External Sector: International Trade, Balance of Payments and Exchange Rate

External Sector

Shekhar Sengar

Demand Led Growth and Export Led Growth

International trade is considered as a special case of inter-regional trade. When different nations trade goods and services among them, it is called international trade. Today there is a common understanding among economists and policy makers that trade enhances income, output and employment. It finally raises the standard of living. Free trade optimizes the resource use at international level. It allows consumers to get best quality products at lower prices. International trade offers competition to local products, leading to improved research and development, thereby improving the product quality and choices available to consumers. Protection through tariff or quantitative restrictions is considered inefficient except in case of “fledgling industry argument” and “deindustrialization” argument. If local industries are nascent and weak and foreign competition can destroy local industries, protection as a policy may be legitimately resorted to. Even the WTO provisions allow import restriction in case a country is running unsustainable trade deficit or balance of payments crisis.

Autarky, protection and free trade

 Among many, there are two prominent models of economic growth- “Domestic Demand led growth” and “Export led growth.”  Domestic demand led growth is also known as import substitution strategy of growth. The erstwhile Soviet Union model was based on a closed economic model or what is called autarky (self sufficient economy) without international trade or at best trading with the communist countries only. The newly independent economies like India which got freedom in 1950s and 1960s also opted for import substitution strategy or strategy for self reliance due to bitter experience of drain of wealth during the colonial past. These economies resorted to various protectionist measures like high customs duty wall or quantitative restrictions. There were more compelling reasons initially to adopt a strategy of self reliance, import substitution and protection, but it had its own costs for these economies. These economies failed to take advantage of international trade as an engine of growth.

In the last five decades of global economic scenario, it is amply clear that those economies which opened up initially like USA, west European countries and Japan in post second world war period or which opened up later like South Korea in 1967 and China in 1979 gained much in income, output and employment and those who kept themselves closed to international trade could not sustain high growth rate, even if they recorded some growth initially from import substitution.

  In the decades of 1980s and 1990s, the eastern tigers (so called for high economic growth) like Japan, South Korea, Singapore and even Thailand were praised for their export-led growth. Free trade and their integration of the global economies were cited as the most important reasons for their rapid economic growth. After opening in the 1979, China for example, also opened up to the world in a large way and it pursued the strategy of export-led growth through a cluster approach of industrialization giving emphasis to development of manufacturing sector through a variety of incentives in its Special Economic Zones. China along with the east Asian countries and USA & west European countries became the manufacturing hub of the world and produced exportable surplus that enhanced their GDP, employment and foreign exchange reserves. Later these economies also became preferred investment destinations as well.  Eventually these  economies were able to take advantage of international trade as an engine of growth.

The winds in the global economy have changed. As things stand after the sub-prime crisis in the US in 2007-08 and sovereign debt crisis in Europe in 2010, finally taking the shape of a global financial crisis and recession, protectionist wave engulfed the developed world giving a great jolt to free trade. Multilateral trading system led by the WTO started losing its trust and appeal especially among the developed countries, which were behind the birth of globalization, free trade and multilateralism. It is an irony that today it is these economies which are adopting various protectionist measure and trying to scuttle the WTO negotiations.

Is international trade an engine of growth?

There are different schools of thought in economics with different views on reasons, but all of them agree on one point that trade is gainful. However, all these schools have certain assumptions under which trade is gainful. The assumptions, however, were refined over time to bring theoretical analysis closer to reality. Here are the theories of international trade:


Trade is gainful to participants. The Mercantilist school, born in the U.K., believed that trade is the means of economic growth, but only if exports are kept higher than imports (what we call positive balance of trade).The idea of gain from trade was accepted by subsequent economist, but the idea of maintaining net exporter positive was found logically inconsistent? How can all trading countries maintain a positive balance of trade?

Absolute Advantage Theory of International Trade

Adam Smith, the father of modern market economics, propounded that international trade is beneficial for the trading countries as well as for optimization of resource uses. He propounded the classical theory of international trade wherein he argued that every country has some absolute advantage in production of some commodities due to specialization or availability of natural resources. According to absolute advantage theory a country should export the commodity in which has absolute advantage and import that commodity in which it has absolute disadvantage. The idea of trade being a means of economic gains was accepted, but a question remained unanswered- that is what if country A has absolute advantage in production of both commodity X and Y as against country B, will trade still be beneficial for both countries A and B. Adam Smith’s theory failed to answer. Other flaw of Adam Smith’s theory was that it was based on the labour theory of value (no. of labour hours required to produce one unit of a commodity), and he did not account for the other factors of production.

Comparative Advantage Theory of International Trade

Ricardo removed the problem in the theory of Absolute advantage by theorizing that it is not absolute advantage, but the comparative advantage that gives birth to gain from international trade. A country should in case of lack of absolute advantage in any commodity can still trade and gain. Such a country should compare its disadvantages in production in X and Y commodity with another country and its absolute disadvantage is less in X, it should keep on producing X whereas it should import Y in which its absolute disadvantage is bigger. Overall, the country would enjoy comparative advantage and optimum use of resource, than what would have been without international trade.

 The absolute advantage and comparative advantage theories are called classical theories of international trade.

Modern Theory of International Trade

Heckscher –Ohlin, Swedish economists gave factor endowment theory of international trade, wherein they explained why comparative advantage arises, and how it leads to specialization in of a country in production of that commodity which uses its abundant factor and what are the consequences of international trade. They assumed perfect competition and constant technology and factor intensity of production. With these assumptions they mathematically proved that a country would enjoy comparative advantage if it specializes in production of the commodity that uses its abundant factor and imports that commodity that it uses its scarce factor. From this logic India should specialize in the production of labour intensive products while import capital intensive products and just the opposite incase of the US. These economists concluded that if free trade takes place there would be a tendency of factor and product price equalization in the world.

Leontief Paradox

Leontief’s paradox in economics is that a country with a higher capital per worker has a lower capital/labor ratio in exports than in imports. This econometric find was the result of Wassily W. Leontief’s attempt to test the Heckscher–Ohlin theory (“H–O theory”) empirically. In 1953, Leontief found that the United States—the most capital-abundant country in the world—exported commodities that were more labor-intensive than capital-intensive, contrary to H-O theory. Leontief inferred from this result that the U.S. should adapt its competitive policy to match its economic realities. Later the supporters of Heckscher-Ohlin said that Leonteif paradox may be explained by the fact thet labour force in the US is not labour but human capital due to investment in nutrition and skill. Further some of them said that technology does not remain constant overtime and as technology changes, factor intensity (in what proportion factors would be mixed) also changes.

Immiserazing growth

Immiserizing growth is a theoretical situation first proposed by Jagdish Bhagwati, in 1958, where economic growth could result in a country being worse off than before the growth. If growth is heavily export biased it might lead to a fall in the terms of trade of the exporting country. In rare circumstances this fall in the terms of trade may be so large as to outweigh the gains from growth. If so, this situation would cause a country to be worse off after growth than before. Such a case may arise in primary product exporters including agro-exports, mineral/oil and metals exports and other food products. The countries producing industrial/manufactured products enjoy a better term of trade because of innovation, packaging and varying control over the product supplies and prices.

Beggar thy neighbor policy

In economics, a beggar-thy-neighbour policy is an economic policy through which one country attempts to remedy its economic problems by means that tend to worsen the economic problems of other countries. Beggar thy neighbor often refers to international trade policy that benefits the country that enacted it, while harming its neighbors or trade partners. The term is widely credited to the philosopher and economist Adam Smith, who used the term in The Wealth of Nations, in a critique of mercantilism and protectionist trade policies. Smith saw mercantilism, and its zero-sum understanding of the market, encouraging nations to beggar each other in order to increase economic gain, as misguided; instead, he believed that free trade would lead to long-term economic growth that was not zero-sum, but would actually increase the wealth of—you guessed it—all nations.

Beggar thy neighbor policies came about, originally, as a policy solution to domestic depression and high unemployment rates. The basic idea is to increase the demand for a nation’s exports, while reducing reliance on imports. This means driving consumption of domestic goods up, as opposed to consumption of imports. This is usually achieved with some kind of trade barrier—tariffs or quotas—, or competitive devaluation, in order to lower the price of exports and drive employment and the price of imports up.

Dutch Disease

The term was coined in 1977 by The Economist to describe the decline of the manufacturing sector in the Netherlands after the discovery of the large Groningen natural gas field in 1959. Dutch disease is the negative impact on an economy of anything that gives rise to a sharp inflow of foreign currency, such as the discovery of large oil reserves. The currency inflows lead to currency appreciation, making the country’s other products less price competitive on the export market. In economics, the Dutch disease is the apparent causal relationship between the increase in the economic development of a specific sector (for example natural resources) and a decline in other sectors (like the manufacturing sector or agriculture). It may be explained as a process in which sudden increase in exports of a commodity produced in country leads  to increase in revenues in the growing sector (or inflows of foreign aid), which in turn leads to appreciation of the given nation’s currency compared to currencies of other nations (manifest in an exchange rate). This results in the nation’s other exports becoming more expensive for other countries to buy, and imports becoming cheaper, making those sectors less competitive. While it most often refers to natural resource discovery, it can also refer to “any development that results in a large inflow of foreign currency, including a sharp surge in natural resource prices, foreign assistance, and foreign direct investment”.

Generally free trade brings gains for all participating countries, but this should be accepted with certain reservations. There are different levels of industrialization and development, different levels of technological progress and different sizes and variations in location, fertility of soil and natural resources. All these factors have a bearing on gains from international trade. Therefore we can say that international trade is an engine of growth, but with certain caveats and cautions.

Balance of Payments

Balance of payments is an annual account of economic transactions/exchanges of a country with the rest of the world. Economic transactions between two or more countries pertain to flow of goods, services and capital among them. Balance of payments accounts is divided broadly in two accounts—(1) Current Account and (2) Capital Account.

Current Account

The current account of the balance of payments presents accounts of export and import of goods and services by a country during a year (accounts may be prepared on quarterly/half yearly basis as well). The current account is further divided into two parts—(1) Visibles or Merchandise account, which presents accounts of export and import of goods only and (2) Invisibles, which present an account of export and import of services only (transport & communication like shipping and air services,  banking, insurance, software services and IT Enabled Services, BPO services, consultancy etc.) during a year. Thus the current account presents accounts of exchanges (export and import) of both goods and services of a country with the rest of the world.

Capital Account

This is part of the balance of payments accounts for inflow and outflow of capital from a country or to a foreign country due to trade surplus/deficit, external loans (public and private both) and foreign investment (both portfolio or financial investment and foreign direct investment or foreign investment in directly productive activities). Foreign Exchange Reserves of a country is part of its capital account. Sovereign (government) or Commercial Market Borrowing (private) and lending are accounted for in the capital account. Likewise inflow and outflow of foreign investment- both financial (portfolio investment) and foreign direct investment (real investment) are also part of capital account. Broadly, the inflow and outflow in the capital account may be categorized as “debt capital flow” e.g. loans and borrowings or “non-debt capital flow”, e.g. foreign investment.

Balance of Payments, balance of current accounts and balance of trade

Balance of payments is the overall record of all economic transactions of a country with the rest of the world. Balance of trade is the difference in the value of exports and imports of only visible items. Balance of trade includes imports and exports of goods alone i.e., visible items. Balance of current Accounts is equal to balance of trade plus net invisibles.

Balance of Payments = Balance of current account + Balance of capital account

Balance of Trade = Value of export of Goods —-  Value of import of goods

Current account balance =  Balance of Trade + Net invisibles, where net invisibles are equal to export of invisibles minus import of invisibles

When all components of the BoP accounts are included they must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counterbalanced in other ways – such as by funds earned from its foreign investments, by running down currency reserves or by receiving loans from other countries. While the overall BoP accounts will always balance when all types of payments are included, imbalances are possible on individual elements of the BoP, such as the current account, the capital account excluding the central bank’s reserve account, or the sum of the two. Imbalances in the latter sum can result in surplus countries accumulating wealth, while deficit nations become increasingly indebted.

Exchange Rate

International trade payments are done with the use of foreign currency, especially currencies categorized as “hard currencies” which are internationally accepted as means of payment due to their relatively stable exchange rate and purchasing capacity. The prominent hard currencies include US dollar, Euro, the British Pound Sterling, Japanese Yen, Chinese Yuan and Canadian Dollar etc. On the other hand there are “soft currencies” whose exchange rates fluctuate and these are not accepted in all foreign trade transactions a means of payments, for example, Russian Ruble, Indian Rupee and currencies of other emerging or developing countries. Petro dollar is dollar earned by petroleum exporting countries whereas Euro dollar refers to dollar deposited in European banks.

Types of exchange rates

Fixed Exchange Rate

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime where a currency’s value is fixed against either the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold. In post first world war period, a fixed exchange rate system prevailed which was called the “Gold Standard” in which all the currencies determined their values against gold (particular amount of gold per dollar for example) and gold being common denominator, cross exchange rates among  different currencies could be easily determined. After the creation of theIMF the world still continued to follow a fixed exchange rate called “pegged exchange rate” wherein all the currencies were pegged against dollar, but the US dollar was pegged against gold.

There are benefits and risks to using a fixed exchange rate. A fixed exchange rate is typically used in order to stabilize the value of a currency by directly fixing its value in a predetermined ratio to a different, more stable or more internationally prevalent currency (or currencies), to which the value is pegged. In doing so, the exchange rate between the currency and its peg does not change based on market conditions, the way floating currencies do. This makes trade and investments between the two currency areas easier and more predictable, and is especially useful for small economies, economies which borrow primarily in foreign currency, and in which external trade forms a large part of their GDP.

Under a fixed exchange rate system, the central bank accommodates those flows by buying up any net inflow of funds into the country or by providing foreign currency funds to the foreign exchange market to match any international outflow of funds, thus preventing the funds flows from affecting the exchange rate between the country’s currency and other currencies. Then the net change per year in the central bank’s foreign exchange reserves is sometimes called the balance of payments surplus or deficit.

Floating Exchange Rate

A floating exchange rate (also called a fluctuating or flexible exchange rate) is a type of exchange-rate regime in which a currency’s value is allowed to fluctuate in response to foreign-exchange market mechanisms, i.e., relative demand and supply of currencies. A currency that uses a floating exchange rate is known as a floating currency. A floating currency is contrasted with a fixed currency whose value is tied to that of another currency, material goods or to a currency basket.

Full float means a currency’s value is determined totally by market mechanism, whereas managed float means that although a currency’s value is determined by the market forces generally, the central bank of the concerned country may intervene to influence exchange rate. Managed float is also called dirty float.

In the modern world, most of the world’s currencies are floating; such currencies include the most widely traded currencies: the United States dollar, the Swiss Franc, the Indian rupee, the euro, the Japanese yen, the British pound, and the Australian dollar. However, central banks often participate in the markets to attempt to influence the value of floating exchange rates. The Canadian dollar most closely resembles a pure floating currency, because the Canadian central bank has not interfered with its price since it officially stopped doing so in 1998. The US dollar runs a close second, with very little change in its foreign reserves; in contrast, Japan and the UK intervene to a greater extent, whereas India has seen medium range intervention by its central bank, the Reserve Bank of India.

From 1946 to the early 1970s, the Bretton Woods system made fixed currencies the norm; however, in 1971, the US decided no longer to uphold the dollar exchange at 1/35th of an ounce of gold, so that the currency was no longer fixed. After the 1973 Smithsonian Agreement, most of the world’s currencies followed suit. However

In a managed float, some changes of exchange rates are allowed while in a purely floating exchange rate (also known as a purely flexible exchange rate), the exchange rate totally depends on market forces. With a pure float the central bank does not intervene at all to protect or devalue its currency, allowing the rate to be set by the market, and the central bank’s foreign exchange reserves do not change, and the balance of payments is always zero.

Nominal, real and real effective exchange rates

Nominal exchange rate is market exchange rate without adjusting inflation with respect to currencies in question whereas real exchange rate in exchange rate adjusted for inflation with respect to currencies in question. The real effective exchange rate is reasl exchange rate of a currency with its trading partners’ currency.

Exchange rate theories

For the determination of the par values of different currencies, alternative theoretical explanations have been given. There are following popular theories in this regard:

  1. The Mint Parity Theory:

The earliest theory of foreign exchange has been the mint parity theory. This theory was applicable for those countries which had the same metallic standard (gold or silver). Under the gold standard, countries had their standard currency unit either of gold or it was freely convertible into gold of a given purity.

  1. The Purchasing Power Parity Theory:

The purchasing power parity theory enunciates the determination of the rate of exchange between two inconvertible paper currencies. Although this theory can be traced back to Wheatley and Ricardo, yet the credit for developing it in a systematic way has gone to the Swedish economist Gustav Cassel.

This theory states that the equilibrium rate of exchange is determined by the equality of the purchasing power of two inconvertible paper currencies. It implies that the rate of exchange between two inconvertible paper currencies is determined by the internal price levels in two countries.

  1. The Balance of Payments Theory:

The balance of payments theory of exchange rate maintains that rate of exchange of the currency of one country with the other is determined by the factors which are autonomous of internal price level and money supply. It emphasises that the rate of exchange is influenced, in a significant way, by the balance of payments position of a country.

A deficit in the balance of payments of a country signifies a situation in which the demand for foreign exchange (currency) exceeds the supply of it at a given rate of exchange. The demand for foreign exchange arises from the demand for foreign goods and services. The supply of foreign exchange, on the contrary, arises from the supply of goods and services by the home country to the foreign country.

  1. The Monetary Approach to Rate of Exchange:

In contrast with the BOP theory of foreign exchange, in which the rate of exchange is determined by the flow of funds in the foreign exchange market, the monetary approach postulates that the rates of exchange are determined through the balancing of the total demand and supply of the national currency in each country.

According to this approach, the demand for money depends upon the level of real income, the general price level and the rate of interest. The demand for money is the direct function of the real income and the level of prices. On the other hand, it is an inverse function of the rate of interest. As regards, the supply of money, it is determined autonomously by the monetary authorities of different countries.

  1. The Portfolio Balance Approach:

In view of the deficiencies in the monetary approach, some writers have attempted to explain the determination of exchange rate through the portfolio balance approach which is more realistic than the monetary approach.

The portfolio balance approach brings trade explicitly into the analysis for determining the rate of exchange. It considers the domestic and foreign financial assets such as bonds to be imperfect substitutes. The essence of this approach is that the exchange rate is determined in the process of equilibrating or balancing the demand for and supply of financial assets out of which money is only one form of asset.

To start with, this approach postulates that an increase in the supply of money by the home country causes an immediate fall in the rate of interest. It leads to a shift in the asset portfolio from domestic bonds to home currency and foreign bonds. The substitution of foreign bonds for domestic bonds results in an immediate depreciation of home currency. This depreciation, over time, causes an expansion in exports and reduction in imports.

It leads to the appearance of a trade surplus and consequent appreciation of home currency, which offsets part of the original depreciation. Thus the portfolio balance approach explains also exchange over-shooting. This explanation, in contrast to the monetary approach, brings in trade explicitly into the adjustment process in the long run.

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