The Theory of International Trade

Globalization versus Inter-Regional IntegrationEconomic Alliances

NAFTAUSA, Canada, Mexico

European UnionCurrently 25 members

10 new members joined in May of 20043 more countries are being considered

Association of Southeast Asian Nations10 member countries

Ongoing negotiations between ASEAN, China, Japan, India

WTO provides the following note of caution on Regional Trade Agreements: RTAs can complement the multilateral trading system, help to build and strengthen it. But by their very nature RTAs are discriminatory: they are a departure from the MFN principle, a cornerstone of the multilateral trading system. Their effects on global trade liberalization and economic growth are not clear given that the regional economic impact of RTAs is ex ante inherently ambiguous. Though RTAs are designed to the advantage of signatory countries, expected benefits may be undercut if distortions in resource allocation, as well as trade and investment diversion, potentially present in any RTA process, are not minimized, if not eliminated altogether. Source: WTO Website: http://www.wto.org

• All members of WTO (previously parties to GATT) are required to notify WTO of any trade agreement. (See the handout)

• 1948-1994, GATT received 124 notifications.

• 1995-2002 WTO (established in 1995) received 130 notifications

MERCOSURSouthern Common MarketOriginal members: Argentina,

Brazil, Uruguay, ParaguayAndean Community

Bolivia, Colombia,Ecuador, Peru, Venezuela

Growth in International Trade

Trade – Specialization. The Theory

• Absolute advantage principle– Why specialize in the production of something

that is cheaper to purchase from abroad?

• Comparative advantage principle– Specialize in the production of those products

in which you have the lowest relative (opportunity) cost of production

Specialization

Sources for Comparative Advantage• Resource Endowment

– Heckscher-Ohlin Theorem• Past economic development/planning is responsible for

current comparative advantage

Leontief ParadoxFactor Price equalization• Stopler-Samuelson Theorem and H-O theorem

– Increase in the earnings of relatively abandoned factor, decrease in the earnings of relatively scarce factor

US example

• US trade balance (available on BEA website)– http://www.bea.gov/bea/di/home/trade.htm

• How does the US afford to run this large trade deficit continuously?– Demand for the US dollar– BoP (available through the BEA website)

• http://www.bea.gov/bea/di/home/bop.htm

Current Account Balance (~Trade balance) as % of GDP, 2001

Less than –8.2-8.2 < . < - 4.8-4.8 < / <-2

-2 < . < 2.9Over 2.9No data available

Forms of Common Trade Restrictions

• Quota

• Tariff

Arguments against free trade

- strategic industry

- infant industry

- cultural or social values

- job preservation

Forms of Trade Agreements

•Preferential trade arrangement (one sided or reciprocal)

•Free trade area (reciprocal)

•Customs Union

•Common market – factors mobility

•Economic union – policy coordination

International Arrangements

GATT – General Agreement on Tariffs and Trade. Instituted in 1947. In 1945, the USpresented the IMF with a draft charter for an International Trade

Organization,but that failed to materialize in part due to the US congress lack of approval.Instead, an agreement (GATT) under the Reciprocal Trade Agreements Actwas introduced.

GATS – General Agreement on Trade in Services.

General Agreement on Trade-Related Aspects of Intellectual Property Rights.

Under GATT (Article 1) all countries signing the treaty must extend the Most-Favored Status (treat all countries equally) to all other countries that ratified GATT. There aretwo exceptions to Article 1: customs unions and free-trade areas, and countries arePermitted to apply lower import tariffs to goods coming from developing countries.

Movement away from quotas towards tariffs, and subsequent reduction in tariffs

Some famous rounds of negotiations: The Uruguay Round 1986-1993 lead to the Establishment of WTO in 1995.The Kyoto Round: The Kyoto Protocol of 1997 set targets for reductions of

greenhouse gas emissions for industrialized countries from the 1990 level by 2012: 8% in Europe, 7% in US, 6% in Japan, and stabilization of emissions in Russia.

WTO

Monitors and administers all WTO trade agreements (GATT)

Presents a forum for future trade negotiations

Provides arbitrage in trade disputes between nations (WTO has a nice case study example on their website at: http://www.wto.org/english/thewto_e/whatis_e/tif_e/disp3_e.htm)

Provides technical assistance, policy recommendations forDeveloping countries.

Established January 1, 1995Located in Geneva SwitzerlandCurrently 146 member nations

EU1948 Benelux – the custom union of Belgium, Luxemburg, the Netherlands• 1950 proposition of forming a larger of six countries: Belgium,

Luxemburg, the Netherlands, France, Germany, and Italy (European Economic Community, 1957)

• 1968 Customs union with common external tariffs is established• 1973 Denmark, Ireland, United Kingdom join the European

Community• 1979 Establishment of European Monetary System• 1981 Greece becomes a member• 1986 Spain and Portugal enter• 1995 Austria, Sweden and Finland• 1993 Maastricht Treaty is ratified (plans to establish a common

currency in 1999). Three step approach: free capital movement and close policy coordination, then establishment of central European banks to control the currencies followed by the establishment of fixed exchange rate and transfer of monetary authority.

• January 1 1999 Euro is launched• May 2004 Massive expansion into Eastern Europe• Perspective members: Bulgaria, Romania, Turkey

Can Euro be a problem for the Dollar?

• Price of oil

• International reserve currency

• Competition for investment funding

Foreign Exchange

Foreign exchange (Nominal) – simply the price of one currency in terms of another (1 dollar = 30 roubles , 1 dollar = 0.85 euros)

The currency appreciates when the number of units of foreign currency required to purchase it increases (1 dollar = 36 roubles would be an example of a 20% appreciation in the value of the dollar). Depreciation is just the opposite of appreciation.

Why should we be concerned about the exchange rate of the dollar?

Effect of the currency on trade: If a US firm sells a product in Russia that is priced at 300 roubles, then given the exchange rate of 1USD=30R, the US firm receives 10 dollars per unit sold, but what if during the time between shipping the product to Russia and actually selling it and converting the proceeds into dollars the value of the dollar changes to 1USD=40 R, then the US firm will receive only 7.5 dollars per unit sold => 25% loss in revenues!

Investment is similarly effected by the exchange rate fluctuations.

These fluctuations in the exchange rate create uncertainty for export/import firms and international investors causing those agents to hedge against foreign exchange fluctuations.

Singapore 166 Estonia 77Hong Kong, China 133 United States 11Malaysia 122 Slovak Republic 62Luxembourg 113 Czech Republic 61Ireland 88 Austria 45Malta 91 Russian Federation 44Angola 86 Netherlands 61Belgium 77 Sweden 44

Exports as % of GDP in 1999

In addition, currency conversion has a cost, that can play a significantrole. Every time you convert currencies you are charged conversion fees by the bank. It was estimated that in Europe these fees, because of large volume of trade ran near 1% point of the GDP – a strong reason for creating a common currency.

Hedging works like an insurance against currency fluctuations:there are several mechanisms that exist in currency markets for thispurpose: futures, forwards, options, swaps. Perhaps options should bemost familiar, since those are also used in the stock market as well. Options can be of two setups: European (like stock index options), and American, like stock options. More importantly, options are done in two types: calls and puts.Consider the following simple example:You intend to sell your product in Russia at 300 roubles per unit, but you are not sure what the exchange rate between the rouble and the dollar will be when you complete your sale, you can protect yourself by purchasing a put option on the rouble with a given strike price today and an expiration period that is sufficient for your sale. (use stock example here)

Clearly, options like any risk shifting instrument will have premiums, and hence may be quite expensive, especially on volatile currencies.

What if the demand for the dollar suddenly drops?Can the government do anything to stop the value of the dollar from falling?

The preceding discussion concentrated on the floating exchange rate regime, but that wasn’t always the case.

Alternative regimes:

Gold Standard – 1880’s-1914. Gold standard made the exchange rates fixed, removing all the complexities of the floating exchange rate that we previously mentioned. Gold acted as international money! Hume’s correction mechanism and the balance of payments.

1944 – Bretton Woods conference and the birth of WB and IMF, the Gold Exchange Standard. Fixed exchange rate system – under a fixed exchange rate system the government specifies the exchange rate. In many places this system lead to parallel markets, as the government regulations expended in order to protect the government reserves of forex.

Fixed exchange rate continued: many countries fix their currencies to the currency of their major trading partner to insure stability in trade (Bulgaria, Estonia and the Deutsche mark in the late 1990’s, Argentina and the USD)

Although, fixing the exchange rate has its benefits, it may also be quite costly. What if my currency is overvalued, like the Mexican Peso in 1994, prior to the December crisis, then my economy will experience growing trade deficit. The currency crisis doesn’t need to come from the trade side, in the case of Russia in 1998, and in the earlier currency crisis, one of the larger contributors was the capital flight (Financial account instead of the current account, know this distinction, as I may put it on the exam)

Relatively recent solution – the currency board!

Policy and exchange rate regime

FLOATstrong open economy effect, thus weak fiscal policy.

Monetary expansion causes depreciation in the value of the currency, thus strong monetary policy

FIXEDno open economy effect, weak indirect crowding out effect, thus strong fiscal policy

no currency depreciation, inability to change domestic interest rate due to international capital mobility

Economic Development

Establishment of World Bank/Bank for Reconstruction and DevelopmentCapital growth and productionTargeted developmentDebt

Role of Human Capital

Institutions and their development

Political Stability and Economic Prosperity

Multinational firm

• Exchange rate and translation impact

• Political and institutional changes

• Transfer pricing– ‘window dressing’– Profit transfer