sub-prime Lending

Subprime lending is the practice of extending credit to borrowers with certain credit characteristics e.g. a FICO score of less
than 620 that disqualify them from loans at the prime rate (hence the term 'sub-prime'). Sub-prime lending covers different
types of credit, including mortgages, auto loans, and credit cards. Since sub-prime borrowers often have poor or limited credit
histories, they are typically perceived as riskier than prime borrowers. To compensate for this increased risk, lenders charge
sub-prime borrowers a premium. For mortgages and other fixed-term loans, this is usually a higher interest rate; for credit
cards, higher over-the-limit or late fees are also common. Despite the higher costs associated with sub-prime lending, it does
give access to credit to people who might otherwise be denied. For this reason, sub-prime lending is a common first step
toward credit repair; by maintaining a good payment record on their sub-prime loans, borrowers can establish their
creditworthiness and eventually refinance their loans at lower, prime rates.
Sub-prime lending became popular in the U.S. in the mid-1990s, with outstanding debt increasing from $33 billion in 1993 to
$332 billion in 2003. As of December 2007, there was an estimated $1.3 trillion in sub-prime mortgages outstanding.20% of all
mortgages originated in 2006 were considered to be sub-prime, a rate unthinkable just ten years ago. This substantial increase
is attributable to industry enthusiasm: banks and other lenders discovered that they could make hefty profits from origination
fees, bundling mortgages into securities, and selling these securities to investors.
These banks and lenders believed that the risks of sub-prime loans could be managed, a belief that was fed by constantly
rising home prices and the perceived stability of mortgage-backed securities. However, while this logic may have held for a
brief period, the gradual decline of home prices in 2006 led to the possibility of real losses. As home values declined, many
borrowers realized that the value of their home was exceeded by the amount they owed on their mortgage. These borrowers
began to default on their loans, which drove home prices down further and ruined the value of mortgage-backed securities
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(forcing companies to take write downs and write-offs because the underlying assets behind the securities were now worth
less). This downward cycle created a mortgage market meltdown.
The practice of sub-prime lending has widespread ramifications for many companies, with direct impact being on lenders,
financial institutions and home-building concerns. In the U.S. Housing Market, property values have plummeted as the
market is flooded with homes but bereft of buyers. The crisis has also had a major impact on the economy at large, as lenders
are hoarding cash or investing in stable assets like Treasury securities rather than lending money for business growth and
consumer spending; this has led to an overall credit crunch in 2007. The sub-prime crisis has also affected the commercial real
estate market, but not as significantly as the residential market as properties used for business purposes have retained their
long-term value.
The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and
from bad loans from January 2007 to September 2009. These losses are expected to top $2.8 trillion from 2007-10. U.S. banks
losses were forecast to hit $1 trillion and European bank losses will reach $1.6 trillion. The IMF estimated that U.S. banks were
about 60 percent through their losses, but British and euro zone banks only 40 percent.
Drivers of Sub-prime Lending

Home Price Appreciation
Home price appreciation seemed an unstoppable trend from the mid-1990's through to today. This "assumption" that real
estate would maintain its value in almost all circumstances provided a comfort level to lenders that offset the risk associated
with lending in the sub-prime market. Home prices appeared to be growing at annualized rates of 5-10% from the mid-90s
forward. In the event of default, a very large percentage of losses could be recouped through foreclosure as the actual value of
the underlying asset (the home) would have since appreciated.
Lax Lending Standards
Outstanding mortgages and foreclosure starts in 1Q08, by loan type. The reduced rigor in lending standards can be seen as the
product of many of the preceding themes. The increased acceptance of securitized products meant that lending institutions
were less likely to actually hold on to the risk, thus reducing their incentive to maintain lending standards. Moreover,
increasing appetite from investors not only fueled a boom in the lending industry, which had historically been capital
constrained and thus unable to meet demand, but also led to increased investor demand for higher-yielding securities, which
could only be created through the additional issuance of sub-prime loans. All of this was further enabled by the long-term
home price appreciation trends and altered rating agency treatment, which seemed to indicate risk profiles were much lower
than they actually were.
As standards fell, lenders began to relax their requirements on key loan metrics. Loan-to-value ratios, an indicator of the
amount of collateral backing loans, increased markedly, with many lenders even offering loans for 100% of the collateral
value. More dangerously, some banks began lending to customers with little effort made to investigate their credit history or
even income. Additionally, many of the largest sub-prime lenders in the recent boom were chartered by state, rather than
federal, governments. States often have weaker regulations regarding lending practices and fewer resources with which to
police lenders. This allowed banks relatively free rein to issue sub-prime mortgages to questionable borrowers.
Adjustable-rate Mortgages and Interest Rates
Adjustable-rate mortgages (ARMs) became extremely popular in the U.S. mortgage market, particularly the sub-prime sector,
toward the end of the 1990s and through the mid-2000s. Instead of having a fixed interest rate, ARMs feature a variable rate
that is linked to current prevailing interest rates. In the recent sub-prime boom, lenders began heavily promoting ARMs as
alternatives to traditional fixed-rate mortgages. Additionally, many lenders offered low introductory, or teaser, rates aimed
at attracting new borrowers. These teaser rates attracted droves of sub-prime borrowers, who took out mortgages in record
numbers.
While ARMs can be beneficial for borrowers if prevailing interest rates fall after the loan origination, rising interest rates can
substantially increase both loan rates and monthly payments. In the sub-prime bust, this is precisely what happened. The
target federal funds rate (FFR) bottomed out at 1.0% in 2003, but it began hiking steadily upward in 2004. As of
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mid-2007, the FFR stood at 5.25%, where it had remained for over one year. This 4.25% increase in interest rates over a threeyear period left borrowers with steadily rising payments, which many found to be unaffordable. The expiration of teaser rates
didnt help either; as these artificially low rates are replaced by rates linked to prevailing interest rates, sub-prime borrowers
are seeing their monthly payments jump by as much as 50%, further driving the increasing number of delinquencies and
defaults. Between September of 2007 and January 2009, however, the U.S. Federal Reserve slashed rates from 5.25% to 0-.25%
in hopes of curbing losses. Though many sub-prime mortgages continue to reset from fixed to floating, rates have fallen so
much that in many circumstances the fully indexed reset rate is below the pre-existing fixed rate; thus, a boon for some subprime borrowers.
Case Study
When SEC sued Goldman Sachs for Sub Prime-linked Fraud
Goldman Sachs Group was sued by US regulators for fraud tied to collateralised debt obligations that contributed to the
worst financial crisis since the Great Depression. The firms shares tumbled as much as 16% in early trade and financial
stocks slumped.
Goldman Sachs misstated and omitted key facts about a financial product tied to subprime mortgages as the US housing
market was starting to falter, the Securities and Exchange Commission said in a statement on Friday. The SEC also sued
Fabrice Tourre, a Goldman Sachs vice-president.
The product was new and complex but the deception and conflicts are old and simple, SEC enforcement director
Robert Khuzami said in the statement. Goldman wrongly permitted a client that was betting against the mortgage
market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors
that the securities were selected by an independent, objective third party.
The SEC alleged that Goldman Sachs, led by chief executive officer Lloyd Blankfein, 55, structured and marketed CDOs
that hinged on the performance of subprime mortgage-backed securities. The New York-based firm failed to disclose to
investors that hedge fund Paulson & Co was betting against the CDO, known as Abacus, and influenced the selection of
securities for the portfolio, the SEC said. Paulson wasnt accused of wrongdoing.
A gauge of banks and broking houses in the Standard & Poors 500 Index sank 3.9% for the top loss among 24 groups
after the SEC announced its action. Bank of America and JPMorgan Chase lost at least 3.5% as all 27 companies in the
S&P 500 Diversified Financial Index declined.
This gave the politicians everything they need to push for stronger financial reform and its going to further shake
investor confidence in Wall Street, said Matthew McCormick, a banking-industry analyst and portfolio manager at Bahl
& Gaynor in Cincinnati, which oversees $2.8 billion.
Goldman Sachs spokesman Lucas Van Praag didnt return a call and an e-mail seeking comment. A call to Richard
Klapper, an attorney for Goldman Sachs at Sullivan & Cromwell, wasnt returned. Tourre, reached by phone in London
on Friday, declined to comment. A call to Pamela Chepiga, a lawyer for Tourre at Allen & Overy, wasnt returned.
Stefan Prelog, a spokesman for New York-based Paulson, said he couldnt comment. The company oversees $32 billion.
Questions
1.
What was the problem with Goldman Sachs?
2.
How this problem could have been solved?
Source: www.economictimes.com
5.3.3 International Regulation

The growing internationalisation and universalisation of banking operations have made the bank regulators realise the
necessity of establishing a well-defined set of ground rules for the safe operation of all banks. It is being argued that the
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weaknesses in the governance of the financial and corporate sectors have contributed to the severity of the recent crises. As
such, international organisations are placing a lot of emphasis on the development and implementation of international
standards and principles.
In the banking area the Basle Committee under the auspices of the Bank for International Settlements in Basle, Switzerland,
has set the Basle Accord of 1988 which marks an important watershed in establishing capital standards among banks across
the globe. The Basel Capital Accord which was launched in 1988 became a global standard by which the financial soundness of
the bank is assessed.
Under the risk-based capital standards, banks were required to maintain capital equal to atleast 8 per cent of risk adjusted
assets. Capital was divided into two components according to the availability of funds to buffer losses. The tier 1 or core
capital consists of shareholders funds or retained earnings. Tier 2 capitals or supplementary capital consists of components
such as undisclosed reserves, preferred shares and subordinated debt.
However, with the progress of time, new risk-management techniques have developed and in the backdrop of these the Basel
Capital Accord seems to be rudimentary and outdated. This has led the regulators to search for feasible alternative possibilities
to regulate market risks in banks. The Basel Committee has thus revised its Capital Adequacy Ratios (CAR) to incorporate
market risks, the risk that asset prices will change in response to changes in market factors like interest rates, exchange rates
etc.
IOSCO is working to establish standard principles for securities market regulation and to improve disclosure standards. It has
also issued recommendations regarding disclosure of trading and derivatives activities of banks and securities firms, to assist
markets in making sound risk assessment.
The International Accounting Standards Committee has completed and promulgated a series of International Accounting
Standards aimed at achieving uniformity in international accounting practices, while international auditing standards have
been established by the International Federation of Accountants and the World Bank.
The World Bank is developing a set of principles and Guidelines on Insolvency Regimes for developing countries in
collaboration with international organisations and insolvency experts. The Organisation for Economic Corporation and
Development (OECD), the Basle Committee, the World Bank and the European Bank for Reconstruction and Development
(EBRD) are all involved in the development of principles in the area of corporate governance. The OECD has developed a set
of Principles of Corporate Governance, which were endorsed in May 1999.
Table 5.1: Aggregated MPIs vs. Macro Economic Indicators
Aggregated Micro Prudential Indicators
Capital adequacy
Aggregate capital ratios
Frequency distribution of
capital ratios
Asset Quality
Lending institution
Sectorial credit concentration
Foreign-currency-denominated lending
Non-performing loans and provisions
Loans to public sector entities
Risk profile of assets
Connected lending
Leverage ratios
Borrowing entity
Debt-equity ratios
Corporate profitability
Other indicators of corporate conditions
Macro Economic Indicator

Economic growth
Aggregate growth rates
Sectoral slumps
Balance of payments
Current account deficit
Foreign exchange reserve adequacy, external debt
(including maturity structure)
Terms of trade
Composition and maturity of capital flows
Inflation
Volatility in inflation
Interest and exchange rates
Volatility in interest and exchange rates
Level of domestic real interest rates
Exchange rate sustainability
Exchange rate guarantees
Contd
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Household indebtness
Management soundness
Expense ratios
Earnings per employee
Growth in number of financial institutions
Earnings and profitability
Return on assets
Return on equity
Income and expense ratios
Structure profitability indicators.
Liquidity
Central bank credit to financial institutions
Deposits in relation to monetary aggregates
Segmentation of Interbank rates
Loan-to-deposit ratios
Maturity structure of assets and liabilities.
Measures of secondary market liquidity
Sensitively to market risk
Foreign exchange risk
Interest rate risk
Equity price risk
Commodity price risk
Market-based indicators
Market prices of financial Instruments
Indicators of excess yields
Credit ratings
Sovereign yield spreads
Lending and asset price booms

Lending booms
Assets price booms
Contagion effects
Financial market correlation
Trade spillovers
Other factors
Directed lending and investment
Government resource to banking system
Arrears in the economy
Source: Finance & Development, September, 2000
Macro Prudential Indicators (MPIs)

In the aftermath of the international financial turmoil of the second half of the 1990s, the World Bank and the IMF have tried
to work on ways to strengthen the global financial system. The MPIs defined broadly as indicators of the health and
stability of the financial system can help countries access their banking systems vulnerability to crisis. This process, as part of
the joint World Bank-IMF Financial Sector Assessment Programme (FSAP), May 1999, was introduced in MPIs compare both
aggregated micro prudential indicators of the health of individual financial institution and macro economic variables
associated with financial system soundness. Table 5.1 gives the details. Financial crises often occur when both types of
indicators point to vulnerabilities that is, when financial institutions are weak and face macroeconomic shocks.
5.3.4 Managing Risk in Foreign Exchange Trading

The performance of banks or other institutions trading in the foreign exchange market depends on how well they assess the
nature and type of risk and accordingly measure and manages the risk. There are basically two forms of risks that are involved
in foreign exchange trading market risk and credit risk. Both these kinds of risks are faced in foreign exchange trading and
the issue of managing risk is a continuous and tough part of trading in foreign exchange.
1.
Market Risk: This risk refers to the risk of adverse changes in a currency rate or in an interest rate. Two major forms of
market risk are exchange rate risk and interest rate risk.
Exchange rate risk is inherent in foreign exchange trading. A traderwhen he buys or sells foreign currency to a customer
or to another bank is creating an open or uncovered position (long or short) for his bank in that currency, unless he
is covering or transferring out of some previous position. Every time a dealer takes a new foreign exchange position in
spot, outright forwards, currency options that position is immediately exposed to the risk that the exchange rate may
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move against it and the dealer remains exposed until the transaction is completed. Interest rate risk arises when there is
any mismatching or gap in the maturity structure. Thus, an uncovered outright forward position can change in value, not
only because of a change in the spot rate (foreign exchange risk), but also because of a change in interest rates (interest
rate risk), since a forward rate reflects the interest rate differential between the two currencies. In an FX swap, there is no
shift in foreign exchange exposure and the market risk is interest rate risk. In addition to FX swaps and currency swaps,
outright forwards, currency futures and currency options are all subject to interest rate risk.
2.
Credit Risk: This refers to the risk of not getting back the payment on time. Credit risk, inherent in all banking activities,
arises from the possibility that the counterparty to a contract cannot or will not make the agreed payment at maturity.
When an institution provides credit, whatever the form, it expects to be repaid. When a bank or other dealing institution
enters a foreign exchange contract, it faces a risk that the counterparty will not perform according to the provisions of the
contract. Between the time of deal and the time of the settlement, be it a matter of hours, days, or months, there is an
extension of credit by both parties and an acceptance of credit risk by the banks or other financial institutions involved. As
in the case of market risk, credit risk is one of the fundamental risks to be monitored and controlled in foreign exchange
trading.
3.
Sovereign Risk: It is a variation of credit risk which is very important and relevant in foreign exchange trading. It refers to,
the political, legal and other risks associated with a cross-border payment. In many cases, many governments have
interfered with international transactions in their currencies. Although in todays liberalised markets and less regulated
environment, there are fewer and fewer restrictions imposed on international payments, the possibility that a country
may prohibit a transfer cannot be ignored. In order to limit their exposure to this risk, banks and other foreign exchange
market participants sometimes establish ceilings for individual countries, monitor regulatory changes, watch credit
ratings and, where practicable, obtain export risk guarantee.

Fill in the blanks:
1.
Negotiations between the commercial banks, LDCs and the IMF were held in ...
2.
. is the practice of extending credit to borrowers with certain credit characteristics.
3.
Loan-to-value ratio is an indicator of the amount of ..backing loans.
4.
ARMs can be beneficial for borrowers if the prevailing interest rates .. after the loan origination.
5.4 International Capital Flows

The International Monetary Fund (IMF) pays particular attention to capital flows in its analysis of economic trends, both at the
global and at the national level. Its articles of agreement clearly state that the Fund shall oversee the international monetary system
in order to ensure its effective operation" (Article IV, Section 3. Moreover, the IMF should "seek to promote stability by fostering
orderly underlying economic and financial conditions and a monetary system that does not tend to produce erratic
disruptions" (Article IV, Section 1).
The IMF has engaged in a number of efforts, together with other international organisations and national governments, to
make our world less vulnerable to financial crises and to handle them as effectively as possible whenever they occur. As IMF
Managing Director, Horst Khler, said recently "Private capital flows are now a major source for promoting growth and productivity,
but they can also be a source of abrupt volatility and crisis. To contain the latter and to promote the former is the issue at stake."
Capital flows-particularly long-term flows, such as foreign direct investment, are a constructive force in raising economic
development in developing and developed countries alike. The problem of some countries, particularly the least-developed
countries, is not that they have attracted too many capital flows, and in the process have made their economies vulnerable and
unstable. Rather, many of them failed to attract significant capital flows, often because of protracted macroeconomic
imbalances and an inhospitable business environment, and therefore have not enough resources to invest. If your house is not
in order you actually encourage capital flight by nationals trying to protect their savings by investing them abroad.
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Therefore, the first aspect of preventing financial crises is to take appropriate steps to ensure proper macroeconomic
stability and a sound business environment. Attention should also be given to external vulnerability and financial sector
stability. Finally, countries should be encouraged to follow best international practices, particularly those related to financial
markets, and to remain committed to providing more and better information about their policies and economic developments
to financial markets and the public at large.
The work of the Fund in support of crisis prevention is broadly incorporated in our surveillance efforts, that is, our
monitoring of the economies of member countries. Starting from an assessment of economic and financial conditions in the
country-and policy recommendations developed by the staff-the IMF Executive Board makes a number of suggestions for
consideration and implementation by the national authorities. Among the factors impinging on the external vulnerability of a
country, four have proven to be crucial: the existence of macroeconomic imbalances, deficiencies in the management of
domestic and external debt, inadequate exchange rate arrangements, and, last but not least, weak and poorly supervised
financial systems.
Because of the importance of the latter, since 1999, the IMF, in collaboration with the World Bank, has been carrying out
the Financial Sector Assessment Program (FSAP). Through this program, strengths and vulnerabilities in financial systems
are identified and remedial measures proposed with the aim of reducing the likelihood and severity of financial crises.
Financial Sector Stability Assessments of 24 countries are scheduled to be conducted in FY2001. The Fund has contributed to
the work of the Basel Committee on Banking Supervision on new standards for capital adequacy, which we hope will be
applied by all internationally active banks in 2004, but also by domestically-oriented banks around the world.
The IMF has also been fostering the development and implementation of internationally recognized codes of conduct,
developed through a participatory process in which a broad range of players and institutions have made their contributions.
These codes of conduct are geared towards promoting the efficient functioning of financial markets and improving national
governance. The IMF itself has taken a lead in developing standards for data dissemination and codes of good practices for
transparency in fiscal, monetary and financial policies. Other international organisations have developed-or are developing
with our collaboration-standards of banking supervision and regulation, securities and insurance regulations, payment and
settlement systems, accounting and auditing, corporate governance, and insolvency regimes.
Greater transparency in country economic developments and policies helps inform financial markets allowing them to
distinguish more clearly the special circumstances of each country. The Fund has just completed its review of the experience
with the publication of Article IV staff reports and will continue to encourage the voluntary publication of these reports by
country authorities. The Fund is also promoting greater exchange of information and dialogue with the private financial sector
as an important element of crisis prevention. For that purpose a Capital Markets Consultative Group was established at the
IMF and had its first meeting in September 2000. A meeting with financial market executives in Asia was held in January 2001.
Country surveillance is complemented by global and regional surveillance, that is by the understanding of forces affecting the
world economy and global financial markets that may be of concern to all countries or to countries in a region. The IMF
reports on the World Economic Outlook and the International Capital Markets are examples of such work.
Regarding crisis management, the Fund has reviewed its facilities to make sure that they are well-tailored to help our member
countries. A new loan facility, the Contingent Credit Line (CCL) was reformulated in 2000 to help countries that have
undertaken appropriate policies to better withstand any negative impact on their economy from contagion effects. The basic
idea is straightforward: the IMF offers a precautionary line of credit to countries that have demonstrably sound policies, but
which nonetheless believe they may be vulnerable to contagion from crises elsewhere.
While the Fund's role is to provide a credible crisis response whenever prevention fails, creditors and borrowers must know
that the IMF's resources are limited and that the private sector will have to be involved in the orderly and timely resolution of
crises. Work on a suitable framework for private sector involvement continues. Valuable experience has been gained with
securing the involvement of the private sector in the resolution of a number of recent crises. Despite progress, more needs to
be done to strike the right balance between the clarity needed to guide market expectations and operational flexibility needed
to allow the most effective response to each crisis situation. Work is ongoing on the comparability of treatment between
official bilateral and private creditors and on prospects for market access for countries emerging from crises. A progress
report is expected for the next International Monetary and Financial Committee meeting in April 2001.
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There are a few forms of harmful international capital flows whose existence is due to in part to lack of sufficient
collaboration among the international community. They include capital movements aimed at evading taxes and money
laundering.
Regarding tax havens, the IMF supports the work being undertaken by the OECD on harmful tax competition, including the
identification of non cooperating countries and territories. Prevention of money laundering is being pursued by the Financial
Action Task Force set up by the G-7. The task force has developed a regulatory framework, which if effectively applied by all
countries, would reduce greatly the opportunities for money laundering. Following recommendations of the Financial
Stability Forum, the IMF is conducting an assessment of offshore financial centers, which will emphasize compliance with
internationally agreed standards and codes, including those relating to the transparency of financial sector activities.
Short-term speculative flows are sometimes associated with financial crises, but are often difficult to distinguish from other
short-term flows that finance trade and other worthwhile economic activities. The judicious use of controls on short-term
inflows can help slowdown surges of capital flows, which could contribute to deepen the crisis. Two points, however, are
difficult to dispute: (a) capital controls cannot be used successfully as a substitute for sound macroeconomic policies and an
appropriate business environment and (b) kept for extended periods, capital controls are bound to be circumvented. Past
experience with capital liberalization also shows that proper sequencing is essential, a lesson that we need to keep in mind in
the future. Further research in this area is crucial. For example, a study on advanced country experiences with capital account
liberalization will be conducted by the Fund staff in 2001 in cooperation with the OECD. (www.imf.org)
5.5 FDI and Portfolio Investment

In imperfect market conditions, multinational corporations (MNCs) taking advantage of their supremacy over the rivals in
terms of cost, quality, speed and flexibility vigorously endeavour to expand their operations in different potential countries
and for that matter, adopt entry strategies based on strength, weakness, opportunity and threat i.e. SWOT analysis and choose
a particular mode of entry. Foreign direct investment (FDI), which involves building productive capacity directly in a foreign
country, is one of the most important modes of entry in foreign markets. MNCs conduct FDI through joint ventures with
foreign firms, cross-border mergers and acquisitions and formation of new foreign subsidiaries.
In foreign direct investment, the parent company builds productive capacity in a foreign country. In a cross-border
acquisition, a domestic parent acquires the use of an asset in a foreign company. A company can acquire productive capacity
in a foreign country in one of the two ways, viz., cross-border acquisition of assets and cross-border acquisition of stock.
Cross-border acquisition of assets is the most straightforward method of acquiring productive capacity because only the asset
is acquired without the transfer of liabilities to the purchase. As against this, under a cross-border acquisition of stock, a MNC
has to buy an equity share in a foreign company. In a cross-border merger, two firms pool their assets and liabilities to form a
new organisation.
FDI, as a mode of foreign market entry, provides a permanent foothold in the foreign market and can generate high returns
when managed properly. However, FDI requires a substantial investment which entails an additional overlay of foreign
exchange risk, political risk and cultural risk that do not exist in case of domestic investment. These additional risks may or
may not be offset by higher expected earnings. Given these risks and return complexion of FDI, MNCs obviously tend to
analyze carefully the potential benefits and costs before deciding about kind of FDI.
5.5.1 Nature and Significance

In view of their superior competitive advantages over local firms in terms of economies of scale, production differentiation,
managerial and technological acumen, speed of services, flexibility and financial strengths, MNCs extend their areas of
operations beyond domestic boundaries so as to derive mileage from existing imperfections in national markets for products,
factors of production and capital markets and thereby improve profitability and enhance shareholders value. Initially, MNCs
are motivated by strategic consideration of extending corporate control overseas and pre-empting their competitors or gaining
advantage over them in the search for markets, raw materials sources, or technological know-how, skilled work-force
establishment of related industries but the ultimate objective must be the accomplishment of favourable pecuniary results,
sometimes during the life cycle of the investment.
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According to Ahorani, the foreign investment decision is typically a response to a specific opportunity arising from
stimulating forces inside or outside the firm, rather than a systematic search for profitable investment opportunities abroad.
The external stimulus may originate with the host country, the MNCs clients, or distributors of its products. Irrespective of
whether the stimulus originates within the firm or without, strategic motivations, such as the fear of losing a market, the
bandwagon effect, or strong competition from abroad in the home market, would impel the firm to seriously consider the
opportunity. In addition, there are other strategic factors that act as stimulating forces for overseas investment.
Thus, the key factors that spur foreign investment are discussed below:
Product and Market Imperfections
MNCs possessing specific intangible capital in the form of trademarks, patents, general marketing skills, and other
organisational abilities may be induced to make overseas investment through new product development and adaptation,
quality control, advertising, distribution, after sales service and the general ability to read changing market desires and
translate them into saleable products and take advantage of market imperfections and those establishment of their business
empire and capturing market. It is for this fact that they find it too difficult to unbundle these services and sell them apart from
the firm. However, internationalizing the market for an intangible asset by setting up foreign affiliates makes economic sense
of the benefits from circumventing market imperfections, outweighing the administrative and other costs of central control.
At times, MNCs prefer FDI to other modes of entry into overseas markets for protection against misuse of their intangible
assets by local firms. Coca-Cola chose FDI as a mode of entry into foreign markets, and set up bottling plants instead of
licensing local firms mainly to protect the formula for its famed soft drink. If the company licenses a local firm to produce
coke, it has no guarantee that the secrets of the formula will be maintained and once the formula is leaked out the market for
Coca-Cola could be ruined.
Market imperfections may lead to both vertical and horizontal investment. Vertical investmentinvolving direct investment
across industries that are related to different stages of production of particular goodenables the MNC to substitute internal
production and distribution systems for inefficient markets. On the contrary, horizontal direct investmentinvolving crossborder but within industryenables the MNC to utilize its intangible assets such as know-how or technology and avoid the
problems of dealing with unrelated parties like conflicts in viewpoint, breach of contract etc.
It must, however, be remembered that mere existence of market failure is not sufficient to justify FDI, for the fact that local
firms have an inherent cost advantage over foreign investors and MNCs can succeed abroad only if the production or
marketing edge that they possess cannot be purchased or initiated by local firms. They have to create and preserve on
enduring basis effective barriers to the direct competition in product and factor markets.
Market Opportunities
Existence of tremendous market opportunities abroad and fierce competitive domestic market limiting the growth in demand
and the consequent decline in market share may stimulate MNCs to enter into highly potential overseas markets. For instance,
many of the developing countries, viz., Argentina, China, Mexico, Chile and Hungary have, of late, been able to attract FDI
flows because of existence of attractive markets. As MNCs find it more attractive to invest in developing market so as to
establish their excellence and derive maximum benefits from the customers of host country.
Trade Barriers
Because of government created restrictions in the form of tariffs, quotas, etc. on imports and exports hindering the free flow of
the products across national boundaries, a firm may decide to set up production plants in such countries as means of
circumventing the trade barriers. Honda, for example, set up a plant in Ohio to produce cars to escape from the US
Government tariff control. The recent spurt in FDI in Mexico and Spain can be partly attributed to the desire of MNCs to
circumvent external trade barriers imposed by NAFTA and the European Union.
Existence of Superior Profits in Overseas Markets
The possibility of making superior earnings in certain overseas market may also allure the MNCs to divert their funds in these
markets. However, MNCs are likely to face competitive challenge from the local firms who may prevent a new competitor
from taking their business by lowering their prices.
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Imperfect Labour Market

The labour market is the most imperfect among all the factors of production; Among all the other factors of production labour
is the most variable factor both in terms of skill as well as cost further labour costs vary widely in different countries. Wage
costs in Mexico, Malaysia and India are relatively much lower. Substantially lower labour costs in these countries have
attracted MNCs like Black & Decker Corporator, Eastman Kodak Co., Ford Motor Co., General Electric Co., Smith Corona,
Zenith Corp. and Honeywell to invest.
Access to Inputs
Due to transport costs, MNCs generally avoid importing raw materials from a country where it is available at a stable price,
especially when they plan to sell the finished product to consumers of that very country. Under the circumstances, it would be
pertinent to set up production plants in the country where the raw materials are easily and profusely available. Many MNCs
involved in extractive/natural resources tend to directly own oil fields, mine deposits and forests for these reasons.
Access to Foreign Technology
Another important motivator for investing in other country is the lust to have opportunity to access technology used in that
county. Infact, MNCs are growingly setting up manufacturing plants or acquiring existing plants in those countries just to
learn about the advanced technology and use them to improve their own production processors at all subsidiary plants
around the globe.
Capitalizing on Monopolistic Status
According to the Industrial Organisations Theory, many firms gravid with unique resources and skills not possessed by
competing firms tend to internationalize their operations to exploit the benefits of these unique competencies particularly
when they find that they had already exploited this advantage successfully in local markets.
Product Life Cycle
The Product Life Cycle Theory of Raymond Vernon suggests that firms undertake FDI at a particular stage in the life cycle of a
new product introduced to the market. According to Vernon, when US firms first launched new products, they decided to
restrict production facilities to home market. Being the pioneer of products, they can charge relatively high price in the initial
stage because of consumers insensitivity to the price at this stage. They have the opportunity to improve the product keeping
in view the changing customers needs.
After the product is perfected and standardized to benefit from internal and external economies of scale due to the increased
level of production and savings in distribution, output would begin to exceed the home market requirements. In the
meanwhile, demand for the new product develops in foreign countries, the pioneering firms decide to export the excess
product to those countries.
With continued growth in product demand in overseas countries, US firms may be tempted to set up production plants in
those countries to cater to local markets.
As the product reaches maturity and the market is eventually flooded with similar products leading to decline in profit
margins, it becomes imperative for the firms to cut cost to remain competitive. This may induce the firms to search for
locations overseas where imperfections in the factor market result in lower product cost. Thus, FDI becomes useful for MNCs
when the product reaches maturity and cost becomes predominant consideration.
It may, however, be noted that the Vernon Theory developed in the 60s of the last century when the US was the unchallenged
leader in R&D capabilities, products and innovations cannot be the only basis for justifying FDI in foreign countries in view of
growing complexity in the behaviour and strategies of MNCs on the one hand and increasing product innovations in many
advanced countries and increasing complexity in the international system of production on the other. In the changed
environment, firms may set up production plants in a number of countries right from the introduction of a new product.
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Behaviour of Foreign Exchange Rate

MNCs FDI decisions are also influenced by exchange rate movements because cost is one of the key determinants. Firms may
be tempted to invest in a country whose currency is perceived by a firm to be undervalued. This is so because making
investment in a country having lesser exchange rate will tend to lower outlay and hence more lucrative to MNC.
At times, FDI is driven by the firms desire to offset the changing demand for its exports owing to exchange rate fluctuations.
Financial Market Imperfections
Existence of financial market imperfections across the globe may provide impetus to MNCs to undertake FDI. Alongside their
capability to reduce taxes and circumvent currency controls, MNCs desire to reduce risks of exchange rate changes, currency
controls, expropriation and other forms of government intervention through international diversification may be the driving
force for FDI. The diversification effect stemming out of operation in a number of countries having imperfect economic cycles
and diverse economic and financial conditions tends to reduce the volatility of MNCs earnings. In addition, the firm may
enjoy a lower cost of capital as shareholders and creditors perceive the MNCs risk to be lower as a result of more stable cash
flows.
Inefficient Financial System
At times, inefficiency in the system of allocation of financial resources of a country resulting in the wide gap between demand
for and supply of funds to viable organisations can attract FDI to fill his gap. For example, China got so much FDI essentially
because the domestic financial system allocated domestic savings very inefficiently in the sense that most of the money goes to
inefficient firms like state-owned enterprises and most efficient firms, like private firms remain deprived of desired funds. In
such type of situation domestic firms have to take assistance of external finance from outside of domestic territory in form of
FDI. It is FDI which plays a crucial role inasmuch as it provides financial support to private entrepreneurs who could not get
financing from the formal financial system.
Decisions Subsequent to FDI

In order to ensure sustainable competitive superiority to their rivals and continue to make maximum mileage of opportunities
in foreign markets, MNCs are supposed to make periodic decisions particularly with regard to the following:
1.
Whether further expansion should take place in a given location;
2.
What steps should be taken to meet the competition from local producers;
3.
Whether to have the earnings generated by the project remitted to the parent company or used by the subsidiary;
4.
Whether MNC should opt strategic measures like integration, diversification etc. or not.
5.
How can barriers to entry be managed in the foreign country where an MNCs project is in operation?
Among these the most crucial decisions subsequent to FDI to be taken by MNCs is how to maintain their competitive edge in
the current foreign market. The MNCs might have created in the initial years barriers to entry by continuing introducing new
products and differentiating existing ones. But over a period of time, technological leads have the tendency to erode. It would,
therefore, be pertinent for the MNCs to employ other factors to replace technology as a barrier to entry. One such variable
could be the presence of economies of scale. The existence of economies of scale signifies that there are inherent cost
advantages to being large. The more significant of these economies is, the greater will be the cost disadvantage faced by a new
entrant to the market as they have to start with comparatively lesser scale of production leading to non-attainment of internal
and external economies of scale.
Host Government View on FDI

The extent of FDI in a particular country is dependent upon a host of factors such as the countrys markets and resources as
well as government regulations and fiscal and financial incentives. Countries like Singapore and Hong Kong and more
recently China, could attract burgeoning amount of FDI mainly because of liberal policies of the ruling government and few
business restrictions. Our country has, of late, attracted huge funds from FDI to the extent of $ 39 billion during 1991-2006
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because of the adoption of the policy of globalization and economic liberalization permitting foreign investors to hold 49%
ownership share in the infrastructural sectors including banks and telecom sectors with government assurance to raise the
ceiling to 74%. During 2006-07 FDI flows in India totaled $ 19.5 billion. Some countries offer various types of fiscal and
financial concessions in the form of various subsidies and grants to attract foreign investments. Mexico recently reduced its
restrictions on automobiles produced there. It has recently announced that it would allow foreign companies to own 100% of
their subsidiaries established in Mexico. In a refreshing contrast, Japan could not attract much investment because of major
entry barriers.
FDI as a means of accelerated economic growth should be assessed in terms of its potential gains and disadvantages for the
country. As there could be different modes to get assistance of external funds and ensuring foreign capital inflow, the selection
of mode is very much crucial. As some types of FDI may be more attractive to some countries than others. Obviously, FDI will
be most welcomed in a country if it solves its problem of unemployment and provides technology support without taking
business away from local firms. Further, FDI involving establishment of a manufacturing plant that uses local labour and then
exports the products not done by local firms would also be appreciated by the host country as it provides employment
opportunities to the local workers.
The host government, while evaluating an FDI proposal, should assess its potential advantages and disadvantages to the
economy. Where the potential gains are expected to be greater than the potential disadvantages, every attempt should be
made to provide additional concessions such as tax-holiday, liberal duties rent-free land and buildings, lower interest loans,
subsidized energy and reduced environmental restrictions so as to attract foreign investors. The amount of the fiscal and
financial incentives that a government provides depends to a great degree, on the extent to which MNCs FDI would benefit
that country.
5.5.2 Trends in FDI

There has been phenomenal growth in FDI in the world following the pursuance of the policy of liberalization and
globalization across different countries. According to a recent UN survey, the world FDI buoyed up about twice as fast as
worldwide exports of goods and services that themselves soared faster than the world GDP by about 50%. FDI by MNCs has
now come to be recognized as a powerful means of linking national economies and defining the character of the merging
global economy. Many MNCs like Sony, Toyota, Royal Dutch Shell, IBM, GM, Coca Cola, McDonalds, Daimler-Benz and
Nestle have established their presence worldwide by dint of FDI. These MNCs have invested burgeoning resources, both
tangible and intangible, in different parts of the world in their stride to take maximum mileage of their competitive
superiority.
A close scrutiny of over the period 1993-2004 shows that, FDI inflows to developing economies registered a rise by over 60%
from $138.9 billion during 1993-98 to $ 232.2 billion in 2004. In contrast, inflows to developed economies surged by
49% from $256.2 billion to $ 380 billion during the corresponding period. As a result, relative share of FDI inflows to
developing economies in world inflows marginally increased from 34.6% to 36.3%, while that of developed economies fell
from 63.8% to 58.6% during the period. United States continues to remain on the top in attracting FDI.
Major factors contributing to growth of FDI in developing countries are as under:
z
Liberalization of foreign investment policy.
Fierce competitive pressure in domestic economy following liberal economic policy.
Rationalization and streamlining of production activities with a view to reap the benefits of economies of scale and
reduced cost.
Higher commodity prices stimulating FDI flows to countries gravid with natural resources such as oil and minerals.
Spate of mergers and acquisitions at global level led to increase in FDI flows to developing countries.
As regards FDI outflows, it has been observed that there has been tremendous increase in FDI outflows from developed
economies from $353.3 billion during 1993-98 to $637.4 billion growth of 80%. The largest growth was registered in the USA
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from $92.3 billion to $229.3 billion during the period. In contrast, moderate increase in outward FDI was noticeable in the case
of developing countries.
It could be observed from the study of FDI flows in developing countries vis--vis world FDI. That there has been about five
fold increase in FDI flows to developing countries from $49.8 billion during 1994-05 to $233.3 billion in 2004 as against 3.5
times increase in world FDI inflows. As a result, percentage share of inward FDI of developing countries as a percentage of
gross fixed capital formation spurted from 4.6 percent to 10.5% during the period. In the case of world FDI inflows, the
corresponding rise was from 3.8% to 7.5% during the period.
Among the Asian countries, China and Indiathe two fastest growing countries of the worldreceived the largest amount of
FDI, figuring out $ 66 billion (China 60.6 billion and India $ 5.3 billion). In view of the tremendous potential in India, following
the adoption of new economic policy and speedier economic and industrial growth, the country received FDI inflows of $38.9
billion between August, 1991 when the economy was opened and March 2006. The FDI during 2006-07 amounted to about 16
billion, representing almost 50% of the investment received in the previous 14 years. FDI during the year 2006-07 exceeded FII
flows, showing higher confidence in India and Indian corporate sector. In 2007-08, India received FDI of $24.5 billion, a rise of
56% over the previous year. By AT Kearneys FDI confidence index 2006, India has emerged as the second most attractive FDI
destination after China, pushing the USA to the third position. Rise in FDI flows the growing confidence of the foreign
investors over the Indian Economy. While the entire world is facing a financial turmoil, India continues to be a safe and stable
investment destination.
Like FDI inflows, developing countries recorded about four fold rise in FDI outflows during the period 1994-2004 as against
three and half times increase in Outward FDI of the world. It is interesting to note from the table that Indias outward FDI
soared from $25 million in 1994-95 to over $22 billion in 2004. However, modest increase was observed in the case of China.
During the last three years2004-06, Indian corporates have made aggressive forays in international markets through mergers
and acquisitions, indicating their enormous confidence in managing business overseas.
5.6 International Labour Migration

Labour, is, of course, one of societys most valuable resources. Labour economics seeks to understand the functioning and
dynamics of the market for labour. Labour markets function through the interaction of workers and employers. Labour
economics looks at the suppliers of labour services (workers), the demanders of labour services (employers), and attempts to
understand the resulting pattern of wages, employment, and income.
In economics, labour is a measure of the work done by human beings. It is conventionally contrasted with such other factors of
production as land and capital. There are theories which have developed a concept called human capital (referring to the skills
that workers possess, not necessarily their actual work), although there are also counter posing macro-economic system
theories that think human capital is a contradiction in terms.
While the liberalization of international flows of goods, capital, and information is well underway, progress toward the free
movement of persons is harder to achieve. Indeed, the impact of migration on countries of origin and destination is more
controversial, and States are more concerned about losing their sovereignty in this matter.
5.6.1 Types
Labour migration is generally defined as a cross-border movement for purposes of employment in a foreign country.
However, there is no universally accepted definition of labour migration.
Sometimes, the term economic migrant is also used as an equivalent to the term labour migrant or migrant worker. However,
the two terms may not be the same and cover different categories. The term labour migrant can be used restrictively to only
include the movement for the purpose of employment, while economic migrant can be used either in a narrow sense, which
includes only movement for the purpose of employment, or in a broader sense that includes people crossing borders and
visiting other countries to perform other types of economic activities as investors or business travellers.
Categorization of labour migration is usually based on the duration of activities, as well as on the distinctions made by
receiving countries in their regulatory framework where conditions of admission and stay are established.
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Depending on the category, procedures of admission can be more or less burdensome and conditions of stay more or less
generous. Persons entering a country for job training are included in some labour migration classifications but excluded from
others. Although the purpose of a trainees movement is not employment, some consider that these schemes should be
included, because they are employment-based and can have important labour market implications.
5.6.2 Factors Involved

The factors that induce labour emigration are:
z
Differences in employment opportunities and living standards between countries
Increased education and broader access to information on living conditions and employment opportunities abroad
Established inter-country networks based on family, culture, and history.
On the demand side, changing demographics and labour market needs in many industrialised countries will put pressure on
many governments to consider more open approaches to labour migration.
The impact of labour migration varies from country to country. Economic migration can have different effects resulting from
the volume, composition, and characteristics of the migratory flows as well as the context in which the flows take place.
Impacts will also vary depending on the skill level, geographical source, employment situation, age, and gender of the
migrants. Other variables are the duration of stay, the organised or spontaneous nature of the movements, their legal or
irregular character as well as the stages of development, and the demographic and labour market conditions in both sending
and receiving countries.
Labour migration may have vast potential for countries at both ends of the migration continuum. For countries of origin, in
addition to the possibility of providing some relief from unemployment and absorbing an increase in the labour force, it can
provide a form of developmental support, especially through remittances, transfer of know-how, and creation of business and
trade networks. For receiving countries facing labour shortages, immigration can alleviate labour scarcity, facilitate
occupational mobility, and add to the human capital stock of the receiving countries. In the context of demographic changes,
labour migration can help receiving countries to maintain workforce levels.
5.7 Technology Transfer: Need, Issues and Trends

Technology denotes the utilisation of the materials and processes necessary to transform inputs into outputs. People create
technology and technology affects people in turn, especially through the goods it produces and the working conditions it
creates. Technology may be described as a set of specialised knowledge applied to achieving a practical purpose.
Developing countries in particular, see technology transfer as part of the bargain in which they have agreed to protect
intellectual property rights. The TRIPS Agreement includes a number of provisions on this. For example, it requires developed
countries governments to provide incentives for their companies to transfer technology to least-developed countries.
The concept of technology transfer is not new. In the thirteen century Marco Polo helped introduce to the Western world
Chinese inventions such as the compass, papermaking, printing, and the use of coal for fuel. In Islamic countries, knowledge
of the technology of manufacturing paper came in AD 751 following a battle between Arab and Chinese forces in which the
Chinese were defeated.
The Arab captured skilled Chinese paper manufacturers and began to produce a paper in Samarkand. Technology transfer is
infact the translocation of innovations arising in one firm or country to others. In technology transfer, knowledge passes from
the innovator to one or more recipient, who thus avoids the need to conduct independent research, or to develop projects, or
to test and evaluate the outcomes of research.
Technology transfer is the application of technology to a new use or user. It is the process by which technology developed for
one purpose is employed either in a different application or by a new user. The activity principally involves the increased
utilisation of the existing science/technology base in new areas of applications as opposed to its expansion by means of further
research and development. (Languish et al, 1982, Wealth from knowledge, Macmillan, London)
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Seaton and Cordey-Hayes (1993), the development and application of interactive models of technology transfer, Technovation,
13(1), 45-53 have defined technology transfer in following manner:
The process of promoting technical innovation through the transfer of ideas, knowledge, devices and artefacts from leading
edge companies, R&D organisations and academic research to more general and effective application in industry and
commerce.
Point to Point technology transfer occurs when a single donor transfers technology to a single recipient, e.g., firm to firm or
from one research institute to another. Diffusion conversely refers to the situation where there are many recipients, all having
easy access to technology.
5.7.1 Need for Technology Transfer

There are various reasons because of which companies engage in transfer of technology. Some of them are as follows:
z
Profit from selling technology: The biggest reason for the transfer of technology is profit. Many companies sell their
technology to earn a profit. When after the Second World War, Kodak had to quit the Japanese market because of certain
restrictions, it frequently sold its technology to Japanese firms like Konica and Fuji to earn profit.
Location and Logistics Advantage: Technology is transferred as production may be cheaper abroad and output does not
have to be transported over long distances to reach the end consumer.
Competitive Edge: To gain competitive edge in foreign markets through the supply of technically superior products.
To Obtain Grants and Subsidies: Many underdeveloped and developing countries give various incentives to MNCs to
invite them and their relative advanced technology into their country.
Limitations of Home Country: Many companies find that the scope for expansion in their home countries is limited. In
order to expand, they have to transcend their national boundaries, as well as be ready for technology transfers. For that
they have to transfer their technology.
To exploit superior capital markets, access to skilled labour and other inputs in foreign countries.
To enhance the competence and potential of foreign subsidiaries.

1.
Existence of financial market imperfections across the globe may provide impetus to MNCs to undertake FDI.
2.
The term labour migrant can be used restrictively to include the movement for the purpose of employment,
business travel and investment purposes.
3.
Technology transfer is the application of technology to a new use or user.
4.
Technology is transferred as production may be costlier abroad and output does not have to be transported over
long distances to reach the end consumer.
5.7.2 Methods of Technology Transfer

Technology can be transferred via the following methods:
1.
Direct Foreign Investment
2.
Licensing
3.
Franchising
4.
Management Contracts and/or Turnkey Arrangement
146
5.
Contract Manufacturing
6.
Joint Venture
Foreign Direct Investment: Through the FDI rout organisations transfer the technology to target nations through its own
subsidiary, that is, by investing themselves. As in India, Hyundai established its own subsidiary and thus brought its
technology to India.
Licensing: Organisations transfer the technology and provide licences to the user for use of technology. Under this
arrangement only a license holder can use the technology. As in the case of software, the user purchases the licence to use the
software from the technology provider, against royalty or payment of other fee.
Franchising: Franchising is similar to licensing, where organisations establish their own franchise and transfer their technology
to the franchisee. The franchisee operates on behalf of the organisation. In the franchisee system, companies have a direct
control, but under the licensing system the control of the company is only up to the limit of providing technology. As the
franchisee operates on behalf of franchiser, the franchisee carries the name and trademark of the franchiser. For instance
McDonald's creates its franchises and transfers the technology to the franchisee.
Management Contracts and/or Turnkey Arrangement: This is a point to point technology transfer where organisations either
transfer the technology to other organisations under certain terms and conditions, or simply establish a project for a host, train
its personnel to operate it and transfer the control to the host. In India the steel plants of Bokaro, Bhilai, etc., are established
under this type of contract.
Contract Manufacturing: Under contract manufacturing organisations transfer the technology to the user and get the product
manufactured from the user for themselves. It is a common type of technology transfer. BPOs are a typical type of contract
manufacturing. Many Multi National Pharmaceutical Companies transfer their technology to the companies of nations like
India and get their built drug manufactured from India because of low manufacturing costs in the country. Similarly, many
Indian companies like HUL, Marico, Bajaj Electricals, Colgate, etc., transfer their technology to some other manufacturers and
get the products manufactured from them.
Joint Venture: Under joint ventures organisations transfer the technology to their joint venture partner. They provide the
technology to the host nation through a partner from a host nation. This arrangement is beneficial for both. Maruti Suzuki,
Swaraj Mazda are examples of very successful joint ventures where technology transfer have taken place.
5.8 Let us Sum up

The IMF came into existence in December 1945, when the first 29 countries signed its Articles of Agreement. The purpose of
the International Monetary Fund is to promote international monetary cooperation to facilitate the expansion and balanced
growth of international trade, to promote exchange stability, to maintain orderly exchange arrangements among members, to
shorten the duration and lessen the degree of disequilibria in the international balances of payments.
The IMFs resources come mainly from the quota (or capital) subscriptions that countries pay when they join the IMF, or
following periodic reviews in which quotas are increased. Quotas also are the main determinant of countries voting power in
the IMF. The SDR, or Special Drawing Right, is an international reserve asset introduced by the IMF in 1969. The SDRs value
is set daily using a basket of four major currencies: the euro, Japanese yen, pound sterling, and US dollar.
The World Bank is one of the worlds largest sources of finance and knowledge to its member countries to improve the
condition of health centres, provide water and electricity, fight disease, and protect the environment. The main purpose of the
World Bank is to assist economies in the reconstruction and development by facilitating the investment of capital for
productive purposes. It also helps in reconstruction of economies destroyed or disrupted by war, and it encourages the
development of productive facilities and resources in less developed countries.
The debt crisis of the 1980s affected all the countries. The international financial markets were severally affected when a
number of developing countries found that they were unable to meet the payments amounting to several hundred billion
dollars to major banks around the world. As countries trade with each other, economies are integrated. The stagnant
economies in Europe and the United States had an adverse affect on many Less Developed Countries (LDC) economies.
147
FDI as a mode of foreign market entry provides a permanent foothold in the foreign market and can generate high return
when managed properly. However, it requires a substantial investment, which involves additional overlay of foreign
exchange risk, political risk and cultural risk. Given these risks and return complexion of FDI, MNCs obviously tend to
analyze carefully the potential benefits and costs before deciding about kind of FDI.
In order to ensure sustainable competitive superiority to their rivals and continue to derive maximum mileage from
opportunities in foreign markets, MNCs need to make decisions in respect of location, deployment of earnings generated by
the project and management of entry barriers.
The magnitude of FDI in a particular country depends upon a host of factors such as the countrys markets, customers
attitude, competitors soundness, and availability of labour, cost of production, economies of scale as well as government
regulations and fiscal and financial incentives.
Technology transfer is a key issue in today's global environment. It is the transmission of innovations arising in one firm or
country to others. Technology passes from the innovator to one or more recipient, who thus avoids the need to conduct
independent research, or to develop projects, or to test and evaluate the outcome of research.

Emerging markets have always been affected with every major international financial crisis, whether it is the Mexican Peso
(1994), the Thai Baht (1997), or the Russian Ruble (1998). Using internet and other sources like Journal and research papers find
out the reasons as to why these markets come under pressure when a crisis occurs.
5.10 Keywords
Sub-prime: Sub-prime lending is the practice of extending credit to borrowers with certain credit characteristics.
Sovereign Risk: It refers to the political, legal and other risks associated with a cross-border payment.
Credit Risk: This refers to the risk of not getting back the payment on time.
Cross-border Merger: In cross-border merger, two firms pool their assets and liabilities to form a new organisation.
Foreign Exchange Risk: Risk factors associated with foreign exchanges.
Foreign Subsidiaries: Units of MNCs located in various countries.
Labour Migration: Cross-border movement for purposes of employment in a foreign country.
Technology Transfer: Assignment of technological intellectual property, developed and generated in one place, to another
through legal means such as technology licensing or franchising.

1.
Explain the purpose of IMF. Discuss how far it has been successful in achieving these purposes.
2.
Evaluate the achievements and failures of IMF.
3.
State the merits and demerits of SDRs.
4.
Comment on the achievements and failures of the World Bank in context of economic development.
5.
The ability to monitor financial sector soundness presupposes the existence of valid indicators of the health and stability
of the financial system. Elucidate in the context of MPIs.
6.
The IMFs prescription at the time of the Asian crisis has come in for serve criticism. Elucidate.
7.
Discuss recent trends in FDI in the globe.
8.
Why are China and India emerging as attractive centres of FDI?
148
9.
What forces stimulate FDI in a country?
10. What is internationalization theory of FDI? Discuss strengths and weaknesses of the theory?
11. Discuss the concept of international labour migration.
12. What do you mean by technology transfer? Why is it needed?

CYP 1
1.
True
2.
True
3.
False
4.
True
CYP 2
1.
1983
2.
Subprime lending
3.
Collateral
4.
Rise
CYP3
1.
True
2.
False
3.
True
4.
False

Fuad, A. Abdullah, Financial Management for Multinational firms, Prentice-Hall International, USA
Robert, J. Carbaugh, "International Economics", 9th Edition, Thomson Asia Pvt. Ltd., Singapore
149

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