NOTES FOR

MASTER OF BUSINESS ADMINISTRATION

M.B.A
(Semester-III)
SUBJECT CODE : 305 (IB)
SUBJECT: International Business Economics

Syllabus
Unit:1
Background for International Business Economics : Globalization and International Business – The Emergence of
Global Institutions – Drivers of Globalizations - The Globalization Debate - The Gains from Trade - Foreign Trade
Multiplier - Balance of Payments
Unit:2
The International Trade Theory : The Law of Comparative Advantage – The– Demand and Supply, Offer Curves,
and the Terms of Trade – Factor Endowments and the Heckscher – Ohlin theory – Implications of Trade Theories -
Economics of Scale, Imperfect Competition, and International Trade.
Unit:3
a) International Trade Policy : Trade Restrictions - Tariffs , Non-Tariff Trade Barriers - Tariff vs. Quota - The New
Protectionism – Economic Integration - Custom Unions and Free Trade Areas - Major Regional Trade Agreements
b) Foreign Exchange : Foreign Exchange Market – Types of Foreign Exchange Transactions – Reading Foreign
Exchange Quotations – Forward and Futures Market – Foreign-Currency Options – Exchange Rate Determination
– Arbitrage – Speculation and Exchange-Market Stability
Unit:4
World Financial Environment: Global Foreign – Exchange Markets – Economic Theories of Exchange Rate
Determination - International Regime for FDI and MNC- Do Global Corporations Pose a Threat? - Consequences
of Economic Globalization
Unit:5
International Banking : Reserves, Debt and Risk : Nature of International Reserves – Demand for International
Reserves – Supply of International Reserves – Gold Exchange Standard – Special Drawing Rights – International
Lending Risk – The Problem of International Debt – Financial Crisis and the International Monetary Fund –
Eurocurrency Market

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 Chapter 1:

Background for International Business Economics : Globalization and International Business – The
Emergence of Global Institutions – Drivers of Globalizations - The Globalization Debate - The Gains
from Trade - Foreign Trade Multiplier - Balance of Payments

Background for International Business Economics

International Business Economics is designed for students that have a background in business and
management studies. The aim is to provide an opportunity to expand knowledge of the international
business environment using economic analysis in a practical way. As such, the it looks to provide a
grounding in aspects of quantitative methods, business economics, the international business
environment, the multinational enterprise and the international macro financial environment. The
combination of international business and applied economics is designed to provide an overview of the
international world of business and a solid foundation for a career in a variety of organisations operating
internationally, or as an applied/business economist.
International Business Economics provide insight into economic, political, social and cultural
aspects of international business management, Analyzing and evaluating a company’s opportunities in
the global market, Translating the market and the company’s resource potential into company strategies,
plans and actions and Leadership and international human resource management

Globalization and International Business

‘Globalization’ has become the buzzword that has changed human lives around the world in a
variety of ways. The growing integration of societies and national economies has been among the most
fervently discussed topics during recent years. Globalization refers to the free cross-border movement of
goods, services, capital, information, and people. It is the process of creating networks of connections
among actors at multi- continental distances, mediated through a variety of flows including people,
information and ideas, capital, and goods. The breakthroughs in the means of transport and
communication technology in the last few decades have also made international communication,
transport, and travel much cheaper, faster, and more frequent.
Globalization is the closer integration of the countries and peoples of the world, brought about by the
enormous reduction in the costs of transportation and communications and the breaking down of artificial
barriers to the flow of goods and services, capital, knowledge, and (to a lesser extent) people across the
borders.
With the arrival of the Internet, the transaction costs of transferring ideas and information have
declined enormously. ‘Global village’ is the term used to describe the collapse of space and time barriers
in human communication, especially by using the World Wide Web, enabling people to interact on a
global scale.
Moreover, a number of interesting terms to signify the various aspects of globalization, such as
Westernization, Americanization, Walmartization, McDonaldization, Disneyfication, Coca-Colanization,
etc., have also emerged
Globalization tends to erode national boundaries and integrate national economies, cultures,
technologies, and governance, leading to complex relations of mutual interdependence.
Globalization refers to the intensification of cross-national economic, political, cultural, social, and
technological interactions that leads to the establishment of transnational structures and the integration of
economic, political, and social processes on a global scale.
The forces of globalization have hardly been as intense before as to be explicitly evident as influencing
our daily lives. The advents in information and communication technology (ICT) and the rapid economic
liberalization of trade and investment in most countries have accelerated the process of globalization.
Markets are getting flooded with not only industrial goods but also with items of daily consumption.
Each day, an average person makes use of goods and services of multiple origins—for instance,
the Finnish mobile Nokia and the US toy-maker’s Barbie doll made in China but used across the world; a

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software from the US-based Microsoft, developed by an Indian software engineer based in Singapore,
used in Japan; the Thailand-manufactured US sports shoe Nike used by a Saudi consumer. The increased
integration of markets—goods and financial—the mobility of people with transnational travels for jobs
and vacations, and the global reach of satellite channels, the Internet, and the telephone all have virtually
transformed the world into a ‘global village’.
‘Globalization’, one of the most complex terms used in international business, has wide
connotations. Interestingly, ‘globalization’ is a term not only used and heard frequently, but also as often
misused and misinterpreted. Globalization is used to refer to the increasing influence exerted by
economic, political, socio-cultural, and financial processes across the globe. Globalization not only offers
numerous challenges to business enterprises but also opens up new opportunities. In the earlier era of
restrictive trade and investment regimes with much lower degree of interconnectedness among countries,
companies solely operating in their home markets were generally protected and isolated from the vagaries
of upheavals in the international business environment. Therefore, developing a thorough conceptual
understanding of international business has become inevitable not only for the managers who operate in
international markets, but also for those who operate only domestically.
Economic restrictions became pervasive around the world after World War I, leading to de-facto
de-globalization. Besides, the import substitution strategies followed by most developing countries,
which gained independence from colonial rule in the post-World War II era, considerably restricted
international trade and investment.
A number of multilateral organizations set up after World War II under the aegis of the United
Nations, such as the World Bank (WB), the International Monetary Fund (IMF), the General Agreement
on Tariffs and Trade (GATT), and the World Trade Organization (WTO), facilitated international trade
and investment.
Elucidating the conceptual framework of globalization, encompassing financial, cultural, and
political aspects, besides the economic. Movers and restraining factors of globalization have also been
examined at length.
The arguments both for support and criticism of globalization have also been critically evaluated.
Globalization offers challenges and opportunities for business enterprises and firms are required to adopt
the most effective response strategy.

The Emergence of Global Institutions –

A number of multilateral institutions under the UN framework, set up during the post-World War
II era, have facilitated exchanges among countries and became prominent forces in present-day
globalization.
Multilateral organizations such as the GATT and WTO contributed to the process of globalization
and the opening up of markets by consistently reducing tariffs and increasing market access through
various rounds of multilateral trade negotiations.
The evolving multilateral framework under the WTO regime, such as Trade-Related Investment
Measures (TRIMS), Trade-Related Aspects of Intellectual Property Rights (TRIPS), General Agreement
on Trade in Services (GATS), dispute settlement mechanism, anti-dumping measures, etc., has facilitated
international trade and investment. Besides, the International Monetary Fund has contributed to ensuring
the smooth functioning of the international monetary system.
International Economic Integrations:
Consequent to World War II, a number of countries across the world collaborated to form
economic groupings so as to promote trade and investment among the members. The Treaty of Rome in
1957 led to the creation of the European Economic Community (EEC) that graduated to the European
Union (EU) so as to form a stronger Economic Union.
The US, Canada, and Mexico collaborated to form the North American Free Trade Agreement
(NAFTA) in 1994. The reduction of trade barriers among the member countries under the various
economic integrations around the world has not only contributed to the accelerated growth in trade and
investment but also affected the international trade patterns considerably.

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Dr. Bhati Rakesh 4
Drivers of Globalizations –
The main forces that have driven global integration have been technological innovations, broader
political changes and economic policies.
On a large time scale, the world has been on a gradual, but accelerating, track of globalization for
the last thousand years. Advancements in transportation technology enabled intercontinental trade, and
this led to the exchange of goods, ideas and cultural influences over large portions of the planet. By the
17th century, explorers and merchants were capable of circumnavigating the globe; this was the first time
the world became a single, contained system of politics and economics.
In more recent times, the advancement of technology has accelerated the trend of globalization.
For instance, telecommunications technology allows for instantaneous exchange of information around
the world in the form of telephone calls, emails and video conferences.
Digital technology allows for distribution of information content around the world, so European
music or American films can reach remote villages in Asia and Africa within minutes. This advancing
technology allows for commercial opportunities on broader market scales as well as exchanges of cultural
elements to an unprecedented degree.
As a result, children growing up anywhere in the world can experience the same culture and
pursue the same economic opportunities as they mature. Political forces around the world are also serving
to open up trade between nations and facilitate cooperative development of commercial opportunities.

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The Globalization Debate –
Globalization is one of the most important topics being discussed economically and politically
today. It is the idea of slowly shifting to a fully integrated world where all countries cooperate with each
other in politics, cultural values, knowledge, and politics. The reason that this idea has come to be is
largely due to the internet. The internet has allowed the entire world to link together, enabling
communication and collaboration with people from all over the world. The core values of globalization
have truly changed the way that we see the world, travel, and conduct business, but has it all been good?
Let’s take a close look at the good and bad things that have or will come from globalization of the planet.
The Pros of Globalization
1. Improving The Global Economy
One of the most significant changes that has been brought on by globalization is the access to
international sale and business. The market that companies can reach is huge and rapidly
expanding everyday. This has helped to breach the opportunity gaps between many countries.
2. Expanding Knowledge Of Foreign Cultures
People from all over the world now have the access to communicate freely with one another. This
is helping to break down cultural barriers that have hurt the integration of countries for centuries.
Gaining a better understanding of how people around the world live is a key point of
globalization.
3. Decisions For The World, Not The Country
Political powers and governments are joining together all over, one great example of this is the
European Union. This promotes for political and economical decisions to be made that are good
for a global benefit, instead of only focusing on local areas.
4. Free Trade Makes A Happy Economy
Through globalization, the idea that all trade barriers would be lifted is very real. Having no
restrictions or crazy taxes to purchase and sell goods all over the world would help to grow the
struggling economy. This would also help to improve poverty and unemployment rates all over
the world.
5. Movement of Labor
Another thing much discussed is the free movement of labor all over the world. If workers could
move from country to country, they would be able to market themselves in areas that need people
with their skills. This would even further help the economy and provide much needed workers to
certain areas of the world.

The Cons of Globalization

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 1. Not Good For The Underdogs
If all countries where free to trade with one another, then the entire world would be put at an even
playing field. Early developing or under developed countries would not be able to compete with
the larger economies of the world and would likely crumble underneath the competition.
2. Makes the Rich, Richer
Globalization is a great thing for owners and managers, but it is detrimental to workers and
laborers. The competitive nature of this idea puts people that are already rich, in very successful
situations. They often exploit workers, children, and prisoners to keep up with demand.
3. The Labor Drain \
Everyone wants to make money and be able to live a successful and comfortable life. With
globalization, you are able to move freely from country to country in order to find work. People
would flock to areas with higher paying jobs, and leave poorer countries to fend for themselves.
They would sufficiently “drain” the country of all of their workers that keep things up and
running.
4. A Loss Of Cultures
With globalization, eventually, every country would run and function the same way. The deep
rooted cultures of these countries would be lost due to mass migration and western influences.
This is a scary thing for many people. Arguers of globalization believe that cultural barriers are
necessary in order to have culture.

THE GAINS FROM TRADE

Nations—developed or underdeveloped- trade with each other because trade is mutually
beneficial. In other words, the basic motivation of trade is the gain or benefit that accrues to nations.
In the case of autarky or isolation, benefits of international division of labour do not flow between
nations. It is advantageous for all the countries of the world to engage in international trade. However,
the gains from trade can never be same for all the trading nations. Some countries may reap a larger gain
compared to others. Thus, gains from trade may be inequitable but what is true is that “some trade is
better than no trade”.
In simple words, gain from trade refers to extra production and consumption effects that countries
can achieve through international trade. These gains are, thus, of two types gain from exchange and gain
from specialisation in production.
The idea of gains from trade was at the core of the classical theory of international trade
propounded by Adam Smith and David Ricardo. According to Smith, the gains from trade arise form the
advantages of division of labour and specialisation—both at the national and international level. Such
advantages arise, according to Smith, due to the absolute differences in costs. Ricardo goes a step further.
He says that trade contributes “to increase the mass of commodities, and therefore, the sum of
enjoyments…” Ricardo adds that the gain from trade consists in the saving of cost resulting from
obtaining the imported goods through trade instead of domestic production.
Ricardo’s comparative cost thesis may be applied to establish the existence of gains from trade. In
other words, gain from trade depends on the comparative cost conditions. Comparative cost doctrine
suggests that trade can provide benefit to all countries if they specialise in the production of those goods
and, hence, export them in which they have comparative advantage.
A country, thus, specialises in production and export in accordance with its comparative
advantage. Ricardo’s trading nations acquire complete specialisation in production. As a result, global
output becomes larger than under autarky. Trade also enables each country to consume more than under
isolation. Thus, there is a production gain and a consumption gain arising out of international trade. Such
gains cannot be reaped in the absence of trade.
However, in determining the exact volume of gains from trade, Ricardo’s doctrine is incomplete.
For this, what is required is the determination of the actual terms of trade or exchange rate at which trade
would take place. The rate at which one commodity (say, export good) is exchanged for another
commodity (say, import good) is called terms of trade. Or what import the export buys is called the TOT.
Of course, export (and, hence, import) varies with the change in TOT.

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 This concept of TOT was introduced in the literature by J. S. Mill by introducing the concept of
reciprocal demand. By reciprocal demand we mean demand of each country for the other’s goods. On the
basis of the principle of reciprocal demand, Mill determined a final TOT at which trade between two
nations takes place.
At the final TOT, goods demanded by one country are equal to the goods demanded by the other,
or one country’s supply or the export of good must equal the other country’s demand for that good. Thus,
TOT is an index of measuring a country’s gain from trade. As a result, if a poor, small, less developed
country (LDC) trades with a large, rich, developed country’s (DC) autarkic or domestic cost ratio, then
the LDC will acquire all the gains from trade. If the actual TOT lies between two domestic cost ratios
then gains from trade will accrue to both the countries.
However, gains from trade depend on the :
i. Relative strengths of elasticity of demand for export and import of goods;
ii. Size of the country;
iii. Changes in technology;
iv. Supply of goods traded; etc.
In general, greater the inelasticity in the foreign demand for exports and greater the elasticity of
foreign demand for imports, greater will be the gains from trade.
Further, trade leads to increased competition. Competition enhances efficiency LDCs gain largely
in this competitive world. Improved research and technology of the developed world flow in these
countries. Openness to trade supports technological upgrading via learning. Evidence on learning and
technological up gradation is observed in many activities, mainly in the manufacturing and service
sectors.
Larger output and productivity increases indeed can occur not only in the manufacturing sector, but also
in other sectors in which technological upgrading of the advanced countries is embodied. In addition,
variety of products becomes available to consumers. All these suggest that trade is an ‘engine of growth’.
However, gains from trade can never be unambiguous for all the countries. Sometimes, TOT may
turn adverse against poor LDCs. Further, trade policy is often designed by the advanced countries in such
a way that it reduces benefits of the LDCs from trade. Possibly, due to this fact it is said that free trade is
better than restricted trade. Of course, restricted trade has merits too. By imposing a tariff, a poor country
can even improve its TOT and, hence, can obtain benefits from trade
FACTORS AFFECTING GAINS FROM TRADE
There are several factors which determine the gains from international trade:
1. Differences in cost ratio: The gains from international trade depends upon the cost ratios of
differences in comparative cost ratios in the two trading countries. The smaller the difference
between exchange rate and cost of production the smaller the gains from trade and vice versa.
2. Demand and supply: If a country has elastic demand and supply gains the gains from trade are
higher than if demand and supply are inelastic.
3. Factor availability: International trade is based on the specialization and a country specializes
depending upon the availability of factors of production. It will increase the domestic cost ratios
and thereby the gains from trade.
4. Size of country: If a country is small in size it is relatively easy for them to specialize in the
production of one commodity and export the surplus production to a large country and can get
more gains from international trade. Whereas if a country is large in size then they have to
specialize in more than one good because the excess production of only one commodity cannot be
exported fully to a small sized country as the demand for good will reduce very frequently. So the
smaller the size of the country, the larger the gain from trade.
5. Terms of Trade: Gains from trade will depend upon the terms of trade. If the cost ratio and terms
of trade are closer to each other more will be the gains from trade of the participating countries.
6. Productive Efficiency: An increase in the productive efficiency of a country also determines its
gains from trade as it lowers the cost of production and price of the goods. As a result, the country
importing gains by importing cheap goods.
FOREIGN TRADE MULTIPLIER –

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 The foreign trade multiplier, also known as the export multiplier, operates like the investment
multiplier of Keynes. It may be defined as the amount by which the national income of a country will be
raised by a unit increase in domestic investment on exports.
As exports increase, there is an increase in the income of all persons associated with export
industries. These, in turn, create demand for goods. But this is dependent upon their marginal propensity
to save (MPS) and the marginal propensity to import (MPM). The smaller these two marginal
propensities are, the larger will be the value of the multiplier, and vice versa.
Foreign Trade Multiplier: Working
The foreign trade multiplier process can be explained like this. Suppose the exports of the country
increase. To begin with, the exporters will sell their products to foreign countries and receive more
income. In order to meet the foreign demand, they will engage more factors of production to produce
more. This will raise the income of the owners of factors of production. This process will continue and
the national income increases by the value of the multiplier.
The value of the multiplier depends on the value of MPS and MPM, there being an inverse relation
between the two propensities and the export multiplier. Which is the equilibrium condition of national
income in an open economy. The foreign trade multiplier coefficient (Kf) is equal to Kf = ∆Y/∆X And
∆X = ∆S + ∆M

It shows that an increase in exports by Rs. 1000 crores has raised national income through the foreign

trade multiplier by Rs. 2000 crores, given the values of MPS and MPM.
Foreign Trade Multiplier: Assumptions
The foreign trade multiplier is based on the following assumptions:
1. There is full employment in the domestic economy.
2. There is direct link between domestic and foreign country in exporting and importing goods.
3. The country is small with no foreign repercussion effects.
4. It is on a fixed exchange rate system.
5. The multiplier is based on instantaneous process without time lags.
6. There is no accelerator.
7. There are no tariff barriers and exchange controls.
8. Domestic investment (Id) remains constant.
9. Government expenditure is constant.
10. The analysis is applicable to only two countries.
Criticisms of Foreign Trade Multiplier:

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 The two models of the foreign trade multiplier presented above are based on certain assumptions
which make the analysis unrealistic.
1. Exports and Investment not Independent:
The analysis of simple foreign trade multiplier is based on the assumption that exports and investment
(both domestic and foreign) are independent of changes in the level of national income. But, in
reality, this is not so. A rise in exports does not always lead to increase in national income. On the
contrary, certain imports, of say capital goods, have the effect of increasing national income.
2. Legless Analysis:
The foreign trade multiplier is assumed to be an instantaneous process whereby it provides the final
results. Thus it involves no lags and is unrealistic.
3. Full Employment not Realistic:
The analysis is based on the assumption of a fully employed economy. But there is less than full
employment in every economy. Thus the foreign trade multiplier does not find clear expression in an
economy with less than full employment.
4. Not Applicable to More than two Countries:
The whole analysis is applicable to a two-country model. If there are more than two countries, it
becomes complicated to analyse and interpret the foreign repercussions of this theory.
5. Neglects Trade Restrictions:
The foreign trade multiplier assumes that there are no tariff barriers and exchange controls. In reality,
such trade restrictions exist which restrict the operations of the foreign trade multiplier.
6. Neglects Monetary-Fiscal Measures:
This analysis is based on the unrealistic assumption that the government expenditure is constant. But
governments always interfere through monetary and fiscal policies which affect exports, imports and
national income. Despite these shortcomings, the foreign trade multiplier is a powerful tool of
economic analysis which helps in formulating policy measures.
BALANCE OF PAYMENTS
Balance of Payments (BoP) statistics systematically summaries the economic transactions of an
economy with the rest of the World (i.e.transactions between resident & non resident entities) during a
given period. It comprises of current and capital & financial accounts . Adverse trade balance (or trade
deficit) is reflected in Current Account of BOP, which besides covering goods and services, also covers
income (investment income & compensation of employees) and current transfers (remittances, grants
etc). In case the combined net effect of trade balance, income and current transfers is also negative, the
same results in Current Account Deficit . The deficit needs to be financed by external borrowings and/or
investments which are constituents of Financial Accounts.
Current Account : As per Balance of Payment Manual(IMF), current account covers all
transactions (other than those in financial items) that involve economic values and occur between resident
and nonresident entities. Also covered are offsets to current economic values provided or acquired
without a quid pro quo. Specifically, the major classifications are goods and services, income, and
current transfers. Thus, current account is a broader measure than trade balance as it also includes
income( investment income & compensation of employees ) & current transfers.
The current account of the BoP provides information not only on international trade in goods, but
also on international transactions in services. Current account of the BoP, transactions can be classified
into merchandise (exports and imports) and invisibles.
Invisible transactions are further classified into three categories, namely
(a) Services-travel, transportation, insurance, Government not included elsewhere (GNIE) and
miscellaneous (such as, communication, construction, financial, software, news agency, royalties,
management and business services etc);
(b) Income ( investment income & compensation of employees ); and
(c) Current Transfers (grants, gifts, remittances, etc.) which do not have any quid pro quo.
Investment income covers receipts and payments of income associated, respectively, with residents’
holdings of external financial assets and with residents’ liabilities to non-residents. Investment income
consists of direct investment income, portfolio investment income, and other investment income.

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 The former balance of payments capital account has been redesignated as the capital and
financial account as per the fifth edition of Balance of Payments Manual(IMF) and the revised account
has two major components: - The Capital Account - The Financial Account These are in accordance with
the same accounts in the System of National Accounts (SNA). Assets represent claims on residents and
liabilities represent indebtedness to non residents.
Capital Account: The major components of the capital account are (a) capital transfers and (b)
acquisition/disposal of non produced, nonfinancial assets.
Financial Account: The financial account records an economy’s transaction in external financial assets
and liabilities. All components are classified according to type of investment or by functional subdivision
((a) direct investment, (b) portfolio investment, (c) other investment,(d) reserve assets (external assets
that are readily available to and controlled by monetary authorities for direct financing of payments
imbalances, for indirectly regulating the magnitude of such imbalances through intervention in exchange
markets to affect the currency exchange rate, and/or for other purposes)).
For the category of direct investment, there are directional distinctions (abroad or in the reporting
economy) and, for the equity capital and other capital components within this category, asset or liability
distinctions. For the categories of portfolio investment and other investment, there are the customary
assets or liability distinctions. Particularly significant for portfolio investment and other investment is the
distinction by type of instrument (equity or debt securities, trade credits, loans, currency and deposits,
other assets or liabilities). The traditional distinction, which is based on original contractual maturity of
more than one year or one year or less, between long- and short-term assets and liabilities, applies only to
other investment. Classification according to Sector of the domestic transactor (general government,
monetary authorities, banks and other sectors) is also used .
Chapter :2
The International Trade Theory : The Law of Comparative Advantage – The– Demand and Supply,
Offer Curves, and the Terms of Trade – Factor Endowments and the Heckscher – Ohlin theory –
Implications of Trade Theories - Economics of Scale, Imperfect Competition, and International Trade.

The International Trade Theory

International trade theories are simply different theories to explain international trade. Trade is the
concept of exchanging goods and services between two people or entities. International trade is then the
concept of this exchange between people or entities in two different countries. People or entities trade
because they believe that they benefit from the exchange. They may need or want the goods or services.
While at the surface, this many sound very simple, there is a great deal of theory, policy, and business
strategy that constitutes international trade.
To better understand how modern global trade has evolved, it’s important to understand how
countries traded with one another historically. Over time, economists have developed theories to explain
the mechanisms of global trade. The main historical theories are called classical and are from the
perspective of a country, or country-based. By the mid-twentieth century, the theories began to shift to
explain trade from a firm, rather than a country, perspective. These theories are referred to as modern and
are firm-based or company-based. Both of these categories, classical and modern, consist of several
international theories.

Classical or Country-Based Trade Theories

1. Mercantilism
Developed in the sixteenth century, mercantilism was one of the earliest efforts to develop an
economic theory. This theory stated that a country’s wealth was determined by the amount of its

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 gold and silver holdings. In it’s simplest sense, mercantilists believed that a country should
increase its holdings of gold and silver by promoting exports and discouraging imports. In other
words, if people in other countries buy more from you (exports) than they sell to you (imports),
then they have to pay you the difference in gold and silver. The objective of each country was to
have a trade surplus, or a situation where the value of exports are greater than the value of
imports, and to avoid a trade deficit, or a situation where the value of imports is greater than the
value of exports.
A closer look at world history from the 1500s to the late 1800s helps explain why
mercantilism flourished. The 1500s marked the rise of new nation-states, whose rulers wanted to
strengthen their nations by building larger armies and national institutions. By increasing exports
and trade, these rulers were able to amass more gold and wealth for their countries. One way that
many of these new nations promoted exports was to impose restrictions on imports. This strategy
is called protectionism and is still used today.
Nations expanded their wealth by using their colonies around the world in an effort to
control more trade and amass more riches. The British colonial empire was one of the more
successful examples; it sought to increase its wealth by using raw materials from places ranging
from what are now the Americas and India. France, the Netherlands, Portugal, and Spain were
also successful in building large colonial empires that generated extensive wealth for their
governing nations.
Although mercantilism is one of the oldest trade theories, it remains part of modern
thinking. Countries such as Japan, China, Singapore, Taiwan, and even Germany still favor
exports and discourage imports through a form of neo-mercantilism in which the countries
promote a combination of protectionist policies and restrictions and domestic-industry subsidies.
Nearly every country, at one point or another, has implemented some form of protectionist policy
to guard key industries in its economy. While export-oriented companies usually support
protectionist policies that favor their industries or firms, other companies and consumers are hurt
by protectionism. Taxpayers pay for government subsidies of select exports in the form of higher
taxes. Import restrictions lead to higher prices for consumers, who pay more for foreign-made
goods or services. Free-trade advocates highlight how free trade benefits all members of the
global community, while mercantilism’s protectionist policies only benefit select industries, at the
expense of both consumers and other companies, within and outside of the industry.
2. Absolute Advantage
In 1776, Adam Smith questioned the leading mercantile theory of the time in The Wealth
of Nations.Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations
(London: W. Strahan and T. Cadell, 1776). Recent versions have been edited by scholars and
economists. Smith offered a new trade theory called absolute advantage, which focused on the
ability of a country to produce a good more efficiently than another nation. Smith reasoned that
trade between countries shouldn’t be regulated or restricted by government policy or intervention.
He stated that trade should flow naturally according to market forces. In a hypothetical two-
country world, if Country A could produce a good cheaper or faster (or both) than Country B,
then Country A had the advantage and could focus on specializing on producing that good.
Similarly, if Country B was better at producing another good, it could focus on specialization as
well. By specialization, countries would generate efficiencies, because their labor force would
become more skilled by doing the same tasks. Production would also become more efficient,
because there would be an incentive to create faster and better production methods to increase the
specialization.
Smith’s theory reasoned that with increased efficiencies, people in both countries would
benefit and trade should be encouraged. His theory stated that a nation’s wealth shouldn’t be
judged by how much gold and silver it had but rather by the living standards of its people.
3. Comparative Advantage
The challenge to the absolute advantage theory was that some countries may be better at
producing both goods and, therefore, have an advantage in many areas. In contrast, another
country may not have any useful absolute advantages. To answer this challenge, David Ricardo,
Dr. Bhati Rakesh 12
 an English economist, introduced the theory of comparative advantage in 1817. Ricardo reasoned
that even if Country A had the absolute advantage in the production of both products,
specialization and trade could still occur between two countries.
Comparative advantage occurs when a country cannot produce a product more efficiently
than the other country; however, it can produce that product better and more efficiently than it
does other goods. The difference between these two theories is subtle. Comparative advantage
focuses on the relative productivity differences, whereas absolute advantage looks at the absolute
productivity.
Let’s look at a simplified hypothetical example to illustrate the subtle difference between
these principles. Miranda is a Wall Street lawyer who charges $500 per hour for her legal
services. It turns out that Miranda can also type faster than the administrative assistants in her
office, who are paid $40 per hour. Even though Miranda clearly has the absolute advantage in
both skill sets, should she do both jobs? No. For every hour Miranda decides to type instead of do
legal work, she would be giving up $460 in income. Her productivity and income will be highest
if she specializes in the higher-paid legal services and hires the most qualified administrative
assistant, who can type fast, although a little slower than Miranda. By having both Miranda and
her assistant concentrate on their respective tasks, their overall productivity as a team is higher.
This is comparative advantage. A person or a country will specialize in doing what they do
relatively better. In reality, the world economy is more complex and consists of more than two
countries and products. Barriers to trade may exist, and goods must be transported, stored, and
distributed. However, this simplistic example demonstrates the basis of the comparative
advantage theory.
4. Heckscher-Ohlin Theory (Factor Proportions Theory)
The theories of Smith and Ricardo didn’t help countries determine which products would
give a country an advantage. Both theories assumed that free and open markets would lead
countries and producers to determine which goods they could produce more efficiently. In the
early 1900s, two Swedish economists, Eli Heckscher and Bertil Ohlin, focused their attention on
how a country could gain comparative advantage by producing products that utilized factors that
were in abundance in the country. Their theory is based on a country’s production factors—land,
labor, and capital, which provide the funds for investment in plants and equipment. They
determined that the cost of any factor or resource was a function of supply and demand. Factors
that were in great supply relative to demand would be cheaper; factors in great demand relative to
supply would be more expensive. Their theory, also called the factor proportions theory, stated
that countries would produce and export goods that required resources or factors that were in
great supply and, therefore, cheaper production factors. In contrast, countries would import goods
that required resources that were in short supply, but higher demand.
For example, China and India are home to cheap, large pools of labor. Hence these countries have
become the optimal locations for labor-intensive industries like textiles and garments.
5. Leontief Paradox
In the early 1950s, Russian-born American economist Wassily W. Leontief studied the US
economy closely and noted that the United States was abundant in capital and, therefore, should
export more capital-intensive goods. However, his research using actual data showed the
opposite: the United States was importing more capital-intensive goods. According to the factor
proportions theory, the United States should have been importing labor-intensive goods, but
instead it was actually exporting them. His analysis became known as the Leontief Paradox
because it was the reverse of what was expected by the factor proportions theory. In subsequent
years, economists have noted historically at that point in time, labor in the United States was both
available in steady supply and more productive than in many other countries; hence it made sense
to export labor-intensive goods. Over the decades, many economists have used theories and data
to explain and minimize the impact of the paradox. However, what remains clear is that
international trade is complex and is impacted by numerous and often-changing factors. Trade
cannot be explained neatly by one single theory, and more importantly, our understanding of
international trade theories continues to evolve.
Dr. Bhati Rakesh 13
Modern or Firm-Based Trade Theories
In contrast to classical, country-based trade theories, the category of modern, firm-based theories
emerged after World War II and was developed in large part by business school professors, not
economists. The firm-based theories evolved with the growth of the multinational company (MNC). The
country-based theories couldn’t adequately address the expansion of either MNCs or intraindustry trade,
which refers to trade between two countries of goods produced in the same industry. For example, Japan
exports Toyota vehicles to Germany and imports Mercedes-Benz automobiles from Germany.
Unlike the country-based theories, firm-based theories incorporate other product and service factors,
including brand and customer loyalty, technology, and quality, into the understanding of trade flows.
1. Country Similarity Theory
Swedish economist Steffan Linder developed the country similarity theory in 1961, as he
tried to explain the concept of intraindustry trade. Linder’s theory proposed that consumers in
countries that are in the same or similar stage of development would have similar preferences. In
this firm-based theory, Linder suggested that companies first produce for domestic consumption.
When they explore exporting, the companies often find that markets that look similar to their
domestic one, in terms of customer preferences, offer the most potential for success. Linder’s
country similarity theory then states that most trade in manufactured goods will be between
countries with similar per capita incomes, and intraindustry trade will be common. This theory is
often most useful in understanding trade in goods where brand names and product reputations are
important factors in the buyers’ decision-making and purchasing processes.
2. Product Life Cycle Theory
Raymond Vernon, a Harvard Business School professor, developed the product life cycle
theory in the 1960s. The theory, originating in the field of marketing, stated that a product life
cycle has three distinct stages: (1) new product, (2) maturing product, and (3) standardized
product. The theory assumed that production of the new product will occur completely in the
home country of its innovation. In the 1960s this was a useful theory to explain the manufacturing
success of the United States. US manufacturing was the globally dominant producer in many
industries after World War II.
It has also been used to describe how the personal computer (PC) went through its product
cycle. The PC was a new product in the 1970s and developed into a mature product during the
1980s and 1990s. Today, the PC is in the standardized product stage, and the majority of
manufacturing and production process is done in low-cost countries in Asia and Mexico.
The product life cycle theory has been less able to explain current trade patterns where
innovation and manufacturing occur around the world. For example, global companies even
conduct research and development in developing markets where highly skilled labor and facilities
are usually cheaper. Even though research and development is typically associated with the first
or new product stage and therefore completed in the home country, these developing or emerging-
market countries, such as India and China, offer both highly skilled labor and new research
facilities at a substantial cost advantage for global firms.
3. Global Strategic Rivalry Theory
Global strategic rivalry theory emerged in the 1980s and was based on the work of
economists Paul Krugman and Kelvin Lancaster. Their theory focused on MNCs and their efforts
to gain a competitive advantage against other global firms in their industry. Firms will encounter
global competition in their industries and in order to prosper, they must develop competitive
advantages. The critical ways that firms can obtain a sustainable competitive advantage are called
the barriers to entry for that industry. The barriers to entry refer to the obstacles a new firm may
face when trying to enter into an industry or new market. The barriers to entry that corporations
may seek to optimize include:
a) research and development,
b) the ownership of intellectual property rights,
c) economies of scale,
d) unique business processes or methods as well as extensive experience in the
industry, and
Dr. Bhati Rakesh 14
 e) the control of resources or favorable access to raw materials.
4. Porter’s National Competitive Advantage Theory
In the continuing evolution of international trade theories, Michael Porter of Harvard
Business School developed a new model to explain national competitive advantage in 1990.
Porter’s theory stated that a nation’s competitiveness in an industry depends on the capacity of the
industry to innovate and upgrade. His theory focused on explaining why some nations are more
competitive in certain industries. To explain his theory, Porter identified four determinants that he
linked together. The four determinants are (1) local market resources and capabilities, (2) local
market demand conditions, (3) local suppliers and complementary industries, and (4) local firm
characteristics.

1. Local market resources and capabilities (factor

conditions). Porter recognized the value of the factor
proportions theory, which considers a nation’s resources
(e.g., natural resources and available labor) as key factors in
determining what products a country will import or export.
Porter added to these basic factors a new list of advanced
factors, which he defined as skilled labor, investments in
education, technology, and infrastructure. He perceived
these advanced factors as providing a country with a
sustainable competitive advantage.
2. Local market demand conditions. Porter believed that a sophisticated home market is critical to
ensuring ongoing innovation, thereby creating a sustainable competitive advantage. Companies
whose domestic markets are sophisticated, trendsetting, and demanding forces continuous
innovation and the development of new products and technologies. Many sources credit the
demanding US consumer with forcing US software companies to continuously innovate, thus
creating a sustainable competitive advantage in software products and services.
3. Local suppliers and complementary industries. To remain competitive, large global firms
benefit from having strong, efficient supporting and related industries to provide the inputs
required by the industry. Certain industries cluster geographically, which provides efficiencies
and productivity.
4. Local firm characteristics. Local firm characteristics include firm strategy, industry structure,
and industry rivalry. Local strategy affects a firm’s competitiveness. A healthy level of rivalry
between local firms will spur innovation and competitiveness.
In addition to the four determinants of the diamond, Porter also noted that government and chance play a
part in the national competitiveness of industries. Governments can, by their actions and policies,
increase the competitiveness of firms and occasionally entire industries.
Porter’s theory, along with the other modern, firm-based theories, offers an interesting interpretation of
international trade trends. Nevertheless, they remain relatively new and minimally tested theories.
Which Trade Theory Is Dominant Today?
The theories covered in this chapter are simply that—theories. While they have helped economists,
governments, and businesses better understand international trade and how to promote, regulate, and
manage it, these theories are occasionally contradicted by real-world events. Countries don’t have
absolute advantages in many areas of production or services and, in fact, the factors of production aren’t
neatly distributed between countries. Some countries have a disproportionate benefit of some factors. The
United States has ample arable land that can be used for a wide range of agricultural products. It also has
extensive access to capital. While it’s labor pool may not be the cheapest, it is among the best educated in
the world. These advantages in the factors of production have helped the United States become the
largest and richest economy in the world. Nevertheless, the United States also imports a vast amount of
goods and services, as US consumers use their wealth to purchase what they need and want—much of
which is now manufactured in other countries that have sought to create their own comparative
advantages through cheap labor, land, or production costs.

Dr. Bhati Rakesh 15

As a result, it’s not clear that any one theory is dominant around the world. This section has sought to
highlight the basics of international trade theory to enable you to understand the realities that face global
businesses. In practice, governments and companies use a combination of these theories to both interpret
trends and develop strategy. Just as these theories have evolved over the past five hundred years, they
will continue to change and adapt as new factors impact international trade.

The Law of Comparative Advantage

David Ricardo stated a theory that other things being equal a country tends to specialise in and
exports those commodities in the production of which it has maximum comparative cost advantage or
minimum comparative disadvantage. Similarly the country's imports will be of goods having relatively
less comparative cost advantage or greater disadvantage.
Ricardo's Assumptions :-
Ricardo explains his theory with the help of following assumptions :-
1. There are two countries and two commodities.
2. There is a perfect competition both in commodity and factor market.
3. Cost of production is expressed in terms of labour i.e. value of a commodity is measured in terms
of labour hours/days required to produce it. Commodities are also exchanged on the basis of
labour content of each good.
4. Labour is the only factor of production other than natural resources.
5. Labour is homogeneous i.e. identical in efficiency, in a particular country.
6. Labour is perfectly mobile within a country but perfectly immobile between countries.
7. There is free trade i.e. the movement of goods between countries is not hindered by any
restrictions.
8. Production is subject to constant returns to scale.
9. There is no technological change.
10. Trade between two countries takes place on barter system.
11. Full employment exists in both countries.
12. There is no transport cost.
Ricardo's Example :-
On the basis of above assumptions, Ricardo explained his comparative cost difference theory, by
taking an example of England and Portugal as two countries & Wine and Cloth as two commodities.
As pointed out in the assumptions, the cost is measured in terms of labour hour. The principle of
comparative advantage expressed in labour hours by the following
table.
Portugal requires less hours of labour for both wine and cloth. One unit
of wine in Portugal is produced with the help of 80 labour hours as
above 120 labour hours required in England. In the case of cloth too,
Portugal requires less labour hours than England. From this it could be
argued that there is no need for trade as Portugal produces both
commodities at a lower cost. Ricardo however tried to prove that Portugal stands to gain by specialising
in the commodity in which it has a greater comparative advantage. Comparative cost advantage of
Portugal can be expressed in terms of cost ratio.
Cost ratios of producing Wine and Cloth

Portugal has advantage of lower cost of production both in wine and cloth. However the
difference in cost, that is the comparative advantage is greater in the production of wine (1.5 — 0.66 =
0.84) than in cloth (1.11 — 0.9 = 0.21).

Dr. Bhati Rakesh 16

 Even in the terms of absolute number of days of labour Portugal has a large comparative
advantage in wine, that is, 40 labourers less than England as compared to cloth where the difference is
only 10, (40 > 10). Accordingly Portugal specialises in the production of wine where its comparative
advantage is larger. England specialises in the production of cloth where its comparative disadvantage is
lesser than in wine.
Comparative Cost Benefits Both Participants
Let us explain Ricardian contention that comparative cost benefits both the participants, though
one of them had clear cost advantage in both commodities. To prove it, let us work out the internal
exchange ratio.

Let us assume these 2 countries enter into trade at an international exchange rate (Terms of Trade)
1 : 1. At this rate, England specialising in cloth and exporting one unit of cloth gets one unit of wine. At
home it is required to give 1.2 units of cloth for one unit of wine. England thus gains 0.2 of cloth i.e. wine
is cheaper from Portugal by 0.2 unit of cloth.
Similarly Portugal gets one unit of cloth from England for its one unit of wine as against 0.89 of
cloth at home thus gaining extra cloth of 0.11. Here both England and Portugal gain from the trade i.e.
England gives 0.2 less of cloth to get one unit of wine and Portugal gets 0.11 more of cloth for one unit
of wine.
In this example, Portugal specialises in wine where it has greater comparative advantage leaving
cloth for England in which it has less comparative disadvantage.
Thus comparative cost theory states that each country produces & exports those goods in which they
enjoy cost advantage & imports those goods suffering cost disadvantage.

Limitations of Ricardian Comparative Cost theory

For considerable period the theory of comparative costs formulated by David Ricardo was the
most acceptable explanation of the international trade. However, Ricardo's theory was subjected to
number of criticisms.
Following are the important limitations of Ricardian Comparative Cost Theory.
1. Restrictive Model: Ricardo's Theory is based on only two countries and only two commodities. But
international trade is among many countries with many commodities.
2. Labour Theory of Value: Value of goods is expressed in terms of labour content. Labour Theory of
value developed by classical economists has too many limitations and thus is not applicable to the
reality. Value of goods and services in the real world is expressed in money i.e. the prices are the
values expressed in units of money.
3. Full employment: The assumption of full employment helps the theory to explain trade on the basis
of comparative advantage. The reality is far from full employment. Cost of production, even in terms
of labour, may change as the countries, at different levels of employment move towards full
employment.
4. Ignore transport cost: Another serious defect is that the transport costs are not consider in
determining comparative cost differences.
5. Demand is ignored: The Ricardian theory concentrates on the supply of goods. Each country
specialises in the production of the commodity based on its comparative advantage. The theory
explains international trade in terms of supply and takes demand for granted.
6. Mobility of factor of production: As against the assumptions of perfect immobility between the
countries, we witness difficulties in the mobility of labour and capital within a country itself. At the
same time their mobility between nations was never totally absent.
7. No Free Trade: Ricardian theory assumes free trade i.e. no restriction on the movement of goods
between the countries. Though it is unrealistic to assume not to have any restriction. what the real
world witnesses is a lot tariff and non-tariff barriers on international trade. Poor countries find it

Dr. Bhati Rakesh 17

 difficult to enjoy the comparative advantage in the production of labour intensive commodities due to
the protectionist policies followed by developed countries.
8. Complete specialization: The comparative advantage theory comes to conclusion of complete
specialisation. In the Ricardian example, England is specialising fully on cloth and Portugal on wine.
Such complete specialisation is unrealistic even in two countries and two commodities model. It is
possible if two countries happens to be almost identical in size and demand. Again, a complete
specialisation in the production of less important commodity is not possible due to insufficient
demand for it.
9. Static Theory: The modern economy is dynamic and the comparative cost theory is based on the
assumptions of static theory. It assumes fixed quantity of resources. It does not consider the effect of
growth.
10. Not applicable to developing countries: Ricardian theory is not applicable to developing countries
as these countries are nowhere near to full employment. They are in the process of change in quality
of their labour force, quality of capital, technology, tapping of new resources etc. In other words
developing countries exhibit all the characteristics of dynamic economy.
11. Constant Returns to Scale: Another drawback of the Ricardian principle of comparative costs is that
assumes constant Returns to scale and thus constant cost of production in both the countries. The
doctrine holds that if England specialises in cloth; there is no reason why it should produce wine.
Similarly if Portugal has a comparative advantage in producing wine, it will not produce cloth; but
import all cloth from England. If we examine the pattern of international trade in practice, we find it
is not so. A time will come when it will not be reasonable for Portugal to import cloth from England
because of increasing cost of production. Moreover, in actual practice a country produces a particular
commodity and also imports a part of it. This phenomenon has not been explained by the theory of
comparative costs.

CONCEPTS OF TERMS OF TRADE:

1. NET BARTER TERMS OF TRADE: The most widely used concept of the terms of trade is
what has been caned the net barker terms of trade which refers to the relation between prices of
exports and prices of imports. In symbolic terms: Tn = Px/Pm
Where
Tn stands for net barter terms of trade.
Px stands for price of exports (x),
Pm stands for price of imports (m).
When we want to know the changes in net barter tends of trade over a period of time, we prepare
the price index numbers of exports and imports by choosing a certain appropriate base year and
obtain the following ratio:
Px1/ Pm1 : Px0/ Pm0
. Px„ Pm„
where Pxo and Pm0 stand for price index numbers of exports and imports in the base year respectively,
and Px1) and Pm1) denote price index numbers of exports and imports respectively in the current year.
Since the prices of both exports and imports in the base year are taken as 100, the terms of trade in the
base year would be equal to one
Px0/ Pm0 = 100/100 = 1
Suppose in the current period the price index number of exports has gone upto 165, and the price
index number of imports has risen to 110, then terms of trade in the current period would be:
165/110: 100/100 = 1.5:1
Thus, in the current period, terms of trade have improved by 50 percent as compared to the base
period. Further, it implies that if the prices of exports of a country rise relatively greater than those of its
imports, terms of trade for it would improve or become favourable.
On the other hand, if the prices of imports rise relatively greater than those of its exports, terms of trade
for it would deteriorate or become unfavourable. Thus, net barter terms of trade is an important concept
which can be applied to measure changes in the capacity of exports of a country to buy the imported
Dr. Bhati Rakesh 18
products. Obviously, if the net barter terms of trade of a country improve over a period of time, it can buy
more quantity of imported products for a given volume of its exports.
But the concept of net barter terms of trade suffers from some important limitations in that it
shows nothing about the changes in the volume of trade. If the prices of exports rise relatively to those of
its imports but due to this rise in prices, the volume of exports falls substantially, then the gain from rise
in export prices may be offset or even more than offset by the decline in exports.
This has been well described by saying, “We make a big profit on every sale but we don’t sell much”.
In order to overcome this drawback, the net barter terms of trade are weighted by the volume of exports.
This has led to the development of another concept of terms of trade known as the income terms of trade
which shall be explained later. Even so, the net barter terms of trade is most widely used concept to
measure the power of the exports of a country to buy imports.
2. GROSS BARTER TERMS OF TRADE:
This concept of the gross terms of trade was introduced by F.W. Taussig and in his view this is an
improvement over the concept of net barter terms of trade as it directly takes into account the volume of
trade. Accordingly, the gross barter terms of trade refer to the relation of the volume of imports to the
volume of exports. Thus,
Tg = Om/Qx
Where
Tg = gross barter terms of trade, Qm = quantity of imports
Qx = quantity of exports
To compare the change in the trade situation over a period of time, the following ratio is employed:
Om1/Qx1 : Qm0/Qx0
Where the subscript 0 denotes the base year and the subscript I denotes the current year.
It is obvious that the gross barter tenns of trade for a country will rise (i.e., will improve) if more imports
can be obtained for a given volume of exports. It is important to note that when the balance of trade is in
equilibrium (that is, when value of exports is equal to the value of imports), the gross barter terms of
trade amount to the same thing as net barter terms of trade.
This can be shown as under:
Value of imports = price of imports x quantity of imports = Pm. Qm
Value of exports = Price of exports x quantity of exports = Px. Qx
Therefore, when balance of trade is in equilibrium.
Px . Qx = Pm. Qm
Px .Qm = Pm Qx
However, when balance of trade is not it equilibrium, the gross barter terms of trade would differ from
net barter terms of trade.
3. INCOME TERMS OF TRADE:
In order to improve upon the net barter terms of trade G.S. Dorrance developed the concept of income
terms of trade which is obtained by weighting net barter terms of trade by the volume of exports. Income
terms of trade therefore refer to the index of the value of exports divided by the price of imports.
Symbolically, income terms of trade can be written as
Ty = Px.Qx/Pm
Where
Ty = Income terms of trade
Px = Price of exports
Qx = Volume of exports
Pm= Price of imports
Income terms of trade yields a better index of the capacity to import of a country and is, indeed,
sometimes called ‘capacity to import. This is because in the long run balance of payments must be in
equilibrium the value of exports would be equal to the value of imports.
Thus, in the long run:
Pm, Qm = Px, Qx
Qm = Px.Qx/Pm

Dr. Bhati Rakesh 19

 It follows from above that the volume of imports (Qm) which a country can buy (that is, capacity
to import) depends upon the income terms of trade i.e., Px.Qx/Pm. Since income terms of trade is a better
indicator of the capacity to import and since the developing countries are unable to change Px and Pm.
Kindleberger’ thinks it to be superior to the net barter terms of trade for these countries, However, it may
be mentioned once again that it is the concept of net barter terms of trade that is usually employed.
Determination of Terms of Trade: Theory of Reciprocal Demand:
As seen above, the share of a country from the gain in international trade depends on the terms of
trade. The terms of trade at which the foreign trade would take place is determined by reciprocal demand
of each country for the product of the other countries.
The theory of reciprocal demand was put forward by JS. Mill and is thought to be still valid and true even
today. By reciprocal demand we mean the relative strength and elasticity of the demand of the two
trading countries for each other’s product.
Let us take two countries and B which on the basis of their comparative costs specialise in the
production of cloth and wheat respectively. Obviously, country would export cloth to country B, and in
exchange import wheat from it. Reciprocal demand means the strength and elasticity of demand of
country A for wheat of country B, and the intensity and elasticity of country B’s demand for cloth from
country A If the country has inelastic demand for wheat of country B, she will be prepared to give more
of cloth for a given amount of wheat. In this case terms of trade will be unfavourable to it and
consequently its share of gain from trade will be relatively smaller.
On the contrary, if country A’s demand for import of wheat is elastic, it will be willing to offer a
smaller quantity of its cloth for a given quantity of the imports of wheat. In this case terms of trade would
be favourable to country A and its share of gain from trade will be relatively larger. The equilibrium
terms of trade would settle at a level at which its reciprocal demand, that is, quantity of its exports which
it will be willing to give for a given quantity of its imports is equal to the reciprocal demand of the other
country.
Note that the equilibrium terms of trade are determined by the intensity of reciprocal demand of the two
trading countries but they will lie in between the comparative costs (i.e., domestic exchange ratios) of the
two countries. This is because no country would be willing to trade at a price which is lower than at
which it can produce at home.
Let us return to the example of the two countries A and B which specialise in the production of
two commodities cloth and wheat respectively, and exchange them with each other. Production
conditions in the two countries are given below:
Table : Production of one man per week

It will be seen from above table that before trade production conditions in country B are such that
12 bushels of wheat would be exchanged for 20 yards of cloth, in it, that is, the domestic exchange ratio
is 12: 20 (or 3: 5). On the other hand, in country A production conditions are such that 4 bushels of wheat
would be exchanged for 12, yards of cloth, that is, the domestic exchange ratio is 4: 12 or 1: 3.
Obviously, after trade, terms of trade will be settled within these domestic exchange ratios of the two
countries.
The domestic exchange ratios of the two countries set the limits beyond which terms of trade
would not settle after trade. It is evident that country B will be unwilling to offer more than 12 bushels of
wheat for 20 yards of cloth since by sacrificing 12 bushels of wheat it can produce 20 yards of cloth at
home.
Likewise, country A would not accept less than 6.66 bushels of wheat for 20 yards of cloth, for this is the
domestic exchange rate cloth of wheat for(l :3) determined by production or cost conditions at home in
country A.
It is within these limits that terms of trade will be settled between the two countries as determined
by the strength of reciprocal demand of the trading countries. It also follows that it is not mere demand
but also the comparative production costs (i.e., the supply conditions) that go to determine the terms of

Dr. Bhati Rakesh 20

trade. Indeed, the law of reciprocal demand, if properly understood, considers both the forces of demand
and supply as determinants of the terms of trade.

Critical Evaluation of the Reciprocal Demand Theory:

The reciprocal demand theory of the terms of trade is based upon two countries, two commodities
model. It assumes that full-employment conditions prevail in the economy and also that there is perfect
competition in both the product and factor markets in the economies of the various countries.
It also assumes the governments of the various countries follow free trade policy and impose no
restrictions on foreign trade by imposing tariffs or adopting other means to restrict imports. Further, this
theory grants that there is free mobility of factors domestically within the economies of the two countries.
To the extent these assumptions do not hold in the real world, the terms of trade would not conform to
those determined by the reciprocal demand.
However, as stated above; every theory makes some simplifying assumptions. The soundness of a
theory depends upon whether the deductive logic it employs is flawless and the conclusions it draws
about the impact of economic forces on the subject investigated are correct or not. On this test the
reciprocal demand theory fares very well as reciprocal demand is undoubtedly an important factor which
influences terms of trade.
F.D. Graham criticized this theory by pointing out that it is applicable only to trade in antiques
and old masters which are found in fixed supplies and therefore in their case demand plays a crucial role
in the determination of terms of trade.
He stressed that the theory of reciprocal demand was not relevant in case of goods produced
currently since their international values (i.e., terms of trade) were determined by comparative production
costs (i.e., the supply conditions). In his view, reciprocal demand theory grossly exaggerates the role of
reciprocal demand and neglects the importance of comparative cost conditions.
However, Graham’s criticism is not valid. The reciprocal demand or offer curve embodies both
demand and production costs. In reply to Graham’s criticism, Viner writes that “The terms of trade can
be directly influenced by the reciprocal demands and by nothing else. The reciprocal demands in turn are
ultimately determined by the cost conditions together with the basic utility function.”
We therefore, conclude that terms of trade are determined by reciprocal demands of the trading
countries. Reciprocal demands in turn are governed by both the demand and supply (cost) conditions.
Thus, the intensity of demand by others for exports of a country and the intensity of its demand for
imports from the other country are the important factors that determine the terms of trade. Besides,
comparative cost conditions of the products exported and those imported have also an important role in
the determination of terms of trade.

Determination of Terms of Trade and Offer Curves:

The theory of reciprocal demand has been explained graphically with the help of the concept of
offer curves developed by Edgeworth and Marshall. The offer curve of a country shows the amounts of a
commodity it offers at various prices for a given quantity of the commodity produced by the other
country.
To understand how offer curves are derived and how with their help determination of the terms of
trade is explained, we shall first explain how a country reaches its equilibrium position about the amounts
of goods to be produced and consumed.
For this purpose, modern economists usually employ the tools of production possibility curve and
the community indifference curves. The production possibility curve represents the combinations of two
commodities which a country, given its resources and technology, can produce.
A community indifference curve shows the combinations of two goods which provide same
satisfaction to the community as a whole. A map of community indifference curves portrays the tastes
and demand pattern of a community for the two goods. A production possibility curve TT’ and a set of
community indifference curves IC1IC2 and IC3 of country A have been drawn in Fig. 45.1.
The country reaches its equilibrium position with regard to production and consumption of cloth
and wheat at the point Q where the production possibility curve TT’ is tangent to the highest possible
indifference curve IC2 at which marginal rate of transformation of cloth for wheat (MRTCW) equals
Dr. Bhati Rakesh 21
marginal rate of substitution of cloth for wheat (MRSCW) as well as the price ratio of the two
commodities Pc/Pw as shown by the slope of the price line P1P1.

Thus, tangency point Q in Fig. 45.1 depicts the

equilibrium position of country in the absence of trade.
Suppose country A enters into trade relation with country B
and price of cloth rises relative to wheat so that new price-
ratio line becomes P2P2.
It will be observed from Fig. 45.1 that with price-
ratio line P2P2 production equilibrium of country is at point
M, its consumption equilibrium is at point R. This shows that
with price-ratio line PP2 country A will offer or export MN of
cloth for RN imports of wheat.
Similarly, if price of cloth further rises relative to
wheat, price-ratio line will become more steep, then for the
same quantity offered of export of cloth, the or import of
wheat will increase. With such information gathered from
Fig. 45.1, we can derive offer curve of country A in Fig. 45.2.
The tangent line in Fig. 45.1 shows the domestic price ratio of the two commodities and has a
negative slope. In the analysis of the offer curve, the price line is drawn with a positive slope from the
origin. This is because in the drawing of an offer curve we are interested only in knowing the quantity of
one commodity which can be exchanged for a certain quantity of another commodity.
In other words, in the analysis of terms of trade what we are really interested is the absolute slope of the
curve, i.e., the price ratio. In Fig. 45.2 the positively sloping price line OP 1 from the origin, which in
absolute terms, has the same slope as P1P1 of Fig. 45.1 has been drawn. In Fig. 45.2 at price ratio line
O1P1 no trade occurs.
When price of cloth rises and price ratio line shifts to OP2 as will be from Fig. 45.2, country A
offers ON1 of cloth (exports) for RN1 of wheat (imports). (Note that at a given price ratio how much
quantity of a commodity, a country will offer for imports from the other country is determined by
production possibility curve and community’s indifference curves as illustrated in Fig. 45.1).
Suppose the price of cloth further rises relatively to that of wheat causing the price line to shift to the
position OP3. It will be seen that with the price line OP3, country A is willing to offer for export ON2
quantity of cloth for SN2 of wheat.

Likewise, Fig. 45.2 portrays the exports and imports of

the country A as price of cloth in terms of wheat increases
further and consequently price line shifts further above to OP4
and OP and the new offers of export of cloth for import of wheat
are determined by equilibrium points T and U. If points such as
R, S, T and U representing the country A’s offers of cloth for
wheat are joined we get its offer curve.
It is important to note that the offer curve may be regarded as the
supply curve in the international trade as it shows amounts of
cloth which the country A is willing to offer for certain amounts
of imports of wheat at various price ratios.
Another important point to be noted is that the offer curve cannot go below the price line OP, which
represents the domestic exchange ratio determined by the tangency point Q of production possibility
curve and community indifference curve of country A as shown in Fig. 45.1. This is because, as stated
above, no country will be willing to export its product for the quantity of the imported product which is
smaller than that it can produce at home.

Dr. Bhati Rakesh 22

 Likewise, we can derive the offer curve of country B.
Figure 45.3 portrays the derivation of the offer curve
of country B. representing quantities of wheat which
it is willing to exchange for certain quantities of cloth
from country A at various prices.

Note that so long as country B is importing a smaller

quantity of cloth, it will be willing to offer relatively
more wheat for cloth. But as the quantity of imported
cloth is increased, it would be prepared to offer
relatively less wheat for the given quantity of imports
of cloth.
In Fig. 45.3 whose Y-axis represents wheat, the origin for
indifference curves of country B will be the North-West Comer
Price lines. OP7, OP6, OP5, OP4 etc., express successively higher
price ratios of wheat for cloth. Price line OP1 represents the domestic price ratio in country B in the
absence of trade. The points C, D, E, F, G which has been obtained from the equilibrium or tangency
points between the community indifference curves of country B and the various price-ratio lines show the
equilibrium offers of wheat by country B for cloth of country A at various prices. By joining together
points, C. D, E, F and G we obtain the offer curve of country B indicating its demand for cloth of country
A in terms of its own product wheat.
It would be observed from Fig. 45.2 and 45.3 that offer curves OA and OB of the two countries have
been drawn with the same origin O (i.e., South-West Corner) as the basis. These offer curves represent
reciprocal demand of the two countries for each other’s product in terms of their own product. The offer
curves OA and OB of the two countries have been brought together in Fig. 45.4.The intersection of the
offer curves of the two countries determines the equilibrium terms of trade. It will be seen from Fig. 45.4
that the offer curves of two countries cross at point T. By joining point T with the origin we get the price-
ratio line OT whose slope represents the equilibrium terms of trade which will be finally settled between
the two countries.
At any other price-ratio line the offer of a product by country A in exchange for the product of the other
would not be equal to the reciprocal offer and demand of the other country B. For instance, at price-ratio
line OP1, country B would offer OM wheat for MH or ON of cloth from country A (H lies on B’s offer
curve corresponding to price-ratio line OP5).
But at this price-ratio line OP country A would demand much greater quantity of wheat UW for OU of
cloth as determined by point W at which the offer curve of country A intersects the price ratio line OP.
This will result in rise in price of wheat and the price-ratio line will shift to the right until it reaches the
equilibrium position OT or OP4.
On the other hand, if price ratio line lies to the right of Or (for instance, if it is OP,), then, as will
be observed from Fig. 45.4, it cuts the offer curve of country A at point L implying thereby that the
country A would offer OR of cloth in exchange for RL of wheat. However, with terms of trade implied
by the price ratio line OP4, the country B would demand OZ of cloth for ZS quantity of wheat as
determined by point S.
It therefore follows that only at the terms of trade implied by the price ratio line OT (i.e., OP 4)
that the offer of a product by one country will be equal to its demand by the other. We therefore conclude
that the intersection of the offer curves of the two countries determines the equilibrium terms of trade.
As explained above, the offer curves of the two countries are determined by their reciprocal demand. Any
change in the strength and elasticity of reciprocal demand would cause a change in the offer curves and
hence in the equilibrium terms of trade.
It is worthwhile to note that terms of trade must settle within the price lines OP 1 and OP7
representing the domestic rates of exchange between the two commodities in the two countries
respectively as determined on the basis of production cost and s demand conditions existing in them.

Dr. Bhati Rakesh 23

When the terms of trade are settled within these limits set by these price lines OP 1 and OP7, both
countries would gain from trade, though one may gain relatively more than the other depending on the
position of terms of trade line.
As explained above, the terms of trade cannot settle beyond these domestic prices ratio lines
because in case of terms of trade line lying beyond these price lines, it will be advantageous for a country
to produce both the goods (wheat and cloth) domestically rather than entering into foreign trade.
Effect of Tariff on Terms of Trade:
The various countries of the world have imposed tariffs (i.e., import duties) to protect their
domestic industries. It has been said in favour of tariffs that through them a country can provide not only
protection to its industries but under appropriate circumstances it can also improve its terms of trade, that
is, tariffs under favourable circumstances enable a country to get its imports cheaper.
These favourable circumstances are:
(1) The demand for the exports of the tariff-imposing countries is both large and inelastic
(2) The demand for the imports by the country is quite elastic. Under these circumstances, as a result of
the imposition of tariff by that country, the imports of the country will decline since the price of the
imported commodity will rise. But this is not the end of the story.
The decline in imports of the tariff-imposing country would reduce the export earnings of its trading
partner as it will lead to the decrease in demand for it exported commodity. The decrease in demand for
the exported commodity in the trading partner would result in lowering its domestic price.
As a result of the fall in the domestic price of the exported commodity and in order to maintain its
export earnings the exporting country is likely to reduce the price of its exports. This means that the
tariff- imposing country would now be able to get its imports at a relatively lower price than before.
Given the demand and price of its exports, the fall in
its prices of imports of the tariff- imposing country would
imply the improvement in its terms of trade. It is worth
mentioning that the improvement in the terms of trade
through tariff depends upon the changes in price and
resultant changes in quantity demanded of imports and
exports of the trading countries which in turn depends upon
the elasticity’s of their reciprocal demand.
The effect of tariff on the terms of trade can be
explained through the geometrical device of offer curves. In
Fig. 45.5 the offer curves OA and OB respectively of the
two countries A and B are shown. These offer curves intersect at T implying thereby that terms of trade
equal to the slope of OT are determined between them.
Now, suppose that country A imposes import duty on wheat from country B. As a result of this
imposition of tariff, the offer curve of country A will shift to a new position OA ‘(dotted). This implies,
for instance, that, before tariff, country was prepared to offer ON of cloth for NQ of wheat, but after
imposition of tariff it requires NT’ of wheat for ON of cloth and collects QT ‘ as import duty.
It will be noticed from Fig. 45.5 that the new offer curve OA ‘(dotted) of country A intersects the
offer curve OB of country B at point T and thereby the terms of trade changes from OT to OT’. Note that
the slope of the terms of trade line OT’ is greater than that of OT’.
Thus terms of trade for country A have improved consequent upon the imposition of tariff by
country A. For instance, whereas according to terms of trade line OT country A was exchanging ON of
cloth for N L imports of wheat, it is now exchanging ON of cloth for NT’ of wheat.
The following three things are worth nothing about the impact of tariffs on terms of trade:
1. The gain in terms of trade from imposing a tariff depends on the elasticity of the offer curve of
the opposite trading country. If the offer curve of the opposite trading country is perfectly elastic, that is,
when it has constant costs so that offer curve is the straight line OB from the origin with slope equal to
that of OT as shown in Fig. 45.6, the imposition of tariff would reduce the volume of trade between them,
the terms of trade remaining the same.

Dr. Bhati Rakesh 24

For example, if in the situation depicted in Fig. 45.6 country A imposes a tariff on imports of a wheat
from the country B and as a result the offer curve of A shifts upward to
the new position OA’ (dotted), the terms of trade remain constant as
measured by the slope of the terms of trade line OT. It will be seen
from Fig. 45.6 that in this case only volume of trade has declined from
ON to OM

2. The gain in terms of trade from imposing a tariff will finally

accrue to a country only in the absence of retaliation from the trading
country B. But when one country can play a game to improve its
position, the other can retaliate and play the same game.
That is, on country A imposing a tariff on its imports from country B in
a bid to improve its terms of trade, the latter can also impose a tariff on
the imports from the former and thereby cancels out the original gain
by country A. Such competition in imposing tariffs on each other’s product would greatly reduce the
volume of trade and leave the terms of trade between them unchanged.
As a result of the reduction in volume of trade, both countries would suffer a loss. “The imposition of
tariffs to improve the terms of trade, followed by retaliation, ensures that both countries lose. The
reciprocal removal of tariffs, on the other hand, will enable both countries to gain. That is why different
countries enter into bilateral agreements to reduce tariffs on each other’s products.” Further, there is now
World Trade Organisation (WTO) which requires the member countries to reduce tariffs so that the
volume of international trade expands.

Heckscher Ohlin's H-O Theory

The Modern Theory of international trade has been advocated by Bertil Ohlin. Ohlin has drawn
his ideas from Heckscher's General Equilibrium Analysis. Hence it is also known as Heckscher Ohlin
(HO) Model / Theorem / Theory.
According to Bertil Ohlin, trade arises due to the differences in the relative prices of different
goods in different countries. The difference in commodity price is due to the difference in factor prices
(i.e. costs). Factor prices differ because endowments (i.e. capital and labour) differ in countries. Hence,
trade occurs because different countries have different factor endowments.
The Heckscher Ohlin theorem states that countries which are rich in labour will export labour intensive
goods and countries which are rich in capital will export capital intensive goods.

Assumptions of Heckscher Ohlin's H-O Theory

Heckscher-Ohlin's theory explains the modern approach to international trade on the basis of
following assumptions :-
1. There are two countries involved.
2. Each country has two factors (labour and capital).
3. Each country produce two commodities or goods (labour intensive and capital intensive).
4. There is perfect competition in both commodity and factor markets.
5. All production functions are homogeneous of the first degree i.e. production function is subject to
constant returns to scale.
6. Factors are freely mobile within a country but immobile between countries.
7. Two countries differ in factor supply.
8. Each commodity differs in factor intensity.
9. The production function remains the same in different countries for the same commodity. For e.g.
If commodity A requires more capital in one country then same is the case in other country.
10. There is full employment of resources in both countries and demand are identical in both
countries.
Dr. Bhati Rakesh 25
 11. Trade is free i.e. there are no trade restrictions in the form of tariffs or non-tariff barriers.
12. There are no transportation costs.
Given these assumption, Ohlin's thesis contends that a country export goods which use relatively a
greater proportion of its abundant and cheap factor. While same country import goods whose production
requires the intensive use of the nation's relatively scarce and expensive factor.
Understanding The Concept of Factor Abundance
In the two countries, two commodities & two factor model, implies that the capital rich country
will export capital intensive commodity and the labour rich country will export labour intensive
commodity. But the concept of country being rich in one factor or other is not very clear. Economists
quite often define factor abundance in terms of factor prices. Ohlin himself has followed this approach.
Alternatively factor abundance can be defined in physical terms. In this case, physical amounts of capital
& Labour are to be compared.
• Price Criterion for defining Factor Abundance
A country where capital is relatively cheaper and labour is relatively costly is said to be capital rich
country. Whereas a country where labour is relatively cheaper and capital is relatively costly is said to be
labour rich country.
Price of the factor can be symbolically measured as follows :-
In above relation, P refers to price of the factor, K refers to Capital,
L refers to Labour, E stands for England, and I stands for India.
Note:- In reality, England is not a country else a part of United Kingdom
(U.K). England is called a country in this article just for the sake of learning
example.
The above analysis highlights a fact that in England capital is cheap, and hence it is a capital abundant
country. Whereas in India, Labour is cheaper, and thus it is a labour rich country.
Now lets understand how such a pattern of trade will necessarily emerge.

Diagram Explaining Heckscher Ohlin's H-O Theory

Let us take an example of same two countries viz; England and
India where England is a capital rich country while India is a
labour abundant nation.
In the above diagram XX is the isoquant (equal product curve) for
the commodity X produced in England. YY is the isoquant
representing commodity Y produced in India. It is very clear that
XX is relatively capital intensive while YY is relatively labour
incentive. The factor capital is represented on Y-axis while the
factor labour is represented on the horizontal X-axis.
PA is the price line or budget line of the country England. The
price line PA is tangent to XX at E. The price line PA is also
tangent to YY isoquant at K. The point K will help us to find out how much of capital and labour is
required to produce one unit of Y in England.
P1B is the price line of the country India, The price line P1B is tangent to YY at I. The price line
RS which is drawn parallel to P1B is tangent to XX at M. This will help us to find out how much of
capital and labour is required to produce one unit of commodity X in India.
Under the given situations, the country England will choose the combination E. Which means more
specialisation on capital goods. It will not choose the combination K because it is more labour intensive
and less capital intensive.
Thus according to Ohlin, England will specialise on production of goods X by using the cheap
factor capital extensively while India specialises on commodity Y by using the cheap factor labour
available in the country.
The Ohlin's theory concludes that :-
The basis of internal trade is the difference in commodity prices in the two countries.
Differences in the commodity prices are due to cost differences which are the results of differences in
factor endowments in two countries.
Dr. Bhati Rakesh 26
A capital rich country specialises in capital intensive goods & exports them. While a Labour abundant
country specialises in labour intensive goods & exports them.

Limitations of Heckscher Ohlin's H-O Theory

Heckscher Ohlin's Theory has been criticised on basis of following grounds :-

1. Unrealistic Assumptions : Besides the usual assumptions of two countries, two commodities, no
transport cost, etc. Ohlin's theory also assumes no qualitative difference in factors of production,
identical production function, constant return to scale, etc. All these assumptions makes the theory
unrealistic one.
2. Restrictive : Ohlin's theory is not free from constrains. His theory includes only two commodities,
two countries and two factors. Thus it is a restrictive one.
3. One-Sided Theory : According to Ohlin's theory, supply plays a significant role than demand in
determining factor prices. But if demand forces are more significant, a capital abundant country will
export labour intensive good as the price of capital will be high due to high demand for capital.
4. Static in Nature : Like Ricardian Theory the H-O Model is also static in nature. The theory is based
on a given state of economy and with a given production function and does not accept any change.
5. Wijnholds's Criticism : According to Wijnholds, it is not the factor prices that determine the costs
and commodity prices but it is commodity prices that determine the factor prices.
6. Consumers' Demand ignored : Ohlin forgot an important fact that commodity prices are also
influenced by the consumers' demand.
7. Haberler's Criticism : According to Haberler, Ohlin's theory is based on partial equilibrium. It fails
to give a complete, comprehensive and general equilibrium analysis.
8. Leontief Paradox : American economist Dr. Wassily Leontief tested H-O theory under U.S.A
conditions. He found out that U.S.A exports labour intensive goods and imports capital intensive
goods, but U.S.A being a capital abundant country must export capital intensive goods and import
labour intensive goods than to produce them at home. This situation is called Leontief Paradox which
negates H-O Theory.
9. Other Factors Neglected : Factor endowment is not the sole factor influencing commodity price and
international trade. The H-O Theory neglects other factors like technology, technique of production,
natural factors, different qualities of labour, etc., which can also influence the international trade.

Implications of Trade Theories - Economics of Scale, Imperfect Competition, and International

Trade.
In those industries when output required to attain economies of scale represents a significant
proportion of total world demand, the global market may only be able to support a small number of
enterprises first mover advantages - the economic and strategic advantages that accrue to early entrants
into an industry economies of scale first movers can gain a scale based cost advantage that later entrants
find difficult to match
Nations may benefit from trade even when they do not differ in resource endowments or
technology a country may dominate in the export of a good simply because it was lucky enough to have
one or more firms among the first to produce that good Governments should consider strategic trade
policies that nurture and protect firms and industries where first mover advantages and economies of
scale are important
National External Economies of Scale
Assume increasing returns to scale external to the from but internal to the industry in the country.
Production of IRS good tends to be concentrated all in one country, if possible. If start with identical
countries, role of countries random and so multiple equilibrium can occur ñ Mirror equilibrium where
only identity of countries is changed. Knife edge: both incompletely specialized (unstable) Graham:
one specialized in IRS good, other incompletely specialized; incompletely specialized country loses from
trade but identity of the losing country not known before trade occurs FPE: one specialized in CRS
good, other incompletely specialized; equal factor prices across countries since CRS good produced in
both countries
Dr. Bhati Rakesh 27
 Ricardian: both countries completely specialized; as if the IRS technology were CRS with the
technology at equilibrium level of output - wages react technology differences across countries Move to
more general models of scale economies without multiplicity of equilibrium.
International Economies of Scale

Global size of an industry may be more relevant for scale economies than geographic location. Returns to
scale modeled as depending on the size of the world industry rather than national industry. World
production possibilities well-defined although national production possibilities are not.
Efficient resource allocation same as if no scale economies. Inconveniences of Graham
equilibrium eliminated by making scale economies international. Thus the possibility of a country losing
from trade relies on national IRS (and parameters that lead to the Graham equilibrium rather than
Ricardian or FPE).
Intra industry Trade: Assume IRS sector has horizontally differentiated product (different
varieties).Assume all existing varieties enter consumers utility symmetrically. All varieties will be
produced and consumed in equal amounts. Countries will both import and export differentiated IRS
good; intra industry trade occurs. Assuming factor endowment differences as well generates HOS-style
inter industry trade also. As factor endowments become more similar, intra industry trade expands. Inter
industry trade, based on factor differences, substitutes for international factor mobility. Intra industry
trade, based on differentiated products, is complementary to factor mobility. Dissimilar countries have
predominantly inter industry trade; similar countries have predominantly intraindustry trade.
Product Differentiation: Each variety of a good is produced by a single firm operating under
monopolistic competition. Vertically differentiated products (quality) have all consumers agree on what
brand is best; horizontally differentiated products (variety) have consumers disagree on what brand is
best. Ideal variety approach equivalent to having consumers love variety for its own sake.Even if national
IRS, product differentiation is sufficient to ensure that no country loses from international trade (and so
Graham case requires homogeneous goods).
Oligopoly: Suppose each country has a single monopolist in autarky and countries identical.
Duopoly when trade opened. In Cournot-Nash, firms choose quantity and total quantity increases with
increased competition. Free trade price below both autarky prices. Can have gains from trade even
though no trade actually occurs; gains are from potential competition. If firms choose quantity for each
market get two-way trade. If impose transport costs, get wasteful two-way trade of identical products.
Interesting welfare conclusions because oligopoly products contribute to national income. Assume all
output sold toa third country to eliminate consumer surplus effects in welfare. If government can credibly
commit to subsidizing exports, can increase products. Explains why trade policy might take form of
promotion rather than restriction. Uncertainty over correct policy limits usefulness in practice. As number
of domestic firms increases, optimal policy shifts from subsidy to tax; also if firms choose price instead
of quantity, optimal policy becomes a tax. A common resource available in Öxed supply limits product
shifting ability of export subsidies for symmetric firms.
Foreign Direct Investment: Many models developed to explain why firms produce in more than
one country when doing so is expensive (due to lack of familiarity with the foreign economic
environment, difficulty coordinating activities over large distances, etc.).
Ownership advantage if some patent or special ability (even reputation) can be exploited in multiple
markets Location advantage if tariff (or transportation cost or factor price difference) rules out
concentrating production in one country and exporting to the other.
Internalization advantage if arms length use of markets unattractive due to risk of opportunistic behavior
by licensee (international enforcement of contracts difficult) or other reasons. When ownership, location
and internalization advantages coexist, optimal way to serve a foreign market is though foreign direct
investment (FDI or DFI). Firms with production or other activities in multiple countries are culled
multinational firms (or multinational enterprises or multinational corporations or MNEs or MNCs or just
plain multinationals). FDI has been growing rapidly, making FDI a ripe area for further research.

Dr. Bhati Rakesh 28

 Chapter 3:
a) International Trade Policy : Trade Restrictions - Tariffs , Non-Tariff Trade Barriers - Tariff vs. Quota - The
New Protectionism – Economic Integration - Custom Unions and Free Trade Areas - Major Regional Trade
Agreements
b) Foreign Exchange : Foreign Exchange Market – Types of Foreign Exchange Transactions – Reading
Foreign Exchange Quotations – Forward and Futures Market – Foreign-Currency Options – Exchange Rate
Determination – Arbitrage – Speculation and Exchange-Market Stability

International Trade Policy :

The integration of the domestic economy through the twin channels of trade and capital flows has
accelerated in the past two decades which in turn led to the Indian economy growing from Rs 32 trillion
(US$ 474.37 billion) in 2004 to about Rs 153 trillion (US$ 2.3 trillion) by 2016. Simultaneously, the per
capita income also nearly trebled during these years. India’s trade and external sector had a significant
impact on the GDP growth as well as expansion in per capita income.
Total merchandise exports from India grew by 17.48 per cent year-on-year to US$ 24.49 billion in
February 2017, while overall trade deficit declined by 24 per cent year-on-year to US$ 41.8 billion in
April-February 2017, according to data from the Ministry of Commerce & Industry.
According to Ms Nirmala Sitharaman, Minister of State (Independent Charge) for Commerce and
Industry, the Government of India is keen to grow exports and provide more jobs for the young, talented,
well-educated and even semi-skilled and unskilled workforce of India.
All export and import-related activities are governed by the Foreign Trade Policy (FTP), which is
aimed at enhancing the country's exports and use trade expansion as an effective instrument of economic
growth and employment generation.
The Department of Commerce has announced increased support for export of various products
and included some additional items under the Merchandise Exports from India Scheme (MEIS) in order
to help exporters to overcome the challenges faced by them.
The Central Board of Excise and Customs (CBEC) has developed an 'integrated declaration' process
leading to the creation of a single window which will provide the importers and exporters a single point
interface for customs clearance of import and export goods.
As part of the FTP strategy of market expansion, India has signed a Comprehensive Economic
Partnership Agreement with South Korea which will provide enhanced market access to Indian exports.
These trade agreements are in line with India’s Look East Policy. To upgrade export sector infrastructure,
‘Towns of Export Excellence’ and units located therein will be granted additional focused support and
incentives.
RBI has simplified the rules for credit to exporters, through which they can now get long-term
advance from banks for up to 10 years to service their contracts. This measure will help exporters get into
long-term contracts while aiding the overall export performance.
The Government of India is expected to announce an interest subsidy scheme for exporters in order to
boost exports and explore new markets.
Foreign Trade Policy of India 2015-20 (FTP 2015-20) announced on 01st April 2015 to support
manufacturers and service sectors with special emphasis to improve ease of doing business. This five
year foreign trade policy introduces new schemes for exporters of India called MEIS, Merchandise
Exports from India Scheme and SEIS, Service Exports from India Scheme. Special focus on trade
facilitation also is one of the features of Foreign Trade Policy of India 2015-20.

Trade Restrictions –
Trade restrictions generally refer to the various barriers to free trade (imports and exports)
imposed by governments.
Different reasons have been given for restricting trade. Among them are:
1. National security: Governments often determine that restricting the export or import of specific
products is in the national best interest. A nation which produces weapons systems may want to
prohibit those systems from being sold to potential enemies of the state. Some products may be
deemed to be vital to the well-being of the country. The government doesn't want to rely on
Dr. Bhati Rakesh 29
 imports for a significant portion of the nation's supply, even if imports are less expensive than
domestic production.
2. Infant industry: Sometimes governments believe that specific industries which are less efficient
than foreign competition would become more efficient if given time to develop without being
undermined by cheaper foreign prices. This is based on the idea that new industries tend to have
high startup costs, but the costs will decrease if the industry has time to develop. Without
restrictions, these domestic industries might not survive long enough to realize such cost savings.
3. Retaliation: The argument for this is that "if they impose restrictions on us, we should impose
restrictions on them in order to level the playing field - in order to make trade more fair".
4. Protecting jobs: If jobs are "shipped overseas", then domestic unemployment increases.
Evidence shows that trade restrictions to protect jobs can increase employment in protected
industries, but will not increase employment in the overall economy. The job gains in the
protected industries might be offset by job losses in perhaps more efficient industries
(Specialization & trade). This would indicate that this argument may be more valid in terms of
national interest than in terms of jobs.
5. Low foreign wages: Countries with a lower standard of living tend to pay lower wages. This is
often true when comparing developing nations with established industrialized nations. Some
countries have few laws to protect workers - such as minimum wage, working conditions, and
child labor laws. With lower labor costs, businesses - especially manufacturing businesses - will
be able to produce more efficiently if they produce in a foreign country. One offsetting argument
to this is that efficiency may not be real if foreign workers are less productive than domestic
workers who may be more educated, better trained, etc.
6. Politics: Politicians may find it desirable to bow to pressure from special interests, and protect
specific industries located in their districts. This protection wouldn't necessarily be based on
national security, infant industry, or other arguments. It would, however, give special treatment to
specific industries over other industries.
Tariffs
Tariffs are the most common kind of barrier to trade; indeed, one of the purposes of the WTO is
to enable Member countries to negotiate mutual tariff reductions. A tariff is a tax imposed on the import
or export of goods. In general parlance, however, it refers to "import duties" charged at the time goods
are imported.

Functions of Tariffs:
Tariffs have three primary functions: to serve as a source of revenue, to protect domestic
industries, and to remedy trade distortions (punitive function).
The revenue function comes from the fact that the income from tariffs provides governments with
a source of funding. In the past, the revenue function was indeed one of the major reasons for applying
tariffs, but economic development and the creation of systematic domestic tax codes have reduced its
importance in the developed countries. For example, Japan generates about one trillion yen in tariff
revenue, but this is less than two percent of total tax revenues (fiscal 1996). In some developing
countries, however, revenue may still be an important tariff function.
Tariffs is also a policy tool to protect domestic industries by changing the conditions under which
goods compete in such a way that competitive imports are placed at a disadvantage. In point of fact, a
cursory examination of the tariff rates employed by different countries does seem to indicate that they
reflect, to a considerable extent, the competitiveness of domestic industries. In some cases, "tariff quotas"
are used to strike a balance between market access and the protection of domestic industry. Tariff quotas
work by assigning low or no duties to imports up to a certain volume (primary duties) and then higher
rates (secondary duties) to any imports that exceed that level.
The WTO bans in principle the use of quantitative restrictions as a means of protecting domestic
industries but does allow tariffs to be used for this purpose. The cost of protecting domestic industry
comes in the form of a general reduction in the protecting country's economic welfare and in the welfare
of the world economy at large, but tariffs are still considered to be more desirable than quantitative
restrictions.
Dr. Bhati Rakesh 30
 Punitive tariffs may be used to remedy trade distortions resulting from measures adopted by other
countries. For example, the Antidumping Agreement allows countries to use "antidumping-duties" to
remedy proven cases of dumping; similarly, the Subsidies Agreement allows countries to impose
countervailing duties when an exporting country provides its manufacturers with subsidies that, while not
specifically banned, nonetheless damage the domestic industry of an importing country.

Non-Tariff Trade Barriers –

Non-Tariff Barriers (NTBs) refer to restrictions that result from prohibitions, conditions, or
specific market requirements that make importation or exportation of products difficult and/or costly.
NTBs also include unjustified and/or improper application of Non-Tariff Measures (NTMs) such as
sanitary and phytosanitary (SPS) measures and other technical barriers to Trade (TBT).
NTBs arise from different measures taken by governments and authorities in the form of
government laws, regulations, policies, conditions, restrictions or specific requirements, and private
sector business practices, or prohibitions that protect the domestic industries from foreign competition.
The following points highlight the top six types of non-tariff barriers.
The barriers are: 1. Quantity Restrictions, Quotas and Licensing Procedures 2. Foreign Exchange
Restrictions 3. Technical and Administrative Regulations 4. Consular Formalities 5. State Trading 6.
Preferential Arrangement.
1. Quantity Restrictions, Quotas and Licensing Procedures:
Under this system, the maximum quantity of different commodities which would be allowed to be
imported over a period of time from various countries is fixed in advance.
The quantity allowed to be imported or quota fixed normally depends upon the relations of the two
countries and the need of the importing country.
Quotas are very often combined with Licensing System to regulate the flow of imports over the quota
period as also to allocate them between various importers and supplying countries. In this system a
license or a permit has to be obtained from the Government to import the goods mentioning the quantity
and the country from which to import.
2. Foreign Exchange Restrictions:
Under this system the importer must be sure that adequate foreign exchange would be made
available for the imports of goods by obtaining a clearance from the exchange control authorities of the
country before concluding the contract with the supplier.
3. Technical and Administrative Regulations:
The imposition of technical production, technical specifications etc. to which an importing
commodity must conform. Such type of technical restrictions is imposed in case of pharmaceutical
products etc. Besides technical restrictions, administrative restrictions such as adherence to certain
documentary procedure are adopted to regulate imports. These measures impede the free flow of trade to
a large extent.
4. Consular Formalities:
Large number of countries demands that shipping documents must accompany the consular
documents such as:
(a) Certificate of origin, (b) Certified invoices, (c) Import certificates etc.
Sometimes, it is also insisted that such documents should be drawn in the language of importing
countries. In case the documentation is faculty and is not drawn in the language of the importing country
heavy penalties are imposed. Fees charged for such documentation are quite heavy.
5. State Trading:
In socialistic countries import and export transactions are handled by certain State Agencies.
These agencies carry international trade strictly according to Government Policies. In India some articles
decided by the government is imported only through the State Trading Corporation (STC). Export of raw
materials such as iron ore, mica are handled by MMTC (Minerals and Metals Trading Corporation).
6. Preferential Arrangement:
The member countries of the group negotiate and arrive at a settlement of preferential tariff rate to
carry on trade amongst themselves. These rates are much lower than the ordinary tariff rates and

Dr. Bhati Rakesh 31

applicable only to the member nations of the small group. This preferential arrangements made outside
the purview of the GATT and EEC etc.

TARIFF BARRIERS v/s NON TARIFF BARRIERS:

1. Meaning: Tariff barriers refer to duties and taxes imposed by the govt. on the goods imported from
abroad. Non tariff barriers are various quantitative and exchange control restrictions imposed in order
to restrict imports.
2. Types: Tariff barriers include import duties, specific duties, and valorem duties protective duties, etc
Non tariff barriers includes import licensing , import quota, consular formalities and so on
3. Effectiveness: Tariff barriers are not very effective as they arise the price but the effect on demand
may be limited. As a protective measure, non tariff barriers are more effective as they restrict imports
within the required limits.
4. Flexibility: Tariffs are not flexible. They can be imposed quickly but it is difficult to remove due to
the opposition of powerful vested interests. Quotas (non tariff barriers) tend to be more flexible more
easily imposed and more easily remove.
5. Effects On Imports: Tariff barriers restrict imports indirectly. Non tariff barriers restrict imports
directly.
6. Revenue Earning Capacity: Provide huge revenue to the government. Non tariff barriers do not
provide additional revenue to the government.
7. Nature Of Protection: Tariff barriers do not offer direct protection to home industries. Non tariff
barriers can offer direct protection to home industries.
8. Formation Of Monopolies: Tariff barriers do not facilitate the formation of monopolistic group of
production. Non tariff barriers encourage the formation of the monopolistic group of procedures for
their benefit.
9. Effect On Price: Tariff barriers affect (increase) the prices of imported items Non tariff barriers
normally do not lead to rise in the prices of imported items.
10. Time Required For Effects: Changes in tariff are quick and give immediate effect in terms of
import reduction. Non tariff barriers take longer time for introduction of changes. The effects on
imports are also slow
11. Preferences: Many countries prefer tariff barriers as they give more revenue and are easy to
introduce Not preferred as they do not provide additional revenue and need complicated procedure.

TARIFF VS. QUOTA –

Tariff: A kind of tax, which is paid on the import of goods and services. It is used as a tool to limit trade,
because, tariffs increase the price of foreign goods and services and thus it makes them more expensive
for the customers. It is levied by the government to increase revenue and also to protect domestic
companies against foreign competition, as the customers will get attracted by the imported goods if they
are comparatively less costly. It acts as a barrier to free trade between nations.
There are two kinds of tariffs, which are indicated below:
1. Ad valorem tariff: A certain percentage of tariff calculated on the value of imported items.
2. Specific tariff: A specified amount is charged depending upon the type of goods.

Quota : Quota refers to a defined upper limit set by the government, on the number of goods or services
imported or exported from/to other countries, in a particular period. It is a measure used in the regulation
of trade volume between nations.
Quotas do not generate revenues for the government, but aims at encouraging the production of goods
within the country; that helps the nation to become self-sufficient and decrease dependency on imports
from other countries. In this way, quota helps in reducing imports and thus, protecting own industries
from foreign competition.
Differences Between Tariff and Quota
The primary differences between tariff and quota are explained in the given below points:
a) The tariff is a tax charged on imported goods. The quota is a limit defined by the government on
the quantity of goods produced in the foreign country and sold domestically.
Dr. Bhati Rakesh 32
 b) Tariff results in generating revenue for the country and hence, increase the GDP. As opposed to
quota, is imposed on the numerical value of goods, not the amount and so it has no effect.
c) With the effect of the tariff, consumer surplus goes down while the producer’s surplus goes up.
On the other hand, quota results in the fall of consumer surplus.
d) Income generated from the collection of the tariff is the revenue of the government. Conversely,
in the case of quota, traders will get extra income from the collection.
Basis for Comparison Tariff Quota
Tariff refers to the tax levied on import Quota refers to the restriction imposed
Meaning
or export of goods. on the quantity of goods imported.
Effect on Gross
Increases GDP. No effect on GDP.
Domestic Product
Fall in consumer's surplus and rise in
Results in Fall in consumer surplus.
producer's surplus.
Income To government To importers

The New Protectionism –

While Economists generally agree that free trade creates more winners than loser, policymakers
don’t always agree, and turn to protectionism to shelter domestic producers from foreign competition.
The free trade refers to unobstructed trade of goods and services between two countries with no
restrictions on imports and exports were as protectionism is where a country erects barriers to trade in
order to protect the domestic economy from the disadvantages of international trade.
Protectionism is the economic policy of restraining trade between nations, through methods
such as high tariffs on imported goods, restrictive quotas, and anti-dumping laws in an attempt to
protect domestic industries in a particular nation from foreign take-over or competition. This
contrasts with free trade, where no artificial barriers to entry are instituted.
The term is mostly used in the context of economics, where protectionism refers to policies or
doctrines which "protect" businesses and living wages by restricting or regulating trade between
foreign nations

TYPES OF PROTECTIONISM
1. Tariffs: A tariff is a tax on foreign goods upon importation. Tariff rates vary according to the type
of goods imported. Import tariffs will increase the cost to importers, and increase the price of
imported goods in the local markets, thus lowering the quantity of goods imported.
2. Quotas: An import quota is a type of protectionist that sets a physical limit on the quantity of a
good that can be imported into a country in a given period of time. This leads to a reduction in the
quantity imported and therefore increases the market price of imported goods. Quotas, like other
trade restrictions, are used to benefit the producers of a good in a domestic economy at the
expense of all consumers of the good in that economy.
3. Subsidies: Government subsidies (in the form of lump-sum payments or cheap loans) are
sometimes given to local firms that cannot compete well against foreign imports. These subsidies
are purported to "protect" local jobs, and to help local firms adjust to the world markets.
4. Voluntary Export Restraints (VERS): Political pressure placed on a country not to export a good.
5. Administrative obstacles: Countries are sometimes accused of using their various administrative
rules (eg. regarding food safety, environmental standards, electrical safety, etc.) as a way to
introduce barriers to imports. Bureaucracy. VERs, voluntary export restraints, through pressuring
country e.g. Japanese export restraints of vehicles to UK.
6. Embargo: A total ban of the import of a particular good. An embargo is the prohibition of
commerce and trade with a certain country, in order to isolate it and to put its government into a
difficult internal situation, given that the effects of the embargo are often able to make its
economy suffer from the initiative.
7. Health and safety standards: Not accepting goods because of possible health risks.

Dr. Bhati Rakesh 33

 8. Environmental standards: Not accepting goods due to pollutive biproducts, e.g. certain chemicals,
not being handled correctly.
9. Import license: A payment to the government for the right to import.

ARGUMENTS FOR PROTECTIONISM.

1. Infant industry argument: This argument suggests that an industry needs times to develop. This
takes into account that it needs to develop economies of scale and a learning curve.
2. Efforts of a developing country to diversify.
3. Protection of employment.
4. Source of government revenue: The consumer has the burden.
5. Strategic arguments.
6. Means to overcome a balance of payments disequilibrium.
7. Anti-dumping: Dumping is known as the selling of goods on the international market below the
production cost.
ARGUMENTS AGAINST PROTECTIONISM.
1. Inefficiency of resource allocation.
2. Costs of long-run reliance on protectionist methods.
3. Increased prices of goods and services to consumer.
4. The cost effect of protected imports on export competitiveness.
5. Less choice for the consumer.
6. Industries may not develop because of a disincentive to be competitive.
7. Trade war.
8. Protection of corrupt management.
9. Negative effect in employment in import sector.
10. Decrease of international competitiveness if imported good is an input for an exporting good.

ECONOMIC INTEGRATION –
Economic integration is an agreement among countries in a geographic region to reduce and
ultimately remove, tariff and non tariff barriers to the free flow of goods or services and factors of
production among each others; any type of arrangement in which countries agree to coordinate their
trade, fiscal, and/or monetary policies are referred to as economic integration.
Obviously, there are many different stages of integration.
a. integration as an outcome – integration as something static; integration can be achived when
certain criteria are fulfilled
b. integration as a process – integration as a dynamic process; represented by stages of integration
going form FTA to political integration
Preferential Trade Agreements
These give preferential access to certain products from certain countries by reducing or
eliminating tariffs, or by other agreements relating to trade. Basically they involve agreements to
improve trade liberalisation between countries. There are two types:
 Bilateral agreements: these are between two countries.
 Multilateral agreements: these are between more than two countries.
Bilateral agreements tend to be easier to implement, however, multilateral agreements tend to be
beneficial to more people.
Trading Blocs
ADVANTAGES OF TRADING BLOCS
1. Free trade within the bloc
2. Easier to access other markets
3. Firms can expand to make use of economies of scale
4. Growth in exports will create jobs
5. Firms inside the bloc are protected from cheaper goods being offered outside of it
6. Trade creation
DISADVANTAGES OF TRADING BLOCS
Dr. Bhati Rakesh 34
 1. Reduce beneficial effects of free trade, like specialisation and exploitation of comparative
advantage
2. Inefficiencies – fail to make use of more efficient firms outside of the bloc
3. Trade diversion
4. The common external tariff may lead others to retaliate.

TRADE CREATION AND DIVERSION

Trade creation is where trading blocs result in high cost domestic products being replaced by
low cost and more efficient imports. This is believed to be beneficial as cheaper supplies from abroad
allows for lower prices that benefit consumers.
As a result of trade agreements, trade may be diverted from a more efficient exporter to a less
efficient one, rather than creating new trade. This is usually due to the common external tariff that the
countries in the trading bloc may agree to. Therefore, trading blocs may not always be best at promoting
free trade.

ADVANTAGES OF A MONETARY UNION

1. Transparency – investors and tourists can more easily compare the international prices of goods.
2. Lower transaction costs – single currency so no need to change currency
3. Certainty – price changes are more predictable so producers can plan ahead and are more willing
to invest
4. Jobs – the export sector is likely to expand

DISADVANTAGES OF A MONETARY UNION

1. Loss of economic sovereignty – individual countries cannot set their own interest rates, which is
particularly bad when the economies of countries within the union are very diverse (like Germany
compared to Greece in the EU)
2. The countries involved may vary greatly in their language, politics and culture, which may make
it very hard to unify them
3. Inefficiencies may bread as firms within the union are favoured over more efficient firms outside
the union.

CUSTOM UNIONS AND FREE TRADE AREAS –

A free trade area (FTA) is formed when at least two states partially or fully abolish custom
tariffs on their inner border. Free trade area is a type of trade bloc, a designated group of countries that
have agreed to eliminate tariffs, quotas on most (if not all) goods traded between them.
To exclude regional exploitation of zero tariffs within the FTA there is a rule of certificate of
origin for the goods originating from the territory of a member state of an FTA. Unlike a customs union,
members of a free trade area do not have a common external tariff (with respect to non-members),
meaning different quotas and customs. To avoid evasion (through re-exportation) the countries
use the system of certification of origin most commonly called rules of origin , where
there is a requirement for the minimum extent of local material inputs and local transformations adding
value to the goods. Goods that don't cover these minimum requirements are not entitled for the special
treatment envisioned in the free trade area provisions.
Examples of FTA :
1. Central European Free Trade Agreement (CEFTA),
2. North American Free Trade Agreement (NAFTA)
A customs union introduces unified tariffs on the exterior borders of the union (common external
tariffs). A customs union is a type of trade bloc which is composed of a free trade area with a common
external tariff. The participant countries set up common external trade policy.
ADVANTAGES OF A CUSTOMS UNION:

Dr. Bhati Rakesh 35

 Without a unified external tariff, trade flows would become distorted. If, for example, Germany
imposes a 10% tariff on Japanese cars, while France imposes a 2% tariff, Japan would export its cars to
French car dealers, and then sell them on to Germany, thereby avoiding 80% of the tariff. This is avoided
if a common tariff is shared between Germany and France (and other members of the customs union.) A
common external tariff effectively removes the possibility of arbitrage and, some would argue, is one of
the fundamental building blocks of economic integration.

THE DISADVANTAGES OF A CUSTOMS UNION:

Union members must negotiate collectively with non-members or organisations like the WTO as a
single group of countries. While this is essential to maintain the customs union, it means that members
are not free to negotiate individual trade deals. For example, if a member wishes to protect a declining or
infant industry it cannot do so through imposing its own tariffs. Equallly, if it wishes to open up to
complete free trade, it cannot do so if a common tariff exists. Also, it makes little sense for a particular
member to impose a tariff on the import of a good that is not produced at all within a that country.

MAJOR REGIONAL TRADE AGREEMENTS

Regional Trade Blocs or Regional Trade Agreements (or Free Trade Agreements) are a type of
regional intergovernmental arrangement, where the participating countries agree to reduce or eliminate
barriers to trade like tariffs and non-tariff barriers. The RTBs are thus historically known for promoting
trade within a region by reducing or eliminating tariff among the member countries.
Over the last few decades, international trade liberalisations are taking place in a serious manner
through the formation of RTBs. They are getting wide attention because of many important international
developments. First, now the world is trying hard to escape from the ongoing great recession phase.
Second is the failure of the WTO to take further liberalisation measures on the trade liberalisation front.
The EU, NAFTA, ASEAN, SAFTA etc are all examples for regional integration. The triad of
North America, Western Europe, and Asia Pacific have the most successful trade blocs. Recently signed
Trans Pacific Partnership is a powerful RTB. Similarly, another one called RCEP is in negotiation round.
India has signed an FTA with the ASEAN in 2009. Simultaneously, the country has signed many
bilateral FTAs.

Different types of RTBs

All regional trade blocs don’t have the same degree of trade liberalisation. They may differ in
terms of the extent of tariff cutting, coverage of goods and services, treatment of cross border investment
among them, agreement on movement of labour etc.
The simple form of regional trade bloc is the Free Trade Area. The Free Trade Area is a type of trade
bloc, a designated group of countries that have agreed to eliminate tariffs, quotas and preferences on most
(if not all)goods and services traded between them.
From the lowest to the highest, regional trade integration may vary from just tariff reduction
arrangement to adoption of a single currency. The most common type of regional trade bloc is the free
trade agreement where the members abolish tariffs within the region. Following are the main types of
regional economic integrations.

Classification of RTBs

1. Preferential trading union: Here, two or more countries form a trading club or a union and
reduce tariffs on imports of each other ie, when they exchange tariff preferences and concessions.
2. Free trade union or association: Member countries abolish all tariffs within the union, but
maintain their individual tariffs against the rest of the world.
3. Customs union: countries abolish all tariffs within and adopt a common external tariff against the
rest of the world.

Dr. Bhati Rakesh 36

 4. Common market: in addition to the customs union, unrestricted movement of all factors of
production including labour between the member countries. In the case of European Common
Market, once a visa is obtained one can get employed in France or Germany or in any other
member country with limited restrictions.
5. Economic union: The Economic Union is the highest form of economic co-operation. In addition
to the common market, there is common currency, common fiscal and monetary policies and
exchange rate policies etc. European Union is the example for an Economic Union. Under the
European Monetary Union, there is only one currency- the Euro.

The major regional trade blocks are, as follows:

1. ASEAN (Association of Southeast Asian Nations) Established on August 8, 1967, in
Bangkok/Thailand.
Member States: Brunei Darussalam, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines,
Singapore, Thailand, and Vietnam.
Goals: (1) Accelerate economic growth, social progress and cultural development in the region and (2)
Promote regional peace and stability and adhere to United Nations Charter.
Important Indicators for 2014: Population 622 million; GDP US$2.6 trillion; and Total Trade US$1
trillion. (Fact Sheet April 2016, ASEAN Website.)
ASEAN Economic Community (AEC): Learn more about ASEAN Leaders' vision to transform ASEAN
into a single market and production base that is highly competitive and fully integrated into the global
ecomony.

2. EU (European Union) Founded in 1951 by six neighboring states as the European Coal and Steel
Community (ECSC). Over timeevolved into the European Economic Community, then the
European Community and, in 1992, was finallytransformed into the European Union.
Regional block with the largest number of members states (28). These include Austria, Belgium,
Bulgaria,Croatia, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece,
Hungary, Ireland,Italy, Latvia, Lithuania, Luxembourg, Malta, Poland, Portugal, Romania, Slovakia,
Slovenia, Spain, Sweden,The Netherlands, and the United Kingdom.
.Goals: Evolved from a regional free-trade association of states into a union of political, economic and
executive connections.
Population estimated at 515 million (July 2016); GDP (PPP) estimated at US$19.18 trillion (2016); and
Total Trade US$4.503 trillion (2014 est.) [All figures from CIA World Factbook updated 12 January
2017.] EU-US Free Trade Alliance (TTIP): For updates on negotiations of the Transatlantic Trade and
Investment Partnership (TTIP) between the EU and the USA. BREXIT - All you need to know about the
UK leaving the EU: On 23 June 2016, the United Kingdom votedin a referendum to leave the European
Union after 43 years as a member state. The process was officiallyinitiated on 29 March 2017, indicating
that the UK is scheduled to leave the EU on 29 March 2019.

3. MERCOSUR (Mercado Comun del Cono Sul - Southern Cone Common Market)
Established on 26 March 1991 with the Treaty of Assunción.
Full members include Argentina, Bolivia, Brazil, Paraguay, Uruguay, and Venezuela. Associate members
includeChile, Colombia, Ecuador, and Peru. Associate members have access to preferential trade but not
to tariffbenefits of full members. Guyana and Suriname signed Framework Agreements in 2013. Mexico,
interested inbecoming a member of the region, has an observer status.
Goals: Integration of member states for acceleration of sustained economic development based on social
justice, environmental protection, and combating poverty.
Population: 295 million people (2014 est.);
GDP (PPP): US$3.2 trillion (Summit of Heads of Member & Associated States, Brazil, July 17, 2015).

4. NAFTA (North American Free Trade Agreement) Agreement signed on 1 January 1994.
Members: Canada, Mexico, and the United States of America.

Dr. Bhati Rakesh 37

Goals: Eliminate trade barriers among member states, promote conditions for free trade, increase
investment opportunities, and protect intellectual property rights.
Population of over 478 million (July 2015 est., The CIA Factbook, February 2016).
GDP (PPP) US$21.818 trillion (2015 est., The CIA Factbook, February 2016).

Other regional trade blocks, regional economic partnerships and free trade associations include the
following:
1. ANDEAN (Andean Community Countries) – Bolivia, Colombia, Ecuador, and Peru.
Associate Members: Argentina, Brazil, Chile, Paraguay, and Uruguay.
Observer Countries: Mexico and Panama.
2. BSEC (Organization of the Black Sea Economic Cooperation) – Albania, Armenia,
Azerbaijan, Bulgaria, Georgia, Hellenic Republic, Moldova, Romania, Russian Federation,
Serbia, Turkey, and Ukraine.

3. CARICOM (Caribbean Community) – Antigua & Barbuda, The Bahamas, Barbados, Belize,
Dominica, Grenada, Guyana, Haiti, Jamaica, Montserrat, Saint Kitts & Nevis, Saint Lucia, Saint
Vincent & The Grenadines, Surinam, and Trinidad & Tobago.
Associate Members: Anguilla, Bermuda, British Virgin Islands, Cayman Islands, and Turks &
Caicos Islands.

4. CIS (Commonwealth of Independent States) Armenia, Azerbaijan, Belarus, Kazakhstan,

Kyrgyz, Moldova, Russia, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan.

5. COMESA (Common Market for Eastern and Southern Africa)

6. Burundi, Comoros, Democratic Republic of the Congo, Djibouti, Egypt, Eritrea, Ethiopia, Kenya,
Libya, Madagascar, Malawi, Mauritius, Rwanda, Seychelles, Sudan, Swaziland, Uganda, Zambia,
Zimbabwe.

7. ECOWAS (Economic Community of West African States)

Benin, Burkina Faso, Cape Verde, The Gambia, Ghana, Guinea, Guinea Bissau, Ivory Coast,
Liberia, Mali, Niger, Nigeria, Senegal, Sierra Leone, and Togo.
8. Eurasian Economic Union - Armenia, Belarus, Kazakhstan, Kyrgyz, and Russia.
9. EFTA (European Free Trade Association) – Iceland, Liechtenstein, Norway, and Switzerland.
10. GAFTA (Greater Arab Free Trade Area) - Algeria, Bahrain, Egypt, Iraq, Jordan, Kuwait,
Lebanon, Libya,Morocco, Oman, Palestine, Qatar, Saudi Arabia, Sudan, Syria, Tunisia, United
Arab Emirates (UAE), and Yemen. (No official Website found.)
11. GCC (Gulf Cooperation Council for the Arab States of the Gulf) – Bahrain, Kuwait, Oman,
Qatar, Saudi Arabia, and the United Arab Emirates (UAE).
12. Pacific Community – comprised of the 22 Pacific island countries and territories of American
Samoa, Cook Islands, Fiji Islands, French Polynesia, Guam, Kiribati, Marshall Islands,
Micronesia, Nauru, New Caledonia, Niue, Northern Mariana Islands, Palau, Papua New Guinea,
Pitcairn Islands, Samoa, Solomon Islands, Tokelau, Tonga, Tuvalu, Vanuatu, Wallis and Futuna,
and the founding countries of Australia, France, New Zealand and the United States of America.
13. SAARC (South Asian Association for Regional Cooperation)
Afghanistan, Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan, and Sri Lanka.
14. SADC (Southern Africa Development Community)
Angola, Botswana, Democratic Republic of Congo, Lesotho, Madagascar, Malawi, Mauritius,
Mozambique, Namibia, Seychelles, South Africa, Swaziland, Tanzania, Zambia, and Zimbabwe.
15. The Shanghai Cooperation Organisation
China, Kazakhstan, Kyrgyz, Russia, Tajikistan, and Uzbekistan.

Dr. Bhati Rakesh 38

 CHAPTER 4
Foreign Exchange : Foreign Exchange Market – Types of Foreign Exchange Transactions – Reading
Foreign Exchange Quotations – Forward and Futures Market – Foreign-Currency Options –
Exchange Rate Determination – Arbitrage – Speculation and Exchange-Market Stability

Foreign Exchange : Foreign Exchange Market –

Foreign exchange market is the market in which foreign currencies are bought and sold. The
buyers and sellers include individuals, firms, foreign exchange brokers, commercial banks and the central
bank.
Like any other market, foreign exchange market is a system, not a place. The transactions in this
market are not confined to only one or few foreign currencies. In fact, there are a large number of foreign
currencies which are traded, converted and exchanged in the foreign exchange market.
Functions of Foreign Exchange Market:
Foreign exchange market performs the following three functions:
1. Transfer Function: It transfers purchasing power between the countries involved in the
transaction. This function is performed through credit instruments like bills of foreign exchange,
bank drafts and telephonic transfers.
2. Credit Function: It provides credit for foreign trade. Bills of exchange, with maturity period of
three months, are generally used for international payments. Credit is required for this period in
order to enable the importer to take possession of goods, sell them and obtain money to pay off
the bill.
3. Hedging Function: When exporters and importers enter into an agreement to sell and buy goods
on some future date at the current prices and exchange rate, it is called hedging. The purpose of
hedging is to avoid losses that might be caused due to exchange rate variations in the future.
Types of Foreign Exchange Transactions –
Foreign exchange markets are classified on the basis of whether the foreign exchange transactions
are spot or forward accordingly, there are two kinds of foreign exchange markets:
(i) Spot Market, (ii) Forward Market.
(i) Spot Market: Spot market refers to the market in which the receipts and payments are made
immediately. Generally, a time of two business days is permitted to settle the transaction. Spot market is
of daily nature and deals only in spot transactions of foreign exchange (not in future transactions). The
rate of exchange, which prevails in the spot market, is termed as spot exchange rate or current rate of
exchange.
The term ‘spot transaction’ is a bit misleading. In fact, spot transaction should mean a transaction,
which is carried out ‘on the spot’ (i.e., immediately). However, a two day margin is allowed as it takes
two days for payments made through cheques to be cleared.
(ii) Forward Market: Forward market refers to the market in which sale and purchase of foreign
currency is settled on a specified future date at a rate agreed upon today. The exchange rate quoted in
forward transactions is known as the forward exchange rate. Generally, most of the international
transactions are signed on one date and completed on a later date. Forward exchange rate becomes useful
for both the parties involved in the transaction.
Forward Contract is made for two reasons:
(a) To minimize the risk of loss due to adverse changes in the exchange rate (through hedging);
(b) To make profit (through speculation).
The instruments of Foreign Exchange market can be divided into the following two categories:
Currency agreements
1. Spot - the exchange of currencies no later than the second working day after the date of
agreement. These kind of transactions are also referred to as cash. Transactions based on the
conditions of spot are made on Over-the-Counter (OTC) interbank market on the basis of the
establishment of currency exchange rates (quotes). Speculative currency transactions of banks,
hedge funds, financial companies and other participants of Foreign Exchange market are made on
Dr. Bhati Rakesh 39
 spot conditions. Up to 65% of the overall turnover of the Foreign Exchange market falls on
trading with the delivery of currencies on the spot conditions.
2. Outright forwards – the exchange of currencies at the rate of “forward” within a range of days
strictly established by parties of the transaction. Such transactions are beneficial in case of
instable exchange of currency rates.
3. Currency swap – the simultaneous buying and selling of currencies with different value dates.
Outright forwards and currency swap form Forward Exchange market, where the exchange of
currencies takes place in the future.
Derivatives – financial instrument derived from the underlying asset (the main product). Any product or
service can be an underlying asset.
1. Synthetic Agreement for Foreign Exchange (SAFE) – these are derivatives of the Over-the-
Counter (OTC) market, which function as an agreement on the future rate of interest (FRA) in
case of currency forward transactions. In other words, this is a guarantee of the exchange rate for
a specific period of time, which starts in the future.
2. Currency futures – these transactions provide the exchange of currencies on a specific date in
the future at the predetermined rate.
3. Interest Rate Swap – an agreement between two parties on the exchange of obligations for one
currency to the obligations of the other one, in which they pay each other interest rates on the
loans in different currencies. In case of the realization of obligations, currencies are being
exchanged to original.
4. Currency Options – an agreement between a buyer and a seller, granting a buyer the right, but
not the obligation to buy a certain amount of currencies on a predetermined price within a specific
period of time, regardless of the market price of the currency.

Reading Foreign Exchange Quotations

One of the biggest sources of confusion for those new to the currency market is the standard for
quoting currencies. When a currency is quoted, it is done in relation to another currency, so that the value
of one is reflected through the value of another. Therefore, if you are trying to determine the exchange
rate between the U.S. dollar (USD) and the Japanese yen (JPY), the forex quote would look like this:
USD/JPY = 119.50
This is referred to as a currency pair. The currency to the left of the slash is the base currency,
while the currency on the right is called the quote or counter currency. The base currency (in this case,
the U.S. dollar) is always equal to one unit (in this case, US$1), and the quoted currency (in this case, the
Japanese yen) is what that one base unit is equivalent to in the other currency. The quote means that
US$1 = 119.50 Japanese yen. In other words, US$1 can buy 119.50 Japanese yen. The forex quote
includes the currency abbreviations for the currencies in question.
Direct Currency Quote vs. Indirect Currency Quote
There are two ways to quote a currency pair, either directly or indirectly. A direct currency quote
is simply a currency pair in which the domestic currency is the quoted currency; while an indirect quote,
is a currency pair where the domestic currency is the base currency. So if you were looking at the
Canadian dollar as the domestic currency and U.S. dollar as the foreign currency, a direct quote would be
USD/CAD, while an indirect quote would be CAD/USD. The direct quote varies the domestic currency,
and the base, or foreign currency, remains fixed at one unit. In the indirect quote, on the other hand, the
foreign currency is variable and the domestic currency is fixed at one unit.
For example, if Canada is the domestic currency, a direct quote would be 1.18 USD/CAD and
means that USD$1 will purchase C$1.18 . The indirect quote for this would be the inverse (1/1.18), 0.85
CAD/USD, which means with C$1, you can purchase US$0.85.
In the forex spot market, most currencies are traded against the U.S. dollar, and the U.S. dollar is
frequently the base currency in the currency pair. In these cases, it is called a direct quote. This would
apply to the above USD/JPY currency pair, which indicates that US$1 is equal to 119.50 Japanese yen.

Dr. Bhati Rakesh 40

 However, not all currencies have the U.S. dollar as the base. The Queen's currencies - those
currencies that historically have had a tie with Britain, such as the British pound, Australian Dollar and
New Zealand dollar - are all quoted as the base currency against the U.S. dollar. The euro, which is
relatively new, is quoted the same way as well. In these cases, the U.S. dollar is the counter currency, and
the exchange rate is referred to as an indirect quote. This is why the EUR/USD quote is given as 1.25, for
example, because it means that one euro is the equivalent of 1.25 U.S. dollars.
Most currency exchange rates are quoted out to four digits after the decimal place, with the exception of
the Japanese yen (JPY), which is quoted out to two decimal places.
Cross Currency
When a currency quote is given without the U.S. dollar as one of its components, this is called a
cross currency. The most common cross currency pairs are the EUR/GBP, EUR/CHF and EUR/JPY.
These currency pairs expand the trading possibilities in the forex market, but it is important to note that
they do not have as much of a following (for example, not as actively traded) as pairs that include the
U.S. dollar, which also are called the majors.
Bid and Ask
As with most trading in the financial markets, when you are trading a currency pair there is a bid
price (buy) and an ask price (sell). Again, these are in relation to the base currency. When buying a
currency pair (going long), the ask price refers to the amount of quoted currency that has to be paid in
order to buy one unit of the base currency, or how much the market will sell one unit of the base currency
for in relation to the quoted currency.
The bid price is used when selling a currency pair (going short) and reflects how much of the
quoted currency will be obtained when selling one unit of the base currency, or how much the market
will pay for the quoted currency in relation to the base currency.
The quote before the slash is the bid price, and the two digits after the slash represent the ask price (only
the last two digits of the full price are typically quoted). Note that the bid price is always smaller than the
ask price. Let's look at an example:

USD/CAD = 1.2000/05
Bid = 1.2000
Ask= 1.2005

If you want to buy this currency pair, this means that you intend to buy the base currency and are
therefore looking at the ask price to see how much (in Canadian dollars) the market will charge for U.S.
dollars. According to the ask price, you can buy one U.S. dollar with 1.2005 Canadian dollars.
However, in order to sell this currency pair, or sell the base currency in exchange for the quoted currency,
you would look at the bid price. It tells you that the market will buy US$1 base currency (you will be
selling the market the base currency) for a price equivalent to 1.2000 Canadian dollars, which is the
quoted currency.
Whichever currency is quoted first (the base currency) is always the one in which the transaction
is being conducted. You either buy or sell the base currency. Depending on what currency you want to
use to buy or sell the base with, you refer to the corresponding currency pair spot exchange rate to
determine the price.
Spreads and Pips
The difference between the bid price and the ask price is called a spread. If we were to look at the
following quote: EUR/USD = 1.2500/03, the spread would be 0.0003 or 3 pips, also known as points.
Although these movements may seem insignificant, even the smallest point change can result in
thousands of dollars being made or lost due to leverage. Again, this is one of the reasons that speculators
are so attracted to the forex market; even the tiniest price movement can result in huge profit.
The pip is the smallest amount a price can move in any currency quote. In the case of the U.S. dollar,
euro, British pound or Swiss franc, one pip would be 0.0001. With the Japanese yen, one pip would be
0.01, because this currency is quoted to two decimal places. So, in a forex quote of USD/CHF, the pip
would be 0.0001 Swiss francs. Most currencies trade within a range of 100 to 150 pips a day.

Dr. Bhati Rakesh 41

 Currency Quote Overview
USD/CAD = 1.2232/37
Base Currency Currency to the left (USD)
Quote/Counter
Currency to the right (CAD)
Currency
Price for which the market maker will
Bid Price 1.2232 buy the base currency. Bid is always
smaller than ask.
Price for which the market maker will
Ask Price 1.2237
sell the base currency.
One point move, in USD/CAD it is
The pip/point is the smallest
Pip .0001 and 1 point change would be
movement a price can make.
from 1.2231 to 1.2232
Spread in this case is 5 pips/points;
Spread difference between bid and ask price
(1.2237-1.2232).

Currency Pairs in the Forwards and Futures Markets

One of the key technical differences between the forex markets is the way currencies are quoted.
In the forwards or futures markets, foreign exchange always is quoted against the U.S. dollar. This means
that pricing is done in terms of how many U.S. dollars are needed to buy one unit of the other currency.
Remember that in the spot market some currencies are quoted against the U.S. dollar, while for others,
the U.S. dollar is being quoted against them. As such, the forwards/futures market and the spot market
quotes will not always be parallel one another.
For example, in the spot market, the British pound is quoted against the U.S. dollar as GBP/USD.
This is the same way it would be quoted in the forwards and futures markets. Thus, when the British
pound strengthens against the U.S. dollar in the spot market, it will also rise in the forwards and futures
markets.
On the other hand, when looking at the exchange rate for the U.S. dollar and the Japanese yen, the
former is quoted against the latter. In the spot market, the quote would be 115 for example, which means
that one U.S. dollar would buy 115 Japanese yen. In the futures market, it would be quoted as (1/115) or
.0087, which means that 1 Japanese yen would buy .0087 U.S. dollars. As such, a rise in the USD/JPY
spot rate would equate to a decline in the JPY futures rate because the U.S. dollar would have
strengthened against the Japanese yen and therefore one Japanese yen would buy less U.S. dollars.

FORWARD AND FUTURES MARKET –

The future market and the forward market differ in notable ways:
1. Price Range: The future market specifies a maximum daily price range for each day; hence a
futures market participant is not exposed to more than a limited amount of daily price change. But
forward contracts have no daily limits on price fluctuations.
2. Maturity: CME futures contracts are available for delivery on one of only four maturity dates per
year, but banks offer forward contracts for delivery on any date. In India, now currency future
contracts are available for delivery on 4th Thursday of each calendar month.
3. Size of Contract: The futures market offers only standardized contracts in pre-determined
amounts, but the forward market offers contracts for specific amounts of currencies tailored to
specific needs.
4. Regulation: The futures market is regulated by the Commodity Futures Commission, but the
forward market is self-regulating.
Dr. Bhati Rakesh 42
 5. Settlement: Less than 2 percent of the futures contracts are settled by actual delivery, but more
than 90 percent of forward contracts are settled by delivery.
6. Location: Futures trading take place on organized exchanges, but forward trading is negotiated
directly between banks and their clients.
7. Credit Risk: The Clearing House of Future market guarantees to deliver the currency on
schedule if the seller defaults or to acquire it if the buyer defaults. On the other hand, a bank
dealing in the forward market must satisfy itself that the party with whom it has a contract is
creditworthy.
8. Speculation: Future market brokers accommodate speculative transactions, whereas banks
generally discourage speculation by individuals.
9. Collateral: A security deposit (margin) is required for every futures contract, but forward
contracts do not require any margin payment. Compensating balances are required in most
forward contracts.
10. Commission: In the futures market, commissions of intermediaries depend on published
brokerage fees and negotiated rates on block trades. In the forward market, a “spread” between
the banks buys and sell prices sets the commissions of intermediaries.
11. Trading: Futures contracts are traded in a competitive arena, but forward contracts are traded by
telephone or telex.

FOREIGN-CURRENCY OPTIONS –
A foreign currency option gives its owner the right, but not the obligation, to buy or sell currency
at a certain price (known as the strike price), either on or before a specific date. In exchange for this right,
the buyer pays an up-front premium to the seller. The income earned by the seller is restricted to the
premium payment received, while the buyer has a theoretically unlimited profit potential, depending
upon the future direction of the relevant exchange rate. Foreign currency options are used to hedge
against the possibility of losses caused by changes in exchange rates.
Foreign currency options are available for the purchase or sale of currencies within a certain future date
range, with the following variations available for the option contract:
1. American option. The option can be exercised on any date within the option period, so that
delivery is two business days after the exercise date.
2. European option. The option can only be exercised on the expiry date, which means that delivery
will be two business days after the expiry date.
3. Burmudan option. The option can only be exercised on certain predetermined dates.
The holder of a foreign currency option will exercise it when the strike price is more favorable than the
current market rate, which is called being in-the-money. If the strike price is less favorable than the
current market rate, this is called being out-of-the-money, in which case the option holder will not
exercise the option. If the option holder is inattentive, it is possible that an in-the-money option will not
be exercised prior to its expiry date. Notice of option exercise must be given to the counterparty by the
notification date stated in the option contract.
A foreign currency option provides two key benefits:
1. Loss prevention. An option can be exercised to hedge the risk of loss, while still leaving open the
possibility of benefiting from a favorable change in exchange rates.
2. Date variability. The treasury staff can exercise an option within a predetermined date range,
which is useful when there is uncertainty about the exact timing of the underlying exposure.
There are a number of factors that enter into the price of a currency option, which can make it difficult to
ascertain whether a quoted option price is reasonable. These factors are:
1. The difference between the designated strike price and the current spot price. The buyer of an
option can choose a strike price that suits his specific circumstances. A strike price that is well
away from the current spot price will cost less, since the likelihood of exercising the option is
low. However, setting such a strike price means that the buyer is willing to absorb the loss
associated with a significant change in the exchange rate before seeking cover behind an option.
2. The current interest rates for the two currencies during the option period.

Dr. Bhati Rakesh 43

 3. The duration of the option.
4. Volatility of the market. This is the expected amount by which the currency is expected to
fluctuate during the option period, with higher volatility making it more likely that an option will
be exercised. Volatility is a guesstimate, since there is no quantifiable way to predict it.
5. The willingness of counterparties to issue options.
Banks generally allow an option exercise period of no more than three months. Multiple partial
currency deliveries within a currency option can be arranged. Exchange traded options for standard
quantities are available. This type of option eliminates the risk of counterparty failure, since the clearing
house operating the exchange guarantees the performance of all options traded on the exchange.
Foreign currency options are particularly valuable during periods of high currency price volatility.
Unfortunately from the perspective of the buyer, high volatility equates to higher option prices, since
there is a higher probability that the counterparty will have to make a payment to the option buyer

EXCHANGE RATE DETERMINATION –

Exchange rates are determined by factors, such as interest rates, confidence, current account on
balance of payments, economic growth and relative inflation rates. For example:
1. If US business became relatively more competitive, there would be greater demand for American
goods; this increase in demand for US goods would cause an appreciation (increase in value) of
the dollar.
2. However, if markets were worried about the future of the US economy, they would tend to sell
dollars, leading to a fall in the value of the dollar.
There are two methods of foreign exchange rate determination. One method falls under the classical gold
standard mechanism and another method falls under the classical paper currency system. Today, gold
standard mechanism does not operate since no standard monetary unit is now exchanged for gold.
All countries now have paper currencies not convertible to gold. Under inconvertible paper
currency system, there are two methods of exchange rate determination. The first is known as the
purchasing power parity theory and the second is known as the demand-supply theory or balance of
payments theory. Since today there is no believer of purchasing power parity theory, we consider only
demand-supply approach to foreign exchange rate determination.

FACTORS THAT INFLUENCE EXCHANGE RATES

1. Inflation : If inflation in the UK is relatively lower than elsewhere, then UK exports will become more
competitive, and there will be an increase in demand for Pound Sterling to buy UK goods. Also, foreign
goods will be less competitive and so UK citizens will buy fewer imports. Therefore countries with lower
inflation rates tend to see an appreciation in the value of their currency. For example, the long term
appreciation in the German D-Mark in the post-war period was related to the relatively lower inflation
rate.
2. Interest rates : If UK interest rates rise relative to elsewhere, it will become more attractive to deposit
money in the UK. You will get a better rate of return from saving in UK banks. Therefore demand for
Sterling will rise. This is known as “hot money flows” and is an important short run factor in
determining the value of a currency.
 Higher interest rates cause an appreciation.
 Cutting interest rates tends to cause a depreciation
3. Speculation : If speculators believe the sterling will rise in the future, they will demand more now to
be able to make a profit. This increase in demand will cause the value to rise. Therefore movements in
the exchange rate do not always reflect economic fundamentals, but are often driven by the sentiments of
the financial markets. For example, if markets see news which makes an interest rate increase more
likely, the value of the pound will probably rise in anticipation. The fall in the value of the Pound post-
Brexit was partly related to the concerns that the UK would no longer attract as many capital flows
outside the Single Currency.
4. Change in competitiveness : If British goods become more attractive and competitive this will also
cause the value of the exchange rate to rise. For example, if the UK has long-term improvements in
Dr. Bhati Rakesh 44
labour market relations and higher productivity, good will become more internationally competitive and
in long-run cause an appreciation in the Pound. This is a similar factor to low inflation.
5. Relative strength of other currencies : In 2010 and 2011, the value of the Japanese Yen and Swiss
Franc rose because markets were worried about all the other major economies – US and EU. Therefore,
despite low interest rates and low growth in Japan, the Yen kept appreciating. In the mid-1980s, the
Pound fell to a low against the Dollar – this was mostly due to strength of Dollar, caused by rising
interest rates in the US.
6. Balance of payments : A deficit on the current account means that the value of imports (of goods and
services) is greater than the value of exports. If this is financed by a surplus on the financial/capital
account, then this is OK. But a country which struggles to attract enough capital inflows to finance a
current account deficit will see a depreciation in the currency. (For example, current account deficit in US
of 7% of GDP was one reason for depreciation of dollar in 2006-07). In the above diagram, the UK
current account deficit reached 7% of GDP at the end of 2015, contributing to the decline in the value of
the Pound.
7. Government debt : Under some circumstances, the value of government debt can influence the
exchange rate. If markets fear a government may default on its debt, then investors will sell their bonds
causing a fall in the value of the exchange rate. For example, Iceland debt problems in 2008, caused a
rapid fall in the value of the Icelandic currency.
For example, if markets feared the US would default on its debt, foreign investors would sell their
holdings of US bonds. This would cause a fall in the value of the dollar.
8. Government intervention : Some governments attempt to influence the value of their currency. For
example, China has sought to keep its currency undervalued to make Chinese exports more competitive.
They can do this by buying US dollar assets which increases the value of the US dollar to Chinese Yuan.
9. Economic growth/recession : A recession may cause a depreciation in the exchange rate because
during a recession interest rates usually fall. However, there is no hard and fast rule. It depends on several
factors

ARBITRAGE –
Arbitrage is the simultaneous purchase and sale of a commodity or asset in different markets with
the sole intent to make profit from the difference in buying and selling prices. Here the asset is a
currency. Arbitrage, especially triangulation methods, is a perfect candidate for computer analysis and
execution; it requires both deep and lightning-fast calculation. In general, arbitrage is the purchase or sale
of any financial instrument and simultaneous taking of an equal and opposite position in a related market
for the purpose of taking advantage of small price differentials between markets. Essentially, arbitrage
opportunities arise when currency prices go out of sync with each other. There are numerous forms of
arbitrage involving multiple markets, future deliveries, options, and other complex derivatives.
A less sophisticated example of a two-currency, two-location arbitrage transaction follows.
Bank ABC offers 170 Japanese Yen for one U.S. Dollar and Bank XYZ offers only 150 Yen for
one Dollar. Go to Bank ABC and purchase 170 Yen. Next, go to Bank XYZ and sell the Yen for $1.13.
In a little more than the time it took to cross the street that separates the two banks, you earned a 13
percent return on your original investment. If the anomaly between the two banks' exchange rates
persists, repeat the transactions. After exchanging currencies at both banks six times, you will have more
than doubled your investment.
Within the FOREX market, triangular arbitrage is a specific trading strategy that involves three
currencies, their correlation, and any discrepancy in their parity rates. Thus, there are no arbitrage
opportunities when dealing with just two currencies in a single market. Their fluctuations are simply the
trading range of their exchange rate.
In the subsequent examples, I refer to four Tables below of currency pairs consisting of the five
most frequently traded pairs (USD, EUR, JPY, GBP, and CHF) with recent bid-ask rates.
Combinations of the Five Most Frequently Traded Currencies[/caption]

Dr. Bhati Rakesh 45

 Formulas for Cross Currencies
CHF/JPY = USD/JPY/USD/CHF 85.14 = 105.61/1.2402 85.1556
EUR/CHF = EUR/USD × USD/CHF 1.5676 = 1.2638 × 1.2402 1.567365
EUR/GBP = EUR/USD / GBP/USD 0.6915 = 1.2638/1.8275 0.691546
EUR/JPY = EUR/USD × USD/JPY 133.51 = 1.2638 × 105.61 133.4699
GBP/CHF = GBP/USD × USD/CHF 2.2666 = 1.8275 × 1.2402 2.266466
GBP/JPY = GBP/USD × USD/JPY 193.02 = 1.8275 × 105.61 193.002

Calculations for Cross Currencies[/caption]

Transaction Cost
EUR/USD 2
USD/JPY +3
EUR/JPY +3
We omitted the other two majors, CAD and AUD, for the sake of simplicity and not because of lack of
arbitrage opportunities in these two majors.
Example 1: Two USD pairs and one cross pair (multiply).
First, we must identify certain characteristics and distinguish the following categories:
USD is the base currency (leftmost currency in the pair):
USD/CHF 1.2402/05
USD/JPY 105.61/64
USD is the quote currency (rightmost currency in the pair):
EUR/USD 1.2638/40
GBP/USD 1.8275/78
Cross Rates (non-USD currency pairs):
CHF/JPY 85.14/19
EUR/CHF 1.5676/78
EUR/GBP 0.6915/17
EUR/JPY 133.51/54
GBP/CHF 2.2666/74
GBP/JPY 193.02/10
Dr. Bhati Rakesh 46
The fact that the USD is the base currency in two of the pairs (USD/CHF and USD/JPY) and is the quote
currency in two other pairs (EUR/USD and GBP/USD) plays an important role in the arithmetic of
arbitrage. We begin our investigation with just the bid prices. (See Table above- Formulas for Cross
Currencies.)
The criterion whether to multiply or divide the USD pairs in order to calculate the cross rate is
simple:
 If the USD is the base currency in both pairs, then divide the USD pairs.
 If the USD is the quote currency in both pairs, then divide the USD pairs.
 Otherwise multiply the USD pairs.
To determine the deviation from parity for each cross pair, subtract the exchange rate from the calculated
rate and convert the floating point decimals to pip values. (See Table- Transaction Cost.)
From Table above (Calculations for Cross Currencies), we can see that the EUR/JPY is out of parity by
four pips. To determine if an arbitrage opportunity is profitable, we must first calculate the total
transaction cost by adding the three bid-ask spreads of the corresponding pairs. (See Table above-
Transaction Cost.)
An eight-pip transaction cost to earn a four-pip profit is counterproductive (it amounts to a four-pip loss).
If the parity deviation (the number of pips by which the three currency pairs are out of alignment) were
greater, say 30 pips, then a definite arbitrage opportunity exists.
The trading mechanism to take advantage of this anomaly requires some consideration. First, determine
what market actions are necessary to correct this anomaly. Assume that the EUR/JPY rate is currently
trading at 133.51 and the calculated rate using the current EUR/USD and USD/JPY pairs is 133.81 (a 30-
pip deviation). Parity between the three currencies will be restored if the following price action occurs:
 The EUR/JPY pair rises to 133.81
 The product of the EUR/USD and USD/JPY pairs drops to 133.51
Therefore, the following trades are required to lock in the 30-pip profit:
 Buy one lot of the EUR/JPY pair.
 Sell one lot of the EUR/USD pair.
 Sell one lot of the USD/JPY pair.
 Liquidate all three trades simultaneously when parity is reestablished.
Warning: Executing only one, or even two, legs of the three trades required in an arbitrage package does
not guarantee a profit and may be quite dangerous. All three trades must be executed simultaneously
before the locked-in profit can be realized.
Example 2: Two USD pairs and one cross pair (divide)
The previous example uses the product of the two USD currencies to calculate the cross rate. An
example of the ratio of the two USD currencies follows. Assume the EUR/GBP cross pair is currently
trading at 0.6992 and that the ratio between the EUR/USD and GBP/USD pairs is calculated as 0.6952, a
40-pip deviation. Parity will be restored when the following price actions occur:
 The EUR/GBP pair drops to 0.6952
 The ratio of the EUR/USD and GBP/USD pairs rises to 0.6992
For the second action to rise, either the EUR/USD pair must also rise or the GBP/USD pair must decline
(this differs from the previous example). Therefore, the following trades are required to realize a 40-pip
profit:
 Sell one lot of the EUR/GBP pair.
 Buy one lot of the EUR/USD pair.
 Sell one lot of the GBP/USD pair.
 Liquidate all three trades the moment parity is reestablished.
Example 3: Three non-USD cross pairs
Technically, the arbitrage strategy can also be performed on three non-USD currency pairs. In this
example, we examine a straddle between the three European majors (EUR, GBP, CHF), where we focus
on the EUR/CHF pair in respect to the two GBP currency pairs (GBP/CHF and EUR/GBP).
Assume the current rates of exchange are:

 EUR/CHF = 1.5676/78
Dr. Bhati Rakesh 47
  EUR/GBP = 0.6915/17
 GBP/CHF = 2.2604/12

and their relationship is:

Thus, the calculated value for the EUR/CHF rate is 0.6915 × 2.2604, or 1.5631. The deviation from
parity is –.0045 (1.5631 â “ 1.5676), or 45 CHF pips, since CHF is the pip currency in the EUR/CHF
pair. The trading strategy is:
 Sell one lot of EUR/CHF.
 Buy one lot of EUR/GBP.
 Buy one lot of GBP/CHF.
 Liquidate all three when parity is reestablished.
If all three trades are executed successfully, a profit of 45 CHF pips is realized. Subtract the three bid-ask
spreads for the transaction costs (2 + 2 + 8 = 12) to see a net profit of 33 CHF pips. Now convert CHF
pips to dollars (33 divided by USD/CHF rate 1.2402) to obtain 27 USD pips.
It should be noted in all the examples presented here that only three currencies are analyzed
simultaneously. It is possible to add a fourth, or even a fifth, currency to the mix, although this is
normally left to the very serious arbitrage strategists.
The methodology for examining four (or even five or six) currencies at one time is to calculate every
possible three-currency combination among the currencies selected. Rearrange them in magnitude of
deviation from parity. Examine the deviations closely to see if there is a single anomaly or possibly even
a double anomaly among the four currencies. This type of scrutiny will then determine if a four-currency
arbitrage opportunity exists.
Specialized software is definitely required when dealing with four or more currencies in a single
arbitrage package. The approach here requires instantaneous calculation of arbitrage values across
multiple pairs using transitivity algorithms. Extreme low latency is required for it to work.

Speculation and Exchange-Market Stability

Foreign exchange market (forex, or FX, market), 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 foreign exchange markets are the original and oldest financial markets and
remain the basis upon which the rest of the financial structure exists and is traded: foreign exchange
markets provide international liquidity, preferably with relative stability.
A foreign exchange market is a 24-hour over-the-counter (OTC) and dealers’ market, meaning
that transactions are completed between two participants via telecommunications technology. The
currency markets are also further divided into spot markets—which are for two-day settlements—and the
forward, swap, interbank futures, and options markets. London, New York, and Tokyo dominate foreign
exchange trading. The currency markets are the largest and most liquid of all the financial markets; the
triennial figures from the Bank for International Settlements (BIS) put daily global turnover in the foreign
exchange markets in trillions of dollars. It is sobering to consider that in the early 21st century an annual
world trade’s foreign exchange is traded in just less than every five days on the currency markets,
although the widespread use of hedging and exchanges into and out of vehicle currencies—as a more
liquid medium of exchange—means that such measures of financial activity can be exaggerated.
The original demand for foreign exchange arose from merchants’ requirements for foreign
currency to settle trades. However, now, as well as trade and investment requirements, foreign exchange
is also bought and sold for risk management (hedging), arbitrage, and speculative gain. Therefore,
financial, rather than trade, flows act as the key determinant of exchange rates; for example, interest rate
differentials act as a magnet for yield-driven capital. Thus, the currency markets are often held to be a
permanent and ongoing referendum on government policy decisions and the health of the economy; if the
markets disapprove, they will vote with their feet and exit a currency. However, debates about the actual
Dr. Bhati Rakesh 48
versus potential mobility of capital remain contested, as do those about whether exchange rate
movements can best be characterized as rational, “overshooting,” or speculatively irrational.
The increasingly asymmetric relationship between the currency markets and national governments
represents a classic autonomy problem. The “trilemma” of economic policy options available to
governments are laid out by the Mundell-Fleming model. The model shows that governments have to
choose two of the following three policy aims: (1) domestic monetary autonomy (the ability to control
the money supply and set interest rates and thus control growth); (2) exchange rate stability (the ability to
reduce uncertainty through a fixed, pegged, or managed regime); and (3) capital mobility (allowing
investment to move in and out of the country).
Historically, different international monetary systems have emphasized different policy mixes.
For instance, the Bretton Woods system emphasized the first two at the expense of free capital
movement. The collapse of the system destroyed the stability and predictability of the currency markets.
The resultant large fluctuations meant a rise in exchange rate risk (as well as in profit opportunities).
Governments now face numerous challenges that are often captured under the term globalization or
capital mobility: the move to floating exchange rates, the political liberalization of capital controls, and
technological and financial innovation.
In the contemporary international monetary system, floating exchange rates are the norm.
However, different governments pursue a variety of alternative policy mixes or attempt to minimize
exchange rate fluctuations through different strategies. For example, the United States displayed a
preference for ad hoc international coordination, such as the Plaza Agreement in 1985 and the Louvre
Accord in 1987, to intervene and manage the price of the dollar. Europe responded by forging ahead with
a regional monetary union based on the desire to eliminate exchange rate risk, whereas many developing
governments with smaller economies chose the route of “dollarization”—that is, either fixing to or
choosing to have the dollar as their currency.
The international governance regime is a complex and multilayered bricolage of institutions, with
private institutions playing an important role; witness the large role for private institutions, such as credit
rating agencies, in guiding the markets. Also, banks remain the major players in the market and are
supervised by the national monetary authorities. These national monetary authorities follow the
international guidelines promulgated by the Basel Committee on Banking Supervision, which is part of
the BIS. Capital adequacy requirements are to protect principals against credit risk, market risk, and
settlement risk. Crucially, the risk management, certainly within the leading international banks, has
become to a large extent a matter for internal setting and monitoring.

Dr. Bhati Rakesh 49

 CHAPTER 4

World Financial Environment: Global Foreign – Exchange Markets – Economic Theories of

Exchange Rate Determination - International Regime for FDI and MNC- Do Global Corporations
Pose a Threat? - Consequences of Economic Globalization

World Financial Environment: Global Foreign – Exchange Markets –

The main feature of this market is that, it is continuous - i.e., open 24 hours a day. The time zones
are as follows: The market begins with New York (6 p.m India time) , then Sydney, followed by Tokyo.
When we come to work in the morning here in India, Tokyo is at lunch.
The Frankfurt market opens at 10 a.m our time; then London (12.30 our time) and we go back full
circle to New York again. This means that there is a price available always, anytime and you can transact
whenever you want.The foreign exchange market is a global online network where traders buy and sell
currencies. It has no physical location and operates 24 hours a day, seven days a week. It sets
the exchange rates for currencies with floating rates.
This global market has two tiers. The first is the Interbank Market. It's where the biggest banks
exchange currencies with each other. Even though it only has a few members, the trades are enormous.
As a result, it dictates currency values.
The second tier is the over-the-counter market. That's where and individuals trade. The OTC has
become very popular since there are now many companies that offer online trading platforms.
Foreign exchange trading is a contract between two parties. There are three types of trades. The spot
market is for the currency price at the time of the trade. The forward market is an agreement to exchange
currencies at an agreed-upon price on a future date. A swap trade involves both. Dealers buy a currency
on the spot market (at today's price) and sell the same amount in the forward market. This way, they have
just limited their risk in the future. No matter how much the currency falls, they will not lose more than
the forward price. Meanwhile, they can invest the currency they bought on the spot market.
Interbank Market
The interbank market is a network of banks that trade currencies with each other.
Each has a currency trading desk called a dealing desk. They are in contact with each other continuously.
That process makes sure exchange rates are uniform around the world. The minimum trade is one million
of the currency being traded. Most trades are much larger, between 10 million to 100 million in value.
As a result, exchange rates are dictated by the interbank market. The interbank market includes
the three trades mentioned above. Banks also engage in the SWIFT market. It allows them to transfer
foreign exchange to each other. SWIFT stands for Society for World-Wide Interbank Financial
Telecommunications.
Banks trade to create profit for themselves and their clients. When they trade for themselves, it's
called proprietary trading. Their customers include governments, sovereign wealth funds, large
corporations, hedge funds and wealthy individuals

ECONOMIC THEORIES OF EXCHANGE RATE DETERMINATION –

Determination of Exchange Rates: Theory # 1: Purchasing Power Parity Theory:

Assuming non-existence of tariffs and other trade barriers and zero cost of transport, the law of
one price, the simplest concept of purchasing power parity (PPP), states that identical goods should cost
the same in all nations. Therefore, prices of goods sold in different countries, converted to a common
currency, should be identical.
The equilibrium price rate between two currencies, according to the purchase power parity
theory, would be equal to the ratio of price levels in two countries, as indicated below:
Se = Px/Py

Dr. Bhati Rakesh 50

 Where, Se indicates spot exchange rate, and Px and Py indicate the price level in two different
countries x and y. However, prices can be distorted by a range of factors, such as taxes, transport costs,
labour laws, and trade barriers like tariffs.
Based on PPP, the cross-country comparison of the exchange rates of currencies may be carried out using
the Big Mac Index and CommSec iPod index.
The Big Mac index:
McDonald’s prices its products in international markets depending upon the country’s purchasing
power as indicated in Exhibit 15.1. Hamburger prices vary from US$1.70 in Malaysia and US$6.37 in
Sweden.

The Big Mac Index was invented in September 1986 as a light-hearted guide for cross-country
comparison of currencies based on prices of McDonald’s Big Mac produced locally and simultaneously
in almost 120 countries.
Big Mac is considered a global product that involves similar inputs and processes in its preparation
across the world. The purchasing power parity is calculated by dividing the price of Big Mac in a country
with the price in the US.
PPP = Big Mac prices in local currency/Big Mac prices in the US
For instance, the PPP of dollar works out to 3.50 (12.5/3.57) of the Chinese yuan, which is its
‘theoretical’ exchange rate.
The over or under-valuation of currency may be arrived at as follows:
Over (+) valuation of currency/Under (-) valuation of currency = {1 – (Implied PPP of the US
dollar/Actual dollar exchange rate/100)}.
As the actual dollar exchange rate was 6.83 yuan in mid-2008, it may be inferred that Chinese yuan was
undervalued by 49 per cent [{1 – (3.50/6.83)} 100], Using a similar formula, it is found that the
currencies of Hong Kong and Malaysia (52%), Thailand (48%), Sri Lanka, Pakistan, and the Philippines
(45%), and Indonesia (43%) were among the most undervalued.
On the other hand, currencies on the rich fringe of the European Union, i.e., Norway (121%), Sweden
(79%), Switzerland (78%), and Denmark and Iceland (each 67%) were the most overvalued.
Despite certain limitations, such as variations in taxation and tariffs and in profit margins due to
competitive intensity and the lack of using a basket of commodities, the Big Mac Index serves as a useful
tool for cross-country comparison of the exchange rates of currencies.
CommSec iPod Index:
Dr. Bhati Rakesh 51
 Launched in January 2007, the Commsec iPod Index presents a modem-day variant of the Big
Mac Index. Both the indices work on the theory of ‘same goods, same price’. That is, the same goods
should trade at broadly the same price across the globe if exchange rates are adjusted properly.
This index too represents a light-hearted approach to assessing the pricing of a standard product
sold worldwide. The index is based on the price variation of 4 gigabytes Apple iPod across countries.
Hong Kong is the cheapest place to buy a 4 gigabyte iPod Nano at just US$147.47 whereas Brazil is the
costliest place to buy at US$403.14.
The cross-country price comparison suggests that the iPod nano can be bought at US$149 in the US,
US$159.42 in India, US$168.26 in Japan, US$174.77 in Singapore, US$181.50 in Australia, US$196.54
in China, US$197.37 in the UK, US$202.78 in South Africa, US$222.34 in Russia, US$241.06 in
Bulgaria, US$279.65 in Turkey, US$302.64 in Iceland, and US$330.58 in Argentina (Fig. 15.1).

The key difference between the iPod and Big Mac approaches is that Big Macs are made in a host of
countries across the globe whereas iPods are predominately made in China. There remain several
limitations in both these indices as a variety of factors, such as transportation costs, labour laws, tariffs,
and taxes, have distorting effects.
Determination of Exchange Rates: Theory # 2: Interest Rate Theories:
Interest rate theories use the inflation rates in determining the exchange rates, unlike the price levels used
under the PPP theory.
Fisher Effect theory:
Establishing a relationship between the inflation and interest rates, the Fisher Effect (FE) theory
states that the nominal interest rate ‘r’ in a country is determined by the real interest rate ‘R’ and the
expected inflation rate ‘i’ as follows
(1 + Nominal interest rate) = (1 + Real interest rate)
(1 + Expected inflation rate)
(l + r) = (l + R)( 1 + i)
or r = R + i + Ri
Since, Ri is of negligible value, the preceding equation is generally approximated as
r=R+i
Nominal interest rate = Real interest rate + Expected inflation rate
Real interest rate is used to assess exchange rate movements as it includes interest and inflation
rates, both of which affect exchange rates. Given all other parameters constant, there is a high co-relation
between differentials in real interest rate and the exchange rate of a currency.
International Fisher Effect theory:
The International Fisher Effect (IFE) combines the PPP and the FE to determine the impact of
relative changes in nominal interest rates among countries on their foreign exchange values. According to
the PPP theory, the exchange rates will move to offset changes in inflation rate differentials.
Thus, a rise in a country’s inflation rate relative to other countries will be associated with a fall in
its currency’s exchange value. It would also be associated with a rise in the country’s interest rate relative
to foreign interest rates. A combination of these two conditions is known as the IFE, which states that the
exchange rate movements are caused by interest rate differentials.

Dr. Bhati Rakesh 52

If real interest rates are the same across the country, any difference in nominal interest rates could be
attributed to differences in expected inflation. Foreign currencies with relatively high interest rates will
depreciate because the high nominal interest rates reflect expected inflation.
The IFE explains that the interest rate differential between any two countries is an unbiased predictor of
the future changes in the spot rate of exchange.
Determination of Exchange Rates: Theory # 3.: Other Determinants of Exchange Rates:
In addition to inflation, real income, and interest rates, other market fundamentals that influence
the exchange rates include bilateral trade relationships, customer tastes, investment profitability, product
availability, productivity changes, and trade policies.

International Regime for FDI and MNC- Do Global Corporations Pose a Threat? -

Overall expectations for FDI prospects over the coming years, with less than half of all MNEs
anticipating FDI increases to 2018; moreover, only 40 per cent of executives at top MNEs expect an
increase. Macroeconomic factors, such as geopolitical uncertainty, exchange rate volatility and debt
concerns in emerging markets, as well as other concerns such as terrorism and cyber threats, are among
the factors cited as influencing future global FDI activity. However, there are differences across sectors
and between economic groupings. Executives from developing and transition economies are more
optimistic than those at MNEs headquartered in developed countries; and not unexpectedly, given the
decline in commodity prices, MNEs from the primary sector are more pessimistic than those in the
manufacturing and, especially, services sectors
Factors influencing FDI activity
MNE executives do not universally agree on the likely impact – positive or negative – of potential
factors on future global FDI activity; in some cases, it is a matter of perceptions (impressions of “the state
of the EU economy”, for instance, depend on the origin of the investor, the industry or the motive behind
an investment) and in others, categories are complex (e.g. some BRICS are doing better than others).
However, executives overwhelmingly considered factors such as the state of the United States
economy; agreements such as the TPP, the RCEP and the TTIP; ongoing technological change
and the digital economy; global urbanization; and offshoring as likely to boost FDI between now
and 2018. Clearly, MNEs have their eyes on longer-term trends such as rising urbanization in developing
as well as developed countries (and hence, for instance, potential consumer markets), the digital economy
and prospective mega groups. Geopolitical uncertainty, debt concerns, terrorism and cyber threats are
almost universally considered in a negative light and as likely to dampen FDI activity
The sectoral distribution of global FDI
The services sector accounts for almost two thirds of global FDI stock. In 2014, the latest year for
which sectoral breakdown estimates are available, services accounted for 64 per cent of global FDI stock,
followed by manufacturing (27 per cent) and the primary sector (7 per cent), with 2 per cent unspecific
The overall sectoral patterns of inward investment are similar in developed and developing
economies, but variations among developing regions are pronounced.
The share of the primary sector in FDI to Africa and to Latin America and the Caribbean – 28 and
22 per cent, respectively – was much higher than the 2 per cent recorded in developing Asia, largely
reflecting the weight of extractive industries. In developing Asia, in contrast, services accounted for a
considerable share of FDI, mainly owing to their predominance in Hong Kong (China).The recent
collapse of commodity prices has started to significantly affect the structural pattern of FDI flows to the
developing world in general, and to Africa and Latin America and the Caribbean in particular.
At the global level, increases in cross-border M&As were particularly significant in
pharmaceuticals (up $61 billion), non-metallic mineral products (up $26 billion), furniture (up
$21 billion) and chemicals and chemical products (up $16 billion).Differences exist between the
developed and developing economies, however, in the sectoral distribution of cross-border
M&As in manufacturing.
Dr. Bhati Rakesh 53
 In developed economies, the increase in cross-border M&As was mainly in pharmaceuticals
and chemicals and chemical products, non-metallic mineral products, and machinery and equipment but
also in industries such as rubber and plastics products, basic metal and metal products, and
motor vehicles and other transport equipment. The high level of M&A sales in the manufacture of
pharmaceuticals and medicinal chemical products in 2014 and 2015.

Consequences of Economic Globalization

Economic globalisation is highly controversial – even more so since the recent global economic
crisis. “Pro-globalists” and “anti-globalists” (also known as “alter-globalists”) have hotly debated the
issue for a good twenty years. Most of this planet’s inhabitants experience some of the considerable
benefi ts and also the tragic downside of globalisation in their daily lives. It is essential to trace the
history of this complex phenomenon and the various forms it takes if we want to tackle the challenges it
brings in its wake.
Financial and industrial globalization is increasing substantially and is creating new opportunities for
both industrialized and developing countries. The largest impact has been on developing countries, who
now are able to attract foreign investors and foreign capital. This has led to both positive and negative
effects for those countries.
1. Increased Standard of Living: Economic globalization gives governments of developing nations
access to foreign lending. When these funds are used on infrastructure including roads, health
care, education, and social services, the standard of living in the country increases. If the money is
used only selectively, however, not all citizens will participate in the benefits.
2. Access to New Markets: Globalization leads to freer trade between countries. This is one of its
largest benefits to developing nations. Homegrown industries see trade barriers fall and have
access to a much wider international market. The growth this generates allows companies to
develop new technologies and produce new products and services.
3. Widening Disparity in Incomes: While an influx of foreign companies and foreign capital
creates a reduction in overall unemployment and poverty, it can also increase the wage gap
between those who are educated and those who are not. Over the longer term, education levels
will rise as the financial health of developing countries rise, but in the short term, some of the
poor will become poorer. Not everyone will participate in an elevation of living standards.
4. Decreased Employment: The influx of foreign companies into developing countries increases
employment in many sectors, especially for skilled workers. However, improvements in
technology come with the new businesses and that technology spreads to domestic companies.
Automation in the manufacturing and agricultural sectors lessens the need for unskilled labor and
unemployment rises in those sectors. If there is no infrastructure to help the unemployed train for
the globalized economy, social services in the country may become strained trying to care for the
new underclass.

Negative Aspects of Globalization

Globalization seems to be looked on as an unmitigated “good” by economists. Unfortunately,
economists seem to be guided by their badly flawed models; they miss real-world problems. In particular,
they miss the point that the world is finite. We don’t have infinite resources, or unlimited ability to
handle excess pollution. So we are setting up a “solution” that is at best temporary.
Economists also tend to look at results too narrowly–from the point of view of a business that can
expand, or a worker who has plenty of money, even though these users are not typical. In real life,
businesses are facing increased competition, and the worker may be laid off because of greater
competition.
The following is a list of reasons why globalization is not living up to what was promised, and is, in fact,
a very major problem.

Dr. Bhati Rakesh 54

1. Globalization uses up finite resources more quickly. As an example, China joined the world trade
organization in December 2001. In 2002, its coal use began rising In fact, there is also a huge increase in
world coal consumption . India’s consumption is increasing as well, but from a smaller base.
2. Globalization increases world carbon dioxide emissions. If the world burns its coal more quickly,
and does not cut back on other fossil fuel use, carbon dioxide emissions increase. Figure 3 shows how
carbon dioxide emissions have increased, relative to what might have been expected, based on the trend
line for the years prior to when the Kyoto protocol was adopted in 1997.
3. Globalization makes it virtually impossible for regulators in one country to foresee the
worldwide implications of their actions. Actions which would seem to reduce emissions for an
individual country may indirectly encourage world trade, ramp up manufacturing in coal-producing areas,
and increase emissions over all.
4. Globalization acts to increase world oil prices. The world has undergone two sets of oil price spikes.
The first one, in the 1973 to 1983 period, occurred after US oil supply began to decline in 1970. After
1983, it was possible to bring oil prices back to the $30 to $40 barrel range (in 2012$), compared to the
$20 barrel price (in 2012$) available prior to 1970. This was partly done partly by ramping up oil
production in the North Sea, Alaska and Mexico (sources which were already known), and partly by
reducing consumption. The reduction in consumption was accomplished by cutting back oil use for
electricity, and by encouraging the use of more fuel-efficient cars.
Now, since 2005, we have high oil prices back, but we have a much worse problem. The reason the
problem is worse now is partly because oil supply is not growing very much, due to limits we are
reaching, and partly because demand is exploding due to globalization.
If we look at world oil supply, it is virtually flat. The United States and Canada together provide the
slight increase in world oil supply that has occurred since 2005. Otherwise, supply has been flat since
2005). What looks like a huge increase in US oil production in 2012 looks much less impressive, when
viewed in the context of world oil production
Part of our problem now is that with globalization, world oil demand is rising very rapidly.
Chinese buyers purchased more cars in 2012 than did European buyers. Rapidly rising world demand,
together with oil supply which is barely rising, pushes world prices upward. This time, there also is no
possibility of a dip in world oil demand of the type that occurred in the early 1980s. Even if the West
drops its oil consumption greatly, the East has sufficient pent-up demand that it will make use of any oil
that is made available to the market.
5. Globalization transfers consumption of limited oil supply from developed countries to developing
countries. If world oil supply isn’t growing by very much, and demand is growing rapidly in developing
countries, oil to meet this rising demand must come from somewhere. The way this transfer takes place is
through the mechanism of high oil prices. High oil prices are particularly a problem for major oil
importing countries, such as the United States, many European countries, and Japan. Because oil is used
in growing food and for commuting, a rise in oil price tends to lead to a cutback in discretionary
spending, recession, and lower oil use in these countries.
6. Globalization transfers jobs from developed countries to less developed countries. Globalization
levels the playing field, in a way that makes it hard for developed countries to compete. A country with a
lower cost structure (lower wages and benefits for workers, more inexpensive coal in its energy mix, and
more lenient rules on pollution) is able to out-compete a typical OECD country. In the United States, the
percentage of US citizen with jobs started dropping about the time China joined the World Trade
Organization in 2001.
7. Globalization transfers investment spending from developed countries to less developed
countries. If an investor has a chance to choose between a country with a competitive advantage and a
country with a competitive disadvantage, which will the investor choose? A shift in investment shouldn’t
be too surprising.Part of the shift in the balance between investment and consumption of assets is rising
consumption of assets. This would include early retirement of factories, among other things. Even very
low interest rates in recent years have not brought US investment back to earlier levels.
8. With the dollar as the world’s reserve currency, globalization leads to huge US balance of trade
deficits and other imbalances.

Dr. Bhati Rakesh 55

With increased globalization and the rising price of oil since 2002, the US trade deficit has soared.
Adding together amounts from Figure 10, the cumulative US deficit for the period 1980 through 2011 is
$8.6 trillion. By the end of 2012, the cumulative deficit since 1980 is probably a little over 9 trillion. A
major reason for the large US trade deficit is the fact that the US dollar is the world’s “reserve currency.”
While the mechanism is too complicated to explain here, the result is that the US can run deficits year
after year, and the rest of the world will take their surpluses, and use it to buy US debt. With this
arrangement, the rest of the world funds the United States’ continued overspending.
The Federal Reserve has been using Quantitative Easing to buy up federal debt since late 2008. This has
provided a buyer for additional debt and also keeps US interest rates low (hoping to attract some
investment back to the US, and keeping US debt payments affordable). The current situation is
unsustainable, however. Continued overspending and printing money to pay debt is not a long-term
solution to huge imbalances among countries and lack of cheap oil–situations that do not “go away” by
themselves.
9. Globalization tends to move taxation away from corporations, and onto individual citizens.
Corporations have the ability to move to locations where the tax rate is lowest. Individual citizens have
much less ability to make such a change. Also, with today’s lack of jobs, each community competes with
other communities with respect to how many tax breaks it can give to prospective employers.
10. Globalization sets up a currency “race to the bottom,” with each country trying to get an export
advantage by dropping the value of its currency.
Because of the competitive nature of the world economy, each country needs to sell its goods and
services at as low a price as possible. This can be done in various ways–pay its workers lower wages;
allow more pollution; use cheaper more polluting fuels; or debase the currency by Quantitative Easing
(also known as “printing money,”) in the hope that this will produce inflation and lower the value of the
currency relative to other currencies.
11. Globalization encourages dependence on other countries for essential goods and services. With
globalization, goods can often be obtained cheaply from elsewhere. A country may come to believe that
there is no point in producing its own food or clothing. It becomes easy to depend on imports and
specialize in something like financial services or high-priced medical care–services that are not as oil-
dependent.
12. Globalization ties countries together, so that if one country collapses, the collapse is likely to
ripple through the system, pulling many other countries with it.
History includes many examples of civilizations that started from a small base, gradually grew to over-
utilize their resource base, and then collapsed. We are now dealing with a world situation which is not
too different. The big difference this time is that a large number of countries is involved, and these
countries are increasingly interdependent.

Dr. Bhati Rakesh 56

 Chapter 5
International Banking : Reserves, Debt and Risk : Nature of International Reserves – Demand for
International Reserves – Supply of International Reserves – Gold Exchange Standard – Special
Drawing Rights – International Lending Risk – The Problem of International Debt – Financial Crisis
and the International Monetary Fund – Eurocurrency Market

INTERNATIONAL BANKING
An international bank is a financial entity that offers financial services, such as payment accounts
and lending opportunities, to foreign clients. These foreign clients can be individuals and companies,
though every international bank has its own policies outlining with whom they do business.
According to OCRA Worldwide -- an organization that matches people and companies to
international banking -- international banks tend to offer their services to companies and to fairly wealthy
individuals, i.e., people with $100,000 and counting [source: OCRA]. But plenty of international banks,
particularly Swiss banks, open their doors to customers of any income bracket [source: Obringer].
Companies do business with international banks to help facilitate international business, the complexities
of which can be quite costly.
Individuals work with international banks for a number of reasons, including tax avoidance,
probably the term you've heard the most in relation to offshore banking. Tax avoidance isn't necessarily
illegal, as you will learn on the pages that follow. But there are plenty of other hazards in international
banking.
Many people around the world use international banks to shelter their money from their home
country's income and estate taxes. Hosts of banks are based in countries with low or no income and estate
taxes, such as the Cayman Islands, Belize, Panama and the Isle of Man. But you can't just put your
income in Belize and not pay taxes. Customers must report their income and work with their bank to
make sure tax avoidance doesn't turn into tax evasion.
Some individuals use international banks to invest in the economies of booming countries and in
developing countries, the same way they might invest in a domestic corporation or real estate venture.
A number of wealthy individuals keep their wealth in offshore banks and other entities to keep it
safe from lawsuits. That doesn't mean these people are criminals; they simply want to avoid losing every
penny to a sudden, unexpected or predatory lawsuit.
Since international banks lend and borrow on international markets, they’re less affected by
domestic interest rate fluctuations. Also, some foreign banks might offer better interest rates than
domestic banks, providing a money-making opportunity for customers.
International banks also make it easier for a company with an international presence to do
business around the world.For one, the company doesn't have to set up a million different bank accounts
around the world, then wait to receive money while the banks deal with one another.
In addition, international banks offer many financial services to facilitate international trade.
Besides offering payroll services for companies with employees and contractors in other countries, they
offer letters of credit to ensure that companies in different countries pay one another for goods and
services. They also offer financing services to support businesses facing the large costs of importing and
exporting products.

International Risk
- Three types of international risk: financial (credit) risk, currency (foreign exchange) risk, and country
risk
- Financial Risk – potential economic inability of a borrower to comply with contractual credit
terms and bears the closet resemblance to domestic lending
- Currency Risk – vulnerability of international lenders to variations in rates of currency exchange,
and in every international extension of credit someone has a currency conversion exposure
- Country Risk – encompasses an entire spectrum of risks arising from economic, social, legal and
political conditions of a foreign country that may result in favorable or unfavorable consequences
Dr. Bhati Rakesh 57
 for borrowers of that country. (Primary factor that differentiates international lending from
domestic lending.)
Forms of International Lending
Trade Financing
- Two most common:
- Commercial Documentary Letter of Credit – an instrument in which a bank (issuing bank)
undertakes to pay a party (the beneficiary) named in the instrument a sum of money on behalf of
the bank’s customer (account party). The beneficiary is paid when the beneficiary submits to the
issuing bank specific documents are required by the terms of the letter of credit
- Standby Letter of Credit – guarantees payment to the beneficiary by the issuing bank in the event
of default or nonperformance by the account party (the bank’s customer)
- Standby letter of credit transactions involve a higher potential risk for the issuing bank than a
commercial documentary letter of credit
- Unsecured standby letters of credit are included, along with loans, within a bank’s unsecured
legal lending limit to one borrower.
Domestic Loans
- Loans to domestic customers where the proceeds are used to finance imports of inventory are
considered international credits.
Loans to Foreign Governments
- Also loans to government controlled entities
- Repayment is dependent upon the government of the country
Direct Credit to Foreign Banks
Indirect Loans to Foreign Banks
- Loans extended to a foreign borrower based primarily on the foreign bank’s guarantee of the loan
Loans to Foreign Business or Individuals
Syndicated Project Loans
- Project loans put together by international consortia and participations in syndications
International Lending Policy
- Every bank engaged in international lending should be guided for a formal policy approved by the
Board
- Policy should address:
- Credit Standards and Information
- Banks should translate and spread foreign financial statements into English, with the foreign
currency converted to US dollars and the applicable exchange rate indicated
- Geographic Limits
- Diversification can reduce country risk
Country Risk
- CR is the primary factor that differentiates international lending from domestic lending
- CR analysis includes assessment of the likelihood of political or social upheaval, nationalization or
expropriation, government repudiation of external debts, and exchange controls of foreign exchange
shortfalls
- Diversification is the primary method of moderating country risk
- (REVIEW BANK OF ANYTOWN)
Classification based on Country Risk
- Other Transfer Risk Problem (OTRP)
- Country is not complying with external debt service obligations, however, the country is taking
positive actions to restore debt service (generally as part of an IMF program)
- Country is meetings its debt obligations, but non-compliance appears imminent
- Country has been classified previously, and recent debt service performance indicates
classification is no longer warranted, but a sustained resumption of performance needs to be
demonstrated
- Substandard
- Country is not complying with external debt service obligations
Dr. Bhati Rakesh 58
 - Country is not in the process of adopting an IMF or another suitable adjustment program
- The country and its bank creditors have not negotiated a viable rescheduling and are unlikely to
do so in the near future
- Value Impaired Classification (when one or more of the following exist)
- Country has not fully paid its interest for 6 months
- Country has not complied with IMF programs
- Country has not met rescheduling terms for over one year
- Country shows no definite prospects for an orderly restoration of debt service in the near future
- Loss Classifications
- No longer considered a bankable asset
- Assignment of adverse classifications and designation of countries as OTRP are the responsibility of
the Interagency Country Exposure Review Committee (however, the examiner does have input)
- Committee prepares a standard narrative on the country to be used in reports of examination
Reserve Requirements
- Part 347
- Requires banks to establish and maintain a special reserve when the value of international loans
has been impaired by a protracted inability of the borrowers in a country to make payments on
external indebtedness or not definite prospects exist for orderly restoration of debt service
- Reserves should be established by a charge against current income and be segregated from the
bank’s general allowance
- Fees in excess of administrative cost on international loans should be amortized over the life of the
loan
Analysis of Management System of Monitoring Country Risk
- System should consist of three important components:
- Evaluation of economic trends, political development, and the country’s social fabric
- Board and management define the level of country exposure the bank is willing to assume
- International reporting system
- Annually (at least) a review of portfolio composition or each individual country should be performed
- Primary Examination Objectives
- Evaluate policies, practices/procedures, and internal controls
- Conformance with operating guidelines
- Impact of country risk on the overall quality of the international loan portfolio
- Corrective action for deficient policies/practices/procedures and exceptions
- Annual report (narrative commentary) of each country
Country Risk Exposure Report
- Must be filed quarterly by banks which meet certain conditions
Foreign Exchange
Exchange of money of one country for money of another
Exchange Rates
- Trade and investment flows affect the supply and demand for currencies, which in turn influence
exchange rates.
- Banks quote different rates based upon the amount of time required to exchange currencies
- Rates vary depending on agreed payment date (value date) of the transaction (overnight, one week,
one month, etc.)
- Banks also quote a different exchange rate for a given transaction when they are buyers (bid) or
sellers (sell/offer) of currency. The spread between bid and offered rates represents the bank’s profit
margin
Spot and Forward Exchange
- Spot Transaction – immediate delivery
- Forward Transaction – delivery at a future date
- Value Date – date on which payment is effected
- Liquidity in the market decreases beyond three months

Dr. Bhati Rakesh 59

Swaps
- Simultaneous purchase and sale of a certain amount of foreign currency for two different value dates
- Swap permits a temporary exchange of currencies and is often used to acquire a foreign currency,
which is then used to make a short-term investment. Maturity of the investment will coincide with
the forward value date and the currency will be returned at that time
Foreign Exchange Risk
Five types of risk
- Exchange Rate Risk - occurs when a bank takes an open position in a currency
- When a bank holds or buys more foreign currency than it sells, or agrees to sell more than it buys,
and exposure is created known as an open position
- Open position can be either long or short
- Long position – bank buys more currency than it sells
- Short position – bank sells more currency than it buys
- A long position is a depreciating currency results in exchange loss relative to book value
- A short position in a currency that is appreciating results in an exchange loss relative to book
value
- Interest Rate Risk – mismatches or gaps in maturity
- When currency is received in advance of any scheduled offsetting payments
- Credit Risk – (two types)
- 1020% risk (exchange rates will fluctuate no more than 10-20% usually)
- Delivery or settlement risk
- Country Risk
- Operational Risk
FDIC Policy Statement
- Covers minimum standards for written bank policies, basic internal controls, and audit documentation
Other International Department Activities
- Cash Accounts
- Due From or Nostro Accounts
- Nostro Accounts – due from accounts established in correspondent banks located in countries
where the bank conducts business
- Investments
- Typically held to meet various local laws or reserve requirements, reduce tax liability, or as an
expression of goodwill
- May be purchased strictly for investment purposes
- Should not be done for speculative purposes (can be unsuitable investment practice)
- International investment portfolio should be reviewed by the board at least annually
- Due From Time Deposits
- Have same risk characteristics as extensions of credit
- Borrowings
Restrictive Trade
- Prohibit exporters and banks from complying in any way with boycott request that would cause
discrimination against US citizens or companies on the basis of race, color, religion, sex or national
origin
- Also prohibit boycotts of countries friendly to the US (this is a violation of Part 369)
Foreign Corrupt Practices Act
- Crime for a US company or individuals action on behalf of a company to bribe foreign officials or
foreign political candidates or parties for the purpose of acquiring or retaining business
- Grease payments are not prohibited
- Grease Payments – payments for expediting shipments through customs, securing required
permits, or obtaining adequate police protection are all considered grease payments even though
such payments may involve the payment of money for the proper performance of duties

Dr. Bhati Rakesh 60

- Act does not apply directly to foreign subsidiaries, however, Congress has noted that any entity that
engages in bribery of foreign officials indirectly through any other entity, including foreign
subsidiaries, would itself be held liable under the Act.

Nature of International Reserves –

A country’s international reserves refer to “...those external assets that are readily available to
and controlled by monetary authorities for meeting balance of payments financing needs, for
intervention in exchange markets other related purposes (such as maintaining confidence in the currency
and the economy, and serving as a basis for foreign borrowing
As defined, the concept of international reserves is based on the balance-sheet framework, with
“reserve assets” being a gross concept. It does not include external liabilities of the monetary authorities
to affect the currency exchange rate, and for
Foreign reserves include gold and/or other central bank assets which come entirely within its
control and are easy to trade on international financial markets. According to the Fifth Edition of the
IMF’s Balance of Payments Manual “ reserve assets consist of those external assets that are readily
available to and controlled by monetary authorities for direct financing of payments imbalances, for
indirectly regulating the magnitude of such imbalances through intervention in exchange markets to
affect the currency exchange rate, and/or for other purposes
The Functions of Foreign Reserves
The main purposes of foreign reserves are:
1. to act as a monetary policy instrument;
2. to act as an exchange rate instrument helping cut fluctuations in the exchange rates of the national
currency against foreign currencies, or maintain a set exchange rate;
3. to act as a liquidity buffer in case of an international financial market crash;
4. to reduce vulnerability to external factors and safeguard against crises;
5. to boost stability and confidence in financial markets, since reserves are among the foremost
indicators monitored by international ratings agencies;
6. to act as a source of subsidiary revenue derived from managing them.

Demand for International Reserves –

Foreign exchange reserves are important indicators of ability to repay foreign debt and for
currency defense, and are used to determine credit ratings of nations, however, other government funds
that are counted as liquid assets that can be applied to liabilities in times of crisis include stabilization
funds, otherwise known as sovereign wealth funds. SWFs have been receiving increased attention since
2007, though they have existed in different forms for more than six decades. There is still a lack of
agreement on the number of SWFs and the size of their assets.
According to the data of IMF, there are 31 SWFs in 29 countries estimated to hold between
US$2.2 trillion and US$3.1 trillion of foreign assets as of February 2008. SWFs’ holdings were nearly a
third of total global foreign exchange reserves as of end-February 2008. A SWF can formally be defined
as an entity that manages specially designated state-owned financial assets, and is legally structured as a
separate fund or fund manager owned by the state. The management of SWFs is not always transparent
and among the cases that are known, different practices have been followed in different countries.
In some countries, international reserves allocated to SWFs are held in the balance sheet of the
central banks and in many instances are also managed by the central bank itself. In others, SWFs are
separated from the central bank but hold and manage reserves on behalf of the central bank. In still some
other cases, SWFs are totally separate from the central bank and managed by the ministry of finance.
SWFs have been established with one or more of the following objectives: insulate the budget and the
economy from excess volatility in revenues; help monetary authorities sterilize unwanted liquidity; build
up savings for future generations; promote economic and social development; and improve returns on
investment.
Global international reserves grew rapidly over the last decade, mainly in emerging market
economies .In some countries reserves were accumulated for precautionary reasons to insure against
Dr. Bhati Rakesh 61
shocks, including those from volatile international capital flows, and to preserve financial stability. In
other countries, reserves grew as a by-product of the pursuit of policy objectives related to the exchange
rate and competitiveness, or from a desire to save the windfall from rising commodity prices and to foster
intergenerational equity. Since the global financial crisis, reserve accumulation has continued, and is
now evident in some economies that have traditionally not emphasized the need for international
reserves
The excessive reserve accumulation as a threat to the international monetary system appeared at a
time when authorities in many countries felt that the reserves they had accumulated before the crisis had
served them well. Authorities in several countries, including some advanced economies, had started
focusing anew on the role of reserves in crisis mitigation and management. Amid persistent uncertainties
in global financial markets, these authorities were re-evaluating the costs and benefits of holding
reserves. Thus the authorities in a number of member countries were skeptical about IMF Management
concerns and the proposals and initiatives to slow reserve accumulation.
International reserves are the assets of governments and central banks, which have an interest in
maintaining both international monetary stability and the value of their official assets. These features do
not preclude the possibility that in attempting to safeguard the value of their assets, official reserve
managers could adversely affect financial stability, for example by withdrawing assets from a
troubled or downgraded commercial bank or by selling a specific security. But this is not a
problem associated with excessive reserve accumulation as such, since it could occur even when
reserves are not excessive.

Supply of International Reserves –

Includes owned reserves, such as key currencies and special drawing rights, and borrowed
reserves that can come from the IMF and other official arrangements or can be obtained from major
commercial banks

GOLD EXCHANGE STANDARD –

A gold exchange standard is a mixed system consisting of a cross between a reserve currency
standard and a gold standard. In general it includes the following rules.
First, a reserve currency is chosen. All non-reserve countries agree to fix their exchange rates to the
reserve at some announced rate. To maintain the fixity, these non-reserve countries will hold a stockpile
of reserve currency assets.
Second, the reserve currency country agrees to fix its currency value to a weight in gold. Finally, the
reserve country agrees to exchange gold for its own currency with other central banks within the system,
upon demand.
One key difference in this system from a gold standard is that the reserve country does not agree to
exchange gold for currency with the general public, only with other central banks.
The system works exactly like a reserve currency system from the perspective of the non-reserve
countries. However, if over time the non-reserve countries accumulate the reserve currency they can
demand exchange for gold from the reserve country central bank. In this case gold reserves will flow
away from the reserve currency country.
The fixed exchange rate system set up after World War II was a gold-exchange standard, as was the
system that prevailed between 1920 and the early 1930s. The post-WWII system was agreed to by the
allied countries at a conference in Bretton-Woods New Hampshire in the US in June 1944. As a result,
the exchange rate system after the war also became know as the Bretton-Woods system.
Also proposed at Bretton-Woods was the establishment of an international institution to help regulate the
fixed exchange rate system. This institution was the International Monetary Fund (IMF). The IMF’s main
mission was to help maintain the stability of the Bretton-Woods fixed exchange rate system.

SPECIAL DRAWING RIGHTS –

The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member
countries’ official reserves. As of March 2016, 204.1 billion SDRs (equivalent to about $285 billion) had
Dr. Bhati Rakesh 62
been created and allocated to members. SDRs can be exchanged for freely usable currencies. The value
of the SDR is based on a basket of five major currencies—the US dollar, the euro, the Chinese renminbi
(RMB), the Japanese yen, and the British pound sterling

The role of the SDR

The SDR was created by the IMF in 1969 as a supplementary international reserve asset, in the
context of the Bretton Woods fixed exchange rate system. A country participating in this system needed
official reserves—government or central bank holdings of gold and widely accepted foreign currencies—
that could be used to purchase its domestic currency in foreign exchange markets, as required to maintain
its exchange rate. But the international supply of two key reserve assets—gold and the US dollar—
proved inadequate for supporting the expansion of world trade and financial flows that was taking place.
Therefore, the international community decided to create a new international reserve asset under the
auspices of the IMF.
Only a few years after the creation of the SDR, the Bretton Woods system collapsed and the
major currencies shifted to floating exchange rate regimes. Subsequently, the growth in international
capital markets facilitated borrowing by creditworthy governments and many countries accumulated
significant amounts of international reserves. These developments lessened the reliance on the SDR as a
global reserve asset. However, more recently, the 2009 SDR allocations totaling SDR 182.6 billion
played a critical role in providing liquidity to the global economic system and supplementing member
countries’ official reserves amid the global financial crisis.
The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the freely
usable currencies of IMF members. Holders of SDRs can obtain these currencies in exchange for their
SDRs in two ways: first, through the arrangement of voluntary exchanges between members; and second,
by the IMF designating members with strong external positions to purchase SDRs from members with
weak external positions. In addition to its role as a supplementary reserve asset, the SDR serves as the
unit of account of the IMF and some other international organizations.

Basket of currencies determines the value of the SDR

The value of the SDR was initially defined as equivalent to 0.888671 grams of fine gold—which, at
the time, was also equivalent to one US dollar. After the collapse of the Bretton Woods system in 1973, the
SDR was redefined as a basket of currencies. Effective October 1, 2016 the SDR basket consists of the US
dollar, euro, the Chinese renminbi, Japanese yen, and British pound sterling.
The value of the SDR in terms of the US dollar is determined daily and posted on the
IMF’s website. It is calculated as the sum of specific amounts of each basket currency valued in US
dollars, based on exchange rates quoted at noon each day in the London market.
The basket composition is reviewed every five years by the Executive Board, or earlier if the IMF
finds changed circumstances warrant an earlier review, to ensure that it reflects the relative importance of
currencies in the world’s trading and financial systems. In the most recent review (concluded in November
2015), the Executive Board decided that, effective October 1, 2016, the Chinese renminbi is determined to
be freely usable (See Article XXX(f)) and was included in the SDR basket.
A new weighting formula was also adopted in the 2015 review. It assigns equal shares to the
currency issuer’s exports and a composite financial indicator. The financial indicator comprises, in equal
shares, official reserves denominated in the member’s (or monetary union’s) currency that are held by
other monetary authorities that are not issuers of the relevant currency, foreign exchange turnover in the
currency, and the sum of outstanding international bank liabilities and international debt securities
denominated in the currency. The next review is currently scheduled to take place by September 30, 2021,
unless an earlier review is warranted by developments in the interim.

The SDR interest rate

The SDR interest rate provides the basis for calculating the interest charged to borrowing
members, and the interest paid to members for the use of their resources for regular (non-concessional)
IMF loans. It is also the interest paid to members on their SDR holdings and charged on their SDR
allocation. The SDR interest rate is determined weekly and is based on a weighted average of
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representative interest rates on short-term debt instruments in the money markets of the SDR basket
currencies.

SDR allocations to IMF members

Under its Articles of Agreement (Article XV, Section 1, and Article XVIII), the IMF may allocate
SDRs to member countries in proportion to their IMF quotas. Such an allocation provides each member
with a costless, unconditional international reserve asset. The SDR mechanism is self-financing and
levies charges on allocations which are then used to pay interest on SDR holdings. If a member does not
use any of its allocated SDR holdings, the charges are equal to the interest received. However, if a
member's SDR holdings rise above its allocation, it effectively earns interest on the excess. Conversely, if
it holds fewer SDRs than allocated, it pays interest on the shortfall. The Articles of Agreement also allow
for cancellations of SDRs, but this provision has never been used.

International Lending Risk –

A few fundamental conclusions come to light from our analysis of the historical record:
1. Defaults and reschedulings are not infrequent occurrences. Since 1800, 72 countries
experienced 166 periods of default or rescheduling, each lasting an average of 11.4 years.
2. Creditworthiness is not a constant. Many of today's most respected borrowers Germany,
Japan, the Netherlands, Spain and Italy to name a few have overcome the damage to their
reputations caused by their defaults. In other regions, namely Latin America, countries have
defaulted regularly.
3. Defaults bunch together in debt crises caused by global, systemic factors. Four major
international debt crises (I 820s, 1870s, 1930s and 1980s), representing 15% of the years since
1800, accounted for 57% of all periods and 70% of total years of default and rescheduling. The
last two debt crises encompassed not only international lending, but also the domestic credit
markets of major creditor countries.
4. Shocks to the world economy have become more prominent in determining default, while wars
and domestic unrest have declined in importance.
5. Official involvement in debt crisis settlements historically has been minimal. Only since World
War II has bilateral and multilateral lending to developing country sovereigns become significant,
prompting substantial official support for debt restructuring in the 1980s.
6. Returns on developing country sovereign bonds—including those that have defaulted—
generally have compared favorably with alternative domestic investments.
The Problem of International Debt –
Foreign or external debt represents the amount a country (both public and private sector) owe to
other countries.
Foreign debt can involve:
 Outstanding loans to foreign private banks (both principle and outstanding interest)
 Due payments to international organisations like the IMF
 Outstanding payments for a current account deficit, with country owing money for imports
Debt includes both
 Short term liabilities – loans which need to be paid in near future (within one year)
 Long term liabilities – long-term loans which are scheduled to be repaid over a longer term.
When is external debt a problem?
The easiest guide is to look at the level of external debt to GDP. However, countries with large financial
sectors, such as UK and Hong Kong have both higher levels of liabilities, but also higher level of assets
because its role as financial centres.
There are no precise rules for when external debt becomes a problem. But, a key factor is whether a
country can satisfactorily meet debt interest payments from export earnings.
The IMF have suggested external debt should be kept below
1. A country’s level of debt in Net Present Value to either 150 percent of exports or 250 percent of
government
Foreign debt interest
Dr. Bhati Rakesh 64
Countries with foreign debt have to meet the interest payments on the debt. This can only be met with:
 Foreign currency earnings from exports
 Gold reserves / foreign currency reserves
 Further borrowing
How foreign debt can become a problem
1. Excessive confidence in borrowing to promote economic growth and development. Equally, there
could be over-confidence in lenders to lend money in short-term without evaluation of possible
problems.
2. Investment that is misplaced and fails to achieve a decent rate of return to help pay the debt
interest payments. For example, developing countries may struggle to make use of funds for
industrialisation if they lack the necessary skills and infrastructure.
3. Unexpected devaluation in exchange rate, which increase the real value of debt interest payments
denominated in dollars.
4. Decline in commodity prices which leads to decline in terms of trade for developing economies
and relative fall in export earnings.
5. Demand side shock which reduces GDP. For example, conflict or global recession which hits
demand and GDP.
6. Servicing external debt (paying debt interest payments) ceteris paribus, reduces GDP because the
monetary payments flow out of the country. These debt payments reduce the amount available to
invest in improving public services, which can help economic development.
7. Growing levels of debt can discourage foreign and private investment because of concerns that
the debt is becoming unsustainable.
8. If a country is struggling to meet interest payments, they may be tempted to borrow to meet debt
interest payments, but then problem can spiral and magnify.
9. Countries in regional areas may suffer from a regional downgrade in credit assessment. For
example, many Sub-Saharan African countries experienced rising external debt ratios and this
made investors reluctant to lend at cheap rates.
Debt cancellation / debt forgiveness
Because of the problem associated with rising external debt, there has been pressure for
developed countries to cancel outstanding debt by developing economies.
The argument is that debt cancellation can make a significant contribution to improving economic
development because it frees up resources to invest in the recipient country – rather than send abroad in
debt interest payments.

Financial Crisis and the International Monetary Fund –

Promoting economic stability is partly a matter of avoiding economic and financial crises, large
swings in economic activity, high inflation, and excessive volatility in foreign exchange and financial
markets. Instability can increase uncertainty, discourage investment, impede economic growth, and hurt
living standards. A dynamic market economy necessarily involves some degree of volatility, as well as
gradual structural change. The challenge for policymakers is to minimize instability in their own country
and abroad without reducing the economy’s ability to improve living standards through rising
productivity, employment, and sustainable growth.
Economic and financial stability is both a national and a multilateral concern. As recent financial
crises have shown, economies have become more interconnected. Vulnerabilities can spread more easily
across sectors and national borders.
How does the IMF help?
The IMF helps countries implement sound and appropriate policies through its key functions of
surveillance, technical assistance, and lending.
Surveillance : Every country that joins the IMF accepts the obligation to subject its economic and
financial policies to the scrutiny of the international community. The IMF’s mandate is to oversee the
international monetary system and monitor economic and financial developments in and the policies of
its 189 member countries. This process, known as surveillance, takes place at the global level and in
individual countries and regions. The IMF assesses whether domestic policies promote countries’ own
Dr. Bhati Rakesh 65
stability by examining risks they might pose to domestic and balance of payments stability and advises
on needed policy adjustments. It also proposes alternatives when countries’ policies promote domestic
stability but could adversely affect global stability.
A- Consulting with member states
The IMF monitors members’ economies through regular—usually annual—consultations with
each member country. During these consultations, IMF staff discusses economic and financial
developments and policies with national policymakers, and often with representatives of the private
sector, labor and trade unions, academia, and civil society. Staff assesses risks and vulnerabilities, and
considers the impact of fiscal, monetary, financial, and exchange rate policies on the member’s domestic
and balance of payments stability and assesses implications for global stability. The IMF offers advice on
policies to promote each country’s macroeconomic, financial, and balance of payments stability, drawing
on experience from across its membership.
The framework for these consultations is set forth in the IMF Articles of Agreement and the Integrated
Surveillance Decision. The consultations are also informed by membership-wide initiatives, including
 work to systematically assess countries' vulnerabilities to crises;
 the Financial Sector Assessment Program, which assesses countries’ financial sectors and helps
formulate policy responses to risks and vulnerabilities; and
 the Standards and Codes Initiative in which the IMF, along with the World Bank and other
bodies, assesses countries’ observance of internationally recognized standards and codes of good
practice in a dozen policy areas.
B- Overseeing the bigger picture
The IMF also closely monitors global and regional trends.
The IMF’s periodic reports, the World Economic Outlook, its regional overviews, the Fiscal
Monitor, and the Global Financial Stability Report, analyze global and regional macroeconomic and
financial developments. The IMF’s broad membership makes it uniquely well suited to facilitate
multilateral discussions on issues of common concern to groups of member countries, and to advance a
shared understanding of policies needed to promote stability. In this context, the Fund has been working
with the Group of 20 advanced and emerging economies to assess the consistency of those countries’
policy frameworks with balanced and sustained growth for the global economy.
The Fund has reviewed its surveillance mandate in light of the global crisis. It has introduced a
number of reforms to improve financial sector surveillance within member countries and across borders,
to enhance understanding of interlinkages between macroeconomic and financial developments (for
example, through the spillover chapters in the World Economic Outlook), and stimulate debate on these
matters. The IMF has also strengthened its analysis of macro-critical structural reforms to the macro
economy to help countries promote durable and inclusive growth.
Data : In response to the financial crisis, the IMF is working with members, the Financial Stability
Board, and other organizations to fill data gaps important for global stability.
Technical assistance : The IMF helps countries strengthen their capacity to design and implement sound
economic policies. It provides advice and training in areas of core expertise—including fiscal, monetary,
and exchange rate policies; the regulation and supervision of financial systems; statistics; and legal
frameworks.
Lending : Even the best economic policies cannot completely eradicate instability or avert crises. If a
member country faces a balance of payment crisis, the IMF can provide financial assistance to support
policy programs that will correct underlying macroeconomic problems, limit disruption to both the
domestic and the global economy, and help restore confidence, stability, and growth. The IMF also offers
precautionary credit lines for countries with sound economic fundamentals for crisis prevention.

EUROCURRENCY MARKET
The Eurocurrency market consists of banks (called Eurobanks) that accept deposits and make
loans in foreign currencies. A Eurocurrency is a freely convertible currency deposited in a bank located
in a country which is not the native country of the currency. The deposit can be placed in a foreign bank
or in the foreign branch of a domestic US bank. [Note of caution! The prefix Euro has little or nothing to
do with the newly emerging currency in Europe.]
Dr. Bhati Rakesh 66
In the Eurocurrency market, investors hold short-term claims on commercial banks which intermediate to
transform these deposits into long-term claims on final borrowers.
The Eurocurrency market is dominated by US $ or the Eurodollar. Occasionally, during weak
dollar periods (latter part of 1970s and 1980s), the EuroSwiss franc and the EuroDM markets increased in
importance. The Eurodollar market originated post WWII in France and England thanks to the fear of
Soviet Bloc countries that dollar deposits held in the US may be attached by US citizens with claims
against communist governments!
Thriving on government regulation
By using Euromarkets, banks and financiers are able to circumvent / avoid certain regulatory costs and
restrictions. Some examples are:
 Reserve requirements
 Requirement to pay FDIC fees
 Rules or regulations that restrict competition among banks
Continuing government regulations and taxes provide opportunities to engage in Eurocurrency
transactions. However, ongoing erosion of domestic regulations have rendered the cost and return
differentials much less significant than before. As a result, the domestic money market and Eurocurrency
markets are closely integrated for most major currencies, effectively creating a single worldwide money
market for each participating currency.

The Important Characteristics of the Eurocurrency market are the following:

(1) It is an International Market and it is under no National Control: The Eurocurrency market has
emerged as the most important channel for mobilising and deploying funds on an international scale. By
its very nature, the Eurodollar market is outside the direct control of any national monetary policy. “It is
aptly said that the dollar deposits in London are outside United States control because they are in
London, and outside British control because they are in dollars.” The growth of the market owes a great
deal to the fact that it is outside the control of any national authority.
(2) It is a Short-Term Money Market: The deposits in this market range in maturity from one day to
several months and interest are paid on all of them. Although some Eurodollar deposits have a maturity
of over one year, Eurodollar deposits are predominantly a short-term instrument. The Eurodollar market
is viewed in most discussions more as a credit market – a market in dollar bank loans – and as an
important accessory to the Eurobond market.
(1) The Eurodollar Loans are Generally for Short Periods: Three months or less, Eurobonds being
employed for longer-term loans. The Eurobonds developed out of the Eurodollar market to provide
longer-term loans than was usual with Eurodollars. A consortium of banks and issuing houses usually
issues these bonds.
(2) It is a Wholesale Market: The Eurodollar market is a wholesale market in the sense that the
Eurodollar is a currency dealt in only large units. The size of an individual transaction is usually above $1
million.
(3) It is a Highly Competitive and Sensitive Market: Its efficiency and competitiveness are reflected in
its growth and expansion. The resiliency of the Eurodollar market is reflected in the responsiveness of the
supply of and demand for funds to the changes in the interest rates vice versa.

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