Transcription Doc

Foreign Trade

Note: This transcription document is a text version of the upGrad videos present in this session. It
is not meant to be read independently, but can be used to complement your video watching
experience.

Video 1

Speaker: Chris Oates

Welcome to the fourth session of this module on macroeconomics and this session is going to be
focused on foreign trade.

Now, a lot of business that happens across borders is the same as what happens within borders.
Costs, Revenues, profits losses, they're the same. But because you might be dealing with different
currencies with different countries with different labour costs. There are some interesting things
that happen in foreign trade that are different from what happens within one country's economy
that are important to point out.

We are going to be covering that in this session and we're going to start with some of the basics
of why foreign trade is so important to the global economy. One of the most important aspects of
foreign trade is that it allows countries to use their comparative advantage to grow economically
and to get surpluses that they may not otherwise be able to get.

Now, let's take just for one example: coffee. Now, I'm here in the United States. There are a lot of
people who drink coffee, but we don't really have a lot of coffee trees that grow beans here. Now
we could try to create them. We could build lots of greenhouses plant a lot of coffee plants, but
that would be really expensive and it would be very inefficient. It's a lot easier for Americans and
American coffee companies to import the beans from the places where it grows much more
cheaply. Guatemala, Colombia, Brazil and so on.

So for us we are able to use the comparative advantage that other countries have in coffee beans
to allow them to grow beans more cheaply, sell it to us and we get those beans at a very good
price. And that's really the basis of much of foreign trade.

It allows countries to export goods at a higher price than they can get domestically or import
goods at a lower price than they can get domestically. How does a country get a comparative
advantage? You could have the natural resources, so Saudi Arabia and Russia have a comparative
advantage in oil production, because oil is located there.

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It could be because of physical assets in a country. So maybe a country has a lot of really great
infrastructure, which means transportation is cheap. It could be human capital. The United States
is a leader in information technology in part, because there are a lot of software engineers in the
United States. Or it could be something like stability. There's a reason why a lot of financial
centers are in politically stable countries. Because if billions of dollars are flowing in and out, you
want to make sure that there's the stability there.

Or it could be because there's a big consumer market. So you might, as a country have a really
big market in a certain products like beverages or food products, because you know there's a
consumer market there. So if you create a new product, there's an immediate market to sell it
into.

So, for whatever reason, you might have a comparative advantage as a business that could be
applied to a country as a whole, or at least the businesses in that country get their comparative
advantage from their location within a country. However, there are some problems with foreign
trade, or at least there are some issues that might become problems with foreign trade.

The world price might not be the price at the domestic level. In fact, it often never is if you are
conducting foreign trade. So if you are a consumer in that country, all of a sudden, you have to
pay the world price for that product. When previously, you only had to pay the lower domestic
price.

So if you are a coffee drinker in Guatemala, if Guatemala did not export any coffee beans, you'd
have a really cheap cup of coffee., But if so many of those beans are being sold to the United
States or Europe or all around the world. Well, you have to compete with those buyers over there
and so there's the problem that consumers might be paying really high prices and prices that they
might not be able to afford.

The other is that domestic suppliers are now being undercut by a lower world price. So steel mills
in the United States, for example, had to compete with mills in China and South Korea after World
War II. And so these mills that had been a staple of the US economy found that they were
competing with cheaper imports from overseas, and so they then had the option of either cutting
their costs, which cuts their profits or cutting their costs by laying off people.

So maybe they automate, maybe they lower the price. Maybe they lose revenue, but the effect is
that it's an industry that had been thriving and now faces competition that it hadn't yet been able
to face, and it faces a lower price than it hadn't been able to charge.

Video 2

Speaker: Amrita Bhattacharya

Now that you have learned what foreign trade means, let's discuss the role of trade policy. What
is trade policy? It refers to the set of regulations and agreements that control the flow of trade
between countries.

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There is broad agreement among economists that free trade is beneficial for all, and even the
decision to allow free trade is a trade policy decision. Through a free trade system, countries
benefit by producing and exporting more of what they specialize in and by importing more cheaply
what they do not produce.

Yet you have must read or heard about trade sanctions and embargoes, as well as extra tariffs
being imposed on some countries. These are some of the barriers to free trade, but why are these
barriers needed if free trade is so beneficial?

Well, let's look at some of the reasons and motivations behind why governments impose trade
barriers. First to support local employment opportunities by decreasing cheap imports from other
countries, that have the advantage of extremely low cost labour. Decond, to protect infant or
nascent industries, that would take time to establish and hence need to be protected from foreign
competition.

Third, to counter aggressive trade policies of other countries. For example, protection against
dumping, which happens when importers sell their products at a lower cost than the production
cost. Fourth, to generate extra revenue through additional taxes and duties on imported goods.

These trade barriers are of two types tariff and non-tariff barriers. Let's first look at the tariff
barriers. Tariff is basically a tax on an imported good or service. It is paid by the importer to the
tariff setting government. When the current US-China trade war started, the US imposed a 30
percent tariff on Chinese made solar panels. That made the price of any solar panel coming from
China to the USA, 30 percent more expensive than the price said by the Chinese firm selling it.

The goal of tariff barriers is to ensure that a domestic version of the product is cheaper than the
foreign one or the foreign product is priced so high because of tariffs that buyers are discouraged
from spending on the foreign product.

Now, let's look at the non-tariff barriers to trade. As the name suggests, these restrict trade by
using barriers that are not in form of tariffs. This could include sanctions, embargoes, quotas,
bans etc.

Some governments could impose import quotas to restrict the amount or monetary value of goods
imported from a country. Some governments would implement regulations like mandating that all
imported fruit products must meet certain pre-established health standards.

This could include a requirement to create a joint venture with a local company in order to do
business in a country which is a common practice for businesses in China.

Now what happens if a business feels that it is being hit by an unfair barrier to trade? What option
does the business have to overcome this issue? Ideally, your government can file a case at the
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world trade organization. The WTO can mediate or decide to resolve any disputes between its
member nations, but what if you want to establish more open trade with a country without any
barriers or even fear of these barriers?

This is where free trade agreements or FTA’s come into the picture. Broadly speaking, FTA’s are
an agreement between two or more countries about how trade should flow among them. The
outcome of the agreement should be increased trade and wealth for all members involved.

Video 3

Speaker: Chris Oates

Investment is a crucial part of foreign trade, and capital flows are a crucial part of how the global
economy functions. There are a few ways that money can move across border and one is foreign
direct investment. This happens when a business sets up operations or acquires a company in
another country. So if a US oil company builds a refinery in Kazakhstan that they fully own, that
would have been foreign direct investment from the United States into Kazakhstan.

Foreign indirect investment is the purchases of shares or bonds of companies in another country
or on another stock market? And then you could also have movement of investment capital from
one country to another. And that's often in the form of buying government debt. So if an
American investor buys government debt from Japan, you know bonds from the Bank of Japan
that would have been a movement of capital from the United States into Japan via the purchase
of a government bond.

Now, why would investors want to do this? Well, it's very simple! If you think that you can get a
better rate of return in another country, then you would want to move your capital into that other
country, and that could be because a country has higher yields on its bonds or you think it's
growing at a faster rate Of GDP.

So foreign investment, like trade, should generate surpluses on both sides. The investing company
should get a better rate of return than they would otherwise receive, and the receiving country
should get capital that they can use to develop. So it's a crucial part of the global economy. It's a
crucial part of economic growth. If you see a country receiving a lot of foreign direct investment,
then that is generally a good sign for their economic prospects.

Video 4

Speaker: Amrita Bhattacharya

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Balance of payments or BOP, also known as the international balance of payments, is the
recorded summary of all the financial transaction that a country entities, including individuals,
companies and governments or government bodies perform with the rest of the world over a
defined time period.

In simple terms, BOP is the difference between the inflow and outflow of money in a country
usually recorded for a period of one year. The balance of payments divides transactions into two
components: the current account and capital account. The current account reflects a country's net
income in case of surplus or net spending in case of a deficit through trade. It includes all exports
and imports in goods and services, interest payments on international investment and transfer
payments, including international remittances.

It is called the current account because it is recorded in real time. The capital account, on the
other hand, reflects all international sales and purchases of assets like purchases of government,
debts, bonds or foreign direct investment, etc.

You might also read or hear about a third component called financial account. Now several
countries, including the US differentiate between financial and capital accounts. However, in India,
all international financial transactions are also recorded under the capital account.

In theory, the sum of all transactions recorded in the balance of payment must be zero, as per the
accounting standards, because every credit appearing in the current account has a corresponding
debit in the capital account, and vice versa.

For example, if a country exports a good which would be recorded under the current account, it
also essentially imports foreign capital in terms of payment, which would be reflected under the
capital account.

Now, let's talk about the concept of balance of trade or BOT. Balance of trade refers to the
difference between the value of countries, exports and imports for a given period of time. BOT is
also the largest component of a country's balance of payments. If the value of a country's exports
exceeds the value of its imports, then the country has a trade surplus. Conversely, if imports
exceed exports in terms of value, then the country has a trade deficit.

To simplify the balance of trade can be calculated as the total value of exports minus the total
value of imports. A positive BOT reflects a higher GDP, and a negative BOT reflects a weaker GDP.

As of 2019, Germany had the highest rate surplus in the world, followed by Japan. On the other
hand, the US had the highest trade deficit, followed by UK, with India at the third position. Let's
now talk about disequilibrium in BOP. When a country's current account reflects a surplus or
deficit, its balance of payments is said to be imbalanced or in disequilibrium.

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A disequilibrium in BOP can result from various causes. First, economic factors which include
imbalance between export and import, higher prices of domestic goods, leading to higher imports,
new supply sources, substitute goods and so on.

Second, political factors, political instability or volatility can lead to capital flight or discourage
foreign investment. Third, social factors which can include change in taste or fashion, leading to
preference for imports or an explosion in population leading to high demand for imports. As
domestic manufacturers struggle to match the demand etc.

A government can correct a disequilibrium in its balance of payments by adopting various

measures like lowering imports through import substitution and trade restrictions. Increasing
exports by offering incentive to domestic producers controlling inflation levels in the country to
discourage import and encourage exports, devaluing the domestic currency to make domestic
goods cheaper and therefore more lucrative to importers among others.

Video 5

Speaker: Debopam Chaudhuri

To give you a brief background of how India was and how reforms changed India. So, for a long
time, even after independence, India was a closed economy. By closed economy, it meant that
India was closed for business for foreign national or foreign companies.

Even within India, significant amount of red tapism, which eventually came to be known as the
license raj prohibited free production or free market economy to thrive within the country. As a
result of which till the 1970s or even till the 1980s, India was stuck in a very low growth rate
situation, which was not more than 3.5 percent. Historians have labelled that growth period till the
1980s as the Hindu rate of growth.

Then in 1980s, some reforms were brought in by the prevailing government and this led to a
marginal uptick in the growth rates. Growth rates improved from three and a half percent till
1980s, since independence to about five percent during the 1980s, till about 90s.

However, many facets of the license raj was also prevalent during the 1980s, which was crippling
Indian domestic production, as well as it was increasing the amount of imported goods within the
country.

As a consequence, by the 1990s because of lack of exports out of the country and a huge influx of
imports, within the country, which included a huge amount of crude as well as gold, India ran into
what is infamously called the balance of payment crisis.

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It was this time when India needed a loan from the IMF or the international monetary fund to bail
it out of the crisis. However, IMF, WTO which is the world trade organization or the world bank,
they are champions of globalization. They only help countries who open their markets to a
globalized world, and this is exactly what was imposed upon India in return for a loan from the
IMF, which would help it glide through its balance of payment crisis and repay the import bill that
India had been able to generate by that point.

As a consequence, the prevailing government of that point in 1991 brought in a major reform
package which was never seen in the country till that date. Today that reform package is termed
as LPG – Liberalization, Privatization, Globalization.

So before we get into the intricacies of the LPG reforms and how it impacted the aggregate
demand and aggregate supply of the economy to take it to the next platform of high growth, let's
look at the some of the problems that the country was facing, which forced it to bring about
liberalization, privatization and globalization by asking for a loan from the IMF.

Because of the license raj and the slow amount of reforms which was taking till the 1990s, what
had happened was there was a huge amount of unemployment in the economy because domestic
producers were at a disadvantage.

They were not competitive to their foreign competitors and as a result of which there was not
enough exports. So, in lack of jobs, there was a significant decline in consumer spending. Now
India has always been a domestic oriented economy, with 55 percent of its GDP driven by
domestic consumption.

At a time between 1980s and 90s because of lack of employment as well as high inflation, when
domestic consumption was falling off the radar, there was a significant slowdown in GDP, and this
slowdown further impacted the tax revenues of the government.

So not only was the government facing a balance of payment crisis, it was also facing a huge
fiscal deficit, because the amount of money it was spending to modernize the economy was much
more than the amount it was earning in the form of tax revenues, because people did not have
the money to pay a lot of taxes, neither the industries nor the private spenders.

So this was the critical situation of the economy from which we had to get out and we got out
through the implementation of LPG. So let's look into what exactly was this LPG group of reforms?
LPG was brought in by the then Congress government when it was headed by Narasimha Rao as
the PM and Dr. Manmohan Singh as the finance minister.

Only after the reforms, did IMF lent us money to pay our import bills. The bailout of India with
IMF also required the Indian government to pledge gold to our lenders, the Bank of Switzerland
and the Union Bank of India.
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One of the measures was to devalue the Indian currency. This attracted more exports because
now exports were cheaper because of a devalued currency, and this also discouraged imports
because imports were expensive because of a devalued currency.

The LPG group of reforms led to increase in investments, job opportunities, as well as per capita
income level in the country. This led to a rise in GDP which increased aggregate demand. This
phenomena was backed by an increase in aggregate supply with new technology and skills from
abroad, because now Indian economy was much more open than it ever was.

As a consequence, we witnessed average GDP growth rate of 7.5 percent, which was the highest
since independence. As a consequence of this high growth, government was able to ensure a
steady stream of tax revenue and money was pulled back from subsidies provided in the economy
to increase the flow of economy.

This fast growth in economy resulted in increased tax revenues and the government was able to
roll back some subsidies and increase its exchequer as well, which was later pumped into the
economy to increase the flow of money in the overall economy.

So how did the economy react to the LPG group of reforms and what led to this increase in a
growth rate of 7.5 percent. Liberalization made it easier for firms to operate in India. This served
as a great incentive for domestic, as well as foreign companies to enter the Indian market,
because now ease of doing business in India was far better than previously.

With an increase in industries, there was more jobs which helped boost aggregate demand of the
economy. These set of reforms helped in bringing foreign investments as well as helped in
improving domestic production techniques building on the efficiencies.

There were also foreign technology agreements, which helped increase productivity of the
economy, with advanced foreign technology. With declining production costs and improving
investments, inflation too decreased to an all-time low in India back then.

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