M.COM. IIIrd Semester Course M.

C 302

INTERNATIONAL FINANCIAL MANAGEMENT AND POLICY (DSC)

Lessons 1- 14

By: Dr. Devinder Sharma

Professor, Department of Commerce, H.P. University, Shimla

INTERNATIONAL CENTRE FOR DISTANCE EDUCATION & OPEN LEARNING

HIMACHAL PRADESH UNIVERSITY, SUMMERHILL, SHIMLA- 171005

2023
 MC 302 INTERNATIONAL FINANCIAL MANAGEMENT AND POLICY
Max. Marks: 80
Internal Assessment: 20

Note: there will be Ten (10) questions in the paper spread into Five Units as Two questions from each
unit. The candidate will be required to attempt One question from each unit. Each question will carry
Sixteen (16) marks.

Learning Objectives: On successful completion of this course, the student will be able to understand the
significance of International Financial Management in the area of commerce education. The course will
also provide an understanding about the various concepts such as cross border investment decisions,
foreign direct investment, international trade and development, balance of trade and balance of payment,
regional economic integration, foreign exchange market, terms of trade and currency derivatives in the
area of policy formulation and implementation for India.

Unit-I International Financial Management; Significance and contemporary issues in International

Financial Mnagment, Cross- border Investment decisions- concept and types, Green field investment Vs.
cross border mergers and acquisitions. Valuation techniques- Net Present Value Model and Adjusted Net
Present Value Model. Risks in cross border investment decisions.
Foreign Direct Investment- Concept, Types, Theories, Significance, Limitations, FDI Trends and Policy
in India.

Unit-II International Trade and Policy; Trade and Development, Significance of International Trade,
Theories of International Trade- including gravity model theory. Free trade Vs. Protection. Trade barriers
and non-trade barriers and their implications. India’s Trade Ploicy.
Balance of Trade and Balance of Payment- Concepts, Components of Balance of Payment, disequilibrium
and remedial steps.

Unit-III Regional Economic Integration; Concept and Rationale, levels of regional economic
integration, free trade, custom union, economic union, common market political union. Trade creation and
trade diversion effects. Regionalism Vs. Multilateralism. India’s trade and economic relations with
SAARC, BIMSTEC, ASEAN, EU, GCC, and BRICS.

Unit-IV Foreign Exchange and Terms of Trade; foreign Exchange Market- Functions, International
Payment, Transactions in the foreign exchange market. Exchange control objectives. Exchange rate
systems. Convertibility of Rupee. Devaluation- Approaches, Significance and Devaluation of Indian
Rupee.
Terms of Trade- Concepts, Management, Importance and Limitations.

Unit-V Currency Derivatives; Currency Forward Market, Currency Futures Market, Currency Options
Market, Currency Call Options, Currency Put Options and Financial Swaps.

Reference Books:

Madura Jeff (2015), International Financial Management, Cengage Learning, New Delhi.
Siddaiah, Thummuluri (2012), International Financial Management, Pearson.
Eun, Cheol S. and Resnick, Bruce G. International Financial Management, Tata McGraw Hill.
Sharan, V. International Financial Management, PHI Learning Pvt. Ltd.
Levi D., Maurice, International Finance, Routledge.
 CHAPTER-I

INTERNATIONAL FINANCIAL MANAGEMENT

Purpose and Structure:

Understanding of financial management is needed for routine as well as professional

requirements. Students of commerce and management must have in-depth knowledge about it.
International financial management denotes practical dimension of the field of financial
management. After reading this chapter, the readers will be able to get acquainted with the
following aspects related with International Financial Management:

1.1 Meaning of International Finance

1.2 Understanding International Finance based on Bretton Woods Theory
1.3 Meaning of International Financial Management
1.4 Difference Between International Financial Management and Financial Management
1.5 Challenges of International Financial Management
1.6 How to Mitigate Foreign Exchange Risk in International Financial Management?
1.7 How Does International Financial Management Impact Revenue and Cash Flow?
1.8 Strategies for Effective Cross-Border Financial Management
1.9 Differences between Domestic and International Financial Management

1.1 Meaning of International Finance

International finance, sometimes known as international macroeconomics, is the study of

monetary interactions between two or more countries, focusing on areas such as foreign direct
investment and currency exchange rates. It can be understood as:

 International finance is the study of monetary interactions that transpire between two or
more countries.
 International finance focuses on areas such as foreign direct investment and currency
exchange rates.
 Increased globalization has magnified the importance of international finance.
 An initiative known as the Bretton Woods system emerged from a 1944 conference
attended by 40 nations and aims to standardize international monetary exchanges and
policies in a broader effort to nurture post World War II economic stability.

1.2 Understanding International Finance based on Bretton Woods Theory

International finance deals with the economic interactions between multiple countries, rather
than narrowly focusing on individual markets. International finance research is conducted by
large institutions such as the International Finance Corp. (IFC), and the National Bureau of
Economic Research (NBER). Furthermore, the U.S. Federal Reserve has a division dedicated to
analyzing policies germane to U.S. capital flow, external trade, and the development of global
markets. International finance analyzes the following specific areas of study:

 The Mundell-Fleming Model, which studies the interaction between the goods market
and the money market, is based on the assumption that price levels of said goods are
fixed.
 International Fisher Effect is an international finance theory that assumes nominal
interest rates mirror fluctuations in the spot exchange rate between nations.
 The optimum currency area theory states that certain geographical regions would
maximize economic efficiency if the entire area adopted a single currency.
 Purchasing power parity is the measurement of prices in different areas using a specific
good or a specific set of goods to compare the absolute purchasing power between
different currencies.
 Interest rate parity describes an equilibrium state in which investors are indifferent to
interest rates attached to bank deposits in two separate countries.

The Bretton Woods System

The Bretton Woods system was created at the Bretton Woods conference in 1944, where the 40
participating countries agreed to establish a fixed exchange rate system. The collective goal of
this initiative was to standardize international monetary exchanges and policies in a broader
effort to create post World War II stability. The Bretton Woods conference catalyzed the
development of international institutions that play a foundational role in the global economy.
These include the International Monetary Fund (IMF), a consortium of 189 countries dedicated
to creating global monetary cooperation, and the International Bank for Reconstruction and
Development, which later became known as the World Bank.

Special Considerations

International trade is arguably the most important influencer of global prosperity and growth. But
there are worries related to the fact the United States has shifted from being the largest
international creditor, to becoming the world's largest international debtor, absorbing excess
amounts of funding from organizations and countries on a global basis. This may affect
international finance in unforeseen ways. International finance involves measuring the political
and foreign exchange risk associated with managing multinational corporations.

1.3 Meaning of International Financial Management

International finance management is the strategic management of financial activities across
national borders. It entails overseeing global financial operations such as investing, financing,
and risk management. The primary actors in international finance management are multinational
corporations, governments, and financial institutions. These organizations must navigate
complex financial systems that differ by country, such as tax laws, regulations, and currency
exchange rates. International finance management entails analyzing and interpreting these
systems and developing and implementing financial strategies to improve performance in various
markets.

1.4 Difference Between International Financial Management and Financial Management

Finance and international financial management are related concepts, but their scope and focus
differ. For example, the primary focus of finance management is managing financial resources
within the organization, like budgeting, investing, and cash flow management. It ensures the
organization’s financial stability and growth while minimizing financial risks. International
finance management, on the other hand, entails managing financial activities in a global context.
This includes managing foreign exchange risks, investing in foreign markets, and adhering to
international financial regulations. The emphasis is on improving financial performance across
countries and regions.

1.5 Challenges of International Financial Management

International financial management entails dealing with a wide range of issues that can emerge
from operating in a global context. The following are some of the most significant challenges:

1. Foreign exchange risk: This is the risk of loss resulting from fluctuations in currency
exchange rates. Hedging strategies such as currency forwards, options, and futures can
help manage this risk
2. Political risk: It is the risk of loss caused by political events such as changes in
government policies, regulations, and insecurity. To mitigate this risk, businesses can
spread their operations across multiple countries and regions
3. Cultural differences: Different cultures have different approaches to business, finance,
and risk. Organizations can overcome this challenge by investing in cross-cultural
training for employees and developing cultural intelligence
4. International financial regulations: Each country has its own set of financial regulations.
To ensure compliance, organizations can hire professionals with experience in
international financial regulations
5. Economic insecurity: Economic conditions can vary greatly across countries and regions.
Organizations can mitigate this risk by diversifying their investments across countries
and industries
1.6 How to Mitigate Foreign Exchange Risk in International Financial Management?

Organizations can use a variety of strategies to mitigate foreign exchange risk. These include:
Hedging

It entails taking positions in the currency market to offset potential losses caused by exchange
rate fluctuations. Currency forwards, options, and futures can be used to reduce uncertainty and
lock in exchange rates.
Netting

It is the process of offsetting the value of payables and receivables in different currencies. This
can reduce the chance of default and ensure a company has sufficient liquidity to function well.
Currency Diversification

Rather than relying on a single currency, organizations can reduce foreign exchange risk by
holding a portfolio of currencies. This can lessen the impact of currency fluctuations.
Natural Hedges

Natural hedges can be used by organizations when revenues and expenses are denominated in the
same currency. For example, a company is naturally hedged against fluctuations in the Euro-
Dollar exchange rate if the revenues are earned and expenses are paid in Euros.
Managing Exposure

Organizations can also manage their exposure to foreign exchange risk by closely monitoring
their cash flows. Additionally, their risk-mitigation strategies can be adjusted to accomplish this.

1.7 How Does International Financial Management Impact Revenue and Cash Flow?

In a global business context, international financial management entails managing financial

resources and risks. It has multiple effects on a company’s revenue and cash flow. These
include:
 Firstly, fluctuations in currency exchange rates can significantly impact a company’s
revenue and cash flow by affecting the value of assets and liabilities as well as the cost of
goods and services
 Secondly, capital structure management is critical for companies that raise funds in
multiple currencies because currency risks can affect cash flows and cause interest rates
to rise
 Thirdly, taxation laws and regulations differ by country; this can increase a company’s
tax liability while decreasing cash flows and revenue
 Finally, financial reporting may be impacted because compliance with various accounting
and financial reporting standards can impact the accuracy and comparability of financial
 statements. This affects investor confidence and a company’s ability to raise funds in the
capital markets

Effective international financial management assists businesses in mitigating risks, optimizing

capital structure, and increasing revenue and cash flow. It entails risk management for currency
fluctuations, capital structure, taxation, and financial reporting. A strong international financial
management system can assist businesses in expanding their global footprint and growing their
operations while maintaining healthy cash flows and revenue

1.8 Strategies for Effective Cross-Border Financial Management

Here are some essential cross-border financial management strategies:

1. Currency risk management: It is the management of the risks associated with currency
fluctuations. To mitigate currency risk, businesses can employ strategies such as hedging,
netting, and currency diversification, as mentioned above
2. Understanding tax and regulatory regimes: To ensure compliance and minimize risk,
businesses must understand the tax and regulatory regimes of the countries in which they
operate
3. Effective cash management: Businesses must manage their cash effectively across
multiple countries and currencies. This helps reduce the costs associated with currency
conversion and transfer fees
4. Local financing: Companies can reduce their exposure to foreign exchange risk by
leveraging local financing sources
5. Centralized treasury function: A centralized treasury function can assist businesses in
managing cash, currency, and funding risks across multiple countries and currencies
more effectively
6. Effective communication and collaboration: For effective cross-border financial
management, effective communication, and collaboration between different teams and
stakeholders are essential

1.9 Differences between Domestic and International Financial Management

Domestic financial management refers to financial operations within a single country.

Meanwhile, international financial management refers to financial operations across multiple
countries and currencies. Here are a few key distinctions between the two:
 Currency risk: One aspect of international financial management is managing currency
risk, which arises from exchange rate fluctuations. Domestic financial management
typically does not involve currency risk
 Legal and regulatory frameworks: When engaging in international financial management,
companies must navigate different legal and regulatory frameworks in different countries.
 Domestic financial management requires dealing with a single legal and regulatory
framework
 Cultural differences: They can affect financial management practices in different
countries, and businesses must be aware of these differences when engaging in
international financial management

Summary:

International finance, sometimes known as international macroeconomics, is the study of

monetary interactions between two or more countries, focusing on areas such as foreign direct
investment and currency exchange rates. International finance management is the strategic
management of financial activities across national borders. It entails overseeing global financial
operations such as investing, financing, and risk management. The primary actors in
international finance management are multinational corporations, governments, and financial
institutions. Risks are involved in International Financial Management in the form of hedging
and other risks which need to be mitigated.

Self Test Questions:

1. What is International Financial Management? State the difference between

International Financial Management and Financial Management
2. What are the Challenges of International Financial Management? How to Mitigate
Foreign Exchange Risk in International Financial Management?
3. What is the Differences between Domestic and International Financial Management?
4. How Does International Financial Management Impact Revenue and Cash Flow? What
are the Strategies for Effective Cross-Border Financial Management? Explain.
 CHAPTER-II

CROSS BORDER INVESTMENT AND ITS REGULATIONS IN INDIA

PURPOSE AND STRUCTURE:

Cross border investments are highly risky as the investments take place in different countries and
regulation of one country is not applicable on the other. In such a situation, to regulate the cross
border investments, peculiar regulations are required. The effort has been made to discuss the
cross border investment and its regulations in India. The reader will be able to know about it by
understanding the following:
2.1 Knowing about Cross Border Investment and its regulations in India
2.2 Type of Cross-Border Investments
2.3 Eligibility for Cross-Border Investments
2.4 Procedure for Investment
2.5 Methods of Cross Border Investment
2.6 Proceeds of External Commercial Borrowings (ECBs) / Foreign Currency Convertible
Bonds (FCCBs)
2.7 Factors to be kept in mind while doing cross border investment

2.8 Green Field vs. International Acquisition: An Overview

2.9 Special Considerations: Financial Analysis

2.10 Risks Faced by International Investors

2.1 Knowing about Cross Border Investment and its regulations in India
Developing countries like India need Foreign Direct Investments for the growth of their
emerging markets and overall growth and development of the nation. This makes Cross-Border
Investment a key player in this regard. But what is a Cross-Border Investment? Cross-border
investment refers to the net inflows of investment to acquire a lasting management interest (10
percent or more of voting stock) in an enterprise operating in an economy other than that of the
investor. In other words, Investing in a company incorporated under the laws of another country
either in the individual capacity by buying shares and/or debentures or in the capacity of a
company by way of mergers and acquisitions and/or forming a new company or taking over an
existing company etc. The Foreign capital is seen as a way of filling in the gap between domestic
savings and investment. One of the key factors for attracting foreign capital is the tax and
regulatory environment, which has a direct bearing on the investment climate in the country.
2.2 Type of Cross-Border Investments
There are two types of Cross-Border Investments

a) Inward Investment
b) Outward Investment

a) An Inward Investment means an external or foreign entity either investing in or

purchasing the ownership of an indigenous company. To elaborate the same “Inward
Investment commonly known as Foreign Direct Investment occurs when instead of
forming a new business, a foreign company acquires and/or merges with an existing
company giving it a platform to grow and open border for international integration”.

b) On the other hand, an Outward Investment means “when a domestic firm expands its
operations to a foreign country either via a Greenfield investment, merger/acquisition
and/or expansion of an existing foreign facility.” To elaborate,” an Outward Investment
commonly known as Outward Direct Investment occurs when a company has bloomed
enough in the domestic market that now it is ready to open a new venture in foreign
country and set up a base in the Foreign market”.

2.3 Eligibility for Cross-Border Investments

a) Anybody from the following can do an Outward Investment in India

 An Individual or a group of related Individuals

 A Public Company
 A Private Company
 A Government Body
 A Trust or Social Institutions.
b) In the case of Inward investment, the following can invest in India.

 An NRI or an OCI
 A non-resident, other than a citizen of Bangladesh or Pakistan or an entity incorporated in
Bangladesh or Pakistan can invest in India, subject to the FDI policy except in those
sectors/activities which are prohibited.
  A company, trust and partnership firm incorporated outside India and owned and
controlled by NRIs can invest in India with the special dispensation as available to NRIs
under the FDI Policy
2.4 Procedure for Investment
The biggest question after understanding the basic idea of investing in a Foreign Country is how
to make such an Investment. The different ways of investing in other countries are through,
 Incorporating a subsidiary or a company which is owned by the original company
 Acquiring shares in an associated enterprise
 Through Mergers and Acquisitions with a local Company
 Participating with an Equity Joint Venture with another investor and/or enterprise
2.5 Methods of Cross Border Investment
Investment (or financial commitment) in an overseas JV / WOS may be funded out of one or
more of the following sources
 Drawal of foreign exchange from an AD bank in India.
 Capitalization of exports.
 Swap of shares.
2.6 Proceeds of External Commercial Borrowings (ECBs) / Foreign Currency Convertible
Bonds (FCCBs).
 In exchange of ADRs/GDRs issued in accordance with the Scheme for issue of Foreign
Currency Convertible Bonds and Ordinary Shares (through Depository Receipt
Mechanism) Scheme, 1993, and the guidelines issued there under from time to time by
the Government of India.
 Balances held in EEFC account of the Indian Party.
 Proceeds of foreign currency funds raised through ADR / GDR issues.
2.7 Factors to be kept in mind while doing cross border investment
Following are the factors of cross border investments:
Economic Conditions
As a Company when you chose to enter a foreign market, you need to study the economic
condition of the market and be sure whether that you are going flourish by investing in that
market or your investment is a total lost call i.e. if the market is ready to accept and invest into
something new or it is too reluctant to accept the change and want to stick with the existing
goods in the market.
Political and Legal Factors
Another very important factor is the attitude of nationals of a country towards foreign
companies, foreign products and foreign citizens. Nationals of countries who have been
dominated by foreign powers in the past are wary of anything foreign and may not be too open to
accept the foreign investment in the country and may instead want to uplift the domestic
products. Moreover, the Legal factor may vary country to country i.e. if one country does not
levy too many legal formalities when it comes to foreign investment it may not be necessary, and
other countries would do the same too.
Social and Cultural Factors
Every Country is different, and thus the people will react differently to different things i.e. a new
product appreciated and welcomed by the people of one country may not be welcomed the same
way by another. When it comes to investing understand the social and cultural factor of a market
is very important because understanding the culture followed by people gives you an idea if the
investment is going to be fruitful or no.
Market Attractiveness
The attractiveness of a market can be assessed by evaluating the market potential in terms of
revenues that can be generated, access to the market in terms of the host country being warm to
investments by multinational companies, and potential competition and dynamics of the industry
in the prospective market. A big market with a rapid rate of growth can be very attractive, and a
big upfront investment can be justified in such a market. Lack of entrenched competitors and
stability in the type and number of competitors add to the attractiveness of the market.
Capability of the Company
The last and the most important factor is the capability of the company to invest in such a
market. Before a company decides to go global, it should conduct an audit of its resources and
capabilities. The Company should have clear competitive advantages in terms of market
knowledge, technology, the portfolio of products, reliable partners and other relevant parameters,
failing which the Company can face a big loss in a foreign market or may end up bearing such
losses that the standing of a company in the domestic market may also suffer.

2.8 Green Field vs. International Acquisition: An Overview

When businesses decide to expand their operations to another country, one of the more
vexing dilemmas they face is whether to create a new operation in a foreign country using a so-
called green field investment, or to directly purchase an existing company in a foreign country
through an international acquisition. While both methods will usually accomplish the goal of
extending a company's operations to a new foreign market, there are several reasons why a
company might choose one over the other. One of the biggest considerations in expanding
abroad is the regulatory and compliance rules that a company may need to research and adhere
to. Acquiring an existing company may prove to make an international business expansion easier
in this regard or a parent company may desire to build out the new infrastructure on their own.
Either way, there will be a multitude of costs and projections to consider with both types of
investments.

 Green field investments and international acquisitions are two ways a company can
choose to expand its business into a foreign market.
 International acquisitions involve acquiring a company that is already in existence.
 A green field investment involves building completely new business through a business
plan developed by the parent company.
 Varying methods of financial analysis are used when assessing the potential profits of an
acquisition vs. a green field investment.

2.8.1 International Acquisition

Acquiring an international company can be structured in a few different ways. A company may
choose to buy the entire company, buy parts of the company, or acquire a significant portion of
the company that gives it certain ownership rights.

Advantages

In general, there are many reasons why an international acquisition can be optimal for expansion.
In most cases, international business is expected to be fully integrated and compliant with
international laws and regulations. In this regard, keeping members of the current management
team and most of the current executive-level processes in place would be beneficial to an
expansion. In general, buying an overseas business can simplify a lot of the tedious details
involved in entering a new market.

Another top reason to choose an acquisition over a green field investment is market share. If an
international business prospect holds a significant market share in the country, the time to market
introduction and competition for a green field investment would likely not be worthwhile. Other
reasons a foreign acquisition could be better than a green field investment include considerations
such as training, supply chain, lower cost of labor, lower cost of service or manufacturing,
existing employed labor, existing executive management team, brand name, customer base,
financing relationships, and financing access.

Finally, the most important consideration is usually cost. An acquisition team will fully consider
the costs of an international acquisition versus the costs of a green field investment in terms of
net present value, internal rate of return, discounted cash flow, and impact on earnings per share.
Based on these areas of analysis a team would want to identify the most cost-effective
investment decision. With all types of investments, there is a multitude of costs involved.
Acquiring a company in another country can often be relatively less expensive because licenses,
registrations, building infrastructures, and other business assets are already in place. Buying an
existing business with existing assets is usually less costly and also includes less time needed for
market introduction.

Disadvantages

Even if an acquisition is the most cost-effective choice, however, it is important to keep in mind
that some caveats might exist. One main potential issue is that when buying a company, there
may be regulatory barriers that inhibit the acquisition because of the scale of the two combined
businesses after the acquisition or for other reasons. International regulatory approvals can be
lengthy. They can also ultimately result in a blocking of the entire acquisition altogether or
certain divesting requirements that can be problematic for a deal.

2.8.2 Green Field Investment

A green field investment is a corporate investment that involves building a new entity in a
foreign country. In a green field investment, the parent company seeks to create a new business,
usually with the parent company’s branding. Green field investments can be undertaken for the
purpose of targeting customers in a foreign region or they may involve building facilities and
employing labor for work that reduces a company’s overall costs. Green field investments are
also known as foreign direct investments (FDI). In a green field investment, the new company
must typically adhere to all local laws regardless of its parent company association.

Advantages

One of the top reasons for making a green field investment is the lack of suitable targets in a
foreign country for acquisition. Alternatively, a company may find acquisition targets but see
serious difficulties involved in integrating a parent company with a target. In some cases, a green
field investment may be the best option because businesses can gain local government-related
benefits by starting up from scratch in a new country, as some countries provide subsidies, tax
breaks, or other benefits in order to promote the country as a good location for foreign direct
investment.

Just like in the analysis of an acquisition, a green field investment requires a detailed analysis of
the investment’s costs and expected return. Green field investment analysis will typically focus
more heavily on the net present value and internal rate of return calculations since the goal is to
make an investment in building a newly created company that will generate returns in the future.
This differs from the need to analyze an already existing business using standard analysis like
discounted cash flow and enterprise value.
Disadvantages

A green field investment analysis can have slightly higher risks than an acquisition because the
costs may be unknown. With an acquisition, analysts usually have actual financial statements
and costs to work with. In a green field investment, it can be important to use analysis of similar
companies or business models in the target market to obtain a framework for costs. In general,
green field investment analysis involves structuring a detailed business plan along with building
a financial model that includes all of the expected costs. With a green field investment, there can
be slightly more flexibility to adjust costs according to the parent company’s business plans. In a
green field investment, a parent company would need to obtain costs for land, building licenses,
building construction, maintenance of new facilities, labor, financing approvals, and more. Both
international acquisitions and green field investments involve understanding and adhering to the
local business laws of a specified foreign country.

2.9 Special Considerations: Financial Analysis

In acquisitions and other large capital project analysis, there are a few common types of financial
modeling analysis that are standard for the financial industry. Net present value (NPV): Net
present value analysis identifies the present value of future cash flows for investment. NPV is
usually used in capital project analysis where investment projections are based on hypothetical
estimates. It uses an arbitrary discount rate depending on risk with the U.S. Treasury’s rate
serving as the risk-free rate.

Discounted cash flow (DCF): Discounted cash flow is similar to NPV. DCF discounts the future
cash flows of a business to arrive at a company’s present value. DCF is usually used when
dealing with valuations of existing companies. It uses a company’s weighted average cost of
capital (WACC) as the discount rate.

Internal rate of return (IRR): The internal rate of return is the discount rate in an NPV calculation
that results in an NPV of zero. This rate provides analysts with the rate of return on the
investment.

2.10 Risks Faced by International Investors

Investors who want to increase the diversification and total return of their portfolios are often
advised to get into international assets. Many hesitate to take that advice. There are, in fact, three
big risks that investors add when they enter international investing. Knowing what they are and
how you can mitigate those risks may help you decide if going global is worth the risk and
potential rewards.

1. Higher Transaction Costs

The biggest barrier to investing in international markets is the added transaction cost. Yes, we
live in a relatively globalized and connected world, but transaction costs still vary greatly
depending on which foreign market you are investing in. Brokerage commissions in international
markets are almost always higher than U.S. rates.

 Expenses on foreign transactions tend to be substantially higher.

 Currency volatility is an additional layer of risk in making foreign transactions.
 Liquidity can be a problem, especially when investing in emerging economies.
On top of the higher brokerage commissions, there can be additional charges specific to the local
market. These can include stamp duties, levies, taxes, clearing fees, and exchange fees.

As an example, here is a general breakdown of what a single purchase of stock in Hong Kong by
a U.S. investor could look like on a per-trade basis:

Fee Type Fee

Brokerage Commission HK$299

Stamp Duty 0.13%

Trading Fees 0.00565%

Transaction Levy 0.0027%

TOTAL HK$299 + 0.138%

That's about $38.28 U.S. in fees per trade, based on the exchange rate on July 20, 2023.

For the manager, the process of recommending international investments involves significant
amounts of time and money spent on research and analysis. This may include hiring analysts and
researchers who are familiar with the market, and other professionals with expertise in foreign
financial statements, data collection, and other administrative services. Investing in American
Depository Receipts (ADRs) is an option for those who want to avoid the higher fees of foreign
asset purchases. For investors, these fees will show up in the management expense ratio.

Minimizing Expenses

One way to minimize transaction costs on international stocks is by investing in American

depositary receipts (ADRs). Depositary receipts, like stocks, are negotiable financial instruments
but they are issued by U.S. banks. They represent a foreign company's stock but trade as a U.S.
stock, eliminating the foreign exchange fees. ADRs are sold in U.S. dollars. And that makes their
investors vulnerable to currency price fluctuations. That is, if you buy an ADR in a German
company, and the U.S. dollar falls in value against the euro, the value of the ADR will drop
correspondingly. Of course, it works both ways, but the risk is there.

2. Currency Volatility

When investing directly in a foreign market (and not through ADRs), you first have to exchange
your U.S. dollars into a foreign currency at the current exchange rate. Say you hold the foreign
stock for a year and then sell it. That means you will have to convert the foreign currency back
into USD. That could help or hurt your return, depending on which way the dollar is moving. It
is this uncertainty that scares off many investors. A financial professional would tell you that the
solution to mitigating currency risk is to simply hedge your currency exposure. The available
tools include currency futures, options, and forwards. These are not strategies most individual
investors would be comfortable using. A more user-friendly version of those tools is the currency
exchange-traded fund (ETF). Like any ETF, these have good liquidity and accessibility and are
relatively straightforward.

3. Liquidity Risks

Another risk inherent in foreign markets, especially in emerging markets, is liquidity risk. This is
the risk of not being able to sell an investment quickly at any time without risking substantial
losses due to a political or economic crisis. There is no easy way for the average investor to
protect against liquidity risk in foreign markets. Investors must pay particular attention to foreign
investments that are or may become illiquid by the time they want to sell. There are some
common ways to evaluate the liquidity of an asset. One method is to observe the bid-ask
spread of the asset over time. An illiquid asset will have a wider bid-ask spread relative to other
assets. Narrower spreads and high volume typically point to higher liquidity.

Summary:

Developing countries like India need Foreign Direct Investments for the growth of their
emerging markets and overall growth and development of the nation. This makes Cross-Border
Investment a key player in this regard. But what is a Cross-Border Investment? Cross-border
investment refers to the net inflows of investment to acquire a lasting management interest (10
percent or more of voting stock) in an enterprise operating in an economy other than that of the
investor. In other words, Investing in a company incorporated under the laws of another country
either in the individual capacity by buying shares and/or debentures or in the capacity of a
company by way of mergers and acquisitions and/or forming a new company or taking over an
existing company etc. The Foreign capital is seen as a way of filling in the gap between domestic
savings and investment. One of the key factors for attracting foreign capital is the tax and
regulatory environment, which has a direct bearing on the investment climate in the country.
Cross Border Investments can be Inward or Outward. Economic Conditions, Political and Legal
Factors, Social and Cultural Factors, Market Attractiveness and Capability of the Company are
the factors of cross border investments. When businesses decide to expand their operations to
another country, one of the more vexing dilemmas they face is whether to create a new
operation in a foreign country using a so-called green field investment, or to directly purchase an
existing company in a foreign country through an international acquisition. While both methods
will usually accomplish the goal of extending a company's operations to a new foreign market,
there are several reasons why a company might choose one over the other. One of the biggest
considerations in expanding abroad is the regulatory and compliance rules that a company may
need to research and adhere to. Acquiring an existing company may prove to make an
international business expansion easier in this regard or a parent company may desire to build
out the new infrastructure on their own.

Self Test Questions:

1. What do you know by Cross Border Investment? What are the regulations related with it
in India? Exp[ain.
2. What are the types of Cross Border Investments and what are the eligibility criteria for it?
Briefly discuss.
3. What is the procedure of Cross Border Investment? State the methods of Cross Border
Investment.
4. What are the Proceeds of External Commercial Borrowings (ECBs) / Foreign Currency
Convertible Bonds (FCCBs)? Also state the factors to be kept in mind while doing cross
border investment.
5. What are the risks faced by international investors? Distinguish between Green Field and
International Acquisition
 CHAPTER-III

BUSINESS VALUATION AND FOREIGN DIRECT INVESTMENT

PURPOSE AND STRUCTURE:

Businesses or fractional interests in businesses may be valued for various purposes such
as mergers and acquisitions, sale of securities, and taxable events. When correct, a valuation
should reflect the capacity of the business to match a certain market demand, as it is the only true
predictor of future cash flows. An accurate valuation of privately owned companies largely
depends on the reliability of the firm's historic financial information. Public company financial
statements are audited by Certified Public Accountants (USA), Chartered Certified
Accountants (ACCA) or Chartered Accountants (UK), and Chartered Professional
Accountants (Canada) and overseen by a government regulator. Alternatively, private firms do
not have government oversight—unless operating in a regulated industry—and are usually not
required to have their financial statements audited. Moreover, managers of private firms often
prepare their financial statements to minimize profits and, therefore, taxes. Alternatively,
managers of public firms tend to want higher profits to increase their stock price. Therefore, a
firm's historic financial information may not be accurate and can lead to over- and
undervaluation. In an acquisition, a buyer often performs due diligence to verify the seller's
information. Since finance is the base for business, foreign direct investment is the purveyor of
it. The chapter is endowed to discuss it as per the following points in details in context to
business valuation.
3.1 Business Valuation Concept
3.2 Business Valuation Methods
3.2.1 Discounted Cash Flow Method
3.2.2 Guideline Companies Method
3.2.3 Net Asset Value Method
3.3 Business Valuation in terms of different Conditions
3.3.1 Valuation of a suffering company
3.3.2 Valuation of a startup company
3.3.3 Valuation of intangible assets
3.3.4 Valuation of mining projects
3.3.5 Valuing financial services firms
3.4 Meaning of Foreign Direct Investment (FDI)
3.5 Process of Foreign Direct Investment
3.6 Special Considerations for Foreign Direct Investment
3.7 Types of Foreign Direct Investment
3.8 Difference between Foreign Direct Investment (FDI) and Foreign Portfolio Investment
(FPI)
3.9 Advantages and Disadvantages of FDI

3.1 Business Valuation Concept

Financial statements prepared in accordance with generally accepted accounting
principles (GAAP) show many assets based on their historic costs rather than at their current
market values. For instance, a firm's balance sheet will usually show the value of land it owns at
what the firm paid for it rather than at its current market value. But under GAAP requirements, a
firm must show the fair values (which usually approximates market value) of some types of
assets such as financial instruments that are held for sale rather than at their original cost. When a
firm is required to show some of its assets at fair value, some call this process "mark-to-market".
But reporting asset values on financial statements at fair values gives managers ample
opportunity to slant asset values upward to artificially increase profits and their stock prices.
Managers may be motivated to alter earnings upward so they can earn bonuses. Despite the risk
of manager bias, equity investors and creditors prefer to know the market values of a firm's
assets—rather than their historical costs—because current values give them better information to
make decisions.
There are commonly three pillars to valuing business entities: discounted cash flow analysis,
comparable company analyses, Net asset value method, and precedent transaction analysis.
Business valuation credentials include the Chartered Business Valuator (CBV) offered by
the CBV Institute, ASA and CEIV from the American Society of Appraisers, and the CVA by
the National Association of Certified Valuators and Analysts.
3.2 Business Valuation Methods:
Following business valuation methods are discussed here:
3.2.1 Discounted Cash Flow Method
This method estimates the value of an asset based on its expected future cash flows, which are
discounted to the present (i.e., the present value). This concept of discounting future money is
commonly known as the time value of money. For instance, an asset that matures and pays $1 in
one year is worth less than $1 today. The size of the discount is based on an opportunity cost of
capital and it is expressed as a percentage or discount rate. In finance theory, the amount of
the opportunity cost is based on a relation between the risk and return of some sort of
investment. Classic economic theory maintains that people are rational and averse to risk. They,
therefore, need an incentive to accept risk. The incentive in finance comes in the form of higher
expected returns after buying a risky asset. In other words, the more risky the investment, the
more return investors want from that investment. Using the same example as above, assume the
first investment opportunity is a government bond that will pay interest of 5% per year and the
principal and interest payments are guaranteed by the government. Alternatively, the second
investment opportunity is a bond issued by small company and that bond also pays annual
interest of 5%. If given a choice between the two bonds, virtually all investors would buy the
government bond rather than the small-firm bond because the first is less risky while paying the
same interest rate as the riskier second bond. In this case, an investor has no incentive to buy the
riskier second bond. Furthermore, in order to attract capital from investors, the small firm issuing
the second bond must pay an interest rate higher than 5% that the government bond pays.
Otherwise, no investor is likely to buy that bond and, therefore, the firm will be unable to raise
capital. But by offering to pay an interest rate more than 5% the firm gives investors an incentive
to buy a riskier bond. For a valuation using the discounted cash flow method, one first estimates
the future cash flows from the investment and then estimates a reasonable discount rate after
considering the riskiness of those cash flows and interest rates in the capital markets. Next, one
makes a calculation to compute the present value of the future cash flows.
3.2.2 Guideline Companies Method
This method determines the value of a firm by observing the prices of similar companies (called
"guideline companies") that sold in the market. Those sales could be shares of stock or sales of
entire firms. The observed prices serve as valuation benchmarks. From the prices, one
calculates price multiples such as the price-to-earnings or price-to-book ratios—one or more of
which used to value the firm. For example, the average price-to-earnings multiple of the
guideline companies is applied to the subject firm's earnings to estimate its value. Many price
multiples can be calculated. Most are based on a financial statement element such as a firm's
earnings (price-to-earnings) or book value (price-to-book value) but multiples can be based on
other factors such as price-per-subscriber.
3.2.3 Net Asset Value Method
The third-most common method of estimating the value of a company looks to
the assets and liabilities of the business. At a minimum, a solvent company could shut down
operations, sell off the assets, and pay the creditors. Any cash that would remain establishes a
floor value for the company. This method is known as the net asset value or cost method. In
general the discounted cash flows of a well-performing company exceed this floor value. Some
companies, however, are worth more "dead than alive", like weakly performing companies that
own many tangible assets. This method can also be used to value heterogeneous portfolios of
investments, as well as nonprofits, for which discounted cash flow analysis is not relevant. The
valuation premise normally used is that of an orderly liquidation of the assets, although some
valuation scenarios (e.g., purchase price allocation) imply an "in-use" valuation such
as depreciated replacement cost new.
An alternative approach to the net asset value method is the excess earnings method. The excess
earnings method has the appraiser identify the value of tangible assets, estimate an appropriate
return on those tangible assets, and subtract that return from the total return for the business,
leaving the "excess" return, which is presumed to come from the intangible assets. An
appropriate capitalization rate is applied to the excess return, resulting in the value of those
intangible assets. That value is added to the value of the tangible assets and any non-operating
assets, and the total is the value estimate for the business as a whole.
3.3 Business Valuation in terms of different Conditions:
Business valuation in terms of different business conditions is explained as under:
3.3.1 Valuation of a suffering company
Investors in a suffering company, or in other "distressed securities", may intend (i) to restructure
the business, with the valuation reflecting its potential thereafter, or (ii) to purchase the company
- or its debt - at a discount, as part of an Investment Strategy aimed at realizing a profit on
recovery. Preliminary to the valuation, the financial statements are initially recast, to "better
reflect the firm's indebtedness, financing costs and recurring earnings". Here adjustments are
made to working capital, deferred capital expenditures, cost of goods sold, non-recurring
professional fees and costs, above- or below-market leases, excess salaries in the case of private
companies, and certain non-operating income/expense items. The valuation is built on this base,
with any of the standard market-, income-, or asset-based approaches employed. Often these are
used in combination, providing a "triangulation" or (weighted) average. Particularly in the
second case above, the company may be valued using real options analysis, serving to
complement (or sometimes replace) this standard value.
As required, various adjustments are then made to this result, so as to reflect characteristics of
the firm external to its profitability and cash flow. These adjustments consider any lack of
marketability resulting in a discount, and re the stake in question, any control premium or lack of
control discount. Balance sheet items external to the valuation, but due to the new owners, are
similarly recognized; these include excess (or restricted) cash, and other non-operating assets and
liabilities.
3.3.2 Valuation of a startup company
Startup companies such as Uber, which was valued at $50 billion in early 2015, are
assigned post-money valuations based on the price at which their most recent investor put money
into the company. The price reflects what investors, for the most part venture capital firms, are
willing to pay for a share of the firm. They are not listed on any stock market, nor is the
valuation based on their assets or profits, but on their potential for success, growth, and
eventually, possible profits. Many startup companies use internal growth factors to show their
potential growth which may attribute to their valuation. The professional investors who fund
startups are experts, but hardly infallible, see Dot-com bubble. Valuation using discounted cash
flows discusses various considerations here.
3.3.3 Valuation of intangible assets
Valuation models can be used to value intangible assets such as for patent valuation, but also
in copyrights, software, trade secrets, and customer relationships. As economies are becoming
increasingly informational, it is recognized that there is a need for new methods to value data,
another intangible asset. Valuations here are often necessary both for financial
reporting and intellectual property transactions. They are also inherent in securities analysis -
listed and private - in cases where analysts must estimate the incremental contribution of patents
(etc) to equity value; see next paragraph. Since few sales of benchmark intangible assets can ever
be observed, one often values these sorts of assets using either a present value model, or
by estimating the cost of recreating the asset in question. In some cases, option-based
techniques or decision trees may be applied. Regardless of the method, the process is often time-
consuming and costly. If required, stock markets can give an indirect estimate of a corporation's
intangible asset value; this can be reckoned as the difference between its market
capitalization and its book value (including only hard assets), i.e. effectively its goodwill.
As regards listed equity, the above techniques are most often applied in the biotech-, life
sciences- and pharmaceutical sectors. These businesses are involved in research and
development (R&D), and testing, that typically takes years to complete (and where the new
product may ultimately not be approved; see Contingent value rights). Industry specialists thus
apply the above techniques - and here especially rNPV - to the pipeline of products under
development, and, at the same time, also estimate the impact on existing revenue streams due
to expiring patents. For relative valuation, a specialized ratio is R&D spend as a percentage of
sales. Similar analysis may be applied to options on films re the valuation of film studios.
3.3.4 Valuation of mining projects
In mining, valuation is the process of determining the value or worth of a mining property - i.e.
as distinct from a listed mining corporate. Mining valuations are sometimes required
for IPOs, fairness opinions, litigation, mergers and acquisitions, and shareholder-related matters.
In valuing a mining project or mining property, fair market value is the standard of value to be
used. In general, this result will be a function of the property's "reserve" - the estimated size and
grade of the deposit in question - and the complexity and costs of extracting this. Analyzing
listed mining corporates (and other resource companies) is also specialized, as the valuation
requires a good understanding of the company's overall assets, its operational business model as
well as key market drivers, and an understanding of that sector of the stock market. a distinction
is usually made based on size and financial capabilities.
The price of a "Junior" mining stock, typically having one asset, will at its early stages be linked
to the result of its feasibility study; later, the price will be a function of that mine's viability and
value, largely applying the above techniques. A "Major", on the other hand, has
numerous properties, and the contents of any single deposit will impact stock value in a limited
fashion; this due to diversification, access to funding, and, also, since the share price inheres
goodwill. Typically, then, the exposure is more to the market value of each mineral in the
portfolio, than to the individual properties.
3.3.5 Valuing financial services firms
There are two main difficulties with valuing financial services firms. The first is that the cash
flows to a financial service firm cannot be easily estimated, since capital expenditures, working
capital and debt are not clearly defined: "debt for a financial service firm is more akin to raw
material than to a source of capital; the notion of cost of capital and enterprise value (EV) may
be meaningless as a consequence. The second is that these firms operate under a highly regulated
environment, and valuation assumptions (and model outputs) must incorporate regulatory limits,
at least as "bounds". The approach taken for a DCF valuation, is to then "remove" debt from the
valuation, by discounting free cash flow to equity at the cost of equity (or equivalently to apply a
modified dividend discount model). This is in contrast to the more typical approach
of discounting free cash flow to the Firm where EBITDA less capital expenditures and working
capital is discounted at the weighted average cost of capital, which incorporates the cost of debt.
For a multiple based valuation, similarly, price to earnings is preferred to EV/EBITDA. Here,
there are also industry-specific measures used to compare between investments and within sub-
sectors; this, once normalized by market cap (or other appropriate measure), and recognizing
regulatory differences:

 Insurance companies: embedded value and actuarial reserves

 Banking sector: net interest margin and provision for credit losses
 Wealth- and investment management firms: assets under management
 Investment banks: price to tangible book value and return on tangible equity

3.4 Meaning of Foreign Direct Investment (FDI)

Foreign direct investment (FDI) is an ownership stake in a foreign company or project made by
an investor, company, or government from another country. Generally, the term is used to
describe a business decision to acquire a substantial stake in a foreign business or to buy it
outright to expand operations to a new region. The term is usually not used to describe a stock
investment in a foreign company alone. FDI is a key element in international economic
integration because it creates stable and long-lasting links between economies. Foreign Direct
Investment can be known as:

 Foreign direct investments (FDIs) are substantial, lasting investments made by a

company or government into a foreign concern.
 FDI investors typically take controlling positions in domestic firms or joint ventures and
are actively involved in their management.
 The investment may involve acquiring a source of materials, expanding a company’s
footprint, or developing a multinational presence.
  The top recipients of FDI over the past several years have been the United States and
China.
 The U.S. and other Organisation for Economic Co-operation and Development (OECD)
countries have been the top contributors to FDI beyond their borders.

3.5 Process of Foreign Direct Investment:

Companies or governments considering a foreign direct investment (FDI) generally consider

target firms or projects in open economies that offer a skilled workforce and above-average
growth prospects for the investor. Light government regulation also tends to be prized. FDI
frequently goes beyond mere capital investment. It may include the provision of management,
technology, and equipment as well. A key feature of foreign direct investment is that it
establishes effective control of the foreign business or at least substantial influence over its
decision making. The net amounts of money involved with FDI are substantial, with more than
$1.8 trillion of foreign direct investments made in 2021. In that year, the United States was the
top FDI destination worldwide, followed by China, Canada, Brazil, and India. In terms of FDI
outflows, the U.S. was also the leader, followed by Germany, Japan, China, and the United
Kingdom. FDI inflows as a percentage of gross domestic product (GDP) is a good indicator of a
nation’s appeal as a long-term investment destination. The Chinese economy is currently smaller
than the U.S. economy in nominal terms, but FDI as a percentage of GDP was 1.7% for China as
of 2020, compared with 1.0% for the U.S. For smaller, dynamic economies, FDI as a percentage
of GDP is often significantly higher: e.g., 110% for the Cayman Islands, 109% for Hungary, and
34% for Hong Kong (also for 2020). In 2020, foreign direct investment tanked globally due to
the COVID-19 pandemic, according to the United Nations Conference on Trade and
Development. The total $859 billion global investment that year compared with $1.5 trillion the
previous year.4 And China dislodged the U.S. in 2020 as the top draw for total investment,
attracting $163 billion compared with investment in the U.S. of $134 billion.5 In 2021, global
FDI bounced back by 88%.

3.6 Special Considerations for Foreign Direct Investment

Foreign direct investments can be made in a variety of ways, including opening

a subsidiary or associate company in a foreign country, acquiring a controlling interest in an
existing foreign company, or by means of a merger or joint venture with a foreign company.The
threshold for an FDI that establishes a controlling interest, per guidelines established by
the Organisation for Economic Co-operation and Development (OECD), is a minimum 10%
ownership stake in a foreign-based company. That definition is flexible. There are instances in
which effective controlling interest in a firm can be established by acquiring less than 10% of the
company’s voting shares.

3.7 Types of Foreign Direct Investment

Foreign direct investments are commonly categorized as horizontal, vertical, or conglomerate.

 With a horizontal FDI, a company establishes the same type of business operation in a
foreign country as it operates in its home country. A U.S.-based cellphone provider
buying a chain of phone stores in China is an example.
 In a vertical FDI, a business acquires a complementary business in another country. For
example, a U.S. manufacturer might acquire an interest in a foreign company that
supplies it with the raw materials it needs.
 In a conglomerate FDI, a company invests in a foreign business that is unrelated to its
core business. Because the investing company has no prior experience in the foreign
company’s area of expertise, this often takes the form of a joint venture.

Examples of Foreign Direct Investment

Foreign direct investments may involve mergers, acquisitions, or partnerships in retail, services,
logistics, or manufacturing. They indicate a multinational strategy for company growth. They
also can run into regulatory concerns. For instance, in 2020, U.S. company Nvidia announced its
planned acquisition of ARM, a U.K.-based chip designer. In August 2021, the U.K.’s
competition watchdog announced an investigation into whether the $40 billion deal would
reduce competition in industries reliant on semiconductor chips.6 The deal was called off in
February 2022.

FDI in China and India

China’s economy has been fueled by an influx of FDI targeting the nation’s high-tech
manufacturing and services. Meanwhile, more recently relaxed FDI regulations in India now
allow 100% foreign direct investment in single-brand retail without government approval.

3.8 Difference between Foreign Direct Investment (FDI) and Foreign Portfolio Investment
(FPI)

Foreign portfolio investment (FPI) is the addition of international assets to the portfolio of a
company, an institutional investor such as a pension fund, or an individual investor. It is a form
of portfolio diversification, achieved by purchasing the stocks or bonds of a foreign company.
Foreign direct investment (FDI) instead requires a substantial and direct investment in, or the
outright acquisition of, a company based in another country, and not just their securities. FDI is
generally a larger commitment, made to enhance the growth of a company. But both FPI and FDI
are generally welcome, particularly in emerging nations. Notably, FDI involves a greater
responsibility to meet the regulations of the country that hosts the company receiving the
investment.

3.9 Advantages and Disadvantages of FDI

FDI can foster and maintain economic growth, in both the recipient country and the country
making the investment. On one hand, developing countries have encouraged FDI as a means of
financing the construction of new infrastructure and the creation of jobs for their local workers.
On the other hand, multinational companies benefit from FDI as a means of expanding their
footprints into international markets. A disadvantage of FDI, however, is that it involves the
regulation and oversight of multiple governments, leading to a higher level of political risk.

Examples

One of the most sweeping examples of FDI in the world today is the Chinese initiative known
as One Belt One Road (OBOR). This program, sometimes referred to as the Belt and Road
Initiative, involves a commitment by China to substantial FDI in a range of infrastructure
programs throughout Africa, Asia, and even parts of Europe. The program is typically funded by
Chinese state-owned enterprises and organizations with deep ties to the Chinese government.
Similar programs are undertaken by other nations and international bodies, including Japan, the
United States, and the European Union.

The Bottom Line

FDI involves the direct investment by companies or governments into foreign firms or projects.
This accounts for nearly $2 trillion in cash flows around the world, with the U.S. and China
leading in the FDI inflow statistics. For smaller and developing countries, FDI funds can be a
substantial part of overall GDP. Foreign portfolio investment (FPI) is related to FDI but instead
involves owning the securities issued by firms (e.g., stock in foreign companies) rather than
direct capital investments.

Summary:

Financial statements prepared in accordance with generally accepted accounting

principles (GAAP) show many assets based on their historic costs rather than at their current
market values. For instance, a firm's balance sheet will usually show the value of land it owns at
what the firm paid for it rather than at its current market value. But under GAAP requirements, a
firm must show the fair values (which usually approximates market value) of some types of
assets such as financial instruments that are held for sale rather than at their original cost. When a
firm is required to show some of its assets at fair value, some call this process "mark-to-market".
But reporting asset values on financial statements at fair values gives managers ample
opportunity to slant asset values upward to artificially increase profits and their stock prices.
Managers may be motivated to alter earnings upward so they can earn bonuses. Despite the risk
of manager bias, equity investors and creditors prefer to know the market values of a firm's
assets—rather than their historical costs—because current values give them better information to
make decisions.
There are commonly three pillars to valuing business entities: discounted cash flow analysis,
comparable company analyses, Net asset value method, and precedent transaction analysis.
Business valuation credentials include the Chartered Business Valuator (CBV) offered by
the CBV Institute, ASA and CEIV from the American Society of Appraisers, and the CVA by
the National Association of Certified Valuators and Analysts. In terms of business conditions,
there are different ways of business valuation. On the other hand, Foreign direct investment
(FDI) is an ownership stake in a foreign company or project made by an investor, company, or
government from another country. Generally, the term is used to describe a business decision to
acquire a substantial stake in a foreign business or to buy it outright to expand operations to a
new region. The term is usually not used to describe a stock investment in a foreign company
alone. FDI is a key element in international economic integration because it creates stable and
long-lasting links between economies. Foreign Direct Investment differs from Foreign Portfolio
Investment.

Self Test Questions:

1. What do you know by Business Valuation? Discuss the methods of Business Valuation.
2. Discuss the criteria of Business valuation in terms of different business conditions.
3. What do you understand by Foreign Direct Investment? State the special conditions and
process of Foreign Direct Investment.
4. What are the different types of Foreign Direct Investment? Distinguish between Foreign
Direct Investment and Foreign Portfolio Investment.
5. What are the advantages and disadvantages of Foreign Direct Investment? Explain.
 CHAPTER-IV
INTERNATIONAL TRADE AND POLICY

PURPOSE AND STRUCTURE

The host country’s trade and FDI policies often influence entry decisions in international
markets. Policy incentives help exporters increase their profitability through foreign sales. High
import tariffs and other import restrictions distort free market forces guarding domestic industry
against foreign competition and support indigenous manufacturing. Therefore, a thorough
understanding of the country’s trade policy and incentives are crucial to the development of a
successful international business strategy. This chapter highlights International Trade and Policy
which will help the readers to know about the following:

4.1 Meaning of Trade Policy

4.2 Characteristics of Developing Countries’ Trade

4.3 Strategies for Trade Policy

4.4 Instruments of Trade Policy or Methods Employed to Regulate Trade Policy

4.5 The WTO’s Trade Policy Review Mechanism

4.1 Meaning of Trade Policy

Trade policy refers to the complete framework of laws, regulations, international agreements,
and negotiating stances adopted by a government to achieve legally binding market access for
domestic firms. It also seeks to develop rules providing predictability and security for firms. To
be effective, trade policy needs to be supported by domestic policies to foster innovation and
international competitiveness. Besides, the trade policy should have flexibility and pragmatism.
Trade in developing countries is characterized by heavy dependence on developed countries,
dominance of primary products, over-dependence on few markets and few products, and
worsening of terms of trade and global protectionism, all of which make formulation and
implementations of trade policy critical to economic development.

The strategic options for trade policy may either be inward or outward looking. As a result of
liberalization and integration of national policies with WTO agreements, there has been a
strategic shift in trade policies. Like other developing countries, India’s trade policies have also
made a gradual shift from highly restrictive policies with emphasis on import substitution to
more liberal policies geared towards export promotion.
India’s foreign trade policy is formulated under the Foreign Trade (Development and
Regulation) Act, for a period of five years by the Ministry of Commerce, Government of India.
The government is empowered to prohibit or restrict subject to conditions, export of certain
goods for reasons of national security, public order, morality, prevention of smuggling, and
safeguarding balance of payments. Policy measures to promote international trade, such as
schemes and incentives for duty-free and concessional imports, augmenting export production,
and other export promotion measures are discussed in-depth.

The multilateral trading system under the WTO trade regime significantly influences trade
promotion measures and member countries need to integrate their trade policies with the WTO
framework. The WTO trade policy review mechanism provides an institutional framework to
review trade policies of member countries at regular intervals. There exists a huge gap in per
capita income between the developed and the developing countries. Most of the world’s
population lives in countries that are considerably poor. Efforts to bridge the income gap
between developed and developing countries, to raise living standards by increasing income
levels, and to cope with the uneven development in the domestic economy, remain the central
concern of economic and trade policies of developing countries. With low production base and
constraints in value addition, most developing countries remain marginal players in international
trade.

4.2 Characteristics of Developing Countries’ Trade

Key characteristics of developing countries’ trade include the following:

(i) Heavy Dependence Upon Developed Countries:
Developing countries’ trade is often dependent upon developed countries which form export
destinations for the majority of their goods. Moreover, developing countries also heavily depend
on developed countries for their imports. Trade among developing countries is relatively meagre.

(ii) Dominance of Primary Products:

Exports from developing countries traditionally comprised primary products, such as agricultural
goods, raw materials and fuels or labour-intensive manufactured goods, such as textiles.
However, over recent years, dependence on primary products has considerably decreased,
especially for newly industrialized countries, such as South Korea and Hong Kong.

India’s dependence on agro exports has also declined considerably from 44.2 per cent in 1960-61
to about 10 per cent in 2006-07.

(iii) Over-dependence on a Few Markets and a Few Products:

A large number of developing countries are dependent on just a few markets and products for
their exports. For instance, Mexico is heavily dependent on the US which is the destination for
89 per cent of its total exports whereas the Dominican Republic exports 80 per cent and Trinidad
and Tobago 68 per cent of its goods to the US. In terms of product composition, petroleum
accounts for 96 per cent of total exports from Nigeria, 86 per cent of total exports from Saudi
Arabia, and 86 per cent of total exports from Venezuela. Over the years, India’s basket of export
products has widened remarkably with decreased dependence on any single product category.

(iv) Worsening Terms of Trade:

Distribution of gains from trade has always been disproportionate and therefore, a controversial
issue. Developing countries often complain of deterioration in their terms of trade, mainly due to
high share of primary products in their exports.

(v) Global Protectionism:

Developed countries often provide heavy subsidies to their farmers for agricultural production
and shield them from competition from imported products, besides imposing tariffs. Moreover, a
number of non-tariff barriers such as quality requirements, sanitary and phytosanitary measures,
and environmental and social issues, such as child labour offers considerable obstacles to
products emanating from developing countries.

(vi)‘Economic Dualism’,

There exists economic dualism where a high-wage capital-intensive industrial sector co-exists
with a low-wage unorganized traditional sector, prevails in most developing countries.
Promoting indigenous industrialization and employment generation become key concerns of
their economic policies.

4.3 Strategies for Trade Policy:

A country may adopt any of the following strategic options for its trade policy.

(i) Inward Looking Strategy (Import Substitution):

Emphasis is laid on extensive use of trade barriers to protect domestic industries from import
competition under the import-substitution strategy. Domestic production is encouraged so as to
achieve self-sufficiency and imports are discouraged.

Import- substitution trade strategy is often justified by the ‘infant industry argument’, which
advocates the need of a temporary period of protection for new industries from competition from
well-established foreign competitors.

Most developing countries, such as Brazil, India, Mexico, Argentina, etc., during the 1950s and
1960s employed an inward-looking trade strategy. The uses of high tariff structure and quota
restrictions along with reserving domestic industrial activities for local firms rather than foreign
investors were the key features of this import substitution policy.

Pros and Cons of Trade Policy Strategies:

The pros and cons of such strategy are given below.

Pros:
i. Protecting start-up industries so as to enable them to grow to a size where they can compete
with the industries of developed nations

ii. Low risk in establishing domestic industry to replace imports especially when the size of
domestic market is large enough to support such industries

iii. High import tariffs that discourage imports but provide foreign firms an inbuilt incentive to
establish manufacturing facilities, leading to industrial development, growth in economic
activities, and employment generation

iv. Relative ease for developing countries to protect their manufacturers against foreign
competition compared to getting protectionist trade barriers reduced by developed countries, in
which they have little negotiating power

Cons:
i. Overprotection of domestic industries against international competition tends to make them
inefficient

ii. Protection primarily available to import substituting industries which discriminates against
other industries

iii. Manufacturers based in countries with relatively small market size find it difficult to take
advantage of economies of scale and therefore have to incur high per unit costs

iv. Industries that substitute imports become competitive because of government incentives and
import prohibitions, leading to considerable investment. Any attempt to reduce incentives or
liberalize trade restrictions face strong resistance

v. Government subsidies and trade restrictions tend to breed corruption

Since independence, India’s trade strategy had been largely inclined to import substitution rather
than export promotion. Earning foreign exchange through exports and conservation thereof had
always been a high-priority task for various governments, irrespective of their political
ideologies. Till 1991, India followed a strong inward-oriented trade policy to conserve foreign
exchange.

In order to facilitate industrialization with the objective of import substitution, important

instruments used by the government included outright ban on import of some commodities,
quantitative restriction, prohibitive tariff structure, which was one of the highest in the world and
administrative restrictions, such as import licensing, foreign exchange regulations, local content
requirements, export obligations, etc.

The policy makers of India had long believed that these policy measures would make India a
leading exporter with comfortable balance of trade. In reality, these initiatives did not yield the
desired results, rather gave rise to corruption, complex procedures, production inefficiency, poor
product quality, and delay in shipment, and, in turn, decline in India’s share in world exports.

The protectionist measures of the inward-oriented economy increased the profitability of

domestic industries, especially in the import substitution sector. The investment made to serve
the domestic market was less risky due to proven demand potential by the existing level of
imports.

Formidable tariff structure and trade policy barriers discouraged the entry of foreign goods into
the Indian market. There was little pressure on domestic firms to be internationally competitive.

(ii) Outward Looking Strategy (Export-led Growth):

Under the outward looking strategy, the domestic economy is linked to the world economy,
promoting economic growth through exports. The strategy involves incentives to promote
exports rather than restrictions to imports.

Major benefits of an outward looking strategy include:

i. Industries wherein a country has comparative advantage are encouraged, for instance labour-
intensive industries in developing countries

ii. Increase in competition in the domestic market leads to competitive pressure on the industry to
increase its efficiency and upgrade quality

iii. Facilitating companies to benefit from economies of scale as large output can be sold in
international markets

The economic liberalization during the last decade paved the way for access of foreign goods to
Indian market, applying competitive pressure even on purely domestic companies. In order to
make exports, the engine of growth, export promotion, gained major thrust in India’s trade
policies, especially in recent years.
With the integration of national trade policies and export promotion incentives with the WTO,
promotional measures to encourage international marketing efforts, rather than export
subsidization, have gained increased significance.

Accordingly, policies were aimed at creating a business-friendly environment by eliminating

redundant procedures, increasing transparency by simplifying the processes involved in the
export sector, and moving away from quantitative restrictions, thereby improving the
competitiveness of Indian industry and reducing the anti-export bias.

Steps were taken to promote exports through multilateral and bilateral initiatives. With the
decline in restrictions on trade and investment, constraints related to infrastructure and regulatory
bottlenecks became increasingly evident.

4.4 Instruments of Trade Policy or Methods Employed to Regulate Trade Policy:

Various methods employed to regulate trade are known as instruments of trade policy, which
include tariffs, non-tariff measures, and financial controls.

(i) Tariffs:
These are official constraints on import or export of certain goods and services and are levied in
the form of customs duties or tax on products moving across borders. However, tariffs are more
commonly imposed on imports rather than exports.

Tariff Instruments:

The tariff instruments may be classified as below.

a) On the basis of direction of trade: import vs. exports tariffs:

Tariffs may be imposed on the basis of direction of product movement, i.e., either on exports or
imports. Generally, import tariffs or customs duties are more common than tariffs on exports
However, countries sometimes resort to impose export tariffs to conserve their scarce resources.
Such tariffs are generally imposed on raw materials or primary products rather than on
manufactured or value-added goods.

b) On the basis of purpose: protective vs. revenue tariffs:

The tariffs imposed to protect the home industry, agriculture, and labour against foreign
competitors is termed as protective tariffs which discourage foreign goods. Historically, India
had very high tariffs so as to protect its domestic industry against foreign competition.

A tariff rate of 200 to 300 per cent, especially on electronic and other consumer goods, created
formidable barriers for foreign products to enter the Indian market.

The government may impose tariffs to generate tax revenues from imports which are generally
nominal. For instance, the UAE imposes 3-4 per cent tariffs on its imports which may not be
termed as protective tariffs.

c) On the basis of time length: tariff surcharge vs. countervailing duty:

d) On the basis of the duration of imposition, tariffs may be classified either as surcharge or
countervailing duty. Any surcharge on tariffs represents a short term action by the
importing country while countervailing duties are more or less permanent in nature. The
raison d’etre for imposition of countervailing duties is to offset the subsidies provided by
the governments of the exporting countries.

e) On the basis of tariff rates: specific, ad-valorem, and combined:

Duties fixed as a specific amount per unit of weight or any other measures are known as specific
duties. For instance, these duties are in terms of rupees or US dollars per kg weight or per meter
or per liter of the product. The cost, insurance, and freight (c.i.f.) value, product cost, or prices
are not taken into consideration while deciding specific duties.

Specific duties are considered to be discriminatory but effective in protection of cheap- value
products because of their lower unit value.

f) Duties levied ‘on the basis of value’ are termed as ad-valorem duties. Such duties are
levied as a fixed percentage of the dutiable value of imported products. In contrast to
specific duties, it is the percentage of duty that is fixed. Duty collection increases or
decreases on the basis of value of the product. Ad-valorem duties help protect against any
price increase or decrease for an import product.

g) A combination of specific and ad-valorem duties on a single product is known as

combined or compound duty. Under this method, both specific as well as ad-valorem
rates are applied to an import product.
 h) On the basis of production and distribution points, these are as below:

Single stage sales tax:

Tax collected only at one point in the manufacturing and distribution chain is known as single
stage sales tax. Single stage sales tax is generally not collected unless products are purchased by
the final consumer.

Value added tax:

Value added tax (VAT) is a multi-stage non-cumulative tax on consumption levied at each stage
of production, distribution system, and value addition. A tax has to be paid at each time the
product passes from one hand to the other in the marketing channel.

However, the tax collected at each stage is based on the value addition made during the stage and
not on the total value of the product till that point. VAT is collected by the seller in the marketing
channel from a buyer, deducted from the VAT amount already paid by the seller on purchase of
the product and remitting the balance to the government.

Since VAT applies to the products sold in domestic markets and imported goods, it is considered
to be non-discriminatory. Besides, VAT also conforms to the WTO norms.

Cascade tax:

Taxes levied on the total value of the product at each point in manufacturing and distribution
channel, including taxes borne by the product at earlier stages, are known as cascade taxes. India
had a long regime of cascade taxes wherein the taxes were levied at a later stage of marketing
channel over the taxes already borne by the product.

Such a taxation system adds to the cost of the product, making goods non-competitive in the
market.

Excise tax:
Excise tax is a one-time tax levied on the sale of a specific product. Alcoholic beverages and
cigarettes in most countries tend to attract more excise duty.

Turnover tax:
In order to compensate for similar taxes levied on domestic products, a turnover or equalization
tax is imposed. Although the equalization or turnover tax hardly equalizes prices, its impact is
uneven on domestic and imported products.

(ii) Non-Tariff Measures:

Contrary to tariffs, which are straightforward, non-tariff measures are non-transparent and
obstruct trade on discriminatory basis. As the WTO regime calls for binding of tariffs wherein
the member countries are not free to increase the tariffs at their will, non-tariff barriers in
innovative forms are emerging as powerful tools to restrict imports on discriminatory basis. The
major non-tariff policy instruments include.

Government participation in trade:

State trading, governments’ procurement policies, and providing consultations to foreign
companies on a regular basis are often used as disguised protection of national interests and
barrier to foreign firms. A subsidy is a financial contribution provided directly or indirectly by a
government that confers a benefit.

Various forms of subsides include cash payment, rebate in interest rates, value added tax,
corporate income tax, sales tax, insurance, freight and infrastructure, etc. As subsidies are
discriminatory in nature, direct subsidies are not permitted under the WTO trade regime.

Customs and entry procedure:

Custom classification, valuation, documentation, various types of permits, inspection

requirements, and health and safety regulations are often used to hinder free flow of trade and
discriminate among the exporting countries. These constitute an important non-tariff barrier.

Quotas:

Quotas are the quantitative restrictions on exports/imports intended at protecting local industries
and conserving foreign exchange. The various types of quotas include

Absolute quota:

These quotas are the most restrictive, limiting in absolute terms, the quantity imported during the
quota period. Once the quantity of the import quota is fulfilled, no further imports are allowed.
Tariff quotas:

They allow import of specified quantity of quota products at reduced rate of duty. However,
excess quantities over the quota can be imported subject to a higher rate of import duty. Using
such a combination of quotas and tariffs facilitates some import, but at the same time discourages
through higher tariffs, excessive quantities of imports.

Voluntary quotas:

Voluntary quotas are unilaterally imposed in the form of a formal arrangement between countries
or between a country and an industry. Such agreements generally specify the import limit in
terms of product, country, and volume.

The multi-fibre agreement (MFA) had been the largest voluntary quota arrangement wherein
developed countries forced an agreement on economically weaker countries so as to provide
artificial protection to their domestic industry.

However, with the integration of multi-fibre agreement with the WTO, the quota regime got
scrapped by 1 January 2005. Summarily, all sorts of quotas have a restrictive effect on free flow
of goods across countries.

Other trade restrictions:

Other trade restrictions include minimum export price (MEP), wherein the government may fix a
minimum price for exports so as to safeguard the interests of domestic consumers. Presently,
India’s trade policy does not impose any restriction of minimum export price.

(iii) Financial Controls:

Governments often impose a variety of financial restrictions to conserve the foreign currencies
restricting their markets. Such restrictions include exchange control, multiple exchange rates,
prior import deposit, credit restrictions, and restriction on repatriation of profits. India had long
followed a stringent exchange control regime to conserve foreign currencies.

(iv) Demand vs Supply Side Policy Measures:

Policy instruments for promoting exports may also operate on the supply and demand side.
Initiatives for creating and expanding export production, developing transportation networks,
port facilities, tax and investment systems form parts of supply side policies.

The demand side initiatives for export promotion include programmes to alert companies to the
opportunities present in international markets and to strengthen the commitment and skills of
those already involved.

State governments generally do not distinguish between production for domestic market and
production for export market. Therefore, there had been few specific measures taken by state
governments targeted at exporting units.

Though, state governments have taken a number of policy measures so as to encourage industrial
activity in the state which mainly relate to:
i. Capital investment subsidy or subsidy for preparation of feasibility reports, project reports, etc.

ii. Waiver or deferment of sales tax or providing loans for sales tax purposes

iii. Exemption from entry tax, octroi, etc.

iv. Waiver of electricity duty

v. Power subsidy

vi. Exemption from taxes for certain captive power generation units

vii. Exemptions from stamp duties

viii. Provision of land at concessional rate

These concessions extended by state governments vary among policies of individual state
governments and have broadly been based on the following criteria:
(a) Size of the unit proposed (cottage, small and medium industry)

(b) Backwardness of the districts or area

(c) Employment to weaker sections of society

(d) Significance of the sector, for example, software, agriculture

(e) Investment source, such as foreign direct investment (EDI) or investment by NRIs
(f) Health of the unit (sick), etc.

Therefore, it may be noted that most of the exemptions tend to encourage capital- or power-
intensive units though some concessions are linked to turnover. Most of the concessions in the
state industrial policies have been designed keeping in view the manufacturing industries.

An analysis of industrial policies of various states indicates that most state governments do
compete among themselves in extending such concessions. On examination of export promotion
initiatives by the state governments, it is difficult to find commonality among various states.
However, some of the common measures taken by the state governments are:

i. Attempting to provide information on export opportunities

ii. Preference in land allotment for starting an EOU

iii. Planning for development of Export Promotion Industrial Parks

iv. Exemption from entry-tax on supplies to EOU/EPZ/SEZ units

v. Exemption from sales tax or turnover tax for supplies to EOU/EPZ/SEZ units and inter-unit
transfers between them.

The emergence of the rule-based multilateral trading system under the WTO trade regime has
affected India’s trade policies and promotional efforts. It provides a rule based framework as to
which subsidies are prohibited, which can face countervailing measures, and which are allowed.
The impact of WTO agreements on trade policy and export promotion measures is examined
here.

Basic Rules of the Framework of GATT

The framework of the GATT is based on four basic rules:

(i) Protection to Domestic Industry Through Tariffs:
Even though GATT stands for liberal trade, it recognizes that its member countries may have to
protect domestic production against foreign competition. However, it requires countries to keep
such protection at low levels and to provide it through tariffs. To ensure that this principle is
followed in practice, the use of quantitative restrictions is prohibited, except in a limited number
of situations.

(ii) Binding of Tariffs:

Countries are urged to reduce and, where possible, eliminate protection to domestic production
by reducing tariffs and removing other barriers to trade in multilateral trade negotiations. The
tariffs so reduced are bound against further increase by being listed in each country’s national
schedule. The schedules are integral part of the GATT legal system.

(iii) Most-Favoured-Nation Treatment:

This important rule of GATT lays down the principle of non-discrimination. The rule requires
that tariffs and other regulations should be applied to imported or exported goods without
discrimination among countries. Thus it is not open to a country to levy customs duties on
imports from one country, at a rate higher than it applies to imports from other countries. There
are, however, some exceptions to the rule.

Trade among members of regional trading arrangements, which are subject to preferential or
duty-free rates, is one such exception. Another is provided by the Generalized System of
Preferences; under this system, developed countries apply preferential or duty-free rates to
imports from developing countries, but apply MFN rates to imports from other countries.

(iv) National Treatment Rule:

While the MFN rule prohibits countries from discriminating among goods originating in
different countries, the national treatment rule prohibits them from discriminating between
imported products and equivalent domestically produced products, both in the matter of the levy
of internal taxes and in the application of internal regulations.

Thus it is not open to a country, after a product has entered its markets on payment of customs
duties, to levy an internal tax (for example, sales tax or VAT) at rates higher than those payable
on a product of national or domestic origin.

The four basic rules are complemented by rules of general application, governing goods entering
the customs territory of an importing country.

These include rules which countries must follow:

i. In determining the dutiable value of imported goods where customs duties are collected on an
ad-valorem basis

ii. In applying mandatory product standards, and sanitary and phytosanitary regulations to
imported products

iii. In issuing authorizations for imports

In addition to the rules of general application described above, the GATT multilateral system has
rules governing:
i. The grant of subsidies by governments
ii. Measures which governments are ordinarily permitted to take if requested by industry

iii. Investment measures that could have adverse effects on tirade

Measures to Restrict Imports

The rules further stipulate that certain types of measures which could have restrictive effects on
imports can ordinarily be imposed by governments of importing countries only if the domestic
industry which is affected by increased import petitions that such actions be taken.

These include:
i. Safeguard actions

ii. Levy of anti-dumping and countervailing duties

Under safeguard action the importing country is allowed to restrict imports of a product for a
temporary period by either increasing tariffs or imposing quantitative restrictions. However, the
safeguard measures can only be taken after it is established through proper investigation that
increased imports are causing serious injury to the domestic industry.

The anti-dumping duties can be imposed if the investigation establishes that the goods are
‘dumped’.

The agreement stipulates that a product should be treated as being ‘dumped’ where its export
price is less than the price at which it is offered for sale in the domestic market of the exporting
country, whereas the countervailing duties can be levied in cases where the foreign company has
charged low export price because its product has been subsidized by the government.

4.5 The WTO’s Trade Policy Review Mechanism:

In order to enhance transparency of members’ trade policies and facilitate smooth functioning of
the multilateral trading system, the WTO members established the Trade Policy Review
Mechanism (TPRM) to review trade policies of member countries at regular intervals.

Under annexure 3 of the Marrakesh Agreement, the four members with largest shares of world
trade (i.e., European communities, the US, Japan, and China) are to be reviewed every two years,
the next sixteen to be reviewed every four years, and the others be reviewed every six years. For
the least developed countries a longer period may be fixed.

Reviews are conducted by the Trade Policy Review (TPR) Body on the basis of a policy
statement by the member under review and a report prepared by staff in the WTO Secretariat’s
TPR Division. Although the secretariat seeks cooperation of the members in preparing the report,
it has the sole responsibility for the facts presented and the views expressed.

The TPR reports contain detailed reports examining the trade policies and practices of the
member and describing policy-making institutions and the macroeconomic situation. The
member’s subsidies contained in the TPR is of particular interest for the purpose of the report.
Information on subsidies distinguished in the subsidies and countervailing measures (SCM) can
be found in the following three parts of the TPR report:
i. Measures directly affecting exports

ii. Trade policies and practices by sector

iii. Government incentives or subsidies that do not directly target imports and exports but
nevertheless have an impact on trade flows

The contents of the report are mainly driven by the member’s main policy changes and
constraints rather than subsidy-related issues and problems. Besides, the coverage of the report is
determined to a large extent by the availability of data.

As a result, the amount of information contained in the reports varies from member to member.
The TPR reports normally do not attempt to assess the effects of the subsidies on trade.

Due to limited availability of detailed information, in many cases, it is difficult to identify the
extent to which a benefit is actually being conferred or the identity of the recipient of the
subsidy.

Despite the shortcomings, especially with respect to cross-country comparability, the TPR report
constitutes one of the few sources that systematically collects and compiles information on
subsidies for a broad range of countries and economic activities.

Summary

Trade policy refers to the complete framework of laws, regulations, international agreements,
and negotiating stances adopted by a government to achieve legally binding market access for
domestic firms. It also seeks to develop rules providing predictability and security for firms. To
be effective, trade policy needs to be supported by domestic policies to foster innovation and
international competitiveness. Besides, the trade policy should have flexibility and pragmatism.
Trade in developing countries is characterized by heavy dependence on developed countries,
dominance of primary products, over-dependence on few markets and few products, and
worsening of terms of trade and global protectionism, all of which make formulation and
implementations of trade policy critical to economic development.
The strategic options for trade policy may either be inward or outward looking. As a result of
liberalization and integration of national policies with WTO agreements, there has been a
strategic shift in trade policies. Like other developing countries, India’s trade policies have also
made a gradual shift from highly restrictive policies with emphasis on import substitution to
more liberal policies geared towards export promotion.

India’s foreign trade policy is formulated under the Foreign Trade (Development and
Regulation) Act, for a period of five years by the Ministry of Commerce, Government of India.
The government is empowered to prohibit or restrict subject to conditions, export of certain
goods for reasons of national security, public order, morality, prevention of smuggling, and
safeguarding balance of payments.

Self Test Questions

1. What do you know by trade policy? Discuss the characteristics of trade in developing
countries.

2. Briefly explain the strategies for trade policy.

3. What are the instruments of trade policy or the methods employed to regulate trade
policy? Explain.

4. State the WTO’s Trade Policy Review mechanism.

 CHAPTER-V
INTERNATIONAL TRADE: THEORIES AND SIGNIFICANCE
PURPOSE AND STRUCTURE

International trade theory is a sub-field of economics which analyzes the patterns of international
trade, its origins, and its welfare implications. International trade policy has been highly
controversial since the 18th century. International trade theory and economics itself have
developed as means to evaluate the effects of trade policies. International Trade has a special
significance to the countries in terms of socio-economic and environmental considerations. In
this chapter, the International Trade theories and significance of International Trade have been
discussed. The readers will be able to understand the following concepts related to it.
5.1 Theories of International Trade:
5.2 Ricardian Trade Theory Extensions
5.3 Phases of Expansion of International Trade
5.4 Global Value Chains
5.5 Significance or Benefits of International Trade
5.6 Impact of International Trade on the Environment
5.7 Unemployment in International Trade Situations

5.1 Theories of International Trade:

International trade policy has been highly controversial since the 18th century. International
trade theory and economics itself have developed as means to evaluate the effects of trade
policies. The International Tradse theories are discussed as under:

Adam Smith's model

Adam Smith describes trade taking place as a result of countries having absolute advantage in
production of particular goods, relative to each other. Within Adam Smith's framework, absolute
advantage refers to the instance where one country can produce a unit of a good with less labor
than another country. In Book IV of his major work the Wealth of Nations, Adam Smith,
discussing gains from trade, provides a literary model for absolute advantage based upon the
example of growing grapes from Scotland. He makes the argument that while it is possible to
grow grapes and produce wine in Scotland, the investment in the factors of production would
cost thirty times more than the cost of purchasing an equal quantity from a foreign country. The
minimization of aggregate real costs and efficient resource allocation through trade without
strong consideration for comparative costs form the basis of Adam Smith's model of absolute
advantage in international trade.

Ricardian model
The law of comparative advantage was first proposed by David Ricardo.
The Ricardian theory of comparative advantage became a basic constituent of neoclassical trade
theory. Any undergraduate course in trade theory includes a presentation of Ricardo's example of
a two-commodity, two-country model. The Ricardian model focuses on comparative advantage,
which arises due to differences in technology or natural resources. The Ricardian model does not
directly consider factor endowments, such as the relative amounts of labor and capital within a
country.
New interpretation
The Ricardian model is often presented as being based on the following assumptions:

 Labor is the only primary input to production.

 The relative ratios of labor at which the production of one good can be traded off for another,
differ between countries.
This is incomplete, because the Ricardian model can be extended to the situation where many
goods can be inputs for a production. See Ricardian trade theory extensions below. Relative ratio
of labor input coefficients has a valid meaning only for simple cases such as two-country, many
commodity case or many-country, two-commodity case without no intermediate goods.
As for the meanings of four magic numbers, a new interpretation became popular in the 21st
century. In 2002, Roy Ruffin pointed the possibility of new reading of Ricardo's explanations.
Andrea Maneschi made a detailed account in 2004

Specific factors model

The specific factors model is an extension of the Ricardian model. It was due to Jacob
Viner's interest in explaining the migration of workers from the rural to urban areas after
the Industrial revolution.
In this model labor mobility among industries is possible while capital is assumed to be
immobile in the short run. Thus, this model can be interpreted as a short-run version of the
Heckscher-Ohlin model. The "specific factors" name refers to the assumption that in the short
run, specific factors of production such as physical capital are not easily transferable between
industries. The theory suggests that if there is an increase in the price of a good, the owners of
the factor of production specific to that good will profit in real terms

Heckscher–Ohlin model
In the early 1900s, a theory of international trade was developed by two Swedish economists, Eli
Heckscher and Bertil Ohlin. This theory has subsequently become known as the Heckscher–
Ohlin model (H–O model). The results of the H–O model are that the pattern of international
trade is determined by differences in factor endowments. It predicts that countries
will export those goods that make intensive use of locally abundant factors and will import goods
that make intensive use of factors that are locally scarce.
The H–O model makes the following core assumptions:

 Labor and capital flow freely between sectors equalising factor prices across sectors within a
country.
 The amount of labor and capital in two countries differ (difference in endowments)
 Technology is the same among countries (a long-term assumption)
 Tastes are the same upon countries
Stolper-Samuelson theorem
According to the Stolper-Samuelson theorem, the export of a product which is a relatively cheap,
abundant resource makes this resource more scarce in the domestic market. Thus, the increased
demand for the abundant resource leads to an increase in its price and an increase in its income.
Simultaneously, the income of the resource used intensively in the import-competing product
decreases as its demand falls.
Simply put, this theorem indicates that an increase in the price of a product rises the income
earned by resources that are used intensively in its production. Conversely, a decrease in the
price of a product reduces the income of the resources that it uses intensively. The abundant
resource that have comparative advantage realizes an increase in income, and the scarce resource
realizes a decrease in its income regardless of industry. This trade theory concludes that some
people will suffer losses from free trade even in the long-term
Empirical Evidence for the Heckscher–Ohlin model
In 1953, Wassily Leontief published a study in which he tested the validity of the Heckscher-
Ohlin theory. The study showed that the United States was more abundant in capital compared to
other countries, therefore the United States would export capital-intensive goods and import
labor-intensive goods. Leontief found out that the United States' exports were less capital
intensive than its imports. The result became known as Leontief's paradox.
After the appearance of Leontief's paradox, many researchers tried to save the Heckscher-Ohlin
theory, either by new methods of measurement, or by new interpretations.

New trade theory

New trade theory tries to explain empirical elements of trade that comparative advantage-based
models above have difficulty with. These include the fact that most trade is between countries
with similar factor endowment and productivity levels, and the large amount of multinational
production (i.e., foreign direct investment) that exists. New trade theories are often based on
assumptions such as monopolistic competition and increasing returns to scale. One result of these
theories is the home-market effect, which asserts that, if an industry tends to cluster in one
location because of returns to scale and if that industry faces high transportation costs, the
industry will be located in the country with most of its demand, in order to minimize cost. New
trade theory is a theory of international trade inaugurated by Marc Melitz in 2003. It discovered
that efficiency of firms in a country changes much and those firms engaged in international trade
have higher productivity than firms which produce only for domestic market. As it is fitted to big
data age, the research produced many follows and the trend is now called New new trade
theory in comparison to Paul Krugman's new trade theory.

Gravity model
The Gravity model of trade presents a more empirical analysis of trading patterns. The gravity
model, in its basic form, predicts trade based on the distance between countries and the
interaction of the countries' economic sizes. The model mimics the Newtonian law of
gravity which also considers distance and physical size between two objects. The model has
significant empirical validity.

5.2 Ricardian Trade Theory Extensions

According to Eaton and Kortum, in the 21 century, "the Ricardian framework has experienced a
revival. Much work in international trade during the last decade has returned to the assumption
that countries gain from trade because they have access to different technologies. This line of
thought has brought Ricardo's theory of comparative advantage back to center stage." The
Ricardian trade theory was expanded and generalized multiple times: notably to treat many-
country many-product situation and to include intermediate input trade, and choice of production
techniques. In Ricardian framework, capital goods (comprising fixed capital) are treated as goods
which are produced and consumed in the production.
5.3 Phases of Expansion of International Trade
There were three waves of expansions and generalizations of International Trade. These are
explained below.
First phase: Major general results were obtained by McKenzie and Jones. McKenzie was more
interested in the patterns of trade specialisiations (including incomplete specializations), whereas
Jones was more interested in the patterns of complete specialization, in which the prices moves
freely within a certain limited range. The formula he found is often cited as Jones' inequality or
Jones' criterion.
Second phase: Ricardo's idea was even expanded to the case of continuum of goods by
Dornbusch, Fischer, and Samuelson (1977) This model is restricted to two country case. It is
employed for example by Matsuyama and others. These theories use a special property that is
applicable only for the two-country case. They normally assume fixed expenditure coefficients.
Eaton and Kortum (2002) inherited Ricardian model with a continuum of goods from Dorbusch,
Fischer, and Samuelson (1977). It has succeeded to incorporate trade of intermediate products.
Countries have different access to technology. The bundle of inputs is assumed as the same
across commodities within a country. This means that all industries of a country consume the
same bundle of inputs and there is no distinction between petrol-consuming and iron-consuming
industries. This is the major reason why Eaton and Kortum (2002) cannot be used as framework
for analyzing global value chains.
Third phase: Shiozawa succeeded to construct a Ricardian theory with many-country, many-
commodity model which permits choice of production techniques and trade of input goods. All
countries have their own set of production techniques. Major difference with H-O model that this
Ricardian model assumes different technologies. Wages determined in this model are different
according to the productivity of countries. The model is therefore more suitable than H-O models
in analyzing relations between developing and developed countries. Shiozawa's theory is now
extended as "the new theory of international values."
Traded Intermediate Goods
Ricardian trade theory ordinarily assumes that the labor is the unique input. This has been
thought to be a significant deficiency for Ricardian trade theory since intermediate goods
comprise a major part of world international trade.
McKenzie and Jones emphasized the necessity to expand the Ricardian theory to the cases of
traded inputs. McKenzie pointed that "A moment's consideration will convince one that
Lancashire would be unlikely to produce cotton cloth if the cotton had to be grown in
England." Paul Samuelson coined a term Sraffa bonus to name the gains from trade of inputs.
John S. Chipman observed in his survey that McKenzie stumbled upon the questions of
intermediate products and postulated that "introduction of trade in intermediate product
necessitates a fundamental alteration in classical analysis". It took many years until Shiozawa
succeeded in removing this deficiency. The new theory of international values is now the unique
theory that can deal with input trade in a general form.
Based on an idea of Takahiro Fujimoto, who is a specialist in automobile industry and a
philosopher of the international competitiveness, Fujimoto and Shiozawa developed a discussion
in which how the factories of the same multi-national firms compete between them across
borders. International intra-firm competition reflects a really new aspect of international
competition in the age of so-called global competition.
5.4 Global Value Chains
Revolutionary change in communication and information techniques and drastic downs of
transport costs have enabled an historic breakup of production process. Networks of fragmented
productions across countries are now called global value chains. The emergence of global
production has changed the way we understand the trade and international economy. Still the
core of international trade theory continues to be dominated by theories which assume trade of
complete goods. As Grossman and Rossi-Hansberg put it, it needs a new paradigm to better
understand the implication of these trends. [39][40] Extended Ricardian trade model provides a new
theory that can treat trade of input goods and the emergence of global value chains. Based on the
new theory of trade, which he names theory of international values, Shiozawa explained why and
how global value chains rapidly spread all over the world at the end of the 20th century.

5.5 Significance or Benefits of International Trade

International trade involves the licensed exchange of goods across borders. It leads to the
establishment of trade agreements and trade policy. These encourage harmonious relationships
between nations that rely on one another for a better standard of living across their populations.
When there is disharmony, sanctions and trade restrictions are often imposed to block the
movement of assets. The European Union is an example of how countries can utilise free trade
agreements to improve their standing in the international market and increase GDP while
contributing to the world economy. Free trade is when member nations of a union become
borderless in terms of trade, meaning that tariffs are not charged on imports and exports. Since
the United Kingdom left the European Union, it has been attempting to forge trade agreements
with other nations around the world.

The concept of the European Union grew in the wake of the Second World War as did the
increase in world trade. Tariffs on industrial products fell steeply and in the 25 years following
the war, world economic growth averaged approximately 5% per year. This high rate can partly
be attributed to the lower trade barriers. During the same period, world trade grew even faster
with an average of approximately 8%. Liberal trade policies that facilitate the unrestricted flow
of goods and services tend to heighten competition and cultivate innovation, leading to
successful business.

Comparative advantage remains, arguably, the most powerful insight according to economists.
Comparative advantage states that even if a country is not as good at making a particular type of
good as another country, it still stands to gain from trade. As the World Trade Organization
(WTO) points out, it is virtually impossible for a country to have no comparative advantage in
anything, simply by the nature of it being comparative.

5.6 Impact of International Trade on the Environment

Global trade has a direct impact on the environment and climate change. About 90% of world
trade is transported by sea and shipping is responsible for about 3% of global carbon emissions.
That may not sound like a lot but that’s about 1 billion metric tonnes of carbon dioxide. The
aviation industry is also recognised as contributing 2.5 % of all global carbon emissions. With
the shipping industry experiencing staff shortages and multiple backlogs in the past few years,
Amazon established its own air cargo operations to maintain its logistical schedules. The
shipping industry is committed to total de-carbonization by 2050 and similarly, the aviation
sector has pledged to be net zero by 2050.

However, the focus is not just on carbon. The demand for consumer goods puts pressure on the
earth’s natural resources. For example the manufacture of smart phones, computers, and tablets
requires precious metals and minerals such as copper, tellurium, lithium, cobalt, and manganese.
Similarly demand for food products such as palm oil, coconuts, and avocados strains the supply
chain, increases air freight, creates higher prices in the local markets, and causes soil degradation
when intensive farming methods are used. Intensive farming also decimates insects and wildlife
due to the use of pesticides and fertilisers, which has a knock-on effect on the entire ecosystem.
When pesticides and fertilisers then enter the water system, this can alter the biosphere further.

The World Bank believes that “Fighting climate change is vital to equitable global development
and poverty reduction” and that international trade can have an important role to play in this
endeavour. In 2021, The World Bank released a report, The Trade and Climate Change Nexus:
the Urgency and Opportunities for Developing Countries, that explores this in depth. As extreme
weather events happen more frequently and rising sea levels have the potential to reshape the
trade map, both developed countries and developing countries will have to consider the impact
on business. Ultimately, business is reliant upon stability and sustainability and so these
considerations will need to be built into the trade system moving forward.

5.7 Unemployment in International Trade Situations

Unemployment is closely related to international trade. Four generations of trade theories
assumed full employment as one of initial conditions and could not treat unemployment.
Shiozawa, based on his discovery of a new definition of regular international value, succeeded to
construct a new theory that permits unemployment.
Summary
International trade policy has been highly controversial since the 18th century. International
trade theory and economics itself have developed as means to evaluate the effects of trade
policies. The international trade theories include Adam Smith’s model, Ricardian model,
Specific Factors model, Hechscher-Ohlin model, Stolper-Samuelson model, New trade theory
and Gravity model. The Ricardian model has been elaborately discussed and it consists of
expansion component in different phases.

Self Test Questions

1. What are the different theories of International Trade? Discuss.
2. Briefly explain the Ricardian Trade theory extensions.
3. What are the phases of expansion of International Trade? Explain.
4. Discuss the points of significance or benefits of International Trade.
5. What is the impact of International Trade on environment? Explain.
 CHAPTER-VI
TRADE BARRIERS AND THEIR IMPLICATIONS WITH REFERENCE TO INDIA’S
TRADE POLICY
PURPOSE AND STRUCTURE
Union Minister of Commerce and Industry, Consumer Affairs, Food and Public Distribution and
Textiles, when launched the Foreign Trade Policy 2023 stated that it is dynamic and has been
kept open ended to accommodate the emerging needs of the time. He stated that the policy had
been under discussion for a long time and has been formulated after multiple stakeholder
consultations. India's overall exports, including services and merchandise exports, has already
crossed US$ 750 Billion and is expected to cross US$ 760 Billion this year, he said. The
Minister referred to the interaction that Prime Minister, with the exporters and encouraged them
to increase exports and get more deeply involved in the global value chain. He discussed that
given the size of the Indian economy and manufacturing & service sector base, the potential for
the country to grow is manifold. The Minister noted that the remarkable achievement in the
overall export figure of crossing US$ 760 Billion in these challenging times across the world has
been the result of enthusiasm and encouragement pumped in by the Prime Minister. He said that
this achievement is in sync with the target set in the roadmap in 2021 after the interaction with
the Prime Minister. He stressed that every opportunity for export must be captured and utilised
effectively. He also mentioned that in the next 5 months during India’s G20 presidency there
should be a massive concentrated outreach with the world both sector-wise and country-wise.
The Key Approach to the policy is based on these 4 pillars: (i) Incentive to Remission, (ii)
Export promotion through collaboration - Exporters, States, Districts, Indian Missions, (iii) Ease
of doing business, reduction in transaction cost and e-initiatives and (iv) Emerging Areas – E-
Commerce Developing Districts as Export Hubs and streamlining SCOMET policy. The readers
will be able to know about the India’s Trade Policy and trade barriers with their implications
covered under the following points:

6.1 Brief India’s Foreign Trade Policy

6.2 India’s Foreign Trade Policy Criteria
6.3 India - Foreign Trade Barriers
6.1 Brief India’s Foreign Trade Policy:
Foreign Trade Policy (2023) is a policy document which is based on continuity of time-tested
schemes facilitating exports as well as a document which is nimble and responsive to the
requirements of trade. It is based on principles of ‘trust’ and ‘partnership’ with exporters. In the
FTP 2015-20, changes were done subsequent to the initial release even without announcement of
a new FTP responding dynamically to the emerging situations. Hereafter, the revisions of the
FTP shall be done as and when required. Incorporating feedback from Trade and Industry would
also be continuous to streamline processes and update FTP, from time to time.
The FTP 2023 aims at process re-engineering and automation to facilitate ease of doing business
for exporters. It also focuses on emerging areas like dual use high end technology items under
SCOMET, facilitating e-commerce export, collaborating with States and Districts for export
promotion.
The new FTP is introducing a one-time Amnesty Scheme for exporters to close the old pending
authorizations and start afresh.
The FTP 2023 encourages recognition of new towns through “Towns of Export Excellence
Scheme” and exporters through “Status Holder Scheme”. The FTP 2023 is facilitating exports by
streamlining the popular Advance Authorization and EPCG schemes, and enabling merchanting
trade from India.
6.2 India’s Foreign Trade Policy Criteria:
The contents of the India’s Foreign Trade policy are described as under:
a) Process Re-Engineering and Automation
Greater faith is being reposed on exporters through automated IT systems with risk management
system for various approvals in the new FTP. The policy emphasizes export promotion and
development, moving away from an incentive regime to a regime which is facilitating, based on
technology interface and principles of collaboration.Considering the effectiveness of some of the
ongoing schemes like Advance Authorisation, EPCG etc. under FTP 2015-20, they will be
continued along with substantial process re-engineering and technology enablement for
facilitating the exporters. FTP 2023 codifies implementation mechanisms in a paperless, online
environment, building on earlier 'ease of doing business' initiatives. Reduction in fee structures
and IT-based schemes will make it easier for MSMEs and others to access export benefits.
Duty exemption schemes for export production will now be implemented through Regional
Offices in a rule-based IT system environment, eliminating the need for manual interface. During
the FY23-24, all processes under the Advance and EPCG Schemes, including issue, re-
validation, and EO extension, will be covered in a phased manner. Cases identified under risk
management framework will be scrutinized manually, while majority of the applicants are
expected to be covered under the 'automatic' route initially.
b) Towns of Export Excellence
Four new towns, namely Faridabad, Mirzapur, Moradabad, and Varanasi, have been designated
as Towns of Export Excellence (TEE) in addition to the existing 39 towns. The TEEs will have
priority access to export promotion funds under the MAI scheme and will be able to avail
Common Service Provider (CSP) benefits for export fulfillment under the EPCG Scheme. This
addition is expected to boost the exports of handlooms, handicrafts, and carpets.
c) Recognition of Exporters
Exporter firms recognized with 'status' based on export performance will now be partners in
capacity-building initiatives on a best-endeavor basis. Similar to the 'each one teach one'
initiative, 2-star and above status holders would be encouraged to provide trade-related training
based on a model curriculum to interested individuals. This will help India build a skilled
manpower pool capable of servicing a $5 Trillion economy before 2030. Status recognition
norms have been re-calibrated to enable more exporting firms to achieve 4 and 5-star ratings,
leading to better branding opportunities in export markets.
d) Promoting export from the districts
The FTP aims at building partnerships with State governments and taking forward the Districts
as Export Hubs (DEH) initiative to promote exports at the district level and accelerate the
development of grassroots trade ecosystem. Efforts to identify export worthy products & services
and resolve concerns at the district level will be madethrough an institutional mechanism – State
Export Promotion Committee and District Export Promotion Committee at the State and District
level, respectively.District specific export action plans to be prepared for each district outlining
the district specific strategy to promote export of identified products and services.
e) Streamlining SCOMET Policy
India is placing more emphasis on the "export control" regime as its integration with export
control regime countries strengthens. There is a wider outreach and understanding of SCOMET
(Special Chemicals, Organisms, Materials, Equipment and Technologies) among stakeholders,
and the policy regime is being made more robust to implement international treaties and
agreements entered into by India.A robust export control system in India would provide access
of dual-use High end goods and technologies to Indian exporters while facilitating exports of
controlled items/technologies under SCOMET from India.
f) Facilitating E-Commerce Exports
E-commerce exports are a promising category that requires distinct policy interventions from
traditional offline trade. Various estimates suggest e-commerce export potential in the range of
$200 to $300 billion by 2030. FTP 2023 outlines the intent and roadmap for establishing e-
commerce hubs and related elements such as payment reconciliation, book-keeping, returns
policy, and export entitlements. As a starting point, the consignment wise cap on E-Commerce
exports through courier has been raised from ₹5Lakh to ₹10 Lakh in the FTP 2023. Depending
on the feedback of exporters, this cap will be further revised or eventually removed. Integration
of Courier and Postal exports with ICEGATE will enable exporters to claim benefits under FTP.
The comprehensive e-commerce policy addressing the export/import ecosystem would be
elaborated soon, based on the recommendations of the working committee on e-commerce
exports and inter-ministerial deliberations. Extensive outreach and training activities will be
taken up to build capacity of artisans, weavers, garment manufacturers, gems and jewellery
designers to onboard them on E-Commerce platforms and facilitate higher exports.
g) Facilitation under Export Promotion of Capital Goods (EPCG) Scheme
 The EPCG Scheme, which allows import of capital goods at zero Customs duty for export
production, is being further rationalized. Some key changes being added are:

 Prime Minister Mega Integrated Textile Region and Apparel Parks (PM MITRA) scheme has
been added as an additional scheme eligible to claim benefits under CSP(Common Service
Provider) Scheme of Export Promotion capital Goods Scheme(EPCG).
 Dairy sector to be exempted from maintaining Average Export Obligation – to support dairy
sector to upgrade the technology.
 Battery Electric Vehicles (BEV) of all types, Vertical Farming equipment, Wastewater
Treatment and Recycling, Rainwater harvesting system and Rainwater Filters, and Green
Hydrogen are added to Green Technology products – will now be eligible for reduced Export
Obligation requirement under EPCG Scheme

h) Facilitation under Advance authorization Scheme

Advance authorisation Scheme accessed by DTA units provides duty-free import of raw
materials for manufacturing export items and is placed at a similar footing to EOU and SEZ
Scheme. However, the DTA unit has the flexibility to work both for domestic as well as export
production. Based on interactions with industry and Export Promotion councils, certain
facilitation provisions have been added in the present FTP such as

 Special Advance Authorisation Scheme extended to export of Apparel and Clothing sector under
para 4.07 of HBP on self-declaration basis to facilitate prompt execution of export orders –
Norms would be fixed within fixed timeframe.
 Benefits of Self-Ratification Scheme for fixation of Input-Output Norms extended to 2 star and
above status holders in addition to Authorised Economic Operators at present.

i) Merchanting trade
To develop India into a merchanting trade hub, the FTP 2023 has introduced provisions for
merchanting trade. Merchanting trade of restricted and prohibited items under export policy
would now be possible. Merchanting trade involves shipment of goods from one foreign country
to another foreign country without touching Indian ports, involving an Indian intermediary. This
will be subject to compliance with RBI guidelines, andwon’t be applicable for goods/items
classified in the CITES and SCOMET list. In course of time, this will allow Indian entrepreneurs
to convert certain places like GIFT city etc. into major merchanting hubs as seen in places like
Dubai, Singapore and Hong Kong.
j) Amnesty Scheme
Finally, the government is strongly committed to reducing litigation and fostering trust-based
relationships to help alleviate the issues faced by exporters. In line with "Vivaad se Vishwaas"
initiative, which sought to settle tax disputes amicably, the governmentis introducing a special
one-time Amnesty Scheme under the FTP 2023to address default on Export Obligations. This
scheme is intended to provide relief to exporters who have been unable to meet their obligations
under EPCG and Advance Authorizations, and who are burdened by high duty and interest costs
associated with pending cases. All pending cases of the default in meeting Export Obligation
(EO) of authorizations mentioned can be regularized on payment of all customs duties that were
exempted in proportion to unfulfilled Export Obligation.The interest payable is capped at 100%
of these exempted duties under this scheme. However, no interest is payable on the portion of
Additional Customs Duty and Special Additional Customs Duty and this is likely to provide
relief to exporters as interest burden will come down substantially. It is hoped that this amnesty
will give these exporters a fresh start and an opportunity to come into compliance

6.3 India - Trade Barriers

Any restriction imposed on the free flow of trade is a trade barrier. Trade barriers can either be
tariff barriers (the levy of ordinary negotiated customs duties in accordance with Article II of the
GATT) or non-tariff barriers, which are any trade barriers other than tariff barriers. Following
are the trade barriers of India:

Import Licensing
India maintains a nontariff regulation on three categories of products: banned or prohibited
items (e.g., tallow, fat, and oils of animal origin); restricted items that require an import license
(e.g., livestock products and certain chemicals); and “canalized” items (e.g., some
pharmaceuticals) importable only by government trading monopolies and subject to cabinet
approval regarding import timing and quantity. India, however, often fails to observe
transparency requirements, such as publication of timing and quantity restrictions in its Official
Gazette or notification to WTO committees.

For purposes of entry requirements, India has distinguished between goods that are new, and
those that are secondhand, remanufactured, refurbished, or reconditioned. India allows imports
of secondhand capital goods by the end users without an import license, provided the goods have
a residual life of five years. India’s official Foreign Trade Policy categorizes remanufactured
goods in a similar manner to secondhand products, without recognizing that remanufactured
goods have typically been restored to original working condition and meet the technical and
safety specifications applied to products made from new materials. The National Trade Estimate
Report published recently by USTR indicates that the U.S. stakeholders continue to inform that
obtaining an import license for remanufactured goods has been onerous and the U.S. exporters
continue to encounter significant tariff and nontariff barriers that impede imports of U.S.
products into India.
Standards, testing, labeling & certification
The Bureau of Indian Standards (BIS) established by the Indian Government under the BIS Act
2016 and is the National Standards Body of India. The Bureau functions under the Ministry of
Consumer Affairs, Food & Public Distribution and is involved in the harmonious development of
the activities of standardization, marking and quality certification of goods.

Another agency, the Food Safety and Standards Authority of India (FSSAI), established through
the food safety and standards act under the Ministry of Health and Family Welfare; along with
the Office of Legal Metrology under the Ministry of Consumer Affairs, Food and Public
Distribution; and the Department of Commerce under the Ministry of Commerce and Industries
(MOCI), regulate food safety, standards, labelling and packaging requirements of food and
agricultural products.

Anti-dumping and countervailing measures

Anti-dumping and countervailing measures are permitted by the WTO Agreements in specified
situations to protect the domestic industry from serious injury arising from dumped or subsidized
imports. India imposes these from time-to-time to protect domestic manufacturers from
dumping. India’s implementation of its antidumping policy has, in some cases, raised concerns
regarding transparency and due process. In recent years, India seems to have aggressively
increased its application of the antidumping law.

Export subsidies and domestic support

Several export subsidies and other domestic support is provided to several industries to make
them competitive internationally. Export earnings are exempt from taxes and exporters are not
subject to local manufacturing tax. While export subsidies tend to displace exports from other
countries into third country markets, the domestic support acts as a direct barrier against access
to the domestic market.

The Indian government’s Foreign Trade Policy (FTP) 2015-2020 announced on April 1, 2015 is
primarily focused on increasing India’s exports of goods and services to raise India’s share in
world exports from 2 to 3.5 percent. The FTP consolidated most of India’s existing export
subsidies and other incentives into two main export incentive schemes, namely the Manufactured
Goods Exports Incentive Scheme (MEIS) and the Service Exports Incentive Scheme (SEIS).
India maintains several export subsidy programs, including exemptions from taxes for certain
export-oriented enterprises and for exporters in Special Economic Zones. Numerous sectors
(e.g., textiles and apparel, paper, rubber, toys, leather goods, and wood products) receive various
forms of subsidies, including exemptions from customs duties and internal taxes, which are tied
to export performance. India not only continues to offer subsidies to its textiles and apparel
sector to promote exports, but it has also extended or expanded such programs and even
implemented new export subsidy programs. As a result, the Indian textiles sector remains a
beneficiary of many export promotion measures (e.g., Export-Oriented Units, Special Economic
Zones, Export Promotion Capital Goods, Interest Credit Schemes, Focus Product, and Focused
Market Schemes). The GOI in July 2016 further increased the subsidy for the garment sector to
boost employment generation in addition to providing for refund of state levies.

In 2017, India graduated from Annex VII of the WTO’s Subsidies and Countervailing Measures
Agreement. In March 2018, the United States requested consultations on India’s export subsidy
schemes in the WTO and a formal panel was established on July 24, 2018.

India maintains a large and complex series of programs that form the basis of India’s public food
stockholding program. India maintains stocks of food grains not only for distribution to poor and
needy consumers but also to stabilize prices through open market sales. India uses export
subsidies to reduce stocks and has permitted exports of certain agricultural commodities from
government public-stockholding reserves at below the government’s costs.

As per the USTR updates, India’s mid-term review of its FTP (released in Dec. 2017) outlined a
renewed focus on promoting Indian exports while highlighting the need to move away from
export subsidies consistent with WTO commitments relating to gross national income levels. As
a result, India’s revised FTP will also focus on reducing the cost of trade internal to the country
and has set forth an agenda to address trade facilitation issues impacting Indian exporters.

Procurement
USTR source states that India lacks an overarching government procurement policy and, as a
result, its government procurement practices and procedures vary among the states, between the
states and the central government, and among different ministries within the central government.
Multiple procurement rules, guidelines, and procedures issued by multiple bodies have resulted
in problems with transparency, accountability, competition, and efficiency in public
procurement. A recent World Bank report stated that there are over 150 different contract
formats used by the state-owned Public-Sector Units, each with different qualification criteria,
selection processes, and financial requirements. The government also provides preferences to
Indian micro, small, and medium enterprises and to state owned enterprises. Moreover, India’s
defense offsets program requires companies to invest 30 percent or more of the acquisition cost
of contracts above the threshold value in Indian produced parts, equipment, or services, a
requirement that continues to prove challenging for manufacturers of high-technology
equipment.

In 2015, the government mandated that 20 percent of its public procurements be awarded to
Indian based micro, small, and medium enterprises, and in 2017, the Indian cabinet approved a
public procurement policy encouraging preferences for Indian manufactured goods with a view
to promote the “Make in India” initiative. The move is aimed at facilitating local manufacturing
and boosting domestic demand for locally manufactured products. As part of this May 2017
policy, the Ministry of Defense approved a model for Strategic Partnerships in certain acquisition
programs, although the strong focus on mandatory technology transfer has given many U.S.
companies reason to exercise caution regarding participation. A local content requirement has
also been extended to the procurement of medical devices, and several government tenders in the
last year have included a 30 percent local content mandate. India’s National Manufacturing
Policy calls for increased use of local content requirements in government procurement in certain
sectors (e.g., information communications technology and clean energy). Consistent with this
approach, India issued the Preferential Market Access notification, which requires government
entities to meet their needs for electronic products in part by purchasing domestically
manufactured goods. Subsequently, in June 2017, the Department of Industry Policy and
Promotion (DIPP) issued two notifications under the Public Procurement “Preferential
Electronics Order” and “Cyber Notification,” which require local content for all state and central
government procurements mandating preferences for domestically manufactured electronic
goods (including medical devices) and cyber-security software products. The notification
indicates that this requirement will apply to procurement by government, government
companies, and other procuring entities. This notification is the culmination of similar Indian
policy proposals over the past year that have outlined discriminatory government procurement
policies as a means to stimulate domestic manufacturing of electronics and telecommunications
equipment at the expense of foreign companies that have invested heavily in India.

Service barriers
Services in which there are restrictions include: insurance, banking, securities, motion pictures,
accounting, construction, architecture and engineering, retailing, legal services, express delivery
services and telecommunication. The Indian government has a strong ownership presence in
major services industries such as banking and insurance. Foreign investment in businesses in
certain major services sectors, including financial services and retail, is subject to limitations on
foreign equity. Foreign participation in professional services is significantly restricted, and in
the case of legal services, prohibited entirely.
Other barriers

Local Content requirements, Export Duties and Transparency continue to be other barriers for
trade.

In 2010, India initiated the Jawaharlal Nehru National Solar Mission (JNNSM), which currently
aims to bring 100,000 megawatts of solar-based power generation online by 2022 as well as
promote solar module manufacturing in India. Under the JNNSM, India imposes certain local
content requirements (LCRs) for solar cells and modules and requires participating solar power
developers to use solar cells and modules made in India to enter into long-term power supply
contracts and receive other benefits from the Indian government. The United States challenged
these requirements through the World Trade Organization (WTO) dispute settlement system. In
February 2016, a WTO panel found India’s LCRs inconsistent with multiple WTO
requirements. These findings were affirmed by the Appellate Body on September 16, 2016,
and the DSB adopted the Appellate Body and Panel reports at a special meeting of the DSB on
October 14, 2016. On December 19, 2017, the United States requested authorization from the
DSB to suspend concessions or other obligations on the grounds that India had failed to comply
with the DSB recommendations within the “reasonable period of time” that the parties agreed to.
The United States’ request was referred to arbitration. On January 23, 2018, India requested the
establishment of a compliance panel, asserting that it had complied with the DSB
recommendations. The arbitration and compliance panel proceedings are ongoing.

India has steadily increased export duties on iron ore and its derivatives. This includes export
duty of 30 percent, ad valorem export duty on iron ore pellets of five percent, an export duty on
iron ore containing less than 58 percent iron of 10 percent, and an export duty on chromium ore
of 30 percent ad valorem. In recent years certain Indian states and stakeholders have
increasingly pressed the central government to ban exports of iron ore. To improve availability
of iron ore for the local steel producers, the GOI in March 2016 enhanced and unified the rate of
export duty for all types of iron ore (other than pellets) at 20 percent; earlier a 15 percent export
tax was applicable on lumps and 5 percent on fines. India’s export duties impact international
markets for raw materials used in steel production. In addition to the steel-related export duties,
India’s March 2017 budget also imposed a 15 percent duty on exports of aluminum ores,
including laterite. India has also maintained, since February 2012, a 30 percent ad valorem duty
on exports of chromium ore.

Lack of transparency with respect to new and proposed laws and regulations affecting traders
remains a problem due to a lack of uniform notice and comment procedures and inconsistent
notification of these measures to the WTO. This in turn inhibits the ability of traders and foreign
governments to provide input on new proposals or to adjust to new requirements. In 2014,
India’s Ministry of Law and Justice issued a policy on pre-legislative consultation, which was to
be applied by all Ministries and Departments of the Central Government before any legislative
proposal was to be submitted to the Cabinet for its consideration and approval. The policy also
required the central government entities to publish draft legislation or a summary of information
concerning the proposed legislation for a minimum period of 30 days. Issuance through
electronic media was also encouraged in the policy, as were public consultations. However,
despite U.S. requests, the Indian government has provided no information on the implementation
of the policy, other than to clarify it is only intended to apply to draft legislation, not regulations
or tariff-setting not. U.S. stakeholders continue to report new requirements that are issued with
no or inadequate public notice and consultation or without WTO notification. This lack of
transparency imparts a lack of predictability in the Indian marketplace, negatively affecting the
ability of U.S. companies to enter or operate in the Indian market. The United States continues
to raise our concerns regarding uniform notice and comment procedures with the government of
India both bi-laterally in the Trade Policy Forum (TPF) and multi-laterally in the WTO and other
fora.
Summary

Foreign Trade Policy (2023) is a policy document which is based on continuity of time-tested
schemes facilitating exports as well as a document which is nimble and responsive to the
requirements of trade. It is based on principles of ‘trust’ and ‘partnership’ with exporters. In the
FTP 2015-20, changes were done subsequent to the initial release even without announcement of
a new FTP responding dynamically to the emerging situations. Hereafter, the revisions of the
FTP shall be done as and when required. Incorporating feedback from Trade and Industry would
also be continuous to streamline processes and update FTP, from time to time. India’s foreign
trade policy criteria involve; process re-engineering and automation, towns of export excellence,
recognition of exporters, promoting exports from the districts, streamlining SCOMET policy,
facilitating e-commerce export, export of capital goods, facilitation under advance authorization
scheme, merchanting trade and amnesty scheme. The trade has to face multiplicity of barriers.

Self Test Questions:

1. Briefly explain the India’s Foreign Trade Policy.

2. What do you understand by Trade Policy? Discuss the criteria of India’s Foreign Trade
Policy.
3. Discuss the barriers in trade policy of India.
 CHAPTER-VII

BALANCE OF TRADE AND BALANCE OF PAYMENTS

PURPOSE AND STRUCTURE:

The balance of trade, commercial balance, or net exports is the difference between the monetary
value of a nation's exports and imports over a certain time period. Sometimes a distinction is
made between a balance of trade for goods versus one for services. The notion of the balance of
trade does not mean that exports and imports are "in balance" with each other. A similar concept
is Balance of Payments. Balance Of Payment (BOP) is a statement that records all the monetary
transactions made between residents of a country and the rest of the world during any given
period. This statement includes all the transactions made by/to individuals, corporates and the
government and helps in monitoring the flow of funds to develop the economy. After reading
this chapter readers will have a clear understanding of the concept of Balance of Trade and
Balance of Payments and also will be able to know about the following:
7.1 Concept of Balance of Trade
7.2 Factors Affecting Balance of Trade
7.3 Impact of Balance of Trade on Economy of the Nations
7.4 Theories on Balance of Trade
7.5 Trade balance’s effects upon a nation's GDP
7.6 Distinction Between Balance of Trade and Balance of Payments

7.7 Concept of Balance of Payments

7.8 Importance of Balance of Payments

7.9 Elements of a Balance of Payment
7.10 Causes and Measures of Disequilibrium (Balance of Payment)
7.11 Measures to correct disequilibrium in BOP

7.1 Concept of Balance of Trade

As stated earlier, the balance of trade, commercial balance, or net exports is the difference
between the monetary value of a nation's exports and imports over a certain time period. If a
country exports a greater value than it imports, it has a trade surplus or positive trade balance,
and conversely, if a country imports a greater value than it exports, it has a trade
deficit or negative trade balance. As of 2016, about 60 out of 200 countries have a trade surplus.
The notion that bilateral trade deficits are bad in and of themselves is overwhelmingly rejected
by trade experts and economists. The balance of trade forms part of the current account, which
includes other transactions such as income from the net international investment position as well
as international aid. If the current account is in surplus, the country's net international asset
position increases correspondingly. Equally, a deficit decreases the net international asset
position.
The trade balance is identical to the difference between a country's output and its domestic
demand (the difference between what goods a country produces and how many goods it buys
from abroad; this does not include money re-spent on foreign stock, nor does it factor in the
concept of importing goods to produce for the domestic market).
Measuring the balance of trade can be problematic because of problems with recording and
collecting data. As an illustration of this problem, when official data for all the world's countries
are added up, exports exceed imports by almost 1%; it appears the world is running a positive
balance of trade with itself. This cannot be true, because all transactions involve an
equal credit or debit in the account of each nation. The discrepancy is widely believed to be
explained by transactions intended to launder money or evade taxes, smuggling and other
visibility problems. While the accuracy of developing countries' statistics would be suspicious,
most of the discrepancy actually occurs between developed countries of trusted statistics.
7.2 Factors Affecting Balance of Trade
Factors that can affect the balance of trade include:

 The cost of production (land, labor, capital, taxes, incentives, etc.) in the exporting
economy vis-à-vis those in the importing economy;
 The cost and availability of raw materials, intermediate goods and other inputs;
 Currency exchange rate movements;
 Multilateral, bilateral and unilateral taxes or restrictions on trade;
 Non-tariff barriers such as environmental, health or safety standards;
 The availability of adequate foreign exchange with which to pay for imports; and
 Prices of goods manufactured at home (influenced by the responsiveness of supply)
In addition, the trade balance is likely to differ across the business cycle. In export-led growth
(such as oil and early industrial goods), the balance of trade will shift towards exports during an
economic expansion. However, with domestic demand-led growth (as in the United States and
Australia) the trade balance will shift towards imports at the same stage in the business cycle.
The monetary balance of trade is different from the physical balance of trade (which is expressed
in amount of raw materials, known also as Total Material Consumption). Developed countries
usually import a substantial amount of raw materials from developing countries. Typically, these
imported materials are transformed into finished products and might be exported after adding
value. Financial trade balance statistics conceal material flow. Most developed countries have a
large physical trade deficit because they consume more raw materials than they produce.
Many countries in early modern Europe adopted a policy of mercantilism, which theorized that a
trade surplus was beneficial to a country. Mercantilist ideas also influenced how European
nations regulated trade policies with their colonies, promoting the idea that natural resources
and cash crops should be exported to Europe, with processed goods being exported back to the
colonies in return. Ideas such as bullionism spurred the popularity of mercantilism in European
governments.

An early statement concerning the balance of trade appeared in Discourse of the Common Wealth
of this Realm of England, 1549: "We must always take heed that we buy no more from strangers
than we sell them, for so should we impoverish ourselves and enrich them." [12] Similarly, a
systematic and coherent explanation of balance of trade was made public through Thomas Mun's
1630 "England's treasure by foreign trade, or, The balance of our foreign trade is the rule of our
treasure".
Since the mid-1980s, the United States has had a growing deficit in tradeable goods, especially
with Asian nations (China and Japan) which now hold large sums of U.S debt that has in part
funded the consumption. The U.S. has a trade surplus with nations such as Australia. The issue
of trade deficits can be complex. Trade deficits generated in tradeable goods such as
manufactured goods or software may impact domestic employment to different degrees than do
trade deficits in raw materials.
Economies that have savings surpluses, such as Japan and Germany, typically run trade
surpluses. China, a high-growth economy, has tended to run trade surpluses. A higher savings
rate generally corresponds to a trade surplus. Correspondingly, the U.S. with its lower savings
rate has tended to run high trade deficits, especially with Asian nations.
7.3 Impact of Balance of Trade on Economy of the Nations:
Some have said that China pursues a mercantilist economic policy. Russia pursues a policy based
on protectionism, according to which international trade is not a "win-win" game but a zero-sum
game: surplus countries get richer at the expense of deficit countries. For the last two decades,
the Armenian trade balance has been negative, reaching 203.9 USD million in March 2019,
which was considered the highest by then, however the most recent ratio of the same indicator is
-273,5 USD million in Oct 2021, which is evidently one of the consequences of 6 weeks war
between Armenia and Azerbaijan in autumn of 2020. The reason for the trade deficit is that
Armenia's foreign trade is limited by its landlocked location and border disputes with Turkey and
Azerbaijan, to the west and east respectively. The situation results in the country's typically
reporting large trade deficits.
The notion that bilateral trade deficits are bad in and of themselves is overwhelmingly rejected
by trade experts and economists. According to the IMF trade deficits can cause a balance of
payments problem, which can affect foreign exchange shortages and hurt countries. On the other
hand, Joseph Stiglitz points out that countries running surpluses exert a "negative externality" on
trading partners, and pose a threat to global prosperity, far more than those in deficit. Ben
Bernanke argues that "persistent imbalances within the euro zone are unhealthy, as they lead to
financial imbalances as well as to unbalanced growth. The fact that Germany is selling so much
more than it is buying redirects demand from its neighbors (as well as from other countries
around the world), reducing output and employment outside Germany." According to Carla
Norrlöf, there are three main benefits to trade deficits for the United States:

1. Greater consumption than production: the US enjoys the better side of the bargain by
being able to consume more than it produces
2. Usage of efficiently produced foreign-made intermediate goods is productivity-enhancing
for US firms: the US makes the most effective use of the global division of labor
3. A large market that other countries are reliant on for exports enhances American
bargaining power in trade negotiations
A 2018 National Bureau of Economic Research paper by economists at the International
Monetary Fund and University of California, Berkeley, found in a study of 151 countries over
1963-2014 that the imposition of tariffs had little effect on the trade balance.
7.4 Theories on Balance of Trade:
The theories on Balance of Trade are discussed here under:
a) Classical theory
In the foregoing part of this chapter I have endeavoured to show, even upon the principles of the
commercial system, how unnecessary it is to lay extraordinary restraints upon the importation of
goods from those countries with which the balance of trade is supposed to be disadvantageous.
Nothing, however, can be more absurd than this whole doctrine of the balance of trade, upon
which, not only these restraints, but almost all the other regulations of commerce are founded.
When two places trade with one another, this [absurd] doctrine supposes that, if the balance be
even, neither of them either loses or gains; but if it leans in any degree to one side, that one of
them loses and the other gains in proportion to its declension from the exact equilibrium.
b) Keynesian theory
In the last few years of his life, John Maynard Keynes was much preoccupied with the question
of balance in international trade. He was the leader of the British delegation to the United
Nations Monetary and Financial Conference in 1944 that established the Bretton Woods
system of international currency management. He was the principal author of a proposal – the so-
called Keynes Plan – for an International Clearing Union. The two governing principles of the
plan were that the problem of settling outstanding balances should be solved by 'creating'
additional 'international money', and that debtor and creditor should be treated almost alike as
disturbers of equilibrium. In the event, though, the plans were rejected, in part because
"American opinion was naturally reluctant to accept the principle of equality of treatment so
novel in debtor-creditor relationships".
The new system is not founded on free-trade (liberalisation of foreign trade) but rather on the
regulation of international trade, in order to eliminate trade imbalances: the nations with a
surplus would have a powerful incentive to get rid of it, and in doing so they would
automatically clear other nations deficits. He proposed a global bank that would issue its own
currency – the bancor – which was exchangeable with national currencies at fixed rates of
exchange and would become the unit of account between nations, which means it would be used
to measure a country's trade deficit or trade surplus. Every country would have an overdraft
facility in its bancor account at the International Clearing Union. He pointed out that surpluses
lead to weak global aggregate demand – countries running surpluses exert a "negative
externality" on trading partners, and posed far more than those in deficit, a threat to global
prosperity. In "National Self-Sufficiency" The Yale Review, Vol. 22, no. 4 (June 1933), he already
highlighted the problems created by free trade.
His view, supported by many economists and commentators at the time, was that creditor nations
may be just as responsible as debtor nations for disequilibrium in exchanges and that both should
be under an obligation to bring trade back into a state of balance. Failure for them to do so could
have serious consequences. In the words of Geoffrey Crowther, then editor of The Economist, "If
the economic relationships between nations are not, by one means or another, brought fairly
close to balance, then there is no set of financial arrangements that can rescue the world from the
impoverishing results of chaos."
These ideas were informed by events prior to the Great Depression when – in the opinion of
Keynes and others – international lending, primarily by the U.S., exceeded the capacity of sound
investment and so got diverted into non-productive and speculative uses, which in turn invited
default and a sudden stop to the process of lending.
Influenced by Keynes, economics texts in the immediate post-war period put a significant
emphasis on balance in trade. For example, the second edition of the popular introductory
textbook, An Outline of Money, devoted the last three of its ten chapters to questions of foreign
exchange management and in particular the 'problem of balance'. However, in more recent years,
since the end of the Bretton Woods system in 1971, with the increasing influence
of monetarist schools of thought in the 1980s, and particularly in the face of large sustained trade
imbalances, these concerns – and particularly concerns about the destabilising effects of large
trade surpluses – have largely disappeared from mainstream economics discourse[47] and Keynes'
insights have slipped from view. They are receiving some attention again in the wake of
the financial crisis of 2007–08.
c) Monetarist theory
Prior to 20th-century monetarist theory, the 19th-century economist and philosopher Frédéric
Bastiat expressed the idea that trade deficits actually were a manifestation of profit, rather than a
loss. He proposed as an example to suppose that he, a Frenchman, exported French wine and
imported British coal, turning a profit. He supposed he was in France and sent a cask of wine
which was worth 50 francs to England. The customhouse would record an export of 50 francs. If
in England, the wine sold for 70 francs (or the pound equivalent), which he then used to buy
coal, which he imported into France, and was found to be worth 90 francs in France, he would
have made a profit of 40 francs. But the customhouse would say that the value of imports
exceeded that of exports and was trade deficit against the ledger of France.
By reductio ad absurdum, Bastiat argued that the national trade deficit was an indicator of a
successful economy, rather than a failing one. Bastiat predicted that a successful, growing
economy would result in greater trade deficits, and an unsuccessful, shrinking economy would
result in lower trade deficits. This was later, in the 20th century, echoed by economist Milton
Friedman. In the 1980s, Friedman, a Nobel Memorial Prize-winning economist and a proponent
of monetarism, contended that some of the concerns of trade deficits are unfair criticisms in an
attempt to push macroeconomic policies favorable to exporting industries. Friedman argued that
trade deficits are not necessarily important, as high exports raise the value of the currency,
reducing aforementioned exports, and vice versa for imports, thus naturally removing trade
deficits not due to investment. Since 1971, when the Nixon administration decided to abolish
fixed exchange rates, America's Current Account accumulated trade deficits have totaled $7.75
trillion as of 2010. This deficit exists as it is matched by investment coming into the United
States – purely by the definition of the balance of payments, any current account deficit that
exists is matched by an inflow of foreign investment.
In the late 1970s and early 1980s, the U.S. had experienced high inflation and Friedman's policy
positions tended to defend the stronger dollar at that time. He stated his belief that these trade
deficits were not necessarily harmful to the economy at the time since the currency comes back
to the country (country A sells to country B, country B sells to country C who buys from country
A, but the trade deficit only includes A and B). However, it may be in one form or another
including the possible tradeoff of foreign control of assets. In his view, the "worst-case scenario"
of the currency never returning to the country of origin was actually the best possible outcome:
the country actually purchased its goods by exchanging them for pieces of cheaply made paper.
As Friedman put it, this would be the same result as if the exporting country burned the dollars it
earned, never returning it to market circulation. This position is a more refined version of the
theorem first discovered by David Hume. Hume argued that England could not permanently gain
from exports, because hoarding gold (i.e., currency) would make gold more plentiful in England;
therefore, the prices of English goods would rise, making them less attractive exports and
making foreign goods more attractive imports. In this way, countries' trade balances would
balance out. Friedman presented his analysis of the balance of trade in Free to Choose, widely
considered his most significant popular work.

7.5 Trade balance’s effects upon a nation's GDP

Exports directly increase and imports directly reduce a nation's balance of trade (i.e. net exports).
A trade surplus is a positive net balance of trade, and a trade deficit is a negative net balance of
trade. Due to the balance of trade being explicitly added to the calculation of the nation's gross
domestic product using the expenditure method of calculating gross domestic product (i.e. GDP),
trade surpluses are contributions and trade deficits are "drags" upon their nation's GDP; however,
foreign made goods sold (e.g., retail) contribute to total GDP.
7.6 Distinction Between Balance of Trade and Balance of Payments
Balance of trade is generally considered as similar to the balance of payments. Actually these are
two different concepts. The points of difference between the two are discussed below:

Balance of trade Balance of payments

Includes only visible imports and exports, i.e. Includes all those visible and invisible items
imports and exports of merchandise. The exported from and imported into the country in
difference between exports and imports is addition to exports and imports of
called the balance of trade. If imports are merchandise.
greater than exports, it is sometimes called an
unfavourable balance of trade. If exports
exceed imports, it is sometimes called a
favourable balance of trade.

Includes revenues received or paid on account Includes all revenue and capital items whether
of imports and exports of merchandise. It visible or non-visible. The balance of trade
shows only revenue items. thus forms a part of the balance of payments.

7.7 Concept of Balance of Payments

Balance Of Payment (BOP) is a statement that records all the monetary transactions made
between residents of a country and the rest of the world during any given period. This statement
includes all the transactions made by/to individuals, corporates and the government and helps in
monitoring the flow of funds to develop the economy. When all the elements are correctly
included in the BOP, it should be zero in a perfect scenario. This means the inflows and outflows
of funds should balance out. However, this does not ideally happen in most cases. A BOP
statement of a country indicates whether the country has a surplus or a deficit of funds, i.e. when
a country’s export is more than its import, its BOP is said to be in surplus. On the other hand, the
BOP deficit indicates that its imports are more than its exports. Tracking the transactions under
 BOP is similar to the double-entry accounting system. All transactions will have a debit entry
and a corresponding credit entry.

Funds entering a country from a foreign source are booked as credit and recorded in the BOP.
Outflows from a country are recorded as debits in the BOP. Let’s say Japan exports 100 cars to
the U.S. Japan books the export of the 100 cars as a debit in the BOP, while the U.S. books the
imports as a credit in the BOP.

Formula for Balance of Payments

The formula for calculating the balance of payments is current account + capital account +
financial account + balancing item = 0.

7.8 Importance of Balance of Payments:

A country’s BOP is vital for the following reasons:

 The BOP of a country reveals its financial and economic status.
 A BOP statement can be used to determine whether the country’s currency value is
appreciating or depreciating.
 The BOP statement helps the government to decide on fiscal and trade policies.
 It provides important information to analyse and understand the economic dealings with other
countries.

7.9 Elements of a Balance of Payment

There are three components of the balance of payment viz current account, capital account, and
financial account. The total of the current account must balance with the total of capital and
financial accounts in ideal situations.
Current Account
The current account monitors the inflow and outflow of goods and services between countries.
This account covers all the receipts and payments made with respect to raw materials and
manufactured goods. It also includes receipts from engineering, tourism, transportation, business
services, stocks, and royalties from patents and copyrights. When all the goods and services are
combined, they make up a country’s Balance Of Trade (BOT).
There are various categories of trade and transfers which happen across countries. It could be
visible or invisible trading, unilateral transfers or other payments/receipts. Trading in goods
between countries is referred to as visible items, and import/export of services (banking,
information technology etc.) are referred to as invisible items.Unilateral transfers refer to money
 sent as gifts or donations to residents of foreign countries. This can also be personal transfers like
– money sent by relatives to their family located in another country.
Capital Account
All capital transactions between the countries are monitored through the capital account. Capital
transactions include purchasing and selling assets (non-financial) like land and properties.
The capital account also includes the flow of taxes, purchase and sale of fixed assets etc., by
migrants moving out/into a different country. The deficit or surplus in the current account is
managed through the finance from the capital account and vice versa. There are three major
elements of a capital account:

 Loans and borrowings – It includes all types of loans from the private and public sectors
located in foreign countries.
 Investments – These are funds invested in corporate stocks by non-residents.
 Foreign exchange reserves – Foreign exchange reserves held by the country’s central bank to
monitor and control the exchange rate do impact the capital account.
Financial Account
The flow of funds from and to foreign countries through various investments in real estate,
business ventures, foreign direct investments etc., is monitored through the financial account.
This account measures the changes in the foreign ownership of domestic assets and domestic
ownership of foreign assets. Analysing these changes can be understood if the country is selling
or acquiring more assets (like gold, stocks, equity, etc.).

Illustration

If, for the year 2018, the value of exported goods from India is Rs. 80 lakh and the value of
imported items to India is 100 lakh, then India has a trade deficit of Rs. 20 lakh for the year
2018. The BOP statement acts as an economic indicator to identify the trade deficit or surplus
situation. Analysing and understanding the BOP of a country goes beyond just deducting the
outflows of funds from inflows. As mentioned above, there are various components of BOP and
fluctuations in these accounts, which provide a clear indication of which economic sector needs
to be developed.
7.10 Causes and Measures of Disequilibrium (Balance of Payment)
Causes and Measures of Disequilibrium
Overall account of BOP is always in equilibrium. This balance or equilibrium is only in
accounting sense because deficit or surplus is restored with the help of capital account. In fact,
when we talk of disequilibrium, it refers to current account of balance of payment. If
autonomous receipts are less than autonomous payments, the balance of payment is in deficit
reflecting disequilibrium in balance of payment.

1. Causes of disequilibrium in BOP:

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

7.11 Measures to correct disequilibrium in BOP:

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

Summary

The balance of trade, commercial balance, or net exports is the difference between the monetary
value of a nation's exports and imports over a certain time period. Sometimes a distinction is
made between a balance of trade for goods versus one for services. The notion of the balance of
trade does not mean that exports and imports are "in balance" with each other. A similar concept
is Balance of Payments. Balance Of Payment (BOP) is a statement that records all the monetary
transactions made between residents of a country and the rest of the world during any given
period. This statement includes all the transactions made by/to individuals, corporates and the
government and helps in monitoring the flow of funds to develop the economy. A BOP statement
of a country indicates whether the country has a surplus or a deficit of funds, i.e. when a
country’s export is more than its import, its BOP is said to be in surplus. On the other hand, the
BOP deficit indicates that its imports are more than its exports. Tracking the transactions under
BOP is similar to the double-entry accounting system. All transactions will have a debit entry
and a corresponding credit entry.

Self Test Questions

1. What is Balance of Trade? What are the factors of Balance of Trade? Discuss the impact
of Balance of Trade on economies of the nations.
2. Discuss the theories of Balance of Trade. Also distinguish between Balance of Trade and
Balance of Payments.
3. What is the importance of the Balance of Payments in India?
4. What is the difference between the balance of trade and payments?
5. What are the sources of supply of foreign exchange?
6. What is the meaning of a deficit in the balance of payments?
7. What are official reserve transactions and their importance in the balance of payments?
 CHAPTER-VIII

REGIONAL AND MULTILATORAL ECONOMIC INTEGRATION

PURPOSE AND STRUCTURE

Economic integration removes all or part of trade barriers between nations for economic, social,
and political stability. It enables global markets to operate more consistently with less
intervention, allowing countries to make the most of their resources. Furthermore, it helps small
countries attract companies, create jobs, and introduce new competition to the market, ultimately
improving economic efficiency and productivity. The chapter is endowed to acquaint readers
about economic integration and its related aspects related with regional and multilateral
economic integration as follows:
8.1 Meaning of Economic Integration

8.2 Understanding Economic Integration

8.3 Stages and Measures of Economic Integration

8.4 Economic Integration Levels

8.5 Benefits of Economic Integration

8.6 Drawbacks of Economic Integration

8.7 Working Process of Economic Integration

8.8 Regional Integration in Economics

8.9 Concepts of Trade in Context to Regional and Multilateral Economic Integration

8.10 Multilateralism and the WTO

8.11 Bilateral Free Trade Agreements

8.1 Meaning of Economic Integration

Economic integration involves agreements between countries that usually include the elimination
of trade barriers and aligning monetary and fiscal policies, leading to a more inter-connected
global economy. Economic integration is consistent with the economic theory, which argues that
the global economy is better off when markets can function in unison with minimal government
intervention.
Economic integration refers to the collaboration of two or more countries to limit or eliminate
trade restrictions and encourage political and economic cooperation. It allows global markets to
function more steadily with less government intervention, giving countries a chance to make the
greatest use of their resources.
It usually takes place between neighboring countries, hence sometimes called regional
integration. The interconnected global commerce boosts industrial production and generates
employment. In addition, more aligned fiscal policy and monetary policy, lower manufacturing
and selling costs, and improved flow of capital, labor, products, and services benefit the
integration.
 Economic integration meaning describes the collaboration of two or more economies to
lower or remove trade barriers and create a shared market and business opportunities for
one another.
 It encourages coordination of fiscal and monetary policies, leading to lower
manufacturing and selling costs, improved movement of capital, labor, products,
increased industrial output, and more employment.
 Economic indicators, such as interconnected global trade, cross-border investment, labor
mobility, trade union membership, and coordinated economic policies, can help measure
it.
 The fundamental economic integration levels include economic, monetary, and customs
unions, preferential and free trade zones, and shared markets.

8.2 Understanding Economic Integration

Economic integration, like the name implies, involves the integration of countries’ economies.
Another term to describe it is globalization, which simply refers to the inter-connectedness of
businesses and trading among countries. An economy is defined as a set of inter-related activities
that determine how limited resources are allocated. In the modern economy, all economies
feature a form of a market system. A market-based economy utilizes the economic forces of
demand and supply in order to distribute these limited resources.

Traditionally, economies were thought of as separate for each region or country, with each
country managing its own separate economy and largely unrelated to other countries. However,
globalization allows the movement of goods, services, capital between countries and blurred the
distinctions between economies.

Today, there is no economy that functions completely isolated from other economies. There is a
simple reason for such an occurrence – trade benefits all economies in most cases. It allows for
specializations of economies with comparative advantages and can trade with other economies
that possess alternative comparative advantages. For example, consider a country that happens to
possess an abundance of oil sands located within its borders. The country can extract the oil and
trade it for other resources that it lacks, perhaps food such as corn or wheat.
Another country may enjoy optimal weather for growing such crops and therefore can specialize
in growing corn or wheat and trade it for oil to provide energy for their society. It illustrates how
trade can benefit all economies by taking advantage of specialization and comparative
advantages.

8.3 Stages and Measures of Economic Integration

Economic integration is expected to improve the outcomes for all economies by many
economists and policymakers. Within economics, there are seven stages that lead to complete
economic integration:

1. Preferential Trading Area

2. Free Trade Area
3. Customs Union
4. Common Market
5. Economic Union
6. Economic and Monetary Union
7. Economic Integration

Many countries move in and out of the above stages with other partner countries. The best
example of complete economic integration is with the European Union (EU). The EU is made up
of separate member countries, including:

 Germany
 France
 Sweden
 Spain
 Italy

There are also many other countries in the EU, totaling 27 separate nations. However, each
country functions separately politically and keeps defined borders, different laws, and
government systems. Economically, the 27 countries function as one – with free trade between
the countries and unified monetary policies and fiscal policies.

How to Measure Economic Integration?

Since regional economic integration is a part of economic development, economic indicators can
help measure it, such as:
 Trade of products and services
 Cross-border capital movements
 Labor mobility
 Trade union membership
 Role of trade unions
 Establishment of supranational
 Unified economic policies

8.4 Economic Integration Levels

Let us look at different regional economic integration types, including:
1 – Free Trade Area
It entails the partial or complete elimination of trade tariffs on goods and services between
member countries. Increased cross-border trade, access to foreign markets, the formation of
interconnected manufacturing chains, and labor migration are among its goals. However, each
country retains control over its trade policy, making this form the least restrictive.
Example – European Free Trade Association and North American Free Trade Agreement
2 – Preferred Trade Area
It assures a better and preferred offering to member countries by cutting tariffs on imports for
one another.
Example – Commonwealth System of Preferences
3 – Monetary Union
It concerns agreeing on fixed relative exchange rates and introducing a common currency to
participate in foreign exchange and settle international transactions.
4 – Economic Union
It involves the coordination of monetary, fiscal, and taxation policies and government
expenditure to promote the free flow of commodities, services, and production inputs.
Example – Belgium, Netherlands, and Luxembourg (BENELUX)
5 – Customs Union
It establishes common external trade tariffs on imports from non-member nations, making
external production factors easier to track and tax within the region. Other features of this shared
trade policy include free trade of goods and services and adoption of common customs and
commercial laws between member countries.
Example – European Economic Community
6 – Common Market
It is similar to free trade zones and customs unions. It facilitates the free movement of production
factors between member countries and liberalizes cross-border labor mobility and investment. Its
features include the reduction of tariff obstacles to internal commerce and the coordination of
economic policy.
7 – Complete Economic Integration
It combines coordination of fiscal policies with comprehensive monetary unification.
Example – European Union
Examples
Let us look at the following economic integration examples to understand the concept better –
Example -1
Russia and Belarus decided to establish a unified energy market for oil, gas, and electricity to
address the unwarranted western sanctions on both economies. In addition, the leaders of the two
countries intend to strengthen global economic integration by reducing business barriers and
assisting one another.
Example -2
The Middle East and North Africa (MENA) countries strive to achieve green growth, efficiency,
and diversification. The collaboration will enable these least economically integrated countries to
generate employment, attract more investment for the water and energy sector, and recover from
the COVID-19 pandemic.

8.5 Benefits of Economic Integration

Let us look at the economic integration advantages

Advantages

Helps developing nations take advantage of economies of scale by integrating with developed
nations.

Expands production capacity and creates new opportunities.

Supports international specialization.

Leads to the development of new products with quality output.

Free flow of labor, capital, and goods.

Increases bargaining power, efficiency, and productivity levels of small countries.

Creates political harmony between member countries.

Economic integration is beneficial in many ways, as it allows countries to specialize and trade
without government interference, which can benefit all economies. It results in a reduction of
costs and ultimately an increase in overall wealth.

Trade costs are reduced, and goods and services are more widely available, which leads to a
more efficient economy. An efficient economy distributes capital, goods, and services into the
areas that demand them the most.

The movement of employees is liberalized under economic integration as well. Normally,

employees would need to deal with visas and immigration policies in order to work in another
country. However, with economic integration, employees can move freely, and it leads to greater
market expansion and technology sharing, which ultimately benefits all economies.

Lastly, political cooperation is encouraged, and there are fewer political conflicts. Political
conflicts usually end with economic losses stemming from trade wars or even military wars
breaking out, resulting in extreme costs for all combatants.

8.6 Drawbacks of Economic Integration

Selective disadvantages or drawbacks of economic integration are explained below:

Trade diversions may deflect small countries’ economies and land and contribute to member
countries.

Developing countries become dependent on more developed nations, thus becoming

depressed regions.

Member nations must follow trade regulations and monetary and fiscal policies set by non-
member nations.

Increased competition may harm high-cost producers.

Can lead to a political disturbance and rivalry between two nations.

Nationalists, or people who believe that their country is superior to others, are critical of
economic integration. In order to appeal to nationalists, some countries employ forms of
protectionism, which leads to higher tariffs and less free trade between other countries.
 The notable feature of economic integration is the loss of individual central banks who
control monetary policy. It leads to less national sovereignty, and the responsibilities of
central banks are delegated to an external body instead. The external control becomes
troublesome in terms of managing a cohesive fiscal and monetary policy among many
different countries.

8.7 Working Process of Economic Integration

Regional economic integration occurs when countries come together to form free trade areas
or customs unions, offering members preferential trade access to each others' markets. The
article reviews the economic effects of such agreements on member countries and on the world
trading system. Effects on member countries include the benefits and costs of trade creation and
trade diversion, as well as gains from increased scale and competition. ‘Deeper’ integration can
be pursued by going beyond abolition of import tariffs and quotas, to further measures to remove
market segmentation and promote integration. Effects on the world trading system are not clear-
cut. There is little evidence that regionalism has retarded multilateral liberalization, but neither is
any support for the view that continuing expansion of regional agreements will obviate the need
for multilateral liberalization efforts. Economic integration strives to harmonize economic
policies among member nations to promote mutual trade and economic and political interests. It,
along with little government interference, creates more business prospects worldwide. As a
result, it is a crucial component of regional and global economic developments. International
commerce allows countries to make the best use of their resources while also granting their
trading partners access to new markets.

Since the 1990s, regional economic cooperation has seen rapid development, promoting the
process of regional economic integration as well as driving the communication and cooperation
among nations and regions in culture and education. As an important part of the integration of
the regional economy, culture and education, the internationalization of higher education plays a
significant role in regional social and economic development, higher education reform and talent
development quality. With the speeding up of reform and opening up and the participation of
Chinese higher education into a regional bilateral or multilateral economy, culture and education
cooperation increases, so it is becoming more urgent to constantly improve the
internationalization of Chinese higher education which not only should conduct communication
and cooperation with the counterparts from the developed nations and regions, but also adapt to
the tide of regional economic integration, adopting more open and flexible policies to strengthen
communication and cooperation with the counterparts from surrounding nations and regions, to
promote international communication of students and teaching staff among regions, to encourage
and support colleges and universities to conduct talent development and academic exchange
programs, and to promote the mutual recognition of academic credits, diplomas and degrees
among regions. The member countries agree on fiscal rates, monetary policies, and export and
import regulations to achieve a stated economic plan. Economic integration maximizes the
benefits for all participating economies by setting the terms of involvement and use. Although it
emphasizes trading relations, integration can take many other forms.

8.8 Regional Integration in Economics

In economics, regional economic integration is a particular case of international

economics and monetary economics. In international economics, states have liberalized trade to
promote comparative advantage and economies of scale. From this perspective, the United States
(in the ninteenth century), the European Union, the North American Free Trade Area and
the World Trade Organization are all examples of the same phenomenon. In all these cases, the
removal of barriers to the free circulation of factors of production was then followed, to a greater
or lesser extent, by the creation of common regulations to address market failures, such as unfair
competition (through merger rules), asymmetric information in market transactions (through
rules on consumer protection), and negative externalities (through rules on environmental
protection).
In monetary economics, the process of economic and monetary union in Europe, with the
creation of the single currency, has led to the resurrection of the old ‘Optimum Currency Area’
(OCA) theory of monetary unions. In the OCA theory, nations decide to form a monetary union
when the benefits of keeping independent exchange rates and interest rates (to address
asymmetric demand shocks) are lower than the benefits of establishing a common currency (of
lower transactions costs and greater certainty). However, through the empirical and theoretical
study of monetary integration in Europe, this theory has been refined to take account of both
political and economic calculations, how costs and benefits change with different levels of trade
integration, and how different assumptions about the trade-off between inflation and
unemployment change these calculations.

8.9 Concepts of Trade in Context to Regional and Multilateral Economic Integration

The concepts related to regional and multilateral economic integration are discussed below:

Trade creation

Trade creation is the increased trade that occurs between member countries of trading blocs
following the formation or expansion of the trading bloc. This comes about as the removal of
trade barriers allows greater specialisation according to comparative advantage. This means that
prices can fall and trade can thus expand.

Trade diversion

Trade diversion is the decrease in trade following the formation of a trading bloc as trade with
low cost non-trading bloc members is replaced by trade with relatively high cost trading bloc
members.
Trade creation and diversion are important direct effects of the formation of a customs union.
Trade creation will mean that consumption shifts from a high-cost producer to a low-cost
producer and trade therefore expands. Trade diversion on the other hand means that trade shifts
from a lower cost producer outside the union to a higher cost producer inside the union. This will
not benefit consumers within the union as they are not getting access to cheaper international
goods.

One of the first acts of Tony Abbott’s government was to declare it intended to “embrace free
trade” in its first term in office. Calling the trade minister Australia’s “ambassador for jobs”, the
Coalition has staked its economic and foreign policy credibility on the promise to finalise a
series of free trade deals that made limited progress under former Labor governments.
But Australia already has a lot of trade on its plate. It’s a participant in the ongoing Doha round
of World Trade Organisation (WTO) talks, and a party to the Trans-Pacific Partnership (TPP)
and Regional Comprehensive Economic Partnership (RCEP) negotiations in Asia.
It has also open bilateral trade negotiations with five of its most important economic partners –
China, Japan, Korea, Indonesia, and India.
This is a very crowded trade policy agenda, characterised by complex, overlapping - and
sometimes competitive - initiatives. Given limited bureaucratic and diplomatic resources, it
would be both difficult and inadvisable to spread efforts evenly across the range of proposals.
So, where should Australia’s priorities lie?
There are multiple ways for governments to advance free trade; trade liberalisation can be
negotiated via multilateral, bilateral or regional mechanisms. Each strategy carries a mix of
benefits and costs.
8.10 Multilateralism and the WTO
Historically, multilateralism has been the dominant approach, embodied in the World Trade
Organisation. The WTO currently has 159 members, who exchange tariff preferences in line
with the non-discriminatory “most-favoured-nation” principle.
The product scope of the WTO has gradually expanded since 1948 through a series
of negotiating rounds; the current one is known as the Doha “development round”, which
commenced in 2001.
Multilateralism is the “policy purist” approach to trade liberalisation. Since Russia’s accession to
the WTO in 2012, practically all significant economies have become members, creating a single
integrated system of global trade rules.
But size has also proven to be one of the WTO’s major weaknesses. Having many members
makes consensus difficult to forge, and recent years have seen the formation of a complex array
of “coalitions” with competing, and often-incompatible, agendas.
Disagreement among these coalitions - particularly over the sensitive issue of agriculture - is one
of the main reasons the Doha round is currently deadlocked after 12 years of talks.
8.11 Bilateral Free Trade Agreements
With the WTO in deadlock, attention has turned to bilateral free trade agreements (FTAs).
Practically unheard of before the mid-1990s, these agreements have expanded exponentially
during the last decade as governments sought to deepen trade ties with key economic partners.
Bilateral FTAs typically involve states swapping trade concessions with each other, but some
also address so-called trade-related measures such as investment, intellectual property, and
biosecurity.
The primary appeal of bilateral FTAs is their ease; with only two parties, deals can be negotiated
efficiently. But as the quick-and-easy option, they often fall short of promoting genuine free
trade.
Important but sensitive trade issues (agriculture, for instance, and services) are
often excluded from bilateral FTAs, and very few deal with trade-related measures substantially.
They also pose the vexing “spaghetti bowl problem” of creating a complex set of overlapping
and inconsistent rules that erode the integrity of the global trade system.
Regional free trade agreements are the third option. Midway between multilateralism and
bilateralism, they involve a group of countries within a geographic region negotiating a free trade
area.
Trade regionalism picked up during the 1990s, through the formation of the Mercosur
bloc (1991), the ASEAN free trade area (1992) and the NAFTA agreement (1994).
Australia is party in two regional trade agreements currently under negotiation in Asia: the US-
led TPP and the ASEAN-centred RCEP.
Regional free trade agreements are sometimes considered a trade sweet spot – easier than
multilateralism, but more substantial than bilateral deals. Indeed, regionalism advocates have
also described them as a building block where multilateral deals can later be built.
Still, they face their own challenges. Power asymmetries within regions are often highly
pronounced, leading to deals that favour the largest member at the expense of smaller partners.
They also pose the risk of “balkanising” the global trading system by dividing the world
economy into competing trade blocs.
Australia’s trade policy choices?
Ideally, multilateralism is the best strategy to genuinely liberalise trade. But the Doha round of
the WTO has stalled, and a small economy such as Australia arguably lacks the heft to
meaningfully advance talks on its own.
In this context, policymakers have increasingly looked to other avenues to promote the national
trade agenda.
Bilateral FTAs became popular during the early 2000s. The Howard government launched FTA
talks with eight trade partners, three of which were completed during its term.
The Rudd/Gillard government took a tougher stance, only signing FTAs that
were comprehensive and genuinely reduced barriers to trade in areas of interest to Australia. This
stance proved problematic, and apart from two minor deals with Malaysia and Chile, the Labor
Party was unable to finalise a major FTA during its term.
The Abbott government has signalled a renewed emphasis on bilateral agreements, promising to
reinvigorate talks with Japan and Korea and finalise an FTA with China within 12 months.
But achieving this will involve significantly watering down Australia’s market access requests,
and may put the government in the unenviable position of having to choose which of its
agricultural sectors to prioritise and which to leave out.
So it’s unlikely that bilateral FTAs will deliver substantial benefits to the Australian economy as
a whole.
In this context, a regional approach such as the TPP is appealing. Easier to negotiate than a WTO
agreement, but still large enough to make a significant impact, the TPP arguably offers the best
hope for Australia to advance trade liberalisation.
The fact that the TPP intends to be a “high-quality agreement” addressing services, investment,
and other regulatory barriers has also raised hopes it will improve on the chequered record of
bilateral FTAs in the region.
But betting the trade farm on the TPP would be a highly risky strategy for the Australian
government. Negotiations are still in the early stages and, as a small player, Australia may not be
able to effectively press for its core trade interests, especially in agriculture.
A further complication is that China is not yet a party to the talks, and is promoting the far-less
ambitious RCEP agreement in competition with the TPP.
None of Australia’s trade policy options are clearly preferable to the others. Difficult decisions
about prioritisation will need to be made if the new government is to fully embrace free trade
Summary

Economic integration involves agreements between countries that usually include the elimination
of trade barriers and aligning monetary and fiscal policies, leading to a more inter-connected
global economy. Economic integration is consistent with the economic theory, which argues that
the global economy is better off when markets can function in unison with minimal government
intervention. Economic integration refers to the collaboration of two or more countries to limit or
eliminate trade restrictions and encourage political and economic cooperation. It allows global
markets to function more steadily with less government intervention, giving countries a chance
to make the greatest use of their resources.

In economics, regional economic integration is a particular case of international

economics and monetary economics. In international economics, states have liberalized trade to
promote comparative advantage and economies of scale. From this perspective, the United States
(in the ninteenth century), the European Union, the North American Free Trade Area and
the World Trade Organization are all examples of the same phenomenon. In all these cases, the
removal of barriers to the free circulation of factors of production was then followed, to a greater
or lesser extent, by the creation of common regulations to address market failures, such as unfair
competition (through merger rules), asymmetric information in market transactions (through
rules on consumer protection), and negative externalities (through rules on environmental
protection).

Historically, multilateralism has been the dominant approach, embodied in the World Trade
Organisation. The WTO currently has 159 members, who exchange tariff preferences in line
with the non-discriminatory “most-favoured-nation” principle. The product scope of the WTO
has gradually expanded since 1948 through a series of negotiating rounds; the current one is
known as the Doha “development round”, which commenced in 2001. Multilateralism is the
“policy purist” approach to trade liberalisation. Since Russia’s accession to the WTO in 2012,
practically all significant economies have become members, creating a single integrated system
of global trade rules.

Self Test Questions

1. What is economic integration? Discuss the benefits and drawbacks of economic

integration.
2. Discuss the working process and levels of economic integration.
3. What do you know by regional integration in economies? State the trade in context to
regional and multilateral economic integration.
4. Discuss multilateralism and role of WTO.
5. Briefly discuss the bilateral free trade agreements.
 CHAPTER-IX

INDIA’S TRADE AND ECONOMIC RELATIONS WITH DIFFERENT GROUPS

PURPOSE AND STRUCTURE

Countries can-not be entirely self dependent and self reliant. To develop the economies and
emerge in the global system, countries form groups and become members of the different groups.
This is also instrumental to protect the nation from outside interventions and influences as the
country concerned can get support from the other countries of the group. There are a series of
factors responsible for forming groups of the countries and becoming member of a particular
group. In the contemporary emerging world system of groups, the major group combinations
include; SAARC, SAFTA, BIMSTEC, ASEAN, EU or European Economic Community,
GCCBRICS etc. A modest attempt has been made in this chapter to make the readers acquainted
with India’s trade and economic relations with different groups and associations. After reading
this chapter, the readers will get the knowledge about India’s trade relations with the following:

9.1 India’s Trade Relations with SAARC

9.2 India’s Trade Relations with SAFTA

9.3 India’s Trade Relations with South Asian neighbors

9.4 India-Sri Lanka Free Trade Agreement

9.5 India’s Trade Relations with BIMSTEC

9.6 India’s Trade Relations with ASEAN

9.7 India’s Trade Relations with EU/ European Economic Community

9.8 India’s Trade Relations with GCC

9.9 India’s Trade Relations with BRICS

9.1 India’s Trade Relations with SAARC

Among the countries, trade between India and Afghanisthan ranges between 0.8% to 5.5% of
share among SAARC nations, with Bhutan 0.1% to 2.5%, with Maldives 0.5% to 1.5%, with
Nepal 7.2% to 22.3%, with Pakistan 6.3% to 20.9%, with Srilanka 25.8% to 36.5% and highest
with Bangladesh 25.2% to 58.8%.

Since 1991, India has strived for economic liberalization by implementing an open trade regime.
This process has however been tempered by local market considerations, with protective
measures erecting direct and indirect market barriers to ensure local players remain competitive.
Currently India has signed free trade agreements (FTAs) with 42 countries, of which 13 are in
effect, 16 are under negotiation, and 12 have been proposed. Many of these preferential trade
arrangements are with South Asian countries, with whom India seeks to better trade
opportunities by reducing import tariffs and simplifying the import license application process.
South Asian businesses exporting to India benefit from preferential market access. For example,
under the India-SAARC FTA or SAFTA, there is no duty on PVC flooring from Nepal and
Bangladesh, although India does not enjoy reciprocal benefits in those countries.

Foreign companies and trading businesses should be able to enjoy easy access to these South
Asian markets with India as an operational base, whose own vast market remains under-explored
in several segments and regions.

Rohit Kapur, Managing Director of Dezan Shira & Associates India Offices, comments: “India is
the economic powerhouse of South Asia. The economies of Nepal, Bangladesh, and Sri Lanka
are closely intertwined with that of India. The trade between India and other South Asian
countries is increasing, which is advantageous for businesses from Europe, US, Australia to
access markets in South Asia from India. This allows them economies of scale. Also, India’s
liberal trade policies encourage foreign companies to store goods in Free Trade Warehousing
Zones (FTWZs), free of customs duties, till the goods are cleared either for sale in the domestic
market or are exported to the neighboring countries. Additionally, South Asian countries can
take advantage of the FTAs India enters into with any country.”

9.2 India’s membership of SAFTA

India and the countries that make up the South Asian Association for Regional Cooperation
(SAARC) – Afghanistan, Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan, and Sri Lanka –
benefit from several bilateral and multilateral free trade agreements (FTAs). These are the India-
Afghanistan Preferential Trade Agreement (PTA), Bangladesh-India-Myanmar-Sri Lanka-
Thailand Economic Cooperation (BIMSTEC), India-Bhutan FTA, India-Maldives FTA, India-
Pakistan FTA, India Nepal FTA, and India Sri Lanka FTA. Trade between these countries stood
at US$31 billion in 2020. Regional multilateral agreements include the South Asian Free Trade
Area (SAFTA), SAARC Preferential Trading Arrangement (SAPTA), and the Asia Pacific Trade
Agreement (APTA).

Implemented starting July 1, 2006, the South Asian Free Trade Area / SAFTA established a trade
agreement between the respective governments of the SAARC member states. SAFTA
categorized Bangladesh, Bhutan, Maldives, and Nepal as Least Developed Contracting States
(LDCs), and India, Pakistan, and Sri Lanka as Non-Least Developed Contracting States
(NLDCs). Based on these categorizations, SAFTA began its phased tariff liberalization program
(TPL), wherein all LDCs were expected to bring down their tariffs to 30 percent, and all NLDCs
to 20 percent. Both the NDLCs and the LDCs were expected to lower the tariffs to zero to five
percent within the next eight and five years, respectively; this was six years for Sri Lanka.

LDCs benefit from smaller sensitive lists in some of the SAFTA members (meaning that they
have duty free, quota free/ DFQF access in a larger number of products) and less stringent Rules
of Origin (requirement of change of tariff heading and value addition of 10 percent less than the
general requirement for non-LDCs; the general rule is 60 percent and there are some product-
specific rules).

Only those goods that have undergone a substantial manufacturing process, defined in terms of
the twin criteria of a) Change of Tariff Heading (CTH) at four-digit Harmonized Coding System
(HS) and b) value content of 30 percent for LDCS and 40 percent for NLDCS – are given
preferential market access. Additionally, given their undiversified industrial structure, LDCS are
provided with technical assistance in the following areas: capacity building, product certification,
data management, institutional upgradation, human resource training, and improvement in legal
systems, customs procedures, and trade facilitation.

Some SAARC member countries have also taken bilateral steps to ease the flow of goods,
services, and capital between their territories. India Briefing recently discussed such prospects
while spotlighting the foreign investment opportunities in Bangladesh and how the country
benefits from its proximity with India.

The Rules of Determination of Origin of Goods under the Agreement on South Asian Free Trade
Area (SAFTA) can be accessed here via India’s Central Board of Indirect Taxes and Customs
website: https://www.cbic.gov.in/htdocs-cbec/customs/cs-act/formatted-htmls/cs-safta-rule

9.3 India’s bilateral trade relationships with its South Asian neighbors

Afghanistan

In March 2003, the India-Afghanistan Preferential Trade Agreement (PTA) was signed, under
which the Indian government allowed substantial duty concessions, ranging from 50 to 100
percent, on certain categories of Afghan dry fruits. Afghanistan has implemented reciprocal
concessions on Indian products, including tea, sugar, cement, and pharmaceuticals. In November
2011, India removed basic customs duties for all SAARC LDCs at the SAARC Summit in Male,
which gave all Afghanistan exports (except alcohol and tobacco) duty free access to the Indian
market.

To overcome land connectivity disruptions caused by neighboring Pakistan, India and

Afghanistan have set up an air freight corridor since June 2017. Afghan exports to India through
this corridor are mainly high value products like dried raisin, walnut, almond, fig, pine nut,
pistachios, dried apricot, and fresh fruits like pomegranate, apple, apricot, cherry, melon,
watermelon, medicinal herbs (asafoteida), and saffron. The Air Freight Corridor connects Kabul,
Kandahar, and Herat with New Delhi, Mumbai, and Chennai. Chahbahar port located in
southeastern Iran, on the Gulf of Oman, is functioning partially and in future will likely boost
India-Afghanistan-Iran trade.

In 2019, Afghanistan’s imports from India were valued at US$453.7 million. The imported
goods included electrical equipment, sugar, iron, steel, pharmaceuticals, fruits, tobacco,
aluminum, and miscellaneous articles of base metals. In 2019, Afghanistan’s exports to India
were valued at US$410.14 million. The exported goods included fruits, coffee, tea, spices,
vegetables, cereals, lead, and wool.

Afghanistan has established government to government procurement contracts with Indian

companies, in areas of pharmaceuticals, medical equipment, IT, and technical services.

Bangladesh

India and Bangladesh have initiated talks on the feasibility of forming a new bilateral FTA with
the purpose of strengthening their economic ties; however, this will be preceded by a study on
the benefits of forming such a pact. Discussions on matters of regional connectivity initiatives,
removal of port restrictions, trade infrastructure etc. have also been held.

As mentioned earlier, the two countries are members of various regional trade agreements,
including APTA, SAPTA, and SAFTA, which facilitate concessionary tariff regimes. Under
SAFTA, India grants duty free and quota free access to Bangladesh on all items, except alcohol
and tobacco. Further, on April 20, 2021, the Indian government approved a Memorandum of
Understanding between India’s Director General of Trade Remedies and the Bangladesh Trade
and Tariff Commission to increase cooperation in trade remedies.

Indo-Bangladesh border trade passes through Petrapole-Benapole, 80 km from Calcutta, the

capital of West Bengal. Some 70 percent of the two-way land trade takes place through this
integrated check post.

In 2019, Bangladesh’s imports from India were valued at US$7.91 billion. The imported goods
included cotton, mineral fuels, vehicles besides railway and tramway, machinery, organic
chemicals, electrical equipment, iron, steel, and plastics. In 2019, Bangladesh’s exports to
crossed US$1 billion. The imported goods included textiles, and textile machinery.

Bhutan

The FTA between India and Bhutan came into effect on July 29, 2006, and was to be maintained
for a period of 10 years. The Agreement on Trade, Commerce, and Transit was last renewed in
2016, and allows for free trade and commerce between India and Bhutan. The agreement also
talks about 21 entry/exit trade points, including 10 trade points with Land Customs Stations
(LCS) at the Indo-Bhutan border. Some of these trade points are used by Royal Government of
Bhutan for trade with third countries.

While non-tariff restrictions are applied on certain Indian goods to protect Bhutan’s industries,
these restrictions are not stricter than those applied on goods originating from third countries.
Further, all Bhutanese trade, including imports and exports to and from countries besides India,
are not subject to Indian customs duties and trade restrictions. To ensure smooth facilitation of
trade in goods between India and Bhutan, consultations between the two countries are held
annually.

To enhance the movement of industrial raw materials and goods after the pandemic outbreak,
July last year India acceded to Bhutan’s request to open an additional trade route under Jaigaon
Land Customs Station. This has been temporarily opened at Ahllay, Pasakha.

In 2018, Bhutan’s imports from India were valued at US$810 million. The imported goods
included diesel, wood, charcoal, and gasoline. In 2018, Bhutan’s exports to India were valued at
US$433 million. The exported goods included cement, dolomite, cement clinkers, timber, wood
products, and fruits.

Maldives

India-Maldives ties have been reset since Ibrahim Mohamed Solih became president in 2018.
Maldives is also reconsidering its trade exposure to China under the FTA it has with Beijing.
Meanwhile, India-backed infrastructure projects are being implemented in Maldives, and Delhi
came forward to assist the country following the COVID-19 outbreak.

In 2020, Maldives’ imports from India were valued at US$196.17 million. The imported goods
included pharmaceuticals, cereals, plastics, machinery, vegetables, medical apparatus, electrical
equipment, dairy products, and fruits. In 2020, Maldives’ exports to India were valued at
US$17.74 million. The exported goods included ships, boats, iron, steel, medical apparatus,
machinery, aluminum, copper, electrical equipment, mineral fuels, and vehicles besides railway
and tramway.

Nepal

According to their bilateral FTA signed March 6, 2005, India and Nepal exempt the application
of customs duties and quantitative restrictions on each other’s imports of primary goods, as
decided mutually. To aid Nepal’s industrial development, India’s imports of its industrial
products will benefit from preferential treatment. The India-Nepal FTA is to be continually
extended for a period of five years at a time, unless either country hands in a written notice three
months in advance, with the intention to terminate the agreement.

In 2020, Nepal’s imports from India were valued at US$782 million. The imported goods
included oil, gold, iron, steel, clothing, pharmaceuticals, cement, electrical equipment, food
items, and vehicles. In 2020, Nepal exported iron, steel, textiles, plastics, knotted carpets, and
vegetables to India.

Pakistan

As per the India-Pakistan FTA, Pakistan currently maintains a Positive List of Importable Items
from India, inclusive of a total of 1,075 items. Some of these items are live animals, vegetables,
pulses, coffee, tea, spices, mineral products, fuel gas, metals, chemicals, homeopathic medicines,
rubber, wood, etc. On the other hand, some of India’s imports from Pakistan do not have any
customs duties levied on them, such as passenger bus spares, fuel, and consumables for the
passenger bus.

In 2020, Pakistan’s imports from India were valued at US$242 million. The imported goods
included organic chemicals, inorganic chemicals, pharmaceuticals, machinery, plastics, ships,
boats, and medical apparatus. In 2020, Pakistan’s exports to India were valued at US$1.6
million. The exported goods included organic chemicals, machinery, wool, fruits, lead, medical
apparatus, and apparel.

Sri Lanka

Commercial relations between Sri Lanka and India marked a milestone when the two countries
signed the India-Sri Lanka Free Trade Agreement (ISFTA) on December 28, 1998, a first such
agreement for Colombo. The ISFTA entered into force March 1, 2000. The ISFTA is now in full
implementation as both sides have completed their phasing out commitments under the
respective Tariff Liberalization Programs (TLP).

9.4 India-Sri Lanka Free Trade Agreement

Products of Sri Lankan origin exported to India under ISFTA are duty free at present, except the
following categories:

1) Products of India’s Negative Lists – 429 tariff lines

2) Products of India’s Tariff Rate Quota (TRQ) Lists as follows:

 For garments – eight million pieces at zero duty

  Tea: 15,000 MT at 50 percent margin of preference (MoP)
 Pepper: 2,500 MT at zero duty
 Desiccated coconut: 500 MT at 30 percent MoP
 Vanaspati, bakery shortening, and margarine: 250,000 MT at zero duty
 Textile: 528 tariff lines at 25 percent MoP

The products of Indian origin exported to Sri Lanka under ISFTA are duty free at present, except
the products of:

 1,180 tariff lines included in the Negative List of Sri Lanka under ISFTA.

Rules of Origin (ROOs) criteria for export products, which are not wholly obtained or products
in Sri Lanka (with imported inputs):

 Minimum Domestic Value Addition (DVA) – 35 percent of FOB price

 With inputs from India – minimum DVA in Sri Lanka is 25 percent of FOB price and the
Aggregate Value Addition (Sri Lanka+ India) should be at least 35 percent of FOB price
 Change of Tariff Heading (CTH) at HS 4-Digit Level
 Sufficient working or processing in Sri Lanka
 The final manufacturing process should take place in Sri Lanka
 Direct consignment

In 2020, Sri Lanka’s imports from India were valued at US$3 billion. The imported goods
included pharmaceuticals, sugar, cotton, mineral fuels, iron, steel, machinery, coffee, tea, spices,
and vehicles besides railway and tramway. In 2020, Sri Lanka’s exports to India were valued at
US$654 million. The exported goods included mineral fuels, coffee, tea, spices, fruits, apparel,
electrical equipment, furniture, and wood.

Exports (US$ million) Imports (US$ million)

Total
Exports % Total Imports
exports % under
Year under under imports under
to ISFTA
ISFTA ISFTA from India ISFTA
India

2000
55.65 8.6 16 600 53.9 9
(March-Dec.)

2001 70.12 15.9 23 601 113.1 19

 2002 168.81 114.2 68 834 81.7 10

2003 241.14 238.8 99 1076 150.4 14

2004 385.49 339.9 88 1342 394.7 29

2005 559.21 543.0 97 1,399.43 246.2 18

2006 494.06 431.1 87 1,822.07 459.3 25

2007 516.4 398.2 77 2,785.04 385.3 14

2008 418.08 309.3 74 3,006.93 541.4 18

2009 324.87 218.5 67 1,709.93 371.7 22

2010 466.60 358.4 77 2,546.23 573.7 23

2011 521.59 391.5 75 4,349.43 579.6 13

2012 566.37 379.5 67 3,517.23 156.4 4

2013 543.37 368.8 65 3,092.67 393.4 13

2014 624.81 375.8 60 3,977.76 540.1 14

2015 643.03 407.28 63 4,273.30 253.3 6

2016 551.20 375.25 68 3,827.50 186.7 5

2017 689.48 442.29 64 4,495.99 257.04 6

2018 768.71 483.48 63 4,158.18 246.87 6

2019 759.37 489.89 64 3,830.82 198.74 5

Source: Sri Lanka Customs and Department of Commerce

9.5 India’s Trade Relations with BIMSTEC

Sri Lanka and Thailand are India's most important trading partners in BIMSTEC region, in terms
of both exports and imports. But India has unfavorable trade balance with Thailand. So, Sri
Lanka is the best trading partner of India among all the BIMSTEC nations.
 BIMSTEC stands for: Bay of Bengal Initiative for Multi-Sectoral Technical and Economic
Cooperation. As part of the BIMSTEC, countries from the Bay of Bengal region jointly address a
variety of issues that concern their countries, such as low investments, trade barriers, poverty,
and crime transnationally. The organisation was founded in 1997, and is now represented by
seven countries – Bangladesh, Bhutan, Myanmar, India, Nepal, Sri Lanka, and Thailand.

A huge portion of India’s trade with other South Asian countries is facilitated by BIMSTEC.
This is a very beneficial platform for India to expand its trade partnerships in Southeast Asia.

Brief about BIMSTEC

BIST-EC (Bangladesh, India, Sri Lanka, and Thailand Economic Cooperation) was formed in
Bangkok on 6 June 1997. After Myanmar was included in the group during the special
ministerial meeting held in Bangkok on 22 December 1997, the group’s name was changed to
BIMST-EC. After becoming an observer in 1998, Nepal became a full member in 2004. Bhutan
became a full member in 2004.

The General Secretary of BIMSTEC is Tenzin Lekphell of Bhutan.

The Chairman of BIMSTEC has been Sri Lanka since 2018.

Secretariat and Headquarters of BIMSTEC – Dhaka, Bangladesh.

2022 marks the 25th anniversary of the founding of BIMSTEC. The theme of the 2022 summit
was “Towards a Resilient Region, Prosperous Economies, Healthy People.”

Objective of BIMSTEC
 Tourism
 Agriculture
 Human resource development
 Transport and communication
 Trade and investment
 Technology
 Climate change
 Energy
 People-to-people contact
 Counter-terrorism
 Poverty alleviation
 Raising the living standards
 Environment and disaster management
 Fisheries
 Education and technical affairs
 Public health
 Cultural cooperation
 Transnational crime

Principles of BIMSTEC
 The BIMSTEC will operate on the principles of sovereign equality and territorial integrity.
 The BIMSTEC will operate on political independence, non-interference in internal affairs,
peaceful coexistence, and mutual benefit.
 BIMSTEC’s cooperation will complement and not replace the cooperation between its member
states on a bilateral, regional, and multilateral basis.

BIMSTEC Priority Sectors

 The security and energy sector is appointed to India.
 The trade, investment and development sector is appointed to Bangladesh.
 The agriculture and food security sector is appointed to Myanmar.
 The connectivity sector is appointed to Thailand.
 The innovation, science and technology sector is appointed to Sri Lanka.
 The people-to-people connect sector is appointed to Nepal.
 The environment and climate change sector is appointed to Bhutan.

India’s role in BIMSTEC

With this new framework, India can engage with its neighbours:

 Neighbourhood First – priority to the immediate neighbour of India.

 Act East – connecting India with Southeast Asian countries.
 Linking India’s northeastern states with the Bay of Bengal region via Bangladesh and Myanmar
will contribute to the development of these states.

India actively pursues new paths of geo-economic cooperation with countries in the region
through BIMSTEC. India’s involvement in making the Bay of Bengal community more
integrated is also a reaction to China’s growing influence in the region. It could be a potentially
game-changing initiative in the quest for the prosperity of the landlocked northeastern states if
India’s role in BIMSTEC is given a boost.

Challenges for India as a member of BIMSTEC

As a strategic challenge, India is confronted with two key issues: the first is realising that
regional integration in South Asia would only be successful without Pakistan’s involvement. It
is, therefore, difficult for India to make BIMSTEC appear more relevant despite its overlap with
SAARC in terms of its mandate and membership.
The second factor is China’s influence over BIMSTEC members from a strategic and economic
standpoint, so that BIMSTEC can become a pawn in the Indo-China rivalry. Therefore, the
Indian government will need to carefully navigate through this new geopolitical environment in
South Asia and work together towards common goals, with India playing its appropriate role.

As of 2017-18, India contributed Rs. 2 crore (32% of the total budget) to the BIMSTEC
secretariat’s budget. With the secretariat planning to enhance its capabilities, India may need to
consider allocating additional resources. An important test of India’s commitment to the sub-
region would be its generosity.

BIMSTEC is also plagued by the fact that it is dominated by India. Despite this, because of the
changes in geo-economics, most of the smaller neighbours are more open to interacting with
India as it grows economically. Those countries need to see India as a constructive partner.

BIMSTEC for India

The BIMSTEC initiative for India stands at the crossroads of the ‘Neighbourhood First’ and ‘Act
East Policy’. Among its key advantages to India are the potential economic rewards of greater
regional connectivity. The second is Asia’s fast-changing geostrategic situation. Indian
policymakers should take advantage of the Bay of Bengal to contain a more assertive and
capable China.

Only BIMSTEC unites India’s strategic peripheries under one umbrella, unlike SAARC, which
focuses on sub continental countries. BIMSTEC is a more natural means of Indian regional
integration than SAARC, which is dominated and hindered by tensions between India and
Pakistan. BIMSTEC also allows India to put forward a positive agenda to combat Chinese
investments.

As a result of projects pending with BIMSTEC, the region, especially India, is likely to undergo
a revolution.

One such project is the multimodal Kaladan project, which connects India and Myanmar. By
river and road, Kolkata would be linked to Myanmar’s Sittwe port and then to Mizoram. A
framework agreement was signed between India and Myanmar in 2008, which has yet to be
implemented.

In addition, Myanmar is part of the Trilateral Highway, which connects India and Thailand. By
connecting Moreh in Manipur with Mae Sot in Thailand via Myanmar, the highway will
establish connectivity between India and Southeast Asia. Construction has already begun.

Conclusion
Through the Bay of Bengal initiative for technical and economic cooperation – BIMSTEC –
India becomes more competitive and opens up more possibilities for trade and connectivity to the
East of the world.

India’s participation in BIMSTEC would positively strengthen its relationship with South East
Asia. The spread of Hinduism and Buddhism in this region attracts India’s ancient ties with these
countries and regions. As a foreign policy initiative, India can, therefore, seriously consider
giving BIMSTEC a higher priority.

9.6 India’s Trade Relations with ASEAN

Preliminary ASEAN data showed that two-way merchandise trade between ASEAN and
India reached USD 77.0 billion in 2019, while total FDI inflows from India amounted to USD
2.0 billion. This placed India as ASEAN's sixth largest trading partner and eight largest source of
FDI among ASEAN Dialogue Partners.

Association of Southeast Asian Nations, or ASEAN, is a regional intergovernmental organisation

including ten Southeast Asian countries. ASEAN was formed in 1995 by Vietnam, Indonesia, the
Philippines, Singapore, Brunei, Malaysia, Myanmar, Cambodia, Thailand, and Laos as a display
of solidarity against communist expansionism. The relationship of India with ASEAN is very
important. Asia-Pacific has become a hotspot for economic growth, political instability and
social tensions. The region continues to be confronted with multiple challenges arising from the
rise of new powers, growing strategic competition, the threats posed by non-traditional security
challenges such as a pandemic, cyber warfare, climate change and natural disasters; tensions
over sovereignty and resource exploration in the South China Sea; and the lack of inclusive
development.

The Relation of India With ASEAN

Although the relation of India with ASEAN has evolved. There has been some conflict due to
strategic and political mistrust but the general trend has been positive. The first phase of the
relationship was marked by distrust and suspicion. The India-ASEAN relations aim to facilitate
economic, cultural, and social development and maintain peace and security among the nations.

India was one of the founding members of the ASEAN-India Centre for Cooperation (AICC),
established in 1995 under an agreement signed between India and ASEAN. The centre serves as
a forum for consultation and cooperation between member countries on security and defence,
education, health and tourism.

In 1995, India became a dialogue partner with ASEAN. India had good bilateral relations with
the Soviet Union and was a spearhead of the Non-Aligned Movement (NAM), which made it
difficult for India to engage with ASEAN. The second phase was marked by the growing
strategic rivalry between India and China. In this period, India was suspicious of Chinese
intentions and felt that ASEAN treated it as a “responsible great power” in the region. The third
phase was marked by the end of the cold war and the end of the Soviet Union. This brought
about a change in India’s outlook, and it began to treat ASEAN as an important partner in the
Asia-Pacific region.

The Significance of ASEAN for India

Cooperation in Defense and Security
India and ASEAN have a common interest in maintaining peace and stability in the region. They
have signed a Joint Declaration on Defense Cooperation, which can guide the future strategic
partnership. India has been a useful partner to ASEAN in this field. It has been helping ASEAN
countries build their defense capabilities. ASEAN-India cooperation in this field can be
enhanced through regular exchanges between military officials and academics.

India and ASEAN conduct many joint military exercises. Cooperation in counter-terrorism can
be initiated by exchanging information between intelligence agencies and joint investigations.
Growing Chinese aggression and assertion in the South China Sea and the Indian Ocean is a
cause for concern. It has made ASEAN reach out for India’s partnership to counter China in this
region. India and ASEAN are important partners in maintaining maritime security.

Cooperation in Countering Climate Change

ASEAN and India are also important players in the global effort to counter the challenge of
climate change. ASEAN and India cooperate on the issue of marine pollution and conduct EEO
(Environmental Emergency Operations), where both sides can share expertise. They can set up a
joint research and development centre. Finally, the two sides can cooperate on renewable energy
and solar and wind power development. It can help reduce carbon emissions and their
dependence on fossil fuels.

Preliminary ASEAN data showed that two-way merchandise trade between ASEAN and
India reached USD 77.0 billion in 2019, while total FDI inflows from India amounted to USD
2.0 billion. This placed India as ASEAN's sixth largest trading partner and eight largest source of
FDI among ASEAN Dialogue Partners.

India-ASEAN relations, as they exist today, are in some ways, a reconfiguration of age-old ties
that date back 2,000 years. Only the modes of trade have changed. Instead of the silk route,
countries now use tech-oriented routes to link up.

ASEAN, the latest version of what was the Asian trade network ages ago, is an effort to establish
cooperation in the economic, social, cultural, technical, educational and other fields among its
 member countries, namely Indonesia, Malaysia, Philippines, Singapore, Thailand, Brunei
Darussalam, Vietnam, Laos, Myanmar and Cambodia.

For a relationship that began warming up only about a decade ago, the India-ASEAN partnership
has been trotting at quite a fast pace.

 India became a sectoral dialogue partner of ASEAN in 1992. The sectors were trade, investment,
tourism and science and technology.
 Mutual interest led ASEAN to invite India to become a full dialogue partner of ASEAN during
the fifth ASEAN summit in Bangkok in 1995 and a member of the ASEAN Regional Forum
(ARF) in 1996.
 India signed an agreement in October 2003 for a free trade area (FTA) with Thailand. Under the
agreement, 84 items can be imported from Thailand from April 2004 at 50 percent of the normal
rate of duty prevailing in India. The pact with Thailand is to be followed by a similar agreement
with Singapore and, ultimately, the entire ASEAN region and India is committed to aligning its
peak tariff to East Asian levels by 2005.
 India has also been engaged in negotiations to form a Comprehensive Economic Cooperation
Agreement (CECA) with Singapore.
 Sub-regional cooperation has accelerated too. The Mekong-Ganga Cooperation (MGC) and the
BIMST-EC (Bangladesh, India, Myanmar, Sri Lanka, Thailand Economic Cooperation) are
indicators to this effect.
 In 2003, India acceded to the Treaty of Amity and Cooperation (TAC) in South-East Asia,
signed a declaration to combat international terrorism, and agreed on comprehensive economic
cooperation to step up their current trade turnover of $12 billion.

The deepening of ties is beginning to show in the intra-country trade figures. India-ASEAN trade
in 2002-03 was about $9.76 billion, about four times the 1993-94-trade figure of $2.5 billion.

India's exports to ASEAN were $4.61 billion while imports came to about $5.15 billion in this
period.

Growth in India's exports to ASEAN in recent years has been much higher in comparison to
other destinations. India's trade with the world in 2003 stood at $114.13 billion, ASEAN
accounting for 8.56 percent of India's global trade.

Relative importance of India's trade with ASEAN

Figures in $million, for the year 2002-03
India's total global trade India's total trade with Percentage share of India's
114,131.56 ASEAN trade with ASEAN
9,768.71 8.56%
India’s total global export India’s total export to 8.76%
52,719.43 ASEAN
4618.54
India’s total global import India’s total import to
61,412.13 ASEAN 8.39%
5150.17

Source: Export-Import Data Bank.

Conclusion
This article discusses the current state of India-ASEAN relations, from conflict to cooperation.
While there is a lot of potential in the relationship, both sides must work towards strengthening
it. Creating a strong bond between ASEAN and India will require taking steps toward the mutual
trust and confidence missing in the relationship. Ultimately, both sides must work towards
creating a stable partnership. ASEAN countries are a huge and relatively untapped market for
India.

9.7 India’s Trade Relations with EU

The EU is India's third largest trading partner, accounting for €88 billion worth of trade in goods
in 2021 or 10.8% of total Indian trade. India is the EU's 10th largest trading partner, accounting
for 2.1% of EU total trade in goods.

Relations between the European Union and the Republic of India are currently defined by the
1994 EU–India Cooperation Agreement. The EU is a significant trade partner for India and the
two sides have been attempting to negotiate a free trade deal since 2007. Indo-EU bilateral trade
(excluding services trade) stood at US$104.3 billion in the financial year 2018–19.

Trade
The EU is India's largest trading partner with 12.5% of India's overall trade between 2015 and
2016, ahead of China (10.8%) and the United States (9.3%). India is the EU's 9th largest trading
partner with 2.4% of the EU's overall trade. Bilateral trade (in both goods & services) reached
€115 billion in 2017 EU exports to India have grown from €24.2 billion in 2006 to €45.7 billion
in 2018. India's exports to the EU also grew steadily from €22.6 billion in 2006 to €45.82 billion
in 2018, with the largest sectors being engineering goods, pharmaceuticals, gems and jewellery,
other manufactured goods and chemicals. Trade in services has also tripled between 2005 and
2016, reaching €28.9 billion. India is among the few nations in the world that run a surplus in
services trade with the EU. Investment stocks from Europe to India reached €51.2 billion in
2015.
As of 2021, EU is India's third largest trading partner, accounting for €88 billion worth of trade
in goods or 10.8% of total Indian trade.
France and Germany collectively represent the major part of EU-India trade.

India–European Economic Community (EEC) relations were established in the early 1960s.
The Joint Political Statement of 1993 and the 1994 Co-operation Agreement were the
foundational agreements for the bilateral partnership. In 2004, India and European Union became
"Strategic Partners". A Joint Action Plan was agreed upon in 2005 and updated in 2008. India-
EU Joint Statements was published in 2009 and 2012 following the India-European Union
Summits. EU-India relationship has been qualified as high on rhetoric[9] and low on substance.
India and the EU have been working on a Broad-based Trade and Investment Agreement (BTIA)
since 2007, but India's trade regime and regulatory environment remains comparatively
restrictive. Seven rounds of negotiations have been completed without reaching a Free Trade
Agreement[4][13] Talks on an EU-India Bilateral Trade and Investment Agreement have stalled
after failing to resolve differences related to matters such as the level of FDI & market access,
manufacture of generic drugs, greenhouse gas emissions, civil nuclear energy, farming subsidies,
regulation & safeguards of the financial sector, cooperation on tax evasion, overseas financing of
NGOs in India, trade controls, technology transfer restrictions and cooperation on embargoes
(Russia).
In January 2015, India rejected a non-binding resolution passed by the European
Parliament pertaining to maritime incidents which occurred within Indian Contiguous Zone.
European Union Ambassador to India Joao Cravinho played down the resolution saying that the
case will be resolved in accordance with Indian and International Laws.
India-EU FTA negotiations restarted in July 2022. Both the sides are aiming to conclude the
negotiations by 2024.
The EU and India agreed on 29 September 2008 at the EU-India summit in Marseille, to expand
their co-operation in the fields of nuclear energy and environmental protection and deepen their
strategic partnership. French President Nicolas Sarkozy, the EU's rotating president, said at a
joint press conference at the summit that "EU welcomes India, as a large country, to engage in
developing nuclear energy, adding that this clean energy will be helpful for the world to deal
with the global climate change." Sarkozy also said the EU and Indian Prime Minister Manmohan
pledged to accelerate talks on a free trade deal and expected to finish the deal by 2009.
The Indian prime minister was also cautiously optimistic about co-operation on nuclear energy.
"Tomorrow we have a bilateral summit with France. This matter will come up and I hope some
good results will emerge out of that meeting," Singh said when asked about the issue. Singh said
that he was "very satisfied" with the results of the summit. He added that EU and India have
"common values" and the two economies are complementary to each other.
European Commission President Jose Manuel Barroso expounded the joint action plan on
adjustments of EU's strategic partnership with India, saying the two sides will strengthen co-
operation on world peace and safety, sustainable development, co-operation in science and
technology and cultural exchanges.
Reviewing the two sides' efforts in developing the bilateral strategic partnership, the joint action
plan reckoned that in politics, dialogue and co-operation have enhanced through regular summits
and exchanges of visits and that in economy, mutual investments have increased dramatically in
recent years, dialogue in macro- economic policies and financial services has established and co-
operation in energy, science and technology and environment has been launched. Under the joint
action plan, EU and Indian would enhance consultation and dialogue on human rights within the
UN framework, strengthen co-operation in world peacekeeping mission, fight against terror and
non-proliferation of arms, promote co-operation and exchange in developing civil nuclear energy
and strike a free trade deal as soon as possible. France, which relies heavily on nuclear power
and is a major exporter of nuclear technology, is expected to sign a deal that would allow it to
provide nuclear fuel to India.
12th EU-India Summit
On the eve of the Summit President Van Rompuy stated: "The 12th EU-India summit will
confirm that EU and India are strengthening and rebalancing their partnership in its political
dimension, thus bringing our relationship to new heights. It will demonstrate that increased co-
operation between India and the EU can make a difference for the security and the prosperity of
our continents." Although there were some apprehension regarding the EU-enforced carbon
tax on all fliers landing or passing through European skies that was opposed by many other
countries, including India, China, the US and Russia, the European Union and India held their
twelfth annual summit in New Delhi on 10 February 2012. Various EU representatives were
present such as President Herman Van Rompuy and European Commission President José
Manuel Barroso. The EU Trade commissioner, Karel De Gucht also attended the summit. The
Republic of India was represented by Prime Minister Manmohan Singh, Foreign Minister S.M.
Krishna, Trade Minister A. Sharma and National Security Adviser, S.S. Menon.
The summit agenda covered bilateral, regional and global issues. The Leaders emphasised the
importance of the EU-India Strategic Partnership. They endeavoured to reinforce co-operation in
security, in particular counter-terrorism, cyber-security and counter-piracy, as well as trade,
energy, research and innovation.
India-EU Summits
Annual summit-level dialogues have been the cornerstone of India-EU relations. The first India-
EU summit, held in Lisbon 2000, was a successful venture, which laid the roadmap for future
partnership. The fifth India-EU Summit upgraded the relations to that of strategic partnership.
Simultaneously, following the sixth India-EU summit held in New Delhi, both sides adopted the
Joint Action Plan (JAP), which set out the roadmap for a strategic partnership between the two.
The JAP included the strengthening of the dialogue and consultation mechanisms, deepening of
political dialogue and cooperation and enhancing of economic policy dialogue and cooperation.
During the ninth summit, India and the EU reviewed the JAP and a revised JAP was adopted
adding 40 new elements in India-EU cooperation. During the 15th India-EU summit held
virtually in 2020, an ambitious Roadmap to 2025 document was adopted. The 16th India-EU
Summit is scheduled for May 2021. These summit-level meetings have provided a platform for
both India and the EU to agree or disagree on a broad range of issues.
Maritime Cooperation
Maritime security has emerged as a critical area of cooperation between India and the European
Union. The Joint Action Plan adopted in 2005, highlighted and emphasized on maritime
cooperation. In the past few decades, both India and the EU have stressed on the idea of freedom
of navigation, maritime piracy, and adherence to United Nation Conventions on the Law of the
Sea (UNCLOS) and the development of the blue economy and maritime infrastructure. Both
have identified the Indo-Pacific as the new avenue for maritime cooperation. In January 2021,
India and the EU hosted the first Maritime security dialogue in a virtual format.
India-EU Cooperation on Climate Change
In the realm of climate change, India-EU relations have witnessed a commitment of international
agreements such as the Kyoto Protocol and the Paris agreement. They have been collectively
pushing for a comprehensive framework for global governance on climate change. The EU has
also invested in numerous programmes such as India-EU water partnership, solar park
programme, and Facilitating Offshore Wind in India (FOWIND). One of the major investments
was the signing of the 200 million EUR loan agreement between the EIB and the Indian
Renewable Energy Development Agency. Notwithstanding all the progress made so far, the
potential for India-EU cooperation in Solar and Green Hydrogen still remains largely untapped.
India-EU Cooperation on Data Protection and Regulation
In the 15th India-EU Summit, both sides highlighted on driving a ‘human-centric’ digital
transformation. The Roadmap 2025 document for the first time reflected the need to build
effective cooperation on data protection and regulation. The differences in regulatory
frameworks for data protection in India and the EU surfaced during the trade negotiations
wherein the EU refused to accord India with ‘data secure’ status.
India and the EU have committed to work together in developing new standards and approaches
for international ICT standardization since 2015. During the 15th India-EU Summit, both sides
agreed for greater convergence of the regulatory frameworks through data adequacy decision for
the facilitation of cross-border data flow as well as engaging in dialogue regarding safe and
ethical usage of AI and 5G.
Trade and Technology Council
In April 2022, the EU and India agreed to set up a Trade and Technology Council (TTC) to step
up on cooperation.[33] It has been established as a coordination platform to address key trade,
trusted technology and security challenges. On 16 May 2023, the European Union and India held
their first ministerial meeting of the TTC in Brussels. Ministerial meetings of the TTC will take
place at least once a year, with the venue alternating between the EU and India. The next
ministerial meeting is scheduled for early 2024 in India.
9.8 India’s Trade Relations with GCC

As per data from India's commerce ministry, bilateral trade between India and the GCC has
increased to US$154.73 billion in FY 2021-22 from US$87.4 billion in 2020-21. India's exports
to the GCC witnessed a 58.26 percent increase to about US$44 billion in FY 2021-22, against
US$27.8 billion in FY 2020-21.

India-GCC trade and investment trends

As per data from India’s commerce ministry, bilateral trade between India and the GCC has
increased to US$154.73 billion in FY 2021-22 from US$87.4 billion in 2020-21. India’s exports
to the GCC witnessed a 58.26 percent increase to about US$44 billion in FY 2021-22, against
US$27.8 billion in FY

The share of these six countries in India’s total exports has risen to 10.4 percent in FY 2021-22,
up from 9.51 percent in FY 2020-21. The data suggests that imports, too, rose by 85.8 percent to
US$110.73 billion compared to US$59.6 billion in 2020-21. The share of GCC members in
India’s total imports rose to 18 percent in FY 2021-22 from 15.5 percent in FY 2020-21.

India’s top three exports to the GCC member countries include crude petroleum (40 percent),
petroleum gas (18 percent), and diamonds (eight percent). At the same time, India’s import
basket from the GCC comprises of refined petroleum (14 percent), jewelry (eight percent), and
rice (seven percent).

Meanwhile, bilateral trade in services between India and the GCC nations was valued at about
US$14 billion at the time, with exports amounting to US$5.5 billion and imports amounting to
US$8.3 billion.

Trade and investment snapshot:

 UAE, one of the six GCC member countries, is India’s third largest trading partners,
following the US and China. At the same time, it is among the top 10 largest source
countries of foreign direct investment (FDI) inflow in India. In 2022, India and UAE
signed a Comprehensive Economic Partnership Agreement (CEPA). Under the
agreement, the UAE is set to eliminate duties on 80 percent of its tariff lines which
account for 90 percent of India’s exports to the UAE by value. This agreement is
expected to increase the total value of bilateral trade in goods to over US$100 billion and
trade in services to over US$15 billion within five years. Key domestic sectors that are
 set to benefit include, gems and jewelry, textiles, leather, footwear, sports goods,
engineering goods, automobiles and pharmaceuticals. India-UAE have also become a part
of I2U2 (India-Israel-US-UAE) economic framework, under which UAE has announced
an investment of US$2 billion to develop integrated food parks in India.
 Saudi Arabia emerged as India’s fourth largest trading partner with a total trade volume
of total volume of US$42.9 billion in FY 2021-22.
 Qatar is another significant partner for India, accounting for 41 percent of India’s total
natural gas imports. India and Qatar have recently launched the “India-Qatar Start Up
bridge” that aims to link the start-up ecosystems of the two countries.
 Oman, too, hosts many important Indian financial institutions as well as companies,
which have invested in sectors like iron and steel, cement, fertilizers, textile etc. Bilateral
trade between Oman and India stood at US$5.931 billion in FY 2019-20, while bilateral
trade in 2020-21 (April 2020 to February 2021) amounted to US$4.63 billion. Omani-
India trade benefits from the fact that Oman’s ports are five days shipping time from
India’s western coast. In 2021, India stated that it was looking at a FTA with Oman.

India’s trade deficit with GCC

Among the GCC countries, the UAE is India’s major destination for exports worth US$28
billion, followed by Saudi Arabia (US$8.8 billion), Oman (US$3.1 billion), Qatar (US$1.8
billion), Kuwait (US$1.2 billion) and Bahrain (US$900 million) in FY 2021-22.
India had the highest trade deficit (FY 2021-22) with Saudi Arabia (US$25.3 billion), followed
by the UAE (US$16.8 billion), Qatar (US$11.4 billion), Kuwait (US$9.8 billion), and Oman
(US$3.6 billion) whereas India had a trade surplus of $147 million with Bahrain.

In FY 2021-22, India’s trade balance with the GCC countries was unfavorable in a number of
areas, including petroleum products, pearls, precious and semi-precious stones, gold, plastic raw
materials, organic chemicals, products made of aluminium, inorganic chemicals, bulk minerals
and ores, and dye intermediaries.

India-GCC Trade Statistics (US$ Million)

Saudi
Year UAE Oman Kuwait Qatar Bahrain Total
Arabia

FY
2017- 22,070 21,739 4,264 7,166 8,409 431 64,079
18
Imports
FY 28,479 29,785 2,759 7,431 10,722 540 79,716
 India-GCC Trade Statistics (US$ Million)

Saudi
Year UAE Oman Kuwait Qatar Bahrain Total
Arabia

2018-
19

FY
2019- 26,857 30,257 3,669 9,574 9,686 422 80,465
20

FY
2020- 16,187 26,623 3,088 5,214 7,930 547 59,589
21

FY
2021- 34,100 44,833 6,840 11,001 13,193 753 1,10,720
22

FY
2017- 5,411 28,146 2,439 1,366 1,472 557 39,391
18

FY
2018- 5,562 30,127 2,246 1,334 1,611 742 41,622
19

FY
2019- 6,237 28,854 2,262 1,287 1,268 559 40,466
Exports
20

FY
2020- 5,857 16,695 2,355 1,287 1,285 528 87,364
21

FY
2021- 8,758 28,044 3,148 1,241 1,837 899 43,927
22
 India FDI Inflows from GCC Countries (April 2020 – March 2022) (US$ Million)

Saudi Arabia 3,145.90

UAE 12,225.13

Oman 561.04

Kuwait 87.53

Qatar 488.01

Bahrain 181.66
India was the largest recipient of remittances in the world in 2021, receiving around US$87
billion, approximately 50 percent of which came from the GCC region, according to a World
Bank report. The GCC countries together host approximately 6.5 million Indians.

9.9 India’s Trade Relations with BRICS

The share of India–BRICS trade in India's total trade has grown from 8 per cent in 2002 to over
14 per cent in 2018. This shows that India is committed to building more robust intra-BRICS
trade relations. However, India's trade is in deficit with the rest of the BRICS members.

Engagement in these Summits provides a platform for discussions and exchange of views on
issues of mutual interest. These interactions help develop congruence on various issues and could
lead to closer cooperation and strengthening of trade and investment ties between BRICS
nations. Through sustained engagement cooperation amongst BRICS partners in the areas of
Trade and Investment over these years has strengthened. The New Development Bank has been
established with the purpose of mobilizing resources for infrastructure and sustainable
development projects in BRICS and other developing countries. At this year’s Trade Ministers
Meeting the Memorandum of Understanding among BRICS Trade and Investment Promotion
Agencies/Trade Promotion Organizations was signed. This provides a framework for forging
collaboration between Trade and Investment Promotion agencies for facilitating greater trade
amongst the BRICS member countries. The BRICS Joint Trade Study Review helps in fostering
greater mutual knowledge, economic cooperation as well as trade and investment opportunities
among BRICS countries.

BRICS countries in 2018 agreed upon a non-binding and voluntary Working Mechanism on
Technical Regulations, Standards, Metrology and Conformity Assessment Procedures for
identifying, preventing and eliminating technical barriers to trade with a view to facilitating trade
and increasing mutual trade flows. The government, through the institutional mechanisms like
Joint Commission Meetings (JCMs) and Joint Trade Committee (JTCs) addresses market access
and other issues like non-tariff measures on a regular basis, with a view to increasing India’s
trade including with BRICS countries.

Table 1: Intra BRICS Trade Data (value in Billion US $) (2017)

% Share
South Intra of its
Country World Brazil China India Russia
Africa BRICS Global
Trade
Brazil 368.49 74.81 5.38 7.60 2.00 89.79 24.37%
China 4107.16 87.81 84.22 84.39 39.20 295.61 7.20%
India 587.36 7.97 84.42 10.12 10.96 113.47 19.32%
Russian 738.42 5.23 85.90 8.32 0.83 100.28 13.58%
South
171.30 1.96 23.89 0.75 8.05 34.65 20.23%
Africa
BRICS 5972.73 633.81 10.61%

Source: COMTRADE

Table 2: India’s Trade with BRCS (in Billion US$)

Counterpart 2014-2015 2015-2016 2016-2017 2017-2018 2018-2019 2019-20

Brazil 11.4 6.7 6.5 8.6 8.2 3.5
China 72.3 70.7 71.5 89.7 87.1 44.7
Russia 6.3 6.2 7.5 10.7 8.2 4.9
South
11.8 9.5 9.4 10.7 10.6 5.4
Africa
India's
Total Intra- 101.9 93.1 94.8 119.6 114.1 58.5
BRICS

Source: DOC

Note: Data for 2019-20 is from April to September, 2019.

Table 3: Percentage Share of India’s Intra-BRICS Trade to Global trade

Country 2014-2015 2015-2016 2016-2017 2017-2018 2018-2019 2019-20
Brazil 1.5 1.04 0.99 1.11 0.97 0.9
China 9.54 10.99 10.82 11.66 10.31 11.0
Russia 0.84 0.96 1.13 1.39 0.97 1.2
South
1.56 1.48 1.42 1.39 1.25 1.3
Africa
India's
Intra- 13.44 14.47 14.36 15.55 13.5 14.4
BRICS

Source: DOC

Note: Data for 2019-20 is from April to September, 2019.

Summary:

Countries can-not be entirely self dependent and self reliant. To develop the economies and
emerge in the global system, countries form groups and become members of the different groups.
This is also instrumental to protect the nation from outside interventions and influences as the
country concerned can get support from the other countries of the group. There are a series of
factors responsible for forming groups of the countries and becoming member of a particular
group. In the contemporary emerging world system of groups, the major group combinations
include; SAARC, SAFTA, BIMSTEC, ASEAN, EU or European Economic Community,
GCCBRICS etc.

Self Test Questions

1. Discuss the India’s trade relations with SAARC

2. Discuss the India’s trade relations with SAFTA
3. Discuss the India’s trade relations withSouth Asian Neighbors
4. Discuss the India’s trade relations with BIMSTEC
5. Discuss the India’s trade relations with ASEAN
6. Discuss the India’s trade relations with EU
7. Discuss the India’s trade relations with GCC
8. Discuss the India’s trade relations with BRICS
 CHAPTER- X

FOREIGN EXCHANGE MARKET

PURPOSE AND STRUCTURE

The foreign exchange market or the forex market, is the largest and most liquid financial market
in the world. It is where different currencies are bought and sold, with the exchange rate
determining the value of each currency relative to another. The forex market plays a critical role
in facilitating international trade and investment, as well as providing opportunities for
individuals and institutions to profit from fluctuations in currency values. The purpose is to
provide necessary academic inputs related with the foreign exchange markets to the readers so
that they get acquainted with the concepts of it. After reading this chapter, the readers will be
able to know about the following:

10.1 The Concept of Foreign Exchange Market

10.2 How does Foreign Exchange Market work?
10.3 Different Types of Foreign Exchange Markets

10.4 Advantages and Disadvantages of Foreign Exchange Markets

10.5 Features of the Foreign Exchange Market
10.6 Participants in a Foreign Exchange Market

10.7 Factors Influencing the Foreign Exchange Market

10.8 Real Effective Exchange Rate (REER)

10.9 Effect of Foreign Exchange Market on the Economy

10.10 What Causes Exchange Rates to Fall?

10.1 The Concept of Foreign Exchange Market

Foreign exchange trading has a long history, with evidence of currency trading dating back to
ancient civilizations. However, modern forex trading as we know it today began in the 1970s
when the Bretton Woods system of fixed exchange rates collapsed, leading to the adoption of
floating exchange rates. The emergence of electronic trading platforms and the internet in the
1990s transformed the forex market, making it more accessible and providing greater
opportunities for individual traders. Today, the forex market is the largest financial market in the
world, with trillions of dollars traded daily.
The Foreign Exchange Market is a global decentralized marketplace where currencies are bought
and sold. It is the largest and most liquid financial market in the world, with trading volumes
exceeding $6 trillion per day. The forex market facilitates international trade and investment by
enabling businesses to convert one currency into another. The forex market operates 24 hours a
day, 5 days a week, with trading taking place in major financial centers around the world. The
market is driven by various factors, including economic data, geopolitical events, and central
bank policies. The exchange rate, which is the value of one currency relative to another, is
determined by supply and demand forces in the market.

Foreign exchange market (forex, or FX, market) is the institution for the exchange of one
country's currency with that of another country. Foreign exchange markets are actually made up
of many different markets, because the trade between individual currencies—say, the euro and
the U.S. dollar—each constitutes a market. The forex market operates 24 hours a day, 5 days a
week, with trading volumes exceeding $6 trillion per day. It is a highly decentralized market,
with no single entity controlling the exchange rates or setting the prices of currencies.
10.2 How does Foreign Exchange Market work?
The foreign exchange market works by facilitating the exchange of one currency for another.
Market participants buy and sell currencies to facilitate international trade and investment and
speculate on currency price movements. The exchange rate, which is the value of one currency
relative to another, is determined by supply and demand forces in the market. Currency values
are influenced by a variety of factors, including economic indicators, geopolitical events, and
central bank policies. Transactions in the forex market can take place over the counter or through
electronic trading platforms, and the market operates 24 hours a day, 5 days a week, across major
financial centers around the world.

10.3 Different Types of Foreign Exchange Markets

The different types of foreign exchange transactions are explained as below:

Types of Foreign Exchange Transactions

1. Spot Transaction: The spot transaction is when the buyer and seller of different currencies settle
their payments within the two days of the deal. It is the fastest way to exchange the currencies.
Here, the currencies are exchanged over a two-day period, which means no contract is signed
between the countries. The exchange rate at which the currencies are exchanged is called
the Spot Exchange Rate. This rate is often the prevailing exchange rate. The market in which the
spot sale and purchase of currencies is facilitated is called as a Spot Market.
2. Forward Transaction: A forward transaction is a future transaction where the buyer and seller
enter into an agreement of sale and purchase of currency after 90 days of the deal at a fixed
exchange rate on a definite date in the future. The rate at which the currency is exchanged is
called a Forward Exchange Rate. The market in which the deals for the sale and purchase of
currency at some future date is made is called a Forward Market.
3. Future Transaction: The future transactions are also the forward transactions and deals with the
contracts in the same manner as that of normal forward transactions. But however, the
transactions made in a future contract differs from the transaction made in the forward contract
on the following grounds:

 The forward contracts can be customized on the client’s request, while the future contracts
are standardized such as the features, date, and the size of the contracts is standardized.
 The future contracts can only be traded on the organized exchanges, while the forward contracts
can be traded anywhere depending on the client’s convenience.
 No margin is required in case of the forward contracts, while the margins are required of all the
participants and an initial margin is kept as collateral so as to establish the future position.

4. Swap Transactions: The Swap Transactions involve a simultaneous borrowing and

lending of two different currencies between two investors. Here one investor borrows the
currency and lends another currency to the second investor. The obligation to repay the
 currencies is used as collateral, and the amount is repaid at a forward rate. The swap
contracts allow the investors to utilize the funds in the currency held by him/her to pay
off the obligations denominated in a different currency without suffering a foreign
exchange risk.
5. Option Transactions: The foreign exchange option gives an investor the right, but not the
obligation to exchange the currency in one denomination to another at an agreed exchange rate
on a pre-defined date. An option to buy the currency is called as a Call Option, while the option
to sell the currency is called as a Put Option.
Thus, the Foreign exchange transaction involves the conversion of a currency of one country into
the currency of another country for the settlement of payments.

10.4 Advantages and Disadvantages of Foreign Exchange Markets

The foreign exchange market has several advantages and disadvantages. Understanding these can
help traders make informed decisions about their participation in the market.
a) Advantages of Foreign Exchange Markets
● High liquidity: The forex market is the largest and most liquid market in the world, making it
easy to buy and sell currencies quickly.
● Accessibility: The forex market is open 24 hours a day, 5 days a week, and can be accessed
by anyone with an internet connection.
● Diverse trading options: Traders can choose from a wide range of currency pairs and trading
strategies, providing ample opportunities for profit.
● Low transaction costs: The cost of trading in the forex market is relatively low compared to
other financial markets.
● Leverage: Forex trading allows traders to use leverage to increase their trading position,
potentially amplifying profits.
● Global market: The forex market is a global market, making it a valuable tool for
international businesses to manage their currency risk.
● Transparency: The forex market is highly transparent, with real-time price data available to
all market participants.

b) Disadvantages of Foreign Exchange Markets

● Volatility: The forex market is highly volatile and can experience sudden and significant
price movements, which can lead to large losses for traders.
● Risk of leverage: While leverage can increase potential profits, it can also magnify losses
and lead to significant financial risk.
● High competition: The forex market is highly competitive, and traders must compete with
other market participants, including large financial institutions.
● Limited regulation: The forex market is not as regulated as other financial markets, which
can lead to fraudulent activities and scams.
● Complex market: The forex market can be complex, and traders must have a good
understanding of the market and its various factors that affect currency values.
● Economic and political events: The forex market is highly influenced by economic and
political events, which can cause significant volatility and unpredictability.
● High barriers to entry: Trading in the forex market requires a significant amount of
knowledge, experience, and capital, making it difficult for inexperienced traders to participate.
10.5 Features of the Foreign Exchange Market
The foreign exchange market has several key features that set it apart from other financial
markets.
 It is a decentralized market that operates 24 hours a day, 5 days a week, across
multiple time zones.
 It is the largest and most liquid market in the world, with high trading volumes
and low transaction costs.
 The market is influenced by a variety of factors, including economic indicators,
geopolitical events, and central bank policies.
 The market provides opportunities for traders to speculate on the movement of
currency values through a range of trading strategies.
 The market is accessible to a wide range of participants, including individuals,
financial institutions, and governments.
10.6 Participants in a Foreign Exchange Market
There are a wide range of participants in the foreign exchange market, including:
● Commercial banks: Banks are the most active participants in the forex market, trading on
behalf of their clients and for their own accounts.
● Central banks: Central banks participate in the market to manage their country's monetary
policy and stabilize currency values.
● Hedge funds and investment firms: These institutions trade in the forex market to generate
returns for their clients.
● Corporations: Multinational corporations use the forex market to manage their currency risk,
particularly when conducting international trade.
● Retail traders: Individual traders can participate in the forex market through online brokers,
seeking to profit from currency price movements.
● Governments: Governments participate in the forex market to manage their currency values
and maintain their country's economic stability.

10.7 Factors Influencing the Foreign Exchange Market

Several factors influence the foreign exchange market, including:

1. Economic indicators: Economic indicators such as inflation, GDP, and employment data can
influence currency values, as they affect a country's economic outlook.
2. Central bank policies: The monetary policies of central banks, including interest rates and
quantitative easing measures, can influence currency values.
3. Geopolitical events: Political events such as elections, wars, and trade agreements can cause
significant currency volatility.
4. Market sentiment: Market sentiment, including investor confidence and risk appetite, can
influence currency values.
5. Natural disasters: Natural disasters can disrupt economic activity and cause currency values
to fluctuate.
6. Speculation: Speculative trading activity can also influence currency values, as traders buy
or sell currencies based on their expectations of future price movements.
10.8 Real Effective Exchange Rate (REER)
The Real Effective Exchange Rate (REER) is a measure of a country's currency value relative to
a basket of other currencies, adjusted for inflation. It takes into account the relative prices of
goods and services between countries and provides a more comprehensive view of a country's
currency value than the nominal exchange rate.
The REER is calculated by adjusting the nominal exchange rate using the country's inflation rate
and the inflation rates of its trading partners. A high REER indicates that a country's currency is
overvalued, while a low REER indicates that it is undervalued.

10.9 Effect of Foreign Exchange Market on the Economy

The foreign exchange market plays a crucial role in the global economy, affecting countries in
several ways:
1. International trade: Changes in currency values can affect a country's balance of trade, as
exports become more expensive when a country's currency appreciates.
2. Capital flows: The forex market facilitates capital flows between countries, allowing
businesses and investors to invest in foreign markets.
3. Monetary policy: The forex market can influence a country's monetary policy, as central
banks may adjust interest rates or intervene in the market to maintain currency stability.
4. Economic growth: A stable currency and exchange rate can support economic growth, while
currency volatility can harm business and consumer confidence, potentially leading to economic
slowdowns.

10.10 What Causes Exchange Rates to Fall?

There are several factors that can cause exchange rates to fall:
● Decreased demand: If demand for a country's currency decreases relative to other currencies,
its exchange rate may fall.
● Economic factors: Economic indicators such as low inflation or slowing economic growth
can lead to a fall in a country's exchange rate.
● Political instability: Political instability, such as political protests or leadership changes, can
cause a country's exchange rate to fall.
● Central bank policies: If a country's central bank reduces interest rates or engages in
quantitative easing, its currency may weaken.
● Trade imbalances: Persistent trade deficits can cause a country's currency to depreciate as
demand for its currency weakens.

Summary
The Foreign Exchange Market is a global decentralized marketplace where currencies are bought
and sold. It is the largest and most liquid financial market in the world, with trading volumes
exceeding $6 trillion per day. The forex market facilitates international trade and investment by
enabling businesses to convert one currency into another. The forex market operates 24 hours a
day, 5 days a week, with trading taking place in major financial centers around the world. The
market is driven by various factors, including economic data, geopolitical events, and central
bank policies. The exchange rate, which is the value of one currency relative to another, is
determined by supply and demand forces in the market.

Foreign exchange market (forex, or FX, market) is the institution for the exchange of one
country's currency with that of another country. Foreign exchange markets are actually made up
of many different markets, because the trade between individual currencies—say, the euro and
the U.S. dollar—each constitutes a market. The forex market operates 24 hours a day, 5 days a
week, with trading volumes exceeding $6 trillion per day. It is a highly decentralized market,
with no single entity controlling the exchange rates or setting the prices of currencies. The
foreign exchange market works by facilitating the exchange of one currency for another. Market
participants buy and sell currencies to facilitate international trade and investment and speculate
on currency price movements. The exchange rate, which is the value of one currency relative to
another, is determined by supply and demand forces in the market. Currency values are
influenced by a variety of factors, including economic indicators, geopolitical events, and central
bank policies.
Self Test Questions:
1. What do you understand by Foreign Exchange Market? How does it work? Discuss the
different types of Foreign Exchange Markets.
2. What are the advantages and disadvantages of Foreign Exchange Market? Explain.
3. Who can be the participants of Foreign Exchange Market? State the features of Foreign
Exchange Market.
4. What factors influence the Foreign Exchange Market? Explain.
5. Briefly discuss the Real Effective Exchange Rate.
6. What are the effects of Foreign Exchange Markets on the economy? Explain.
7. What causes Exchange Rates to fall? Explain.
 CHAPTER- XI
SYSTEM OF EXCHANGE RATE CONTROL

PURPOSE AND STRUCTURE

In the system, residents must sell any foreign currency they acquire to the designated exchange-
control authority (often the central bank or a specific government agency) at the rates specified
by the authority. Some systems allow those who get exchanges from particular sources to sell a
portion of those receipts on a free market. As the only foreign exchange market, the regulatory
authority can set the permitted uses for foreign exchange and the resources and capacities one
can use for each. Exchange controls are government-imposed limitations on the purchase and/or
sale of currencies. These controls allow countries to better stabilize their economies by limiting
in-flows and out-flows of currency, which can create exchange rate volatility. The purpose is to
provide necessary academic input to the readers to make them aware about the system of
exchange rate and exchange control. After reading this chapter, the readers will be able to
understand the following concepts:

11.1 The Concept of Exchange Control

11.2 Understanding Exchange Controls
11.3 Measures of Exchange Controls
11.4 Regulations for Exchange Control
11.5 Objectives of Regulated Exchange Rate Control
11.6 Methods of Exchange Control
11.7 Advantages & Disadvantages of Exchange Control

11.1 The Concept of Exchange Control

Exchange controls are government-imposed limitations on the purchase and/or sale of

currencies. These controls allow countries to better stabilize their economies by limiting in-flows
and out-flows of currency, which can create exchange rate volatility. Not every nation may
employ the measures, at least legitimately; the 14th article of the International Monetary Fund's
Articles of Agreement allows only countries with so-called transitional economies to employ
exchange controls.

Controls in exchanges are essential to managing shortages of freely convertible foreign currency.
Through these measures, governments hope to correct negative balances of payments. The
government achieves it by imposing restrictions on the free flow of capital in and out of the
country and on currency exchange rates. Exchange control refers to actions directly regulating or
affecting the influx and outflow of capital across national borders. These regulate exchanges and
limit the buying and selling of foreign money. It is used to allocate available foreign currency to
suit the country’s interests as a whole and to control local demand for foreign currency to
safeguard the nation’s foreign exchange reserves. It is made for preserving capital, protecting
domestic industries, and maintaining the rate of exchange and balance of payments. Exchange
control is a governmental restriction on private transactions in foreign exchange. These systems
serve as a primary means of preventing or redressing an unfavorable payment residue by
minimizing foreign exchange purchases to an amount that is not more than foreign exchange
receipts.

11.2 Understanding Exchange Controls

Many western European countries implemented exchange controls in the years immediately
following World War II. The measures were gradually phased out, however, as the post-war
economies on the continent steadily strengthened; the United Kingdom, for example, removed
the last of its restrictions in October 1979. Countries with weak and/or developing economies
generally use foreign exchange controls to limit speculation against their currencies. They often
simultaneously introduce capital controls, which limit the amount of foreign investment in the
country.

Countries with weak or developing economies may put controls on how much local currency can
be exchanged or exported—or ban a foreign currency altogether—to prevent speculation.
Exchange controls can be enforced in a few common ways. A government may ban the use of a
particular foreign currency and prohibit locals from possessing it. Alternatively, they can impose
fixed exchange rates to discourage speculation, restrict any or all foreign exchange to a
government-approved exchanger, or limit the amount of currency that can be imported to or
exported from the country.

11.3 Measures of Exchange Controls

One tactic companies use to work around currency controls, and to hedge currency exposures, is
to use what are known as forward contracts. With these arrangements, the hedger arranges to buy
or sell a given amount of an un-tradable currency on a given forward date, at an agreed rate
against a major currency. At maturity, the gain or loss is settled in the major currency because
settling in the other currency is prohibited by controls.
The exchange controls in many developing nations do not permit forward contracts, or allow
them only to be used by residents for limited purposes, such as to buy essential imports.
Consequently, in countries with exchange controls, non-deliverable forwards are usually
executed offshore because local currency regulations cannot be enforced outside of the country.
Countries, where active offshore NDF markets have operated, include China, the Philippines,
South Korea, and Argentina.

11.4 Regulations for Exchange Control

Exchange control refers to actions directly regulating or affecting the influx and outflow of
capital across national borders. These control regulations on exchanges restrict the buying and
selling of foreign money. Most exchange control systems serve as a primary means of preventing
or redressing an unfavorable balance of payments.
Countries use these capital restrictions to try to control the exchange rates of their native
currencies on global markets. The limitations may restrict residents’ ability to purchase foreign
currencies and nonresidents’ ability to buy or sell local money.
The link between capital and exchange control and trade is the key to the smooth functioning of
the international economic and financial system. They represent a noticeable barrier to trade.
However, their impact on international trade depends upon the controls’ structure, interactions,
and effectiveness concerning other economic distortions.
Controlling exchange is a tax on foreign currency necessary to purchase goods and services.
These controls raise the domestic price of imports. And the price rise hurts the trade. It also
influences trade through a variety of channels. These include the cost of transactions, exchange
rates, foreign exchange risk hedging, and financing trade.
In the system, residents must sell any foreign currency they acquire to the designated exchange-
control authority (often the central bank or a specific government agency) at the rates specified
by the authority. Some systems allow those who get exchanges from particular sources to sell a
portion of those receipts on a free market. As the only foreign exchange market, the regulatory
authority can set the permitted uses for foreign exchange and the resources and capacities one
can use for each.
A regulated exchange rate is typically higher than a free-market rate and has the effect of
reducing exports and boosting imports. The authority that monitors the measures can prevent a
drop in its overall gold reserves and payment balances by limiting the number of foreign
exchange residents can purchase. A country’s Specific exchange control authority decides the
limits of control.
11.5 Objectives of Regulated Exchange Rate Control
Some of the main objectives of foreign exchange control measures are as follows:
 o Balance of Payments (BOP)
Negative balances of payments can pull down the economic growth of a nation. Depending on
the circumstances, countries may restrict or remove import restrictions. Specific exchange
control authority may also devalue its currencies to increase exports and bring about a steady
BOP by the exchange control act or other regulations.
o Protection of domestic industries
Curbs on the exchange can induce domestic industries to produce and export more, and
governments can thus protect domestic trade from international competition.
o Rate of exchange
The government resorts to exchange control regulations to bring the exchange rate to the desired
level. The countries can sell their currency from the separate account maintained for the same
purpose, such as the exchange equalization fund, in the open market to reduce the currency rate.
Thus, by increasing or decreasing supply, governments can overvalue or undervalue their
currency depending on the situation.
o Preserve capital
Governments impose exchange control regulations to prevent capital from flowing out of the
country and may limit exports. These regulations can also help the government earn revenue
through the difference in buying and selling rates, stabilize the exchange rate, and even pay off
foreign liabilities. In addition, control measures aim to promote exchange stability by reducing
exchange rates and volatility caused by currency transfers across borders.
Applying foreign exchange regulations can frequently obstruct international investors who want
to transfer their money to other nations. In an ideal scenario, these measures would be helpful to
stop the capital flight from a nation with a weaker currency. However, a country’s exchange
control act or other regulations make decisions on the above matters, which in turn decide the
degree of impact.
11.6 Methods of Exchange Control
Some of the standard foreign exchange control measures are:
a) Exchange pegging
Exchange pegging, or a mild exchange control system, is the government’s attempt to maintain a
rate of exchange at desired levels. Governments maintain exchange equalization funds in foreign
currencies. The U.S. exchange stabilization fund is one such example.
b) Full-Fledged System of Exchange Control
The government controls the exchange rate and all foreign exchange transactions in this system.
The control authority receives all export and other transaction receipts. In this sense, the
government is the only foreign exchange dealer.
c) Compensating Arrangement
This concept works similarly to a barter system where one country exchanges goods or services
on mutual understanding, agreeing on a particular exchange rate.
d) Clearing Agreement
A clearing agreement is between two or more nations to exchange products and services at
predetermined exchange rates for payments. The payment is made exclusively in the purchasers’
home currencies. The central banks satisfy the remaining unpaid claims at the end of the
predetermined periods. It does this through transfers of gold, an approved third currency, or any
other means.
e) Payments Arrangements
The payment arrangement maintains the conventional method of sending money overseas
through the currency market. In addition, each nation consents to set up a system of control
wherein its population is compelled to buy products and services from other nations. This should
be in quantities equal to what that other nation paid to the first nation for those goods and
services.
Example
One of the historical examples related to foreign exchange control can be seen when Britain
abolished controls on foreign currency back in the 1980s. In 1979, Britain could buy and use the
foreign currency without restriction. The regulations were placed in 1939, in the wake of World
War II, to prevent a panic outflow of capital. The changing times and the strength of the sterling
as a strong currency were the primary reasons for regulation rollback.
11.7 Advantages & Disadvantages of Exchange Control
Control measures prevent volatile foreign exchange markets and sudden rate swings. They
prevent capital outflows. Exchange control is used to allocate available foreign currency to suit
the country’s interests and control local demand for foreign currency to safeguard the
nation’s foreign exchange reserves. However, one major drawback of these restrictions is that
they create black markets for foreign currencies. In addition, they can also hurt international
trade in the long term, negatively impacting investments.
The advantages and disadvantages of the fixed and floating exchange rates are further discussed
as under:

1. Advantages and disadvantages of fixed exchange rates

Advantages of fixed exchange rates

 Certainty - with a fixed exchange rate, firms will always know the exchange rate and this
makes trade and investment less risky.
 Absence of speculation - with a fixed exchange rate, there will be no speculation if
people believe that the rate will stay fixed with no revaluation or devaluation.
 Constraint on government policy - if the exchange rate is fixed, then the government may
be unable to pursue extreme or irresponsible macro-economic policies as these would
cause a run on the foreign exchange reserves and this would be unsustainable in the
medium-term.

Disadvantages of fixed exchange rates

 The economy may be unable to respond to shocks - a fixed exchange rate means that
there may be no mechanism for the government to respond rapidly to balance of
payments crises.
 Problems with reserves - fixed exchange rate systems require large foreign exchange
reserves and there can be international liquidity problems as a result.
 Speculation - if foreign exchange markets believe that there may be a revaluation or
devaluation, then there may be a run of speculation. Fighting this may cost the
government significantly in terms of their foreign exchange reserves.
 Deflation - if countries with balance of payments deficits deflate their economies to try to
correct the deficits, this will reduce the surpluses of other countries as well as deflating
their own economies to restore their surpluses. This may give the system a deflationary
bias.
 Policy conflicts - the fixed exchange rate may not be compatible with other economic
targets for growth, inflation and unemployment and this may cause conflicts of policies.
This is especially true if the exchange rate is fixed at a level that is either too high or too
low.

2. Advantages and disadvantages of floating exchange rates

Advantages of floating exchange rates

 Protection from external shocks - if the exchange rate is free to float, then it can change
in response to external shocks like oil price rises. This should reduce the negative impact
of any external shocks.
 Lack of policy constraints - the government are free with a floating exchange rate system
to pursue the policies they feel are appropriate for the domestic economy without
worrying about them conflicting with their external policy.
 Correction of balance of payments deficits - a floating exchange rate can depreciate to
compensate for a balance of payments deficit. This will help restore the competitiveness
of exports. There is a link to Figure 1 below which illustrates the operation of the
automatic adjustment mechanism under a floating exchange rate system.

Disadvantages of floating exchange rates

 Instability - floating exchange rates can be prone to large fluctuations in value and this
can cause uncertainty for firms. Investment and trade may be adversely affected.
 No constraints on domestic policy - governments may be free to pursue inappropriate
domestic policies (e.g. excessively expansionary policies) as the exchange rate will not
act as a constraint.
 Speculation - the existence of speculation can lead to exchange rate changes that are
unrelated to the underlying pattern of trade. This will also cause instability and
uncertainty for firms and consumers.

Summary
Controls in exchanges are essential to managing shortages of freely convertible foreign currency.
Through these measures, governments hope to correct negative balances of payments. The
government achieves it by imposing restrictions on the free flow of capital in and out of the
country and on currency exchange rates. Exchange control refers to actions directly regulating or
affecting the influx and outflow of capital across national borders. These regulate exchanges and
limit the buying and selling of foreign money. It is used to allocate available foreign currency to
suit the country’s interests as a whole and to control local demand for foreign currency to
safeguard the nation’s foreign exchange reserves. It is made for preserving capital, protecting
domestic industries, and maintaining the rate of exchange and balance of payments. Exchange
control is a governmental restriction on private transactions in foreign exchange. These systems
serve as a primary means of preventing or redressing an unfavorable payment residue by
minimizing foreign exchange purchases to an amount that is not more than foreign exchange
receipts.
Many western European countries implemented exchange controls in the years immediately
following World War II. The measures were gradually phased out, however, as the post-war
economies on the continent steadily strengthened; the United Kingdom, for example, removed
the last of its restrictions in October 1979. Countries with weak and/or developing economies
generally use foreign exchange controls to limit speculation against their currencies. They often
simultaneously introduce capital controls, which limit the amount of foreign investment in the
country.

Countries with weak or developing economies may put controls on how much local currency can
be exchanged or exported—or ban a foreign currency altogether—to prevent speculation.
Exchange controls can be enforced in a few common ways. A government may ban the use of a
particular foreign currency and prohibit locals from possessing it. Alternatively, they can impose
fixed exchange rates to discourage speculation, restrict any or all foreign exchange to a
government-approved exchanger, or limit the amount of currency that can be imported to or
exported from the country.
Self Test Questions
1. Discuss the concept of Exchange Rate Control with the measures of exchange controls.
2. Discuss the regulations and objectives of regulated exchange rate control.
3. What are the methods of exchange control? Discuss.
4. What are the advantages and disadvantages of exchange control? Discuss.
 CHAPTER-XII

DEVALUATION CONCEPT AND DEVALUATION OF INDIAN RUPEE

PURPOSE AND STRUCTURE

Countries do devaluation to boost exports, shrink trade deficits, and reduce sovereign debt
burdens. Here attempt has been made to let the reader know about the following concepts related
with devaluation with special reference to India:

12.1 Meaning of Devaluation

12.2 Significance of Devaluation

12.3 Devaluing of Currency

12.4 Reasons for Devaluation of Currency

12.5 What Would Happen if the U.S. Devalued the Dollar?

12.6 What Is U.S. Money Backed by?

12.7 Rupee Devaluation in India

12.8 Objectives of Rupee Devaluation
12.9 History of Rupee
12.10 Causes of Rupee devaluation
12.11 Effect of Devaluation on Economy

12.1 Meaning of Devaluation:

Devaluation is the deliberate downward adjustment of the value of a country's money relative to
another currency or standard. It is a monetary policy tool used by countries with a fixed
exchange rate or semi-fixed exchange rate.

12.2 Significance of Devaluation

Currency devaluation is an economic policy by a country's government to weaken the value of its
currency. Ever since world currencies abandoned the gold standard and allowed their exchange
rates to float freely against each other, there have been many currency devaluation events that
have hurt not only the citizens of the country involved but have also rippled across the globe.

If the fallout can be so widespread, why do countries devalue their currency? In short, countries
do it to boost exports, shrink trade deficits, and reduce sovereign debt burdens. Below we take a
closer look at currency devaluation and the reasons why countries do it.
  Currency devaluation involves taking measures to strategically lower the purchasing
power of a nation's own currency.
 Countries may pursue such a strategy to gain a competitive edge in global trade and
reduce sovereign debt burdens.
 Devaluation, however, can have unintended consequences that are self-defeating.

12.3 Devaluing of Currency

It may seem counter-intuitive, but a strong currency is not necessarily in a nation's best interests.
A weak domestic currency makes a nation's exports more competitive in global markets and
simultaneously makes imports more expensive. Higher export volumes spur economic growth,
while pricey imports also have a similar effect because consumers opt for local alternatives to
imported products. This improvement in the terms of trade generally translates into a
lower current account deficit (or a greater current account surplus), higher employment, and
faster GDP growth.

The stimulative monetary policies that usually result in a weak currency also have a positive
impact on the nation's capital and housing markets, which in turn boosts domestic consumption
through the wealth effect. The United States went off the gold standard in 1933. In 1971, the
U.S. stopped converting dollars to gold at a fixed value. It is worth noting that a strategic
currency devaluation does not always work, and moreover may lead to a 'currency war' between
nations. Competitive devaluation is a specific scenario in which one nation matches an abrupt
national currency devaluation with another currency devaluation. In other words, one nation is
matched by a currency devaluation of another. This occurs more frequently when both currencies
have managed exchange-rate regimes rather than market-determined floating exchange rates.
Even if a currency war does not break out, a country should be wary of the negatives of currency
devaluation.

Currency devaluation may lower productivity, since imports of capital equipment and machinery
may become too expensive. Devaluation also significantly reduces the overseas purchasing
power of a nation’s citizens.

12.4 Reasons for Devaluation of Currency:

Below, we look at the three top reasons why a country would pursue a policy of devaluation:

1. To Boost Exports

On a world market, goods from one country must compete with those from all other countries.
Car makers in America must compete with car makers in Europe and Japan. If the value of the
euro decreases against the dollar, the price of the cars sold by European manufacturers in
America, in dollars, will be effectively less expensive than they were before. On the other hand,
a more valuable currency makes exports relatively more expensive for purchase in foreign
markets. In other words, exporters become more competitive in a global market. Exports are
encouraged while imports are discouraged. There should be some caution, however, for two
reasons. First, as the demand for a country's exported goods increases worldwide, the price will
begin to rise, normalizing the initial effect of the devaluation.

The second is that as other countries see this effect at work, they will be incentivized to devalue
their own currencies in kind in a so-called "race to the bottom." This can lead to tit-for-tat
currency wars and lead to unchecked inflation.

2. To Shrink Trade Deficits

Exports will increase and imports will decrease due to exports becoming cheaper and imports
more expensive. This favors an improved balance of payments as exports increase and imports
decrease, shrinking trade deficits. Persistent deficits are not uncommon today, with the United
States and many other nations running persistent imbalances year after year.

Economic theory, however, states that ongoing deficits are unsustainable in the long run and can
lead to dangerous levels of debt which can cripple an economy. Devaluing the home currency
can help correct the balance of payments and reduce these deficits.

There is a potential downside to this rationale, however. Devaluation also increases the debt
burden of foreign-denominated loans when priced in the home currency. This is a big problem
for a developing country like India or Argentina which hold lots of dollar- and euro-denominated
debt. These foreign debts become more difficult to service, reducing confidence among the
people in their domestic currency.

3. To Reduce Sovereign Debt Burdens

A government may be incentivized to encourage a weak currency policy if it has a lot of

government-issued sovereign debt to service on a regular basis. If debt payments are fixed, a
weaker currency makes these payments effectively less expensive over time.

Take for example a government that has to pay $1 million each month in interest payments on its
outstanding debts. But if that same $1 million of notional payments becomes less valuable, it will
be easier to cover that interest. In our example, if the domestic currency is devalued to half of its
initial value, the $1 million debt payment will only be worth $500,000 now.

Again, this tactic should be used with caution. As most countries around the globe have some
debt outstanding in one form or another, a race-to-the-bottom currency war could be initiated.
This tactic will also fail if the country in question holds a large number of foreign bonds since it
will make those interest payments relatively more costly.

Why Would a Country Want to Devalue Its Currency?

There are a few reasons why a country may want to devalue its currency. Devaluing a currency is
usually an economic policy, whereby devaluation makes a currency weaker compared to other
currencies, which would boost exports, close the gap on trade deficits, and shrink the cost of
interest payments on government debt.

12.5 What Would Happen if the U.S. Devalued the Dollar?

If the U.S. devalued the dollar, the cost of imports would increase because foreign firms would
no longer want to do business in dollars, the government would not be able to borrow at the
current rates, which would mean that it would have to raise taxes or print money to cover its
deficit, and inflation would rise significantly because of the higher cost of imports and the
printing of money. Overall, the economy would severely be hit negatively.

12.6 What Is U.S. Money Backed by?

The U.S. dollar is not backed by any physical asset. Like most currencies in the world today, the
value of a currency is based on the demand for that currency. Many currencies, including the
U.S. dollar., used to be backed by gold, but no longer.

The Bottom Line

Currency devaluations can be used by countries to achieve economic policy. Having a weaker
currency relative to the rest of the world can help boost exports, shrink trade deficits, and reduce
the cost of interest payments on outstanding government debts. There are, however, some
negative effects of devaluations.

They create uncertainty in global markets that can cause asset markets to fall or spur recessions.
Countries might be tempted to enter a tit-for-tat currency war, devaluing their own currency back
and forth in a race to the bottom. This can be a very dangerous and vicious cycle leading to much
more harm than good.

Devaluing a currency, however, does not always lead to its intended benefits. Brazil is a case in
point. The Brazilian real has plunged substantially since 2011, but the steep currency devaluation
has been unable to offset other problems such as plunging crude oil and commodity prices and a
widening corruption scandal. As a result, the Brazilian economy has experienced sluggish
growth
12.7 Rupee Devaluation in India

Devaluation of Rupee refers to the fall in the value of rupee in terms of foreign currency.
Specifically, it implies deliberate official lowering of the value of the country's currency with
respect to the foreign currency. Devalutaion prevails under the fixed exchange rate regime.

Devaluation means reduction in the value of currency with respect to goods, services or other
monetary units with which that currency can be changed. For example suppose the exchange rate
between rupee and dollar is Rs 50 = 1$. If this exchange rate is fixed Rs 55 = 1$then it is called
the devaluation of rupee. This is a monetary policy tool used by countries that have a fixed
exchange rate or semi fixed exchange rate. A country may devaluate its currency is to combat
trade balances. It means the exports are less expensive and more competitive in the global market
and the imports are more expensive so that the people use the domestic products.
Devaluation is a term which is different from depreciation because the value of rupee is
decreased by change in the demand and supply of currency. But devaluation is done by
government to improve the balance of payment.

12.8 Objectives of Rupee Devaluation

• Devaluation is done for correcting the balance of payment.

• For increasing the exports, devaluation is done.
• For decreasing imports, devaluation is done.
12.9 History of Rupee

India got freedom from British rule on August 15, 1947. At that time the Indian rupee was linked
to the British pound and its value was at par with the American dollar. As shown in table, in year
1947 the value of rupee is equal the dollar. But slowly, due to many reasons the value of rupee is
decreased.

Historical Indian Rupee Rate

 Year Exchange Rate
(INR vs. US $)
1947 1.00
1948 4.79
1965 4.79
1966 7.57
1971 8.39
1985 12.0
1991 17.9
1993 31.7
2000 45.0
2013 60.0
2016 67.63

1966 Financial Crises

Since 1950s India suffered in negative balance of payment. The main reasons of devaluation are
huge trade deficit, India – Pakistan war and draught in 1965. So for improving the trade deficit,
India devaluate its currency at first time in 1966. And this devaluation is done by Lal Bahadur
Shastri in June 1966.

1991 Financial Crises

Since 1985 – 1990, India found itself in a serious economic trouble. In 1991 India faced large
government budget deficit. For decreasing the budget deficit, government devalued its currency
by 18 to 19%. The main reasons of devaluation are huge gross fiscal deficit, inflation and rise in
oil prices etc.

12.10 Causes of Rupee devaluation

• High fiscal deficit – High fiscal deficit is regarded as the main reason of devaluation of
currency. Fiscal deficit is the difference between government income and expenditure. In case of
high fiscal deficit government may use foreign reserve to finance the deficit. Due to this, the
reserves are reduced. And this problem encourages the government to devalue its currency.
Budget Deficit as Percentage of Total Government Expenditure
Year Overall Primary Interest
Deficit Deficit Payments
1960 21.05 12.37 8.68
1965-1970 25.75 16.46 9.29
1970-1975 23.14 14.17 8.97
1975-1980 22.62 14.07 8.55
1980-1985 30.23 20.34 9.89
 1985 32.13 20.57 11.56
1986 35.06 23.21 11.85
1987 33.49 20.34 13.15
1988 32.58 17.96 14.62
Source: Foundations of India’s Political Economy, pp. 192
• Current account deficit – It is the difference between the import and export in a country. This
gap between income and expenditure keeps a downward pressure on the value of rupee. In the
year 1990, the current account deficit is US $9.7 billion. The wider CAD creates demand for
dollar which is the reason of devaluation of rupee.
• Inflation 1980 – Inflation means continuously rise in prices. From 1966 to 1980, the value of
rupee is constant. But after this, the value of money is decreased. And it decreases the purchasing
power of money. Due to this there is a decline in demand of the goods and this is cause of
devaluation of currency.
Inflation in India
Year Inflation
1988 9.4%
1989 6.2%
1990 9.0%
1991 13.9%
1992 11.8%
1993 6.4%
1994 10.2%
1995 10.2%
Source:http://oldfraser.lexi.net/publiccations/books/ecom_free/countries/ india.html
• Indo – Pak war 1965 – At the time of war US and other countries friendly with Pakistan and
withdrew foreign aid to India. Because of this reason, the value of rupee is devalued by 57% in
1966.
• Drought of 1965/1966 - In 1965 – 1966, India faces many problems due to natural calamity
draught and the prices of goods are increased because of this. So it is necessary for the
government to devalue the currency.
• Trade deficit – Since 1950s India face the problem of huge trade deficit. So India devalued its
currency in 1966. But again the balance of trade deficit is increased in 1990 was US $ 9.44
billion. Because of this deficit India again devalue its currency in 1991.
Year Exports Imports Deficit
1950 947 1025 78
1951 1106 1379 273
1952 873 1002 129
1953 813 855 42
1954 918 998 80
1955 922 1024 102
1956 977 1423 446
1957 1001 1633 632
1958 903 1424 521
1959 1008 1515 507
1960 997 1768 771
1961 1033 1718 685
1962 1069 1783 714
1963 1241 1927 686
1964 1282 2126 844
1965 1264 2194 930
1966 1153 2078 925
1967 1193 2008 815
1968 1354 1909 555
1969 1409 1567 158
1970 1524 1624 100
Source: Data of export and import are from India and International monetary management.
• Gulf war – India also face a problem because of gulf war. It leads to increase in the prices of
oil. So the imports of India are higher. For controlling this situation, devaluation is done by
government.
• Defence spending – Defense spending in 1965/1966 was 24.06% of total expenditure which is
very high. So this is another factor which affects the value of currency.
• Political and economic instability – Another main reason of devaluation of rupee is political
and economic instability. Before 1966 devaluation, in three years three persons (Nehru, Shastri,
and Indira) were the PM of India. Different PM have different strategies. So this situation
encourages the government to devalue its currency in 1966 and 1991.
• Increasing imports – In 1965 – 1966, Indian exports had increased up to 20% while the imports
had increased up to 131.3%. So for increasing exports and decreasing imports, Indian
government devalue its currency.
Volume of Trade (1950-51 to 1990-91)
Year Exports Imports
1950–51 606 608
1960-61 642 1122
1970-71 1535 1634
1980-81 6711 12549
1990-91 32553 43198
12.11 Effect of Devaluation on Economy
• Exports cheaper – A devaluation of the currency will make exports more competitive and
cheaper to foreigners.
• Imports expensive – Because of devaluation of rupee, the petrol, food and raw material will
become more expensive. This will reduce demand for imports.
• Improvement in current account – Current account deficit is the difference of exports and
imports. Because of devaluation the imports are decreasing and exports are increasing. These
situations reduce the current account deficit.
• Impact on common man – There would be a higher burden on the common man because of
devaluation of currency. For example – the prices of fuel, imported goods and fees of abroad
universities etc. Are increased and trips becomes costlier.
• Impact on infrastructure – The devaluation of rupee has negative impact on the infrastructure
sector. It increases the cost of projects by increasing the cost of raw materials like steel, cement
and price of construction equipment’s.
• Impact on agriculture – Devaluation of rupee has positive impact on agriculture. India is
world’s largest producer of wheat. So fall in the value of rupee increase the profit of Indian
wheat exporters and similarly the export of sugar, rice, cotton and edible oil etc. are increased.
• Impact on real estate – Devaluation of currency increases the cost of projects by increasing the
prices of raw material, transportation, import of construction equipment, wages and salary of
labour etc.
• Impact on foreign investors – Foreign investors bear a loss when the value of currency is
devalued.
• Impact on Economic growth – The devaluation of rupee can only increase the short term
economic growth. But it has negative impact on the long term economic growth. Because of
devaluation, there is a loss of confidence in International and domestic investors. Long term
economic growth is affected by reduction in investment.
• Impact on Inflation – Due to devaluation, the prices of goods are increased because of imports
are more expensive and exports are cheaper. So more money is pay for the same products for
which less money is paid before devaluation. So this situation increased inflation.
• Impact on Foreign Direct Investment – After the devaluation of currency the inflow of foreign
direct investment is increased. As we seen in table after the devaluation of rupee in 1991 the
inflow of FDI is increased from 409 crores to 64,193 crores.
Inflow of FDI in India: Period 1991 to 2015
Years FDI inflow in India
(Rs. In Crores)
1991-92 409
1992-93 1094
1993-94 2018
1994-95 4312
1995-96 6916
1996-97 9654
 1997-98 13,548
1998-99 1,2343
1999-00 10,311
2000-01 10,733
2001-02 18,654
2002-03 12,871
2003-04 10,064
2004-05 14,653
2005-06 24,584
2006-07 56,390
2007-08 98,642
2008-09 142,829
2009-10 123,120
2010-11 97,320
2011-12 165,146
2012-13 121,907
2013-14 147,518
2014-15 64,193
Source: Various issues of SIA Publication
Summary
This chapter helps to find out the causes and effect of devaluation of Rupee. Almost all the
countries of the world have devalued their currencies at any time with a motive of achieving
certain economic objectives. So India also devalued its currency in many times like 1966 and
1991 for achieving many objectives. The main objectives are: - Economic stabilization,
correcting the unfavorable balance of trade, to raise the national income and per capita also.
However devaluation also affects the many parties in positive and negative manner also. So the
Govt. and RBI take the step of devaluation of Rupee.

Self Test Questions

1. What do you understand by devaluation? What are its reasons?

2. What is U.S. money backed by? State what would happen if US devalues Dollar.
3. State the perspective of Rupee devaluation in India.
4. State the history of Rupee. What are the objectives of Rupee devaluation?
5. What are the causes of Rupee devaluation? Explain.
6. What are the effects of devaluation on the economy? Discuss.
 CHAPTER-XIII

TERMS OF TRADE

PURPOSE AND STRUCTURE

Economies simply see benefits in terms of advantages from balances of imports and exports or
trade value. Prices of exports and imports is another important segment. If export price of the
commodity is more than its import price, more units of the commodity can be imported at the
same price which will encourage imports and the terms of trade would indicate more imports
than exports without economic losses. Different types of TOT are needed to be looked at to get a
holistic view of a nation’s economic performance. This segment of financial management is
studied under terms of trade. The purpose is to let the readers know about terms of trade and its
related aspects. After reading this chapter, you will be able to know about the following:
13.1 Meaning of Terms of Trade
13.2 Computation of Terms of Trade
13.3 Implications of Terms of Trade
13.4 Types of Terms of Trade

13.5 Models of Terms of Trade

13.6 Limitations of Terms of Trade

13.1 Meaning of Terms of Trade

The expression terms of trade was first coined by the US American economist Frank William
Taussig in his 1927 book International Trade. However, an earlier version of the concept can be
traced back to the English economist Robert Torrens and his book The Budget: On Commercial
and Colonial Policy, published in 1844, as well as to John Stuart Mill's essay Of the Laws of
Interchange between Nations; and the Distribution of Gains of Commerce among the Countries
of the Commercial World, published in the same year, though allegedly already written in
1829/30.
Terms of trade (TOT) is a measure of how much imports an economy can get for a unit of
exported goods. For example, if an economy is only exporting apples and only importing
oranges, then the terms of trade are simply the price of apples divided by the price of oranges. In
other words, how many oranges can be obtained for a unit of apples. Since economies export and
import many goods, measuring the TOT requires defining price indices for exported and
imported goods and comparing the two.
A rise in the prices of exported goods in international markets would increase the TOT, while a
rise in the prices of imported goods would decrease it. For example, countries that export oil will
see an increase in their TOT when oil prices go up, while the TOT of countries that import oil
would decrease.
In simple words, the concept of TOT studies the import prices in relation to export prices to
bring to light the monetary position of a country. For instance, if a nation’s export prices are
more than its import prices, then it can purchase more imports at the same price. In this case,
TOT will tell us that for the same unit of exports, the country can purchase more imports.

Terms of Trade (TOT) is defined as the ratio of a country’s import and export prices. The
concept of terms of trade is important in economics as it throws light on the extent to which a
nation can fund its imports based on the returns of its exports.

Terms of trade reflect the ratio of a country’s export and import prices and their relative relation.

The concept throws light on a nation’s ability to fund its imports based on the returns of its
exports. For instance, if a nation’s export prices are more than its import prices, then it can
purchase more imports at the same price.

Let us understand the concept in depth with a quick example.

(all units costing 1 USD)
Country A: 1000 tons of corn, (needs 300), 800 tons of wheat ( needs 1000)
700 surplus corn – 200 deficit wheat= 500 surplus remains
Country B: 100 tons of corn, (needs 700), 300 tons of wheat (needs 100)
600 deficit corn + 200 surplus wheat = – 400 deficit.
All prices being equal in our example, we see that the nation with a surplus stock is better suited
to meet its needs. In other words, there is a positive cash flow, and more capital is produced from
exports than imports.

13.2 Computation of Terms of Trade

Now that we have a basic understanding let’s take a look at how it is calculated.
Terms of Trade Formula = (Index of Export Prices/ Index of Import Prices) x 100.
The basic formula for TOT calculations is
Basic terms of trade: (The price of exports /the price of imports) x 100.
Let us understand this with an example.
 Country A can export 700 tons of corn to Country B = $700 export price
Country A needs to import 200 tons of wheat from Country B= $200 import price
(700/200=3.5) x 100 = 350.
With prices remaining constant at $1 per unit across both countries and for both products, the
value for Country A’s terms of trade is 350/1, or 350.

13.3 Implications of Terms of Trade:

Following are the points of implications of terms of trade:

 If the value of terms of trade is less than 100%, it is considered an unfavorable situation. When
the value gets lower than 100 %, it could signify that the country is earning less money in
exports and spending more on imports. It may seem like an alarming situation as it may indicate
that the country is spending more money than it is making in exports-imports.
 A positive TOT shows the value over 100%, reflecting that the country is earning more in
exports than it is spending on imports.
 The calculations of this ratio are not very simplistic, like 1:1 as multiple export and import
figures are involved. Not to mention, the changes in the ratio could flow from many different
reasons throwing a misleading picture. Many studies have been conducted repeatedly to
understand the complex relationship between price volatility and this ratio.
 Many socio-political causes in relations to economic can bring about a change in the ratio. For
instance, import prices fall on account of over availability of the stock due to a self-sufficiency
bill passed in the parliament.
 So, while export prices remain the same, import prices drop. This can drastically push the ratio
up even though there has not necessarily been an improvement in the exports. For this reason,
different types of terms of trade are used for a holistic view of a country’s economic standing.

13.4 Types of Terms of Trade

The different types of terms of trade are discussed below:

o Net Barter
It is calculated as the percentage ratio of the export unit value indexes to the import unit value
indexes, measured relative to the base year 2000. Also, referred to as commodity terms of trade,
it was coined to better understand the overall view of the changes in a country’s trading.
o Gross Barter
It is a ratio of total physical quantities of imports to the total physical quantities of a given
country’s exports. It is measured by
TG = (QM/QX) × 100 where TG is Gross Barter TOT,
 QM is Aggregate Quantity of Imports and
 QX is the Aggregate Quantity of Exports.

A higher TG can indicate that the country can import more units from abroad for the given units
of exports. In our example from earlier, we easily see that Country A has a higher T G, relative to
Country B as it can import more units.
o Income TOT
It is the purchasing power, in terms of (described as) the price of imports, calculated as Pm, of
the value (price times quantity) of a country’s exports: ITT = PxQx/Pm.
ITT can increase through an increase in export prices, a rise in the number of exports, and a
decrease in imports’ prices. Overall, it is used as one of the measurements of the capacity to
import.
o Single Factorial TOT
It is found by multiplying the net barter with the productivity index in the domestic export sector.
This is essentially the net barter terms of trade corrected for changes in the productivity of export
goods.
o Double Factorial TOT
This expresses the change in the productivity of both the domestic export industry and the export
industries of the foreign countries selected.
It is found by TD = TC (ZX/ZM)
where

 TD is the Double Factorial TOT,

 TC is the Commodity TOT,
 ZX is the productivity index in the domestic export sector,
 ZM is the productivity index in the foreign countries’ export sector, or it is an import productivity
index.

o Real Cost TOT

It is the theory that states that an increase in export production drives resources away from other
sectors of the economy to the export sector.
For example, if farm workers are being used to produce wheat to export to other countries,
resources like the labor, extraction, processing, shipping personnel etc. are being pulled from the
production to suffice wheat production. Those workers could also theoretically be used for
community farming or processing other grains needed for domestic consumption.
 The amount of resources allocated elsewhere or “utility” cost (also described as “sacrifices”) per
unit of resources employed in the production of export goods is considered to be the real cost
terms of trade. Therefore, it accounts for the opportunity cost of exporting a good into the overall
picture of exports production.
It is calculated by Tr = Ts. Rx
Where,

 TR = Real Cost TOT

 RX = index of the amount of disutility suffered per unit of the resources utlilized in the
production of exports goods.

Also explained as when the single factorial terms of trade are multiplied by an index of the
relative average utility per unit of imported commodities.
o Utility TOT
This measures the changes in the disutility of producing a unit of exports. It also measures the
changes in the satisfactions arising imports and the indigenous products wasted to produce those
exports. It is essentially the changes in the real cost tot in terms of the utilities wasted.
It is found by multiplying the real cost terms of trade with an index of the relative average utility
of imports and domestic commodities wasted.
The terms of trade (TOT) is the relative price of exports in terms of imports and is defined as the
ratio of export prices to import prices. It can be interpreted as the amount of import goods
an economy can purchase per unit of export goods.
An improvement of a nation's terms of trade benefits that country in the sense that it can buy
more imports for any given level of exports. The terms of trade may be influenced by the
exchange rate because a rise in the value of a country's currency lowers the domestic prices of its
imports but may not directly affect the prices of the commodities it exports.

13.5 Models of Terms of Trade

There are basically two country as well as multi-country with multi-commodity models. These
are explained below:

o Two country model CIE economics

In the simplified case of two countries and two commodities, terms of trade is defined as the
ratio of the total export revenue[clarification needed] a country receives for its export commodity to the
total import revenue it pays for its import commodity. In this case, the imports of one country are
the exports of the other country. For example, if a country exports 50 dollars' worth of product in
exchange for 100 dollars' worth of imported product, that country's terms of trade are 50/100 =
0.5. The terms of trade for the other country must be the reciprocal (100/50 = 2). When this
number is falling, the country is said to have "deteriorating terms of trade". If multiplied by 100,
these calculations can be expressed as a percentage (50% and 200% respectively). If a country's
terms of trade fall from say 100% to 70% (from 1.0 to 0.7), it has experienced a 30%
deterioration in its terms of trade. When doing longitudinal (time series) calculations, it is
common to set a value for the base year[citation needed] to make interpretation of the results easier.
In basic microeconomics, the terms of trade are usually set in the interval between the
opportunity costs for the production of a given good of two nations.
Terms of trade is the ratio of a country's export price index to its import price index, multiplied
by 100. The terms of trade measures the rate of exchange of one good or service for another
when two countries trade with each other.

o Multi-commodity multi-country model

In the more realistic case of many products exchanged between many countries, terms of trade
can be calculated using a Laspeyres index. In this case, a nation's terms of trade is the ratio of the
Laspeyre price index of exports to the Laspeyre price index of imports. The Laspeyre export
index is the current value of the base period exports divided by the base period value of the base
period exports. Similarly, the Laspeyres import index is the current value of the base period
imports divided by the base period value of the base period imports.

Where
price of exports in the current period
quantity of exports in the base period
price of exports in the base period
price of imports in the current period
quantity of imports in the base period
price of imports in the base period

13.6 Limitations of Terms of Trade

Terms of trade should not be used as synonymous with social welfare, or even Pareto
economic welfare. Terms of trade calculations do not tell us about the volume of the
countries' exports, only relative changes between countries. To understand how a
country's social utility changes, it is necessary to consider changes in the volume of trade,
changes in productivity and resource allocation, and changes in capital flows.
The price of exports from a country can be heavily influenced by the value of its
currency, which can in turn be heavily influenced by the interest rate in that country. If
the value of currency of a particular country is increased due to an increase in interest rate
one can expect the terms of trade to improve. However, this may not necessarily mean an
 improved standard of living for the country since an increase in the price of exports
perceived by other nations will result in a lower volume of exports. As a result, exporters
in the country may actually be struggling to sell their goods in the international market
even though they are enjoying a (supposedly) high price.
In the real world of over 200 nations trading hundreds of thousands of products, terms of
trade calculations can get very complex. Thus, the possibility of errors is significant.
Summary
The expression terms of trade was first coined by the US American economist Frank William
Taussig in his 1927 book International Trade. However, an earlier version of the concept can be
traced back to the English economist Robert Torrens and his book The Budget: On Commercial
and Colonial Policy, published in 1844, as well as to John Stuart Mill's essay Of the Laws of
Interchange between Nations; and the Distribution of Gains of Commerce among the Countries
of the Commercial World, published in the same year, though allegedly already written in
1829/30. Terms of trade (TOT) is a measure of how much imports an economy can get for a unit
of exported goods. It is defined as the ratio of a country’s import and export prices. Terms of
trade reflect the ratio of a country’s export and import prices and their relative relation. The
concept throws light on a nation’s ability to fund its imports based on the returns of its exports. If
the value of terms of trade is less than 100%, it is considered an unfavorable situation. When the
value gets lower than 100 %, it could signify that the country is earning less money in exports
and spending more on imports. On the other hand, a positive TOT shows the value over 100%,
reflecting that the country is earning more in exports than it is spending on imports.

Self Test Questions:

1. What do you know by Terms of Trade? How it is computed?
2. Discuss the types and implications of Terms of Trade.
3. Discuss the different models of Terms of Trade.
4. What are the different types of Terms of Trade and what are their limitations?
 CHAPTER-XIV

CURRENCY DERIVATIVES

PURPOSE AND STRUCTURE

In international financial management or international trade, in order to determine the value of

trading commodity particularly when it can-not be derived due to absence of criteria, the value is
derived from the underlying assets. In this regard, for deriving the value of the exchange traded
contracts or commodities, currency derivatives have a special place. The readers must have
knowledge and understanding of the currency derivatives. In this chapter attempt has been made
to let the readers be able to know about the following:

14.1 Meaning of Derivatives

14.2 Meaning of Currency Derivatives

14.3 Meaning of Currency Futures

14.4 Meaning of Currency Options

14.5 Popularity of Currency Derivatives in India

14.6 Uses of Currency Derivatives in India

14.7 How to trade Currency derivatives in India?

14.8 What Are the Benefits of Currency Derivatives in India?

14.9 What Are the Problems Associated with Currency Derivatives in India?

14.1 Meaning of Derivatives

Derivatives are financial contracts that derive their value from the value of the underlying asset.
The underlying asset can be equity, bonds, currencies, commodities or other assets.

Examples of Derivatives

Let’s look at a simple example to understand the complex world of derivatives.

 Do you remember your mother or spouse complaining that the cost of milk has gone up from Rs
59/litre to Rs 61/litre?
 The next day, the cost of curd went up from Rs 58/400 grams to Rs 60/400 grams!
 Then came cheese, which would now cost Rs 150/200 grams instead of Rs 145 /200 grams!

Is this a universal conspiracy by the milk agents? No. This is pure ‘derivatives’.

Curd and cheese have no value of their own. They derive their value from the value of the
underlying asset i.e. ‘milk’.

So, derivatives are financial contracts, which have no value of their own but they derive their
value from the price of the underlying asset. An increase in the price of the underlying asset will
lead to an increase in the price of its derivative.

So, expensive milk equals expensive curd.

14.2 Meaning of Currency Derivatives

Currency derivatives are financial contracts (futures, options and swaps) which have no value of
their own. They derive their value from the value of the underlying asset, in this case, currencies.
Currency Derivatives are exchange-traded contracts deriving their value from their underlying
asset, i.e., the currency. The investor buys or sells specific units of fixed currency on a pre-
specified date and rate.

For example, assume that the current USD/INR rate is 73.2450. A 1 month USD/INR futures
contract is trading at Rs 73.3650.

Here, the underlying asset is the USD/INR exchange rate and the 1 month futures contract being
traded is the currency derivative.

The underlying asset and the derivatives contract have different values. But the value of the
derivative is dependent and derived from the value of the USD/INR current exchange rate.

14.3 Meaning of Currency Futures

Currency futures are exchange traded futures contracts which specify the quantity, the date, and
the price at which currencies will be exchanged in the future. Speculators are the most active
participants in the futures market but close their positions before expiry. So, in reality, they do
not physically deliver the currencies, rather they make or lose money based on the price changes
of the futures contract.

14.4 Meaning of Currency Options

Currency options are contracts that give the buyer the right, but not the obligation, to buy or sell
a certain currency on a future date at a pre-decided price. There are two types of currency
options: ‘Call’ option and ‘Put’ option. The below table demonstrates the relationship between
options and currency pairs.

Currency options can be buying options and sell options. The buy and sell options determine the
direction of rise and fall in currency options as per the call or put options. These are made clear
as below:

Buy a call The price of the currency pair is

option expected to rise

Buy a put The price of the currency pair is

option expected to fall

Sell a call The price of the currency pair is

option expected to fall

Sell a put The price of the currency pair is

option expected to rise

14.5 Popularity of Currency Derivatives in India

While currency futures were introduced in India in 2008 and currency options in 2010, currency
derivatives in India are still mostly dominated by central banks and importers-exporters. The
daily volume of 44,859 Crores is mostly contributed by banks, corporations, importers and
exporters. But speculators and arbitrageurs have also increased their participation in the currency
markets. As more retail investors begin to discover the scope of profit generation in the forex
market, the popularity and demand for currency derivatives in India will witness a substantial
growth.

14.6 Uses of Currency Derivatives in India

Currency derivatives in India are primarily used for:

a. Hedging: By importers / exporters and other hedgers

b. Speculating: By speculative traders
c. Arbitraging: By arbitrage traders

o How hedgers use currency derivatives?

It is being explained with the example of Mr Agarwal who imports 10,000 kgs of Washington
apples from the US worth Rs 14,64,900 at the current USD/INR rate of 73.2450. If he were to
make the payment today, then he will have to shell out Rs 14,64,900. But the payment has to be
made after 2 months. Mr Agarwal is worried. He is expecting the USD/INR rate to go up from
73.2450 to 75.2450 in the next couple of months. This means that Mr Agarwal will now end up
paying Rs 15,04,900 instead of Rs 14,64,900 i.e. Rs 40,000 more! Such losses can be disastrous
for his business.

But Mr Agarwal can hedge this Rs 40,000 loss by using currency derivatives. As he expects the
USD/INR to increase, he can buy 22 lots of currency futures of USD/INR at the current rate of
73.3650. By buying 22 lots, he has taken a position of Rs 16,14,030 (covering his purchase cost).
Let’s say his prediction comes true and the USD/INR rate appreciates to 75.2450. Then he will
end up making a profit of Rs 41,360 by closing his position. So, his Rs 40,000 loss is offset by
his Rs 41,360 profit.This is how currency derivatives help importers and exporters hedge against
currency fluctuations.

o How speculators use currency derivatives?

Again with the example of Mr Sharma, who is a teacher, wants to make some quick profit and
decides to try his luck at currency derivatives trading.He is bearish about USD/INR and believes
that a poor US unemployment data will result in the USD/INR rate falling from 73.2450 to
72.2450 in the coming weeks. So, he shorts (sells) 10 lots of USD/INR at Rs 73.2450. He has
now taken a position of Rs 7,32,450. After the data is released, there is volatility in the USD/INR
rate and USD/INR falls to 71.2450 intraday. Mr Sharma, quickly covers his short position by
buying back the 10 lots at 71.2450. He ends up making a profit of Rs 20,000 in intraday!
Speculators use various indicators and forex trading strategies to identify profit making
opportunities in the forex markets using currency derivatives.

o How arbitrageurs use currency derivatives?

In India, Currency derivatives are traded on NSE, BSE and MCX-SX platforms. There is always
a small price difference between the price of the same currency contract between the three
exchanges. Arbitrageurs make money using this small price difference.

Suppose Mr Verma noticed that the USD/INR October futures was trading at 73.39 on NSE and
at 73.35 on BSE.So, he decided to buy 25 lots from BSE and sell them on the NSE. By
capitalising on the spread between the two exchanges, Mr Verma made 7.4% on his investment
of Rs 20,000 in a matter of minutes!

Buy on BSE Rs 73.33/lot

Total position taken Rs 18,33,250

Sell on NSE Rs 73.39/lot

Total Sell Value Rs 18,34,750

 Profit Rs 1,500

Less: Brokerage Rs 20

Realised Profit Rs 1,480

Profit % 7.72%

Now that we understand how various market participants use currency derivatives in India to
their advantage, let us look at how you can trade currency derivatives in India.

14.7 How to trade Currency derivatives in India?

Currency derivatives trading is no longer a difficult task and can be done from the comfort of
your home, with the best forex broker in India taking the example of Samco. Samco is a SEBI
authorised currency broker, with a flat brokerage charge of Rs 20/trade irrespective of the trade
size. Samco’s trading platform works at lightning speed so you do not miss any action. Samco
also offers the best leverage ratio, which can maximise your profits. The bottom line is that
although currency derivatives are not popular among retail investors, they provide excellent
wealth creation opportunities and deserve to be a part of a retail investor’s portfolio.

14.8 What Are the Benefits of Currency Derivatives in India?

Here are certain benefits of currency derivatives for investors in India.

 With currency derivatives, you can capitalise on short-term market shifts and observe the
pattern and direction of market movements.
 Traders can profit from currency derivatives by strategising their investments per the
market movements.
 Businesses, retail investors and traders can hedge against the rise and fall of prices. One
can also gain from speculation with currency derivatives.
 The tick size for USD/INR is 1/4th of a Rupee or 0.25 Paise with currency options. These
contracts are also highly liquid. Consequently, a small change in the market can bring in
substantial profits for currency derivative traders.
 Arbitrators can take advantage of price differences of currencies in different exchanges.
Due to the size of the trades, even a small difference can yield significant profits.

14.9 What Are the Problems Associated with Currency Derivatives in India?

The points below highlight the risks associated with trading with currency derivatives in India.
  Although currency derivatives offer the benefits of hedging, it carries chances of
inaccurate estimation. A trader must have proper knowledge about trading patterns to
better predict risk. Thus, trading with currency derivatives may not be a wise option for
novice traders.
 Analysing the market movements and spotting risk is also a strenuous and time-
consuming process. Therefore this involves in-depth knowledge and close study.
 Trading with currency options is not obligatory. Therefore, there is always a looming risk
of either buyer or seller changing their mind. This carries a risk for both parties.
 There is a small margin of the total contract value in currency futures. If one does not
predict the accurate direction or pattern of currency movement, the margin may drop
below the minimum. To raise this, you must pay additional charges.
Summary

Currency derivatives are popular financial tools used mainly by exporters and importers exposed
to high currency fluctuations risks. Retail investors/traders, too, can profit massively from
currency trading. However, one must consider the pros and cons of currency derivatives before
actively participating in currency trading. Having a comprehensive knowledge of the foreign
exchange market is also recommended.

Self Test Questions

1. What are the uses of currency derivatives in India? Discuss futures and options.
2. How do currency derivatives help with hedging?
3. What are currency forward contracts? What are the needs for trade with currency
derivatives?
 QUESTIONS FOR PREPARING ASSIGNMENTS

(According to the Exam Pattern)

Note: there are Ten (10) questions in the paper spread into Five Units as Two questions from
each unit. The candidate is required to attempt One question from each unit. Each question will
carry Sixteen (16) marks.

UNIT-I

1. What are the Challenges of International Financial Management? How to Mitigate Foreign
Exchange Risk in International Financial Management?
2. What is the procedure of Cross Border Investment? State the methods of Cross Border
Investment.

UNIT-II

3. What do you understand by Foreign Direct Investment? State the special conditions and
process of Foreign Direct Investment.
4. What do you know by trade policy? Discuss the characteristics of trade in developing
countries. Discuss the criteria of India’s Foreign Trade Policy.

UNIT-III

5. What do you know by regional integration in economies? State the trade in context to
regional and multilateral economic integration.
6. Discuss the India’s trade relations with BRICS.

UNIT-IV
7. What do you understand by Foreign Exchange Market? How does it work? Discuss the
different types of Foreign Exchange Markets.
8. What are the different types of Terms of Trade and what are their limitations?

UNIT-V
9. What are currency forward contracts? What are the needs for trade with currency
derivatives?
10. What are the uses of currency derivatives in India? Discuss futures and options.