International Trade Theories And Financial Flow To Developing Countries

International Trade Theories

Why do nations trade? What is the basis of trade and what are the gains from trade? How large are the gains from trade and how are they divided among the trading nations? What is the pattern of trade? That is, what commodities are exported and imported by each nation? The answers to these questions have been provided by economists which, overtime, have come to be known as trade theories or doctrines.

The Six More Well Known Theories Are:
[1] Mercantilists Views
[2] Absolute Advantage Theory
[3] Comparative Advantage Theory
[4] Comparative Cost Theory
[5] Standard Theory Of International Trade
[6] Modern Theory Of International Trade.

 

• Mercantilist’s View

During the Seventeenth and Eighteenth centuries, a view on international trade was advocated which came to be known as mercantilism. Briefly, the mercantilist’s views on trade were that the way for a nation to become rich and powerful was to export more than it imported. Thus, the government had to do all in its power to stimulate the nation’s exports and discourage and restrict imports, particularly the import of luxury consumption goods. However, since all nations could not simultaneously have an export surplus and the amount of golds and silver available for settling trade balances was fixed at any particular point in time, one nation could gain only at the expense of other nations. In any event, trade was a zero-sum game, according to mercantilists. These views are today important for two reasons. First, the ideas of Adam Smith, David Ricardo and other classical economists can best be understood if they are regarded as reactions to the mercantilists views. Second, today there seems to be a resurgence of neo-mercantilism as nations plagued by high levels of unemployment seek to restrict imports in an effort to simulate domestic production and employment.

 

• Absolute Advantage Theory

According to Adam Smith, Trade between two nations is based on absolute advantage. When one nation is more efficient than [or has an absolute advantage over] another in the production of one commodity but is less efficient than [or has an absolute disadvantage with respect to] the other nation in producing a second commodity, then both nationals can gain by each specializing in the production of the commodity of its absolute advantage and exchanging part of its output with the other nation for the commodity of its absolute disadvantage. By this process, resources are utilized in the most efficient way and the output of both commodities will rise and two nations would gain. Thus, according to absolute advantage theory, international trade is a win-win game.

However, most of the world trade today, especially trade among developed countries would not be explained by absolute advantage. It remained for David Ricardo, with the law of comparative advantage, to truly explain the basis for and the gains from trade. Indeed, absolute advantage will be seen to be only a special case of the more general theory of comparative advantage.

 

• Comparative Advantage Theory

In 1817, Ricardo published his Principles of Political Economy and Taxation, in which he presented the law of comparative advantage. This is one of the most important and still unchallenged laws of economics, with many practical applications. According to the law of comparative advantage, even if one nation is less efficient than [has an absolute disadvantage with respect to] the other nation in the production of both commodities, there is still a basis for mutually beneficial trade. The first nation should specialize in the production for and export the commodity in which its absolute disadvantage is smaller [this is the commodity of its comparative advantage] and import the commodity in which its absolute disadvantage is greater [that is the commodity of its comparative disadvantage].

Ricardo based his law of comparative advantage on a number of simplifying assumptions, namely, [1] Only two nations and two commodities [2] Free trade [3] Perfect mobility of labor within each nation by immobility between the two nations [4] Constant costs of production [5] No transportation costs [6] No technical change, and [7] The labor theory of value. While assumptions one through six can easily be relaxed, assumption seven is basically wrong. Under the labor theory of value, the value or price of a commodity depends exclusively on the amount of labor going into the production of the commodity, and this is certainly not true. By rejecting the labor theory of value, must we reject Ricardo’s law of comparative advantage? The answer is No. We may reject Ricardo’s explanation of comparative advantage, but not the law of comparative advantage. The law of comparative advantage can be explained on the basis of opportunity cost theory or comparative cost [which is acceptable].

 

• Comparative Cost Theory

In 1936 Haberlel’ “Rescued” the law of comparative advantage by basing it on the opportunity cost theory. In this form, the law of comparative advantage is sometimes referred tows the law of comparative cost.

According to the opportunity cost theory, the cost of a commodity is the amount of second commodity that must be given up to release just enough resources to produce one additional unit of the first commodity. No assumption is here made that labor is the only factor of production. Nor is it assumed that the cost or price of a commodity depends on or can be inferred exclusively from its labor content. Consequently, the nation with the lower opportunity cost in the production of a commodity has a comparative advantage in that commodity [and a comparative disadvantage in the second commodity]. In operational terms, a difference in relative commodity prices between two nations in isolation is a reflection of their comparative advantage.

Relative commodity price is the price of one commodity divided by the price of another commodity. The nation with the lower relative price for a commodity has a comparative advantage in that commodity, and a comparative disadvantage in the other commodity, with respect to the second nation.

According to comparative cost theory, thus, each nation should then specialize in the production of the commodity of its comparative advantage and exchange part of its output with the other nation for the commodity of its comparative disadvantage. However, as each nation specializes in producing the commodity of its comparative advantage, it incurs increasing opportunity cost. Specialization will continue until relative commodity prices in the two nations become equal at the level at which trade is in equilibrium. By then trading with each other, both nations end up consuming more than in the absence of trade or autarky. It is also observed that with increasing costs, even if two nations have identical production frontiers there is still a basis for mutually beneficial trade if tastes, or demand preferences differ in the two nations. The nation with the relatively smaller demand or preference for a commodity will have a lower autarky relative price for, and a comparative advantage in, that commodity. This will set the stage for specialization in production and mutually beneficial trade.

 

• Standard Theory Of International Trade

The writings of Smith, Ricardo and other classical economists, as it is clear from the foregone discussion, had established that the basis of international trade is the law of comparative advantage, But what causes the comparative advantage between the two nations? To this question, their answer was that the comparative advantage was based on the difference in the productivity of labor among nations; They however did not provide explanation for difference in labor productivity except for possible difference in climate. The Standard Theory of International Trade or the Heckscher-Ohlin [H-0] Theory went much beyond to examine the basis for comparative advantage. According to the Heckscher-Ohlin theory, which is also known as factor endowment theory, a nation will export the commodity intensive in its relatively abundant and cheap factor of production and import the commodity intensive in its relatively scarce and expensive factor. Out of all the possible forces that could cause a difference in pre-trade relative commodity prices between nations, Heckscher and Ohlin isolated the difference in factor endowments [in the face of equal technology and tastes] as the basic determinant or cause of comparative advantage. The general equilibrium nature of the H-0 theory arises from the fact that all commodity and factor markets are component of an overall unified system so that a change in any part affected every other part. Another point established by H-O theory is that international trade can also be a substitute for the international mobility of factors in equalizing relative and absolute returns to homogeneous factors across nations.

 

• Modern Theory Of International Trade

The H.O. theory of H-O-S theory by adding the name of Prof Samuelson to it, essentially singles out differences between factor-endowments and factor proportions as the determinants of the patterns of trade. The H-O-S thesis have indeed ruled supreme in the teaching, research and policy worlds for the last three to four decades, or perhaps rule supreme even today. Serious doubts have, however, been expressed about the validity of H-O-S theory in explaining the patterns of trade in reality, right with the enunciation of the Leontief Paradox. Indeed the search for new theories of trade became more intense since then. Sixties and Seventies witnessed the neo technological School [Nee because technology as determinant of trade was in a way already recognized in the primary theory of Ricardo]. The neo-technology school has three main formulations. The first one emphasizes the differences in the scale economies as between the products and between the trading countries as significant determinants of trade flows, The second one pronounces the importance of the stages of production hypothesis under which the degree of sophistication in technology achieved by a country at a particular stage of development determines the nature of products of its export and import, Developing countries in the early stages of development are expected to have comparative advantage in simple products and they would move on to more sophisticated products at the higher stages of development, The third major formulation in the neo-technology school may be termed as the technology gap or the product cycle thesis. The main message is that countries which innovate and introduce product diversification and product differentiation early would have the comparative advantages in exporting these new products, while the countries who lag behind are able to export only standardized products. In seventies, trade theorists also analyses the important role that the government intervention and the policies played in the determination of production and trade pattern. Indeed, the literature on distortions in the product market and the factor market and the consequent optimum policy responses to make corrections to these distortions have recognized that the trade flows in reality are governed by a complex set of factors which are not fully conceived in classical neoclassical theories of trade.

 

• Comparative Advantage – Revisited

A wild tour of the theory and practice of international trade, given so far would be wasteful if we do not draw out an inventory of perceptions that have emerged in regard to trade theory and practice. To be brief, there are five important perceptions:

1. 1. Factor proportions theory and other traditional theories are no longer sufficient for explaining the realities of trade flows in practice.
   2. Character of world trade and international economic linkage have undergone significant structural changes; intra-industry trade and intro-firm trade dominate; knowledge-intensive and technology-intensive products are emerging as growth-centers; trade in services has become important; capital flows precede trade flows in goods and services; many new issued like-environment, human rights, are likely to significantly affect the patterns of trade.
   3. International economic relations should be studied in the framework of strategic power games; of course the rules of the games are flexible and the economically powerful players assert their way through with the objective of promoting their national self-interest.
   4. Strategic policy Interventions are regarded as conceptually sound and practically optimum in situations of imperfect competition, scale economies, high-tech products and research & development activities, targeting of policy-interventions towards specific sectors or geographical regions of countries has become a common practice.
   5. The trading regime that is expected to ensue as a result of GATT-94 has in it many more challenges than ever before, and the trading countries – both the developed and the developing ones – will have to bring about significant changes in their policies and the legislative systems.

In the background of these perceptions, our approach to comparative advantage may be restated, we may categorize comparative advantage into three categories;

1. 1. 1. Natural Comparative Advantage
      2. Acquired Comparative Advantage
      3. Induced Comparative Advantage.

Natural Comparative Advantage pertains to the primary products, agriculture, labor, services etc. May be Factor Proportions Theory becomes relevant here. Natural Comparative Advantage would govern the nature of international trade as long as there are no policy-induced or other types of impediments put in its natural operations. The Acquired Comparative Advantage [ACA] is the result of the initiatives at the firm or the industry level to bring about significant structural changes in its production and marketing conditions, through intra-industry specialization, economies of scale and scope, technological innovations through R&D, etc.

The third category is that of Induced Comparative Advantage for which the policy intervention would be important. Induced Comparative Advantage could be of two types: Firstly, Policy Intervention is targeted to those sectors, for which there is the potential for either Natural Comparative Advantage or Acquired Comparative Advantage but which is not realized because of certain impediments, The role of the policy intervention is to remove these impediments. For instance, India has significant potential for Natural Comparative Advantage in Agriculture and Labor Intensive Products. However, the sector faces the problems of inadequate credit, poor quality of seeds, use of traditional technology, poor infrastructure, etc., Policy intervention should be intensive and extensive in removing these impediments. Similarly, many sectors which have potential for economies of large scale and scope, may be suffering from the factors such as restrictions of MRTP, licensing procedures; inadequate power supply, poor infrastructure. The policy intervention should be aimed at removing these impediments by allowing large scale of production and by encouraging investment in infrastructure facilities. This is similar to the measures of “Negative Integration” conceptualized by Jan Tinbergen as those measures which reduce the impediments in the process of integration.

The second category of Induced Comparative Advantage refers to the policy intervention which is aimed at bringing to the national economy increasingly larger share of the rents generated in the international market, as a result of the market imperfections and the policy interventions adopted by the governments of the competing countries, These policies could take the form of export-subsidies, concessional credit, tariff protection, which are product specific. Both of these categories of policy interventions have the rationale based upon the theory of strategic trade policy and it has in it some elements of retaliation to the policy initiatives taken in the other countries.

Most developing countries have the rationale for policy-interventions of all the categories described above, often the policy initiatives required to remove the impediments hindering the Natural Comparative Advantage and Acquirable Comparative Advantage are more pervasive than those required for rent-sharing purposes. The countries which have adopted the policy interventions for removing the impediments in the realization of Comparative Advantage have performed relatively better than those who have not targeted their policy interventions for a specific purpose. Irrationality of the Indian Policy system in the past has been precisely due to the lack of or inappropriate targeting, or may be over targeting of the policy-interventions without any sustained rationale. In fact the irrationality is multiplied by absurdities of the policy interventions some of which first create impediments and then a few others are designed to neutralize them. For instance, restrictions on scale and scope through licensing and controls on capacity expansion and product-mix had created impediments while export-subsidies were designed, to neutralize the disadvantages caused by the scale and limited product mix. Sustained use of such internally inconsistent policy-interventions blunts the competitive-strength of the economy.

The strategic trade policy theory does not provide guidelines about the nature and/or the extent of the policy intervention, its duration and also the criteria for its withdrawal. The policy intervention required for removing the impediments in achieving the existing or potential comparative advantages – Natural or Acquired type – will have to be, in general non-product specific and also valid for a specified period until the impediments are removed. By non-product specific, we mean, facilities which are available for all products, which need such facilities. For instance, irrigation facilities, agricultural extension services, rural infrastructure, are the facilities which are available for all agricultural products, though they are specific to the agricultural sector, further, removal of restrictions on scale economies is available for all products which have the potential of scale economies.

Thus, the policy interventions will have to be adopted with the objectives of: [A] removing the impediments against Natural Comparative Advantage and Acquirable Comparative Advantage and [B] also for increasing the strategic gains from trade. This message of the recent theories of trade clearly puts the free market enthusiasts under a state of suspense, rather dampens that an active state is regarded as a very useful and potent supplement to the market forces.

 

Financial Flow To Developing Countries

Different Type Of Flow To The Developing Countries Are As Follows:

• Bond Finance

The Developing Countries Government can issue bonds to foreign investors with a guaranteed rate of interest depending on maturity date of the bond and the currency in which it is denominated. If the bond is in domestic currency it entails an ‘Inflation Risk‘ and if it is in foreign currency the “Default Risk is associated with the bond.”

• Bank Finance

Developing Countries Government can borrow from commercial banks in form of syndicated loans at variable as fixed rate of interest. The reference interest rate is [$ LIBOR], this is the rate at which banks in London lend dollar to one another. Loans to developing countries are normally expressed as margin over dollar LIBOR.

• Foreign Direct Investment

Developing Countries can also increase capital flows through Foreign Direct Investment. Foreign Direct Investment can be either in form of Green Field Project, Brown Field Acquisition, Merger and Amalgamations etc.

• Official Flows

Apart from private flows the capital flows can occur through official channels also in the form of grants, aids and loans from IMF, world bank and other multilateral donor agencies.

The world Gross Domestic Product [GDP] grew by an estimated 3.8 percent in 2004. The long term interest rates are low in most advanced and developing countries. The GDP growth of developing countries was 6.6 percent in 2004 [much higher than the global average]. Some of the major highlights of capital flows to the developing countries in recent years are as follows:

1. 1. The increase in capital flows to the developing countries over the past few years coincide with the developing countries improvement in their current account balances. Developing countries continue to export capital [mostly to the United States] in the form of rapidly growing accumulation of foreign reserves.
   2. Foreign Direct Investment to developing countries have become increasingly concentrated, whereas FDl outflows from developing countries have increased.
   3. Most developing countries have restructured their debts.
   4. Strong Private Capital flows have enabled developing countries to repay loans taken from bilateral and multilateral creditors picture of financial flows to developing countries.
   5. Official flows [Credit by World Bank, IMF, etc.] has been gradually shifting from loans to grants.

The Net Capital Flows to developing countries in 2004 was $ 323.8 billion representing 4.5 percent of the GDP of developing countries. The current account balance of developing countries was a surplus of $ 153 billion in 2004. This is a significant improvement when compared with an average current account deficit of 1.4 percent these countries ran between 1976 to 1999. The current account surpluses have been primarily used to accumulate foreign exchange reserves. The foreign exchange reserves of developing countries grew by 378 billion in 2004 [4.9 percent of GDP], in the same period the current account deficit of U.S. was $ 666 billion [5.6 percent of GDP]. The acceleration in reserves accumulation was concentrated in just few countries, China accounted for more than half of increase in 2004, where its foreign exchange reserves grew by $ 207 billion. China’s foreign exchange reserves account for 38 percent of foreign exchange reserves of developing countries.

The net equity and debt flows to developing countries in 2004 were $ 192.3 billion and $ 84.1 billion respectively. The equity flows represent 2.7 percent of GDP of developing countries where are debt flow equaled 1.4 percent of GDP. The net equity flows have been much more stable than the debt flows since the 1990s, the reason being, the foreign direct investment which is one of the main component of equity flows has been much more stable than the flow of debts and portfolio investment.

 

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