IFM 7

International financial management 1
Chapter 7
International Trade Financing

Chapter contents
Theory of International trade
Growth and trade
Export-led growth
Instruments of trade policy
Trade policies for developing countries
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5.1Theory of International trade
Why do countries engage in international
trade?
 because they are different from each other,
they can benefit from their differences by
reaching an arrangement in which each
does the things it does relatively well
to achieve economies of scale in production

(1) Comparative advantage
 trade between two countries can benefit both
countries if each country exports the goods in
which it has a comparative advantage.
 a country has a comparative advantage in
producing a good if the opportunity cost of
producing that good in terms of other goods
is lower in that country than it is in other
countries.
Sources of comparative advantage
 Labor productivity(Ricardian Model)
 a country has a comparative advantage when
it can produce more per unit of labor

Comparative advantage(Example)
Suppose that in Germany 10 million roses could
be produced with the same resources that could
produce 100,000 cars.
Suppose that in Ethiopia 10 million roses could be
produced with the same resources that could
produce 30,000 cars.
Workers in Ethiopia would be less productive than
those in Germany in manufacturing cars

 Ethiopia has a lower opportunity cost of
producing roses.
 Ethiopia can produce 10 million roses,
compared to 30,000 cars that it could
otherwise produce.
 Germany can produce 10 million roses,
compared to 100,000 cars that it could
otherwise produce.
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 Germany has a lower opportunity cost of producing
cars .
 Ethiopia can produce 30,000 cars , compared to 10
million roses that it could otherwise produce.
 Germany can produce 100,000 cars , compared to
10 million roses that it could otherwise produce.
 Germany can produce 30,000 cars , compared to
3.3 million roses that it could otherwise produce.

 A country has a comparative advantage in
producing a good if the opportunity cost of
producing that good is lower in the country
than it is in other countries.
 A country with a comparative advantage in
producing a good uses its resources most
efficiently when it produces that good
compared to producing other goods.
 Germany has a comparative advantage in car
production: it uses its resources more efficiently in
producing cars compared to other uses.
 Ethiopia has a comparative advantage in rose
production: it uses its resources more efficiently in
producing roses compared to other uses.
 Suppose initially that Ethiopia produces cars and
Germany produces roses, and that both countries
want to consume cars and roses.
 Can both countries be made better off?
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10
Millions of Thousands of
Roses Cars
Germany -10 +100
Ethiopia +10 -30
Total 0 +70
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Empirical evidence
 Do countries export those goods in which
their productivity is relatively high?
 The ratio of U.S. to British exports in 1951
compared to the ratio of U.S. to British labor
productivity in 26 manufacturing industries
suggests yes.
 At this time the U.S. had an absolute advantage
in all 26 industries, yet the ratio of exports was
low in the least productive sectors of the U.S.
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Fig 1: Productivity and Exports
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Sources of comparative advantage
 Specific factors model(Paul Samuelson &
Ronald Jones)
 allow existence of factors besides labor
 labor is mobile and there are specific factors

(2) Heckscher-Ohlin theory
 state that international trade is largely driven
by differences in countries' resources
 argues that differences in labor, labor skills,
physical capital, land or other factors of
production across countries create productive
differences that explain why trade occurs.
 Countries have a relative abundance of factors of
production.
 Production processes use factors of production with
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(2) Heckscher-Ohlin theory…
 The country that is abundant in a factor
exports the good whose production is intensive
in that factor.
 Countries tend to export goods whose
production is intensive in factors with which the
countries are abundantly endowed.

Empirical evidence
 U.S- Leontief paradox -economist Wassily Leontief
(winner of the Nobel Prize in 1973) found that U.S.
exports were less capital-intensive than U.S. imports.

Empirical evidence
 On a global level test of the theory had mixed results
suggesting that abundance of factors of production is
not the only factor explaining international trade.

(3) The standard trade theory
 combines ideas from the Ricardian model and
the Heckscher-Ohlin model.
 differences in labor services, labor skills,
physical capital, land, and technology between
countries cause productive differences, leading
to gains from trade.
 these productive differences are represented as
differences in production possibility frontiers,
which represent the productive capacities of
19 nations. International financial management
(4) The New trade theory
a firm or industry may have increasing returns to
scale or economies of scale:
When factors of production change at a certain
rate, output increases at a faster rate.
A larger scale is more efficient: the cost per
unit of output falls as a firm or industry
increases output.

 but when economies of scale exist, large firms
may be more efficient than small firms, and the
industry may consist of a monopoly or a few
large firms.
Production may be imperfectly competitive in
the sense that excess or monopoly profits are
captured by large firms.

Economies of scale could mean either that larger
firms or a larger industry is more efficient.
External economies of scale occur when cost
per unit of output depends on the size of the
industry.
Internal economies of scale occur when the cost
per unit of output depends on the size of a firm.

5.2 Trade and growth
 the most important question is ”Does more trade
lead to growth?”
 channels through which trade affects economic
growth are GDP, income distribution, poverty,
and employment.
 trade can be an important stimulus to rapid
economic growth by promoting greater
utilization of idle human and capital resources,
increasing foreign exchange earnings, and
expanding access to technological knowledge.
5.2 Trade and growth
 for a majority of developing countries, the
principal benefits of world trade have accrued
disproportionately to foreign residents and
wealthy nationals
 this is because the bargaining power is
concentrated in the hands of developed country
private and public institutions and wealthy
nationals
 Trade, because of its biased distributional
effects, may often tend to reinforce existing
5.3 Export led growth
 the export-led growth hypothesis(ELGH) states
countries can achieve economic growth through
export.
 it was particularly the characteristic of
development of the Asian Tigers: Hong
Kong, South Korea, Taiwan, and Singapore

 Export enhances growth by
 Creating profit
 allows a country to balance its finances as
well as surpass its debts as long as the
facilities and materials for the export exist.
 Increasing productivity

Types of exports
Manufactured Goods
is the most common way to achieve export-led
growth
but industries compete against industries in
advanced economies, which often include
better technology, better educated workers,
and more capital to start with

Types of exports
Raw Materials/primary goods
it has a considerable amount of risk
compared to manufactured goods.
 Low income and price elasticity of demand
 the terms of trade greatly affect this plan.
For instance, price of coffee has been declining at

an annual rate of 0.77% for approximately 300 years!

Export of primary goods

Table 2: Chinese Vs Ethiopian Export & import
Ethiopia China
Exports $1.716 billion $1.581 trillion
Imports $6.992 billion $1.327 trillion
Export goods Coffee, qat, gold, leather electrical and other machinery,
products, live animals, oilseeds including data processing
equipment, apparel, textiles, iron
and steel, optical and medical
equipment
Export trade China 13.9%, Germany 10.5%, US 18%, Hong Kong 13.8%,
partners Belgium 7.5%, Saudi Arabia Japan 7.6%, South Korea 4.4%,
7.1%, US 6.8%, Sudan 4.6% Germany 4.3
Source: CIA world factbook(https://www.cia.gov)

5.4 Instruments of trade policy
Countries often use different tools to promote
export or discourage import. These tools include:
 Tariffs
 Export subsidies
 Import quotas
 Voluntary export restraints
 Local content requirement

Tariff
 A tariff raises the price of a good in the
importing country, hurting consumers and
benefiting producers there.
 In addition, the government gains tariff
revenue from a tariff

Types of Tariffs
 A specific tariff is levied as a fixed charge for
each unit of imported goods.
For example, Br 5 per kg of sugar
 An ad valorem tariff is levied as a fraction of
the value of imported goods.
For example, 25% tariff on the value of
imported cars.

Export Subsidy
an export subsidy can be specific or ad valorem
A specific subsidy is a payment per unit exported.
An ad valorem subsidy is a payment as a proportion
of the value exported.
 It raises the price of a good in the exporting
country, decreasing consumer surplus and
increasing its producer surplus.
It decreases government revenue.
Export Subsidy
 the European Union’s Common Agricultural
Policy sets high prices for agricultural products
and subsidizes exports to dispose of excess
production.
The subsidized exports reduce world prices of
agricultural products.
 The direct cost of this policy for European
taxpayers is almost $50 billion.
Import Quota
 is a restriction on the quantity of a good that
may be imported.
 It is usually enforced by issuing licenses to
domestic firms that import, or in some cases to
foreign governments of exporting countries.
 It pushes up the price of the import because the
quantity demanded will exceed the quantity
supplied by domestic producers and from
imports.
Import Quota
 When a quota instead of a tariff is used to
restrict imports, the government receives no
revenue.
Instead, the revenue from selling imports at
high prices goes to quota license holders:
either domestic firms or foreign governments.
These extra revenues are called quota rents.

Voluntary Export Restraint
 It works like an import quota, except that the
quota is imposed by the exporting country
rather than the importing country.
 However, these restraints are usually
requested by the importing country.
 The profits or rents from this policy are
earned by foreign governments or foreign
producers.
Local Content Requirement
is a regulation that requires a specified fraction of
a final good to be produced domestically.
It may be specified in value terms, by requiring
that some minimum share of the value of a good
represent domestic valued added, or in physical
units.

Local Content Requirement
From the viewpoint of domestic producers of
inputs, a local content requirement provides
protection in the same way that an import quota
would.
From the viewpoint of firms that must buy
domestic inputs, however, the requirement does not
place a strict limit on imports, but allows firms to
import more if they also use more domestic parts.
Others
Export credit subsidies
A subsidized loan to exporters
US Export-Import Bank subsidizes loans
to US exporters.

Others
Government procurement
Government agencies are obligated to purchase
from domestic suppliers, even when they charge
higher prices compared to foreign suppliers.
Bureaucratic regulations
Safety, health, quality or customs regulations
can act as a form of protection and trade
restriction.
5.5 Trade Policy in Developing Countries
Three alternative policies
Import substituting industrialization
Trade liberalization
Export oriented industrialization

Import substituting industrialization
The principal justification of this policy was/is the
infant industry argument:
Countries may have a potential comparative
advantage in some industries, but these industries
can not initially compete with well-established
industries in other countries.
Governments should temporarily support them
until they have grown strong enough to compete
internationally.
Problems With the Infant Industry Argument
1.It may be wasteful to support industries now that
will have a comparative advantage in the future.
2.With protection, infant industries may never
“grow up” or become competitive.
3.there is no justification for government
intervention unless there is a market failure that
prevents the private sector from investing in the
 Did import substituting industrialization
promote economic development?
No, countries adopting these policies
grew more slowly than rich countries and
other countries not adopting them.

Trade liberalization
 by the mid-1980s many governments had lost
faith in import substituting industrialization and
began to liberalize trade.
has trade liberalization promoted development?
The evidence is mixed. Growth rates in Brazil
and other Latin American countries have been
slower since trade liberalization than the were
during import substituting industrialization,
Trade liberalization
 Other countries like India have grown
faster since liberalizing trade in the 1980s,
but it is unclear to what degree liberalized
trade contributed to growth

Export Oriented Industrialization
 Instead of import substituting industrialization,
several countries in East Asia adopted trade
policies that promoted exports in targeted
industries.
Japan, Hong Kong, Taiwan, South Korea,
Singapore, Malaysia, Thailand, Indonesia
and China are countries that have experienced
rapid growth in various export sectors and
rapid economic growth in general.
 It is also unclear if the high volume of exports
and imports caused rapid economic growth or
was merely correlated with rapid economic
growth.
Some economists argue that the cause of rapid
economic growth was high saving and
investment rates, leading to both rapid
economic growth in general and rapid
economic growth in export sectors.
In addition, almost of the high performance
Asian economies have experienced rapid
growth in education, leading to high literacy
and numeracy rates important for a productive
labor force.

End of Chapter 7

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International financial management 1

International Trade Financing

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Germany -10 +100

Ethiopia +10 -30

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For instance, price of coffee has been declining at

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Imports $6.992 billion $1.327 trillion

Source: CIA world factbook(https://www.cia.gov)

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