International Trade & the Indian Economy

Weightage: Chapters 9 and 10 of ICAI's Paper 4 syllabus, roughly 18 marks. Comparative advantage and the exchange rate distinctions are the reliably examined items; the Indian economy chapter is descriptive and is best revised close to the examination.

Theories of international trade

Absolute advantage

Adam Smith's proposition is that a country should specialise in producing what it can produce more efficiently than others, and exchange for the rest. If India produces cloth at lower cost and England produces steel at lower cost, both gain by specialising and trading.

Its limitation is decisive: it explains nothing about a country that has an absolute advantage in everything, or in nothing. On Smith's reasoning such a country would have no basis for trade at all, which is contrary to observation.

Comparative advantage

Ricardo's answer, and the most important single idea in the chapter. A country should specialise in producing the good in which it has the lower opportunity cost, and trade is mutually beneficial even if one country is absolutely more efficient at producing everything.

The reasoning rests on opportunity cost rather than absolute efficiency. Even a country better at both goods must give up some quantity of one to produce more of the other. If it gives up relatively less of good A when producing good B than its trading partner does, it has a comparative advantage in B, and both countries gain by specialising accordingly.

The everyday illustration makes it concrete. A lawyer may type faster than any available secretary, holding an absolute advantage in both law and typing. She should nonetheless employ a secretary, because the hour spent typing costs her an hour of legal work, which is worth far more. Her comparative advantage lies in law, and the secretary's in typing, notwithstanding the lawyer's absolute superiority in both.

Trade is therefore mutually beneficial whenever opportunity costs differ between countries, which they almost always do. It is only when opportunity costs are identical that no gain arises.

The Heckscher-Ohlin theory

Also called the factor endowment theory. It explains why opportunity costs differ, which Ricardo assumed rather than explained.

A country will export goods intensive in the factor it possesses abundantly and import goods intensive in the factor it is scarce in. A labour-abundant country exports labour-intensive goods; a capital-abundant country exports capital-intensive goods. The abundant factor is relatively cheap, so goods using it intensively can be produced relatively cheaply.

Trade policy instruments

Tariffs are taxes on imports. They raise the domestic price of the imported good, reduce the quantity imported, protect domestic producers, and generate revenue for the government.

Quotas are quantitative limits on the amount that may be imported. They restrict quantity directly rather than through price.

The distinction between them is examined and is worth stating precisely. A tariff works through price and generates government revenue. A quota works through quantity and generates no revenue for the government — the gain from the higher domestic price accrues instead to whoever holds the import licence, as a quota rent. A tariff also leaves the quantity imported responsive to changes in demand, whereas a quota fixes it absolutely.

Subsidies to domestic producers lower their costs and allow them to compete against imports without a formal barrier.

Non-tariff barriers restrict trade by other means — technical standards, licensing requirements, sanitary and phytosanitary rules, customs procedures and local content requirements. They have grown in importance as tariffs have fallen under successive trade agreements.

Arguments for and against protection

For: the infant industry argument, that new industries need temporary shelter until they achieve scale; national security in strategic sectors; protection of employment; correcting a balance of payments deficit; preventing dumping; and revenue.

Against: protection raises prices for consumers; it shelters inefficiency and removes the pressure to improve; it invites retaliation; it misallocates resources away from the country's comparative advantage; and infant industries rarely surrender protection once granted.

Trade negotiations

The General Agreement on Tariffs and Trade governed international trade from 1948 until it was superseded by the World Trade Organization in 1995, following the Uruguay Round.

The WTO administers trade agreements, provides a forum for negotiations, settles disputes through a formal mechanism, monitors national trade policies and provides technical assistance to developing countries.

Its governing principles are examined:

• Most Favoured Nation — a concession granted to one member must be extended to all members. Trade must be conducted without discrimination between trading partners.
• National treatment — imported goods must be treated no less favourably than domestically produced goods once they have entered the market.
• Transparency and progressive liberalisation through successive negotiating rounds.

Regional trade agreements are an exception to the MFN principle, permitting members of a free trade area or customs union to grant one another preferences not extended to other WTO members. A free trade area removes barriers between members while each retains its own external tariff; a customs union additionally adopts a common external tariff.

Exchange rates

An exchange rate is the price of one currency in terms of another.

The systems

Under a fixed exchange rate, the rate is set and maintained by the central bank, which intervenes by buying and selling foreign currency. It provides certainty for traders and investors but requires large reserves and removes monetary policy independence.

Under a flexible or floating exchange rate, the rate is determined by demand and supply in the foreign exchange market. It adjusts automatically to imbalances and preserves monetary independence, but is volatile.

A managed float, which India operates, allows the rate to be market-determined while the central bank intervenes to moderate excessive volatility.

The four terms

These four are the most examined distinctions in the chapter, and they divide along two dimensions.

Under a fixed exchange rate system, a deliberate policy decision by the authorities to:

• lower the value of the domestic currency is devaluation;
• raise it is revaluation.

Under a flexible exchange rate system, a market-driven movement in which the currency:

• falls in value is depreciation;
• rises in value is appreciation.

So devaluation and depreciation both describe a currency losing value, but the first is a policy act under a fixed system and the second a market outcome under a floating one. Confusing them is among the commonest errors in the paper.

Effects of a falling currency

When the domestic currency depreciates or is devalued, exports become cheaper in foreign currency terms and imports become dearer in domestic currency terms. Exports are therefore encouraged and imports discouraged, which tends to improve the trade balance.

Two qualifications are worth knowing. The improvement depends on the elasticities of demand for exports and imports — if both are inelastic, the higher import bill may outweigh the export gain. And the effect is typically perverse in the short run and favourable only later, since quantities take time to adjust while prices change immediately.

Depreciation also raises the domestic price of imported inputs, which is inflationary, and increases the domestic currency cost of servicing foreign currency debt.

Balance of payments

The balance of payments is a systematic record of all economic transactions between the residents of a country and the rest of the world over a period.

It has two principal accounts:

The current account records trade in goods (the visible balance or balance of trade), trade in services (invisibles, including software services and tourism), income flows such as interest and dividends, and current transfers such as remittances.

The capital and financial account records transactions in assets — foreign direct investment, portfolio investment, external borrowing and changes in reserves.

Balance of trade against balance of payments is a distinction examined regularly. The balance of trade covers only merchandise — visible goods. The balance of payments covers all international transactions, including services, income and capital flows. A country may have a trade deficit while its current account is in balance, if services and remittances are large enough to offset it, which is broadly India's position.

The balance of payments always balances in an accounting sense, since every transaction is recorded twice. A "balance of payments deficit" refers to a deficit on the current account, or on the current and capital accounts together before accommodating official reserve transactions.

International capital movements

Foreign direct investment is investment giving a lasting interest and a degree of control in an enterprise — establishing a subsidiary, acquiring a substantial shareholding, or a joint venture.

Foreign portfolio investment is investment in financial assets — shares and bonds — without control.

The distinction matters because FDI is stable and long-term, brings technology, management practice and market access, and is not easily withdrawn. FPI is volatile, can be reversed rapidly, and is sometimes described as hot money because a change in sentiment can trigger large and destabilising outflows.

The concerns associated with foreign investment include the repatriation of profits, effects on domestic industry, and exposure to external shocks; the benefits include capital, technology, employment and integration into global supply chains.

The Indian economy

India is a mixed economy, combining a substantial private sector operating through markets with a public sector in strategic areas, and it has become progressively more market-oriented since the reforms of 1991.

Structure

The economy is conventionally divided into three sectors.

The primary sector covers agriculture, forestry, fishing and mining. It employs a large share of the workforce but contributes a considerably smaller share of output — a disparity that is the central structural feature of the Indian economy and the source of low agricultural productivity and rural underemployment.

The secondary sector covers manufacturing, construction and utilities.

The tertiary sector covers services — trade, transport, finance, information technology, professional services and public administration. It is the largest contributor to output and has grown fastest.

India's development path is distinctive in that services expanded to dominate output before manufacturing had absorbed the workforce released from agriculture, which is the reverse of the historical sequence followed by most industrialised economies.

Features and challenges

The recurring features described in the syllabus include a large and young population, offering a demographic dividend if employment can be created for it; substantial regional disparity; a large unorganised sector; and persistent challenges in infrastructure, education and health.

Since 1991 the policy direction has been liberalisation, reducing licensing and regulatory restrictions; privatisation, reducing the role of the public sector; and globalisation, integrating with the world economy through trade and investment.

How this chapter is examined

Expect questions distinguishing absolute from comparative advantage, and identifying comparative advantage as the basis for trade even where one country is absolutely more efficient in everything; distinguishing a tariff from a quota by whether revenue accrues to government; identifying the WTO principles by name; distinguishing devaluation, depreciation, revaluation and appreciation; stating the effects of a falling currency on exports and imports; distinguishing the balance of trade from the balance of payments; and distinguishing FDI from FPI by control and volatility.

The recurring errors are confusing devaluation with depreciation, treating the balance of trade as identical to the balance of payments, and asserting that a country with an absolute advantage in everything has no basis for trade — which is precisely the proposition comparative advantage refutes.