Unit – 2.

Theories of International Trade and Investment

Introduction:
 International trade, which is trade between two nations or countries, plays a pivotal role in the

economic development of a nation.

 The basis of international trade is the comparative advantage possessed by a nation in producing

commodities in which it has a special advantage and sells its surplus product to foreign

countries.

 The surplus sold is called exports.

 The commodities in which it does not enjoy a special advantage are purchased by it from other

countries, which have a cost advantage in producing it.

 The commodities purchased are known as imports.

 Thus import and exports are the two sides of international trade.
A number of theories have been developed by the international economists to explain how does international
trade takes place:

 Mercantilism

 Theory of absolute cost advantage

 Comparative cost advantage theory

 Comparative cost advantage with money

 Relative factor endowments / Hukscher-Ohlin theory

 Country similarity theory

 Product life cycle theory

 Global strategic rivalry theory

 Porter’s national competitive advantage

 Mercantilism
 Mercantilism is the oldest international trade theory formed by the economic thought during 1500 to
1800.

 According to this theory holdings of country’s treasure in the form of gold.

 This theory specifies that country should export more than the import and receive the value of trade
surplus in the form of gold.

 During this period govt. also imposed restrictions on imports and encouraged exports in order to prevent
trade deficit.

 Colonial powers like British used to export less valued goods and import more valued goods with their
colonies like India, Srilanka etc.,

 Once the gold standard declined, consequently this theory was modified in New- mercantilism.

 This proposes the country attempt to produce more than its demand for the people in order to achieve
social objectives.
Theory of Absolute Cost Advantage
 Adam Smith who proposed this theory based on the principles of division of labour.
 According to him each countries to specialised in the production of those goods in which they have cost
advantages over other countries.
 They can produce with less cost than other countries and exchange these products with other products
produced cheaply by other countries.
 Suitability of the skill labour of the country in producing certain products.
 Specialisation of the labour in producing certain products leads to high productivity and less
labour cost.
 Economies of scale would reduce labour cost.
 Apart from skilled labour, natural advantage also leads to production due to climatic conditions (for ex.
Indian climate suits for producing sweet mangoes, coconuts and cashew etc.,).
 In addition to skilled and natural advantages, countries also acquire advantages through technology and
skill development. Japan produces steel through imports of both iron and coal. The reason for success is
that Japan acquired labour saving and material saving technology.
 Absolute cost advantage can explained by the below example
Output per one day labour

Japan India

Pens 20 60

Audio tape recorders 6 2

 the above example Japan has an absolute advantage of producing tape recorder, while India has
production of pens.
 Assume India and Japan are able to trade with each other, then both will get the advantage.
 Suppose, Japan agrees to exchange 4 tape recorders for 40 pens.
 2 days it will take to produce 40 pens and 0.67 days need to produce 4 tape recorders.
 Japan can save 1.33 days (2-0.67) of labour, if they export tape recorders to India and imports pen from
India.
 Similarly India also can save 1.33 days (2-0.67) of labour, if they export pens to Japan and import tape
recorders.
We shall discuss the criticism levelled against this theory:

 No Absolute Advantage

 Country Size

 Variety of Resources

 Transport Cost

 Scale of Economies

 Absolute Advantage for Many Products

 Comparative cost advantage theory
 This theory is based on relative productivity differences and incorporates the concept of opportunity cost.
 This theory also states that a country should produce and export those products for which it is relatively
more productive than that of other countries and import those goods for which other countries are
relatively more productive than it is.

Output per one day labour

Japan India
Pens 60 50
Audio tape recorders 6 2

 the above ex. Shows Japan is more productive than India in both products. As such no trade should taken
place between Japan and India based on absolute cost advantage theory.
 But relative terms, India is only 0.33 as good as Japan in audio tape recorder production, but 0.83 as good
as in pen production.
 In comparison, Japan is better in audio tape recorder and India is better in pen production.
 If, Japan produces only audio tape recorders and India produces only pens in which they have
comparative advantage.

 Japan produces 60 pens or 6 audio tape recorders and thus cost of one tape recorder = 10 pens

 India can produce either 50 pens or 2 audio tape recorders, thus the cost of one tape recorder = 25 pens

 Suppose Japan offers one audio tape recorder for 18 pens, India would accept the offer because, for
exporting 18 pens would get 1 tape recorder.

 This offer also advantage to Japan, they can get with 8 more pens for one tape recorder.

 As such Japan and India benefit from the trade, thus comparative cost of advantage motivates the
countries to trade with each other.
Assumptions of Comparative cost advantage theory:

 There exists full employment

 The only element of cost of production.

 There are no trade barriers

 Trade is free from cost of production

 Only two products are traded

 There are no transportation cost

Comparative Advantage with Money
 According to F. W. Taussig, comparative differences in labour cost of commodities translated into
absolute differences in prices without affecting the real exchange relations.

 Since modern economy is money economy and almost all the transactions take place in the form of
money.

 Therefore, absolute differences in money prices determine international trade.

 The above example,

 Suppose the daily wage rate in Japan was Yen 360.

 The daily wage rate in India was Rs. 100

 The exchange rate of Indian rupee and Japan yen was 1 / Rs = 2 / Yen
 Cost of producing pens in Japan = 360 / 60 = 6
 Cost of producing tape recorder in Japan = 360 / 6 = 60
 Cost of producing pens in India = 100 / 50 = 2
 Cost of producing tape recorder in India = 100 / 2 = 50

Cost of goods in Japan Cost of goods in India

Japan Made Indian Made Japan Made Indian Made

Pens 6 4 3 2
Tape recorder 60 100 30 50

 If two countries are in trade, Indian made pen is cheaper in Japan and Japan made audio tape recorder
cheaper in India.
 It is beneficial for both the countries.
Criticism:

 Two countries

 Transportation cost

 Two products

 Full employment

 Economic efficiency

 Division of gains

 Mobility

 Services
 Relative factor endowments or Heckscher – Ohlin Theory

 Eli Heckscher & Bertil Ohlin developed the theory.

 To answer the question how do the countries acquire advantage?
 They developed the theory of relative factor endowments
 Factor endowments are land, capital, natural resources, labour, climate etc.,
 According to this theory states ‘the sources of particular factors is plenty in relation with other relative
factors, then the price of factor is low while the price of relative factors will be high (vice versa).
 Labour is available more in number and subsequently the price of land and capital will be high.
 India and China have advantage in labour intensive industry like textile and tobacco, countries export
those they have comparative advantage.
 Countries where area of land available is less in relation to labour, go for multistore factors and produce
light weight products.
 Counties where labour is more in relation to capital to be expected to export labour intensive products.
Country Similarity Theory
 According to this theory international trade takes place within each industry (intra-industry) between two
countries.
 Intra-industry trade amounts to nearly 40% of world trade.
 For ex. Japan exports Toyota cars to Germany, whereas Germany exports BMW cars to Japan.
 According to Linder, the similarities in consumer preferences in the countries that are at the same stage
of economic development. (for ex. India and China are same stage of economic development, India
provides market for low price motor cycles produced in China, whereas China’s rich income group
customer provide market for India's motor cycle) – economic similarity
 Counties prefer to trade with their neighbouring countries in order to have the advantage of less
transportation cost. (SAARC countries prefer to import from India) – Similarity in Location.
 Countries prefer to trade with those countries having similar culture (for ex. Export and import among
European countries) – cultural similarity
 Similar political interests, close political and economic relations enable the countries enter into
agreement of trade (for ex. India have trade relation with Russia). - similarity in political and economics
Product Life Cycle Theory
 Raymond Vernon of the Harvard Business School developed the product life cycle theory.

It has four stages;

 New production introduction: Firms innovative new products based on needs and problems in
domestic country.

 Growth: Attracting competitors, Increased exports, Further innovation and Shift manufacturing to
foreign countries.

 Maturity: Standard products, Large-scale production and economies, low unit cost of production, shift
manufacturing to developing countries.

 Decline: Location of manufacturing facilities in developing countries, original innovating country

becomes net importer.
Global strategic rivalry theory
 International trade takes place between / among companies based on relative competitive advantage.

 Paul Krugman and Kelvin Lancaster have developed the view that firms struggle to acquire and develop
some sustainable competitive advantage.

 This theory focuses on firms strategic decisions to acquire and develop competitive advantage through:

 Intellectual property

 Investment R & D

 Large - scale economies

 Experience curve
Porter’s national competitive advantage theory
According to Porter’s , the competitive superiority is derived from the following factors

 Demand conditions: the existence of large number of domestic consumers to create and improve the
demand for various products in the company.

 Factor endowment: it deals with the classical factors like land, labour and capital. Country ability to
compete globally depends upon the countries factor of sources.

 Related and supporting industries: The growth of the industry to provide scope for raw materials,
market intermediaries and ancillary companies, these supporting services leads to high input and lower
prices.

 Firm strategy, structure and rivalry: firms must continuously improve the quality, product design,
investment R & D in order to compete domestically.
Foreign Direct Investment (FDI)
 Foreign direct investment (FDI) is an investment made by a firm or individual in one country
into business interests in another country.

 Such investments owns 10 percent or more of a foreign company. If an investor owns less than
10 percent, the International Monetary Fund defines it, as part of his or her stock portfolio.

 Generally, FDI takes place the establishment of wholly new operations of foreign business or
purchasing a existing business concerns through merger & acquisitions.

 When they start with new business operations known as “Greenfield Investment”

 When they purchase existing business is known as “Cross – Boarder Acquisition”

 Foreign direct investments are distinguished from portfolio investments in which an investor
merely purchases equities of foreign-based companies.
Strategy of FDI

Firm-Specific Strategy:

 When firm offering new kind of product or differentiated product, the product innovation fails
to work, a firm may adopt product differentiation strategy. This is done through putting trade
mark on the product or branding. Sometimes a firm may adopt different brands for
different markets to make them suitable for local markets.

Cost –Economic Strategy:

 This strategy done through lowering cost by moving the firm to the places where there are
cheap factors of production. The cheapness of these factors of production reduces the cost of
production and maintains an edge over other firms.
 Methods of Foreign Direct Investment

 As mentioned above, an investor can make a foreign direct investment by expanding their business in a
foreign country. (For ex: Amazon opening a new headquarters in Vancouver, Canada).

 Reinvesting profits from overseas operations as well as intracompany loans to overseas subsidiaries are
also considered foreign direct investments.

 Finally, there are multiple methods for a domestic investor to acquire voting power in a foreign company.
Below are some examples:

 Acquiring voting stock in a foreign company

 Mergers and acquisitions

 Joint ventures with foreign corporations

 Starting a subsidiary of a domestic firm in a foreign country

Benefits of FDI

 Availability of scarce factors of production into abundant.

 Improvement in Balance of Payments through export and import substitution.

 Building of economic and social infrastructure.

 Fostering of economic linkages.

 Strengthening of the government budget.

 Stimulation of national economy. Subsidiaries of Trans-National Corporations

(TNCs), which bring the vast portion of FDI, are estimated to produce around a
third of total global exports (UNCTAD 1999).
 Importance of FDI

 Foreign direct investment is critical for developing and emerging market countries. Their companies need
the multinationals' funding and expertise to expand their international sales. Their countries need
private investment in infrastructure, energy, and water to increase jobs and wages. The U.N. report warned
that climate change would hit them the hardest.

 In 2017, developing countries received $694 billion, or 58% of total global FDI. They received 43 of
worldwide investment. Investments rose 8% in developing Asia, which received $502 billion.

 The developed economies, such as the European Union and the United States, also need FDI. Their
companies do it for different reasons. Most of these countries' investments are via mergers and
acquisitions between mature companies. These global corporations' investments were for either
restructuring or refocusing on core businesses.
Theories of FDI

MacDougall – Kemp Hypothesis (Two – country model):

 Assuming two country model; one is being the investing country and other is host country.
According to this theory FDI moves from a capital-abundant economy to a capital-scarce
economy till the marginal productivity of capital is equal in both the countries.

Industrial Organization Theory:

 An MNC with superior technology moves around to different countries to supply innovated
product making in turn ample gain.

Location Specific Theory:

 FDI moves to a country with abundant raw material and cheap labour force encourages the MNCs
to invest in a particular country.
The Electric Paradigm:

 It is the combination of three advantages- ownership, location and internalization that motivates
a firm to make FDI.

Product Cycle Theory:

 FDI takes place when the product in question achieves a specific stage in its life cycle

 STAGE 1: Innovation stage is characterized with quite newness of product having price-
inelastic demand

 STAGE 2: Maturing product stage appears when the product turns price-elastic along with
similar products in the market

 STAGE 3: Standardized product stage with greater price competitiveness motivates firm to start
production in a low cost location

 STAGE 4: De-maturing stage breaks down product standardization with sophisticated model of
the product being manufactured in high-income countries
Internationalization Approach:

 Internalization is a process when an MNC passes on improved technology to its foreign

subsidiary at zero/low cost in order to grab the market

Political – Economic theory:

 Political stable countries leads to FDI (Fatehi-Sedah and Safizedah, 1989).

 Politically instability in the home countries encourages high FDI (Tallman, 1988).

 However, A firm moves from a politically unstable country to a politically stable country

(Schneider and Frey, 1985).

Recent policy measures

 100% FDI allowed in medical devices

 Insurance & sub-activities - 26% to 49% FDI (2019 – 100%)

 100% FDI allowed in the telecom sector.

 100% FDI in single-brand retail.

 Removal of restriction in tea plantation sector.

 FDI limit raised to 74% in credit information & 100% in asset reconstruction companies.

 Railway sector(Construction, operation and maintenance) - 100% FDI.

 FDI limit of 26% in defence sector raised to 49% under Government approval route.

 Foreign Portfolio Investment up to 24% permitted under automatic route.

 Sectors with caps

 Petroleum Refining by PSU (49%)

 Broadcasting content services-

 FM Radio (26%)

 TV channels (26%)

 Print Media (26%)

 Air transport services

 Scheduled air transport (49%)

 Non-scheduled air transport (74%)

 Ground handling services – Civil Aviation (74%)

 Satellites- establishment and operation (74%)

 Banking Sector

 Private Sector Banking : (74%)

 Public Sector Banking (20%)

 Private security agencies (49%)

 Commodity exchanges (49%)

 Credit information companies (74%)

 Infrastructure companies (49%)

 Power (49%)

 Defence (49%)
Measures of control

 The home Govt. can prohibit any investment in, or any technical collaboration with a
particular host country

 It can design fiscal and monetary disincentives to deter any outflow of investment

 The home govt. can tighten the approval rules and regulations ultimately restricting FDI
outflow

 The govt. can introduce extra territorially provisions and can interfere with activities of its
MNC’s foreign subsidiary

 The home govt. can design the anti – trust law that can trim its MNC’s wings to operate in
foreign markets
Eclectic

 An eclectic paradigm, also known as the ownership, location, internalization

(OLI) model or OLI framework, is a three-tiered evaluation framework that

companies can follow when attempting to determine if it is beneficial to

pursue foreign direct investment (FDI).

Market power

 Market power refers to a company's relative ability to manipulate the price of

an item in the marketplace by manipulating the level of supply, demand or

both. In markets with perfect or near-perfect competition, producers have little

pricing power and so must be price-takers.

Internationalization

 Internationalization describes designing a product in a way that it may be

readily consumed across multiple countries. This process is used by

companies looking to expand their global footprint beyond their own

domestic market understanding consumers abroad may have different tastes

or habits.
Instruments of trade policy
 International trade policies deal with the policies of the national governments in
relation to exports of goods and services to various countries in either on equal terms
and conditions or discriminatory terms and conditions.
 For exp: Russia’s trade policy indicates that it allow Indian imports, though the price
and quality unfavourable compared to other countries.
 Similarly, China imports goods from Pakistan on preferential terms like fewer rates of
tariffs etc.
 Trade policies also aiming at protecting domestic industry through imposing quotas.
 Trade policies of some countries aim to building competitiveness through subsidies.
 Government announce their trade policies with regard to the following from time-to-
time. These are called as instruments of trade policies.

 Tariffs

 Subsidies

 Import Quotas

 Voluntary Export Restraints

 Local Content Requirements

 Administrative Policies
Tariffs:
 Tariffs are refer to the tax imposed on imports. Tariffs are two types i.e. 1. specific tariffs 2. ad valorem
tariffs.
 Specific tariffs are levied as a fixed charge for each unit of the products imported i.e. Rs. 500 on each
TV imported.
 ad valorem tariffs levied as a proportion of the value of goods imported i.e. 30% of the value of goods
imported.

 The purpose of tariff is to protect the domestic industry by increasing the cost of imported goods.

Gains from the tariffs:

 Government can get revenues in the form of import duties.
 Importing country would find market as cost of imported goods higher than domestic goods.
 Jobs in the domestic country.
 Business of ancillary industry protected.
Subsidies:
 In order to encourage domestic production or protect the domestic producer from the foreign
competitors, government provides subsidies to a domestic producer.
 Such payments are in the form of cash grants, loans and advances, tax holidays, equity participation and
supply of inputs at lower prices.

Subsidies can help to the domestic producer in the following form;

 High profit margin or fixing the price at lower level
 Compete with a foreign producers
 Enter the foreign markets

 This subsidies are provided by the government not only to the agricultural sectors but also to the
industrial and other sectors also.
Import quota:
 Import quota is a direct restriction on the quantity of goods which are imported into a country.
 These restrictions are imposed by issuing import licences to import a certain quantity of goods.
 India had quotas of imports of various goods like cars, motor cycles, milk etc up to 31 st march 2020.
 Import quotas provide protection to the domestic firms from the foreign competitors.

Voluntary Export Restraints:

 It is a restrictions of exports quantities imposed by exporting country.
 Exporting countries imposes such restriction mostly on the request of the importing country.
 For exp, Japanese automobile exports had such a restrictions in 1981.
 It is mainly for the violation leads to imposing import tariffs and import quotas.
Local content requirement:
 It is a condition that requires some specific fraction of a product produced in domestically rather than
imported.
 This requirement either in physical terms or in value terms. (50% of quantity or value of the product
should be produced in domestically.
 Most of the developing countries on the local content requirements in order to shift the manufacturing
based in their country.
 This helps to enhance the employment opportunities, utilisation of local resources and economic
activities.

Administrative policies:
 In addition to the quotas and other restrictions, government involves either in formal and informal
policies to restrict the imports and boost exports.
 The rules and regulations which are formulated to make it difficult for imports to enter the country .
 Japan uses the administrative policies rather the use of tariffs and quotas.
 Administrative Policies - bureaucratic rules designed to make it difficult for imports
to enter a country, polices hurt consumers by limiting choice

 Antidumping Policies–also called countervailing duties–punish foreign firms that

engage in dumping and protect domestic producers from “unfair” foreign
competition

 Dumping - selling goods in a foreign market below their costs of production, or

selling goods in a foreign market below their “fair” market value enables firms to
unload excess production in foreign markets may be predatory behavior - producers
use profits from their home markets to subsidize prices in a foreign market to drive
competitors out of that market, and then later raise prices
Balance of Payments
 Balance of payments

 It is a statement of international receipts and payments of the country.

 It is based on the concept of double entry system.
 Where credit shows the receipts of the foreign exchange from abroad.
 Debit balance shows payments in foreign exchange to the residents of abroad.
 Receipts and payments are compartmentalised into three heads, i.e. current
account, capital account and reserve account.
Why BOP is needed?

 BOP of a country reveals its financial and economic status.

 BOP statement can be used as an indicator to determine whether the
country’s currency value is appreciating or depreciating.
 BOP statement helps the Government to decide on fiscal and trade
policies.
 It provides important information to analyze and understand the economic
dealings of a country with other countries.
 BOP Accounts
 Since the balance of payments records all type of international transactions of the country
over a certain period of time, it contains a wide variety of accounts.
 However, the countries international transaction can be grouped into the following three
main types
 The current account
 The capital account
 The official reserve account
 The current account includes the export and import of goods and services
 The capital account includes all purchases and sales of assets such as stocks, bonds, bank
accounts, real estate and businesses.
 The official reserve account covers all purchase and sales of international reserve such as
dollars, foreign exchange, gold and special drawing rights (SDRs) etc.
 The current account
 Further the current account have divided into four finer categories
 Merchandise trade, services, factor income and unilateral transfers
 Merchandise trade represents exports and imports of tangible goods such as oil, wheat,
cloths, automobiles, computers and so on.
 Services includes payments and receipts for legal consulting, and engineering services,
royalties for patents and intellectual properties, insurance premiums, shipping fees and tourist
expenditure.
 Factor income consists largely of payments and receipts of interest, dividends, and other
income on foreign investments that were previously made.
 Unilateral transfers involve ‘unrequited’ payments include foreign aid, reparations, official
and private grants and gifts. For the purpose of preserving the double-entry book keeping
rule, unilateral transfers are regarded as an act of buying goodwill from the recipients.
 The capital account
 Capital account can be divided into three sub categories i.e. direct investment, portfolio
investment and other investment.
 Direct investment occurs when the investor acquires a measure of control of the foreign
business. As per the US balance of payments acquisition of 10% or more of the voting shares
of business is considered giving a measure of control to the investor.
 Firms undertake FDI when the expected returns from foreign investments exceeded cost
of capital allowing for foreign exchange and political risk.
 Portfolio investments mostly represents sales and purchases of foreign financial assets such as
stocks and bonds that do not involve a transfer of control. Portfolio investment comprises
equity, debt and derivatives securities.
 Other investment includes transactions in currency, bank deposits, trade credits and so forth.
These investments are quite sensitive to both changes in relative interest rates between
countries and the anticipated change in the exchange rate.
 Official reserves are held by the monetary authorities of a country
 They consists of monetary gold, SDR allocations by the IMF and foreign
currency assets.
 The foreign currency assets are normally held in the form of balances with
foreign central banks and investment in foreign government securities.
 If the overall balance of payment is surplus, the surplus amount adds to the
official reserve account
 If the overall balance of payment is deficit and if accommodating capital is not
available the official reserves account is debited by the amount of deficit.
 Balance of Payments - Format
Credit Debit Balance
A. Current Account
Merchandise import ***
Merchandise export ***
Balance of trade ***
Invisibles
Services (net) ***
Unilateral transfers (net) ***
Investment Income (net) *** ***
Non-monetary movement of gold (net) ***
Balance of current account ***
B. Capital account Long term
Direct investment abroad ***
Direct foreign investment inflow ***
Portfolio investment (net) ***
Loans – official and private net of repayments *** ***
Basic balance ***
Short term
Holding with banks ***
Other short-term transactions ***
Balance of capital accounts ***
C. Errors and Omissions
Overall balance (A+B+C) ***
D. Official reserves
SDR allocations ***
Net official reserves ***
Overall balance ***
 Problem 1
Find out (a) the balance of trade and (b) balance of current account, if: inflow on account of
services $1000; outflow on account of services $800; outflow of dividend, royalty etc., $1100;
inflow of dividend etc., $560; export of goods $10000; import of goods $12000; remittances
$1200.

Solution:
Import -12000
Export 10000
Balance of trade -2000
Services (net) 200
Investment income (net) -540
Remittances (net) 1200
Balance of current account -1140
 Problem 2
Find out the balance of capital account, if: inflow of loans $2000; repayment of loan
$2150; FDI inflow $7000; FDI outflow $1500; FII’s investment in India $500; short term
movement of funds -200.

Solution
Loan -150
FDI 5500
FII’s investment 500
Short term funds -200
Balance of capital accounts: 5650
Balance of payment equations

Balance of trade = exports of goods – import of goods

Balance of current account = balance of trade + net earnings on invisibles

Balance of capital account = foreign exchange inflow – foreign exchange outflow, on

account of foreign investments, foreign loans, banking transactions and other capital flows

Overall balance of payments = balance of current accounts + balance of capital account +

statistical discrepancy
 Problem 3
Find out the amount of foreign exchange reserves for the following information
Foreign exchange reserve $70000; balance of current account $-5500; balance of capital
account $2000; statistical discrepancy $-500.

Solution
Foreign exchange reserve = opening balance of foreign exchange reserve + balance of
current account + balance of capital account + statistical discrepancy
= 70000 + (-5500) + 2000 + (-500)
= 66000
Balance of payment identity

 When the balance of payments accounts are recorded correctly, the combined
balance of the current account, the capital account and the reserve account must
be zero
 BCA + BKA + BRA = 0
 BCA – balance of current account, BKA – balance of capital account and BRA –
balance of reserve account
 Balance of payment identity indicates that a country can run a balance of
payments surplus or deficit by increasing or decreasing its official reserve.
 In fixed exchange rate regime, countries maintain official reserves that allow
them to have balance of payments disequilibrium i.e. BCA + BKA is non zero.
 Under fixed exchange rate regime, the combined balance on the current and capital
accounts will be equal in size but opposite sign.
 BCA + BKA = - BRA
 For exp. If a country runs a deficit on the overall balance, that is BCA + BKA is
negative, the central bank of the country can supply foreign exchanges out of its
reserve holdings. But if the deficit persists, the central bank eventually run out of its
reserve, the country may forced to devaluate its currency.
 Under flexible exchange rate regime, central bank do not intervene in foreign exchange
markets. In fact central bank do not need to maintain official reserves. Under this
overall balance must be
 BCA = - BKA
 In other words current account surplus or deficit must be matched by a capital account
deficit or surplus
Current and Capital account convertibility

Current account convertibility

 The Current Account Convertibility allows free movement of foreign currency inward
and outward for any amount for the trade purposes of imports and exports, Inward and
outward remittances in foreign currency, accessing foreign currency for travel, study
abroad, medical and tourism purpose etc. at existing market rates.

Capital account convertibility

 Capital Account Convertibility means the freedom to convert rupee into any foreign
currency (Euro, Dollar, Yen, Renminbi etc.) and foreign currency back into rupee for
capital account transactions. In very simple terms it means, Indian’s having the freedom
to convert their local financial assets into foreign ones at market determined exchange
rate. CAC will lead to a free exchange of currency at a lower rate and an unrestricted
movement of capital.
Economic Integration
 Countries are creating business opportunities for themselves by integrating their economies in
to other countries in order to avoid unnecessary competition.

 It covers different kind of arrangements between the countries by which two or more countries
link their economies.

Kinds of Economic integration:

Free Trade:

 Member countries are agreed to abolish all trade restrictions and barriers or charge of low rate
of tariffs.

Customs Union:

 The member countries adopt uniform commercial policy of barriers and restrictions jointly
with regard to the trade with non – member countries.
Common Market:

 They allow free movement of human resources and capital among the member countries.

Economic Union:
 They achieve uniformity in monetary and fiscal policy among the member countries.

 Economic integration helps to increase the size of the market, quantity of production,
employment and economic activity of the region.

 Further, people of the region get a variety of products comparatively at lower prices.

 It also enhance the purchasing power and living standard of the people.
General Agreement on Tariffs and Trade (GATT)

 It was established by twenty – three signatory nations in 1947 with a objective to liberalize

world trade, reducing tariffs and abolishing quotas.

 The fundamental principle is “Trade without discrimination”

 That is each member nations must open its markets equally to every other member nation.

 Eight major rounds of negotiations from 1947 to 1994, led to the reduction of both tariff and

nontariff barriers such as industrial standards, government procurement, subsidies, licensing

and customs valuation.

 European Union (EU)

 Initially it was started as European Coal and Steel Community (ECSC) in 1952.

 The aim of ECSC to eliminate import duties and quotas on Coal, Iron ore, Steel and Scrap
between the member countries.

 After successful functioning, the member countries extent this facility to all commodities and
gave the name European Economic Community (EEC) in 1957.

 The number of member countries of EEC six (France, Germany, Italy, Belgium, Netherland and
Luxemburg).

 After the introduction of uniform monetary policy, fiscal policy it became European Union
(EU) in 2004.

 The requirements of joining EU (i). The country must be European country (ii). It must be a
democratic country.
 The main objective of EU, setting up a common market, promote throughout the community
development by economic activities, increase the standard of living of the people and closer
relationship between the member countries.

Activities:

 Elimination of customs duties, quantity restrictions with regard to export and import.

 Establish common commercial policy.

 Formulation of common policy for agriculture and transport.

 To formulate the programmes to control in the balance of payment.

 Establishment of European Social Fund to enhance employment opportunities and standard of

living.

 Establishment of European Investment Bank to contribute the economic development of the union.
Functions of European Monetary Union

Exchange Rate Mechanism (ERM):

It helps member countries to regulate inflation and interest rate, this will prevent shifts in the
value of their currencies.

European Currency Unit:

It is settlement between central bank and member countries. The European currency unit is
weighted basket of all the currencies. This official rate is calculated on daily basis.

European Monetary Co-operation Fund:

it act as “Clearing House” of central banks and member countries.

Regional Development Policy:

One of the objective of EU is to promote balanced development of member countries. To

achieve this EU provide financial assistance for the development of backward regions.
European Investment Bank:

This was established in 1958. It provides loans for the economic development of backward
regions. The grant loans for modernisation, conversion and development projects of the
member governments.

European Social Fund:

Some workers may lost jobs due to EU policies. Such workers assisted to get employment by
European social fund. It meant for vocational training, job creation and income maintenance
and anti-poverty programmes.

European Regional Development Fund:

It provides loans for the backward regions development, the main focused areas of
development of industries, services and infrastructure.
North American Free Trade Agreement (NAFTA)
 The main aim of NAFTA to eliminate all tariffs and trade barriers between the countries.
 It came into being January 1, 1994
 USA, Canada and Mexico joined together to form a trade block
 Initially it was signed by USA and Canada in 1989 (enlarge their economic activity) and
extended to Mexico in 1994 (secure future foreign investment).

Objectives:
 To create new business opportunities (esp. Mexico)
 To enhance competitive advantage of USA, Canada and Mexico with International Markets.
 To enhance industrial development and thereby employment.
 To provide stable and predictable political environment.
 To reduce the prices of goods and services by enhancing competition.
Procedures:

 Opening up of government procurement markets

 The member countries can invest freely

 Protection of intellectual property rights of member countries

 Free flow of human resources (employees and business people) among member
countries

 Avoidance of re-export of the products imported by any member country.

 Pollution control along the USA – Mexico border.

Impact of NAFTA:

 Trade surplus of USA with Mexico (before NAFTA it shows trade deficit)

 Around 10 lakhs jobs created in USA after the creation of NAFTA.

 US workers became insecure economic future to secure.

 Mexico’s export shows significant improvement also create more jobs.

 Mexico’s trade deficit reduced tremendously with Asia and Europe.

Association of South – East Asian Nations (ASEAN)

 A group of six countries i.e. Singapore, Brunei, Malaysia, Philippines, Thailand and

Indonesia agreed in January 1992.

 It was established a Common Effective Preferential Tariffs (CEPT)

 This plan later converted into Association of South – East Asian Nations.

 These countries agreed free trade area 15 years for their member countries from

January 1993.

 This allows a tariff cut ranging from 0.50% to 20% for 15 products.
Benefits:

 The ASEAN member countries have developed economically at a fast rate in globe.

 Their strength enabled them to achieve faster industrialisation (well educated and
skilled labours).

 They also developed in oil, mineral sources, agricultural goods and modern industrial
production.

 These countries invite and allow the free-flow of foreign capital.

 The member countries of ASEAN enable to share their economic and human resources
and achieve the agricultural, industrial and service sectors.
ASEAN Free – Trade Area:

 The ASEAN countries also formed ASEAN Free Trade Area (AFTA) in September
1994.

 The AFTA initially set to function for 10 years in order to develop inter – ASEAN
Trade.

Objectives of AFTA:

 To encourage inflow of foreign investment into this region.

 To establish free trade area in the member countries.

 To reduce tariff of the products produced in ASEAN countries.

South Asian Association for Regional Co-operation (SAARC)

 After the successful performance of EU and NAFTA, some of the trade blocks were
initiated in and around the world.

 On December 1985, India, Bangladesh, Bhutan, Pakistan, Maldives, Nepal and

Srilanka established “South Asian Association for Regional Co-operation (SAARC) for
economic development, employment opportunities and improve the standard of living
of among the member countries.

 Afghanistan joined SAARC in April 2007.

 The countries like Australia, Burma, China, EU, Iran, Japan, Mauritius and USA got
observer status on 1st March 2011.
Objectives:

 To improve the quality of life and welfare of people of the SAARC.

 To develop the region economically, socially and culturally.

 To enhance the cooperation's with other developing countries.

 To enhance the self-reliance of the member countries jointly.

 To enhance the mutual assistance among member countries.

 South Asia Free Trade Agreement

 The council have signed South Asia Free Trade Agreement on April 1993

Objectives:

 To gradually liberalize the trade among member countries of SAARC.

 To eliminate trade barriers among SAARC countries and reduce tariffs.

 To promote and sustain mutual trade and economic co-operation among member

countries.

 SAARC members were expected to bring their duties down to 20%.

Asia – Pacific Economic Cooperation (APEC)
 APEC is the premier forum for facilitating economic growth, co-operation, trade and
investment in the Asia-Pacific region.

 APEC was established in 1989 to enhance the economic growth for the region and strengthen
the Asia – Pacific community.

 APEC is the only inter-governmental grouping in the world operating on the basis of non-
binding commitments.

 Since its inception, it worked to reduce tariffs and other trade barriers across the Asia-Pacific
region and also increasing its exports.

 APEC has 21 members – referred as “Member Economies”

 It has 60% of world GDP (19, 254 billion US $) and 47% of world trade
 In first decade, APEC member economies generated nearly 70% of global economic
growth.

 APEC region consistently outperformed the rest of the world, even during the Asian
Financial Crisis.

Achievements:

 Exports increased by 113% to over 2.5 trillion US $.

 Foreign Direct Investment grew by 210% overall, and by 475% in lower income of
APEC economies.

 Gross National Product grew tremendously