The foreign competitors
Import substitution makes use of trade barriers to protect domestic industries as to aid the industrialization of developing countries. Developing countries establish manufacture their own goods that they imported previously. This is to protect their home industries and also reducing the imports. It protects their manufactures against the foreign competitors. In additional, developed countries are easier to protect its own manufacturers in opposition to the foreign competitors then reducing their trade restrictions on the products exported. One advantage is to avoid the use of tariffs and quotas restricts for imports. Therefore foreigners have to locate manufacturing plants in the developing country, thus this grant job opportunities for the local workers.
The disadvantages of import substitution are the inefficient production due to the trade restrictions against the international competition to aid the domestic industries. Therefore this causes domestic industries to lose their motivation in the market.
Export led-growth involves promoting growth by exporting manufacture goods. This is a growth is to protect the domestic industries from the suffering comparative disadvantage. This encourages developing countries industries to have a comparative advantage, i.e. labor-intensive manufactured goods. The export led-growth provides domestic manufacturers a larger market therefore utilize the economic of scale to sell the goods. To achieve increasing efficiency by imposing a competitive discipline on domestic firms, as to maintain a low restriction on imported goods.
The drawback of export led-growth exists if all developing countries tried to export at the same time. This will cause prices of exports to be driven down in world markets.
'China the process of trade liberalization and development of export oriented industries started, following a period of pursuing import substitution strategy. The country have managed to develop comparative advantage in many industries initiated through import substitution; China has been successful in gradually increasing value added in export oriented industries by substituting domestic production for imported inputs in these industries.' (Shafaeddin, 2007)
'China has a relatively small domestic market, and exports become an inevitable choice to expand growth.'
'The costs of China's export-led growth model are high--underutilizing its burgeoning foreign reserves is the most serious. China has to go through significant structural changes to rebalance its economy. Among them, improving its financial sector, accelerating the pace of urbanization, and establishing a more complete social security system.' (Yang,2009)
Flying-geese pattern of economic growth is where countries gradually move up in technological development by following in the pattern of countries ahead of them in the development process.
For instance, Malaysia and Taiwan took over leadership in textiles and apparel from Japan, when Japan moves into higher technology sectors of automotive, electronic, and other capital goods. Ten years or more lately, Malaysia and Taiwan upgraded to electronic products and automotive, and the textiles and apparel industries moved to Vietnam, Indonesia and Thailand.
This result in market forces whereby labor abundant nations will become globally competitive in labor intensive industries, example footwear, will eventually to more capital or skilled industries when saving and education upgrade the availability of capital and skilled workers. As East Asian governments have utilized several versions of an export platform, such as free-trade zones, bonded warehouse, jointed ventures and strategic alliances with multinational enterprise, and these are the similarities with the international trade policy.
India's economy improved its economic performance following the adoption of freer trade policies. After gaining independent from Britain in 1947, India began to practice socialism and adopted import substitution policy to run its economy. This result fear of imperialism of any kind following its independence, thus the government initiated protectionist trade barriers, bans on foreign investment to restrict competition, strict regulations over financial markets and private business, large public sector and central planning, which result isolating India from the mainstream world from 1950 to 1980. Hence India's economy growth only in modest rate and the poverty was widely spreader.
By 1991, India's policymakers knew that their system of state controls and import substitution was strangling the economy and reformed were needed. Thus they moved towards an outwards oriented, market based economy. The need for the government to approve industrial investment expenditures was removed, quotas on imports were abolished, export subsidies were eliminated, and import tariffs were reduced from average 87% in 1990 to 33% in 1994. Indian companies were allowed to borrow from international markets, and the rupee was devalued. These strategies policy changes, helped to reform India to an open and progressive that encourages foreign investment and draw more wealth from industry and service rather then an agrarian underdeveloped, and closed economy. Hence result in a dramatic increase in economic growth and falling poverty rates.
Multinational enterprises can branch out their operations down vertical, horizontal, conglomerate lines contained by the host and source countries, and foreign direct investment method.
Vertical integration form when the parent Multinational enterprises decide to set up foreign subsidiaries hence to produce intermediary goods or input that aids the production of the finished goods. For instance oil refining and steel industries tend to go for backward integration, include the extraction and processing of raw material. Multinational enterprises also used forward integration for the directioning of the final consumer market. Automobile manufacturers, as such, market the finished goods of the parent company by setting up foreign subsidiaries. In practical world, most perpendicular foreign investment is backward, where Multinational enterprises want to incorporate the operations vertically as to gain from international specialization and economic of scale.
Horizontal integration takes place when the parent company produce a service in the source country establishes a subsidiary to produce the identical product in the host country. Productive capacities in independent units are subsidiaries and where setup to produce as well as market the parent company's merchandise in oversea markets. Example, Pepsi-Cola and Coca-Cola are made not only in U.S. but also throughout the world. Multinational enterprises locate production facilities oversea to avoid the inflexible foreign tariff barriers, whereby this place their products at a disadvantage. The parent companies locate close to their customers; in this case differences in national preferences may need particular designs for their products.
Multinational enterprises can also diversify into no related markets, known as conglomerate integration, which means parent company establish foreign subsidiary for production of unrelated goods. For instance, U.S. oil companies came up with their no energy gaining in response to estimated the declines of future investment opportunities for oil and gas, in the 1980s. Example Exxon Mobil acquired a foreign copper-mining subsidiary in Chile, and Tenneco bought a French company producing automotive exhaust systems.
Lastly to carry out worldwide operation, Multinational enterprises rely on foreign direct investment, by acquisition of a controlling interest in an overseas company or facility. Foreign direct investment occurs when earning of the parent company's foreign subsidiary are reinvested in plant expansion; the parent company acquires or constructs new plants and equipment overseas; the parent company obtains sufficient common stock in a foreign company to assume voting control; the parent company shifts funds abroad to finance an expansion of its foreign subsidiary.
The major issues involving multinational enterprises as a source of conflict for source and host countries are employment, balance of payment, taxation and national sovereignty.
It is often assumed that that when MNEs brings favourable benefits to the labour force of the recipient nation. This is effect MNEs have on the labour force actually varies from business to business. Instead of bringing the recipient country favourable benefits, instead of establishing new businesses, the direct investment spending on the foreign-based MNEs are used to obtain existing local businesses as an alternative. Hence, the investment spending may not bring in much effect on the employment in the host country and may not result in any increase in the production capacity.
When MNEs take in foreign employees to run the subsidiary in the host country, they may deprive the local people of a chance of employment in higher-level positions.
The crucial blow MNEs have on the level of employment on the source and host countries appear to be dependent on the time scale. Not long after, there will likely be an employment downturn in the source country when production is shifted overseas by the MNEs.
Balance of Payments
Balance of payments "is an account of the value of goods and services, capital movements (including foreign direct investment), and other items that flow into or out of the country."
Items like when foreign investments entering the home country and the exports of goods and services make a positive contribution to a nation's payment position, hence the opposite flows weakens the payment position. Balance-of-payments position is strengthens when these items generate an inflow of revenue for the economy for the host country.
U.S. tax laws somewhat discourages investment at home in a way because of its tax concessions (includes tax deferrals and foreign tax credits). This is because United States MNE headquartered allowed to credit the income tax liabilities in an amount equal to the amount of income tax to be pay to foreign governments.
U.S. based MNEs enjoys a tax-deferral advantage. This means that the parent organisation has the option of deferring the U.S. tax that is to be paid on the income generated by the foreign subsidiary as long as the income is not repatriated back to the United States. Such discriminatory tax treatment there will encourage investors to favour foreign direct investment over domestic investment.
A country may result in a loss of its national sovereignty, as some MNEs may use accounting techniques to shift evade taxes of a host country and hence resisting the host country's attempts to redistribute national income through taxation. This will in turn affect the economy and political policies of the source and host governments.
MNEs may politically influence the host country's political scene. This can be seen in the removal of the president of Honduras in 1974 due to a pay-off of $1.25 million fromo Chiquita to the president in order for the company to receive an export-tax reduction applied to bananas.
MNEs may affect the economies of the national governments. For example, MNEs may move funds from one financial centre to another to cut its losses and even make profits due to the changes in the exchange rates during an international crisis.
Both approaches are in agreement with the comparative advantage principle. They agree that a given commodity will be produced in a low-cost country.
- Theory of multinational enterprises emphasizes on the international movement of factor inputs but the conventional trade theory emphasizes on the movement of merchandise among the different nations.
- The conventional trade theory suggest that are exchanged of goods between independent organizations on the international market at competitive prices that are determined however in an MNEs it intermediate goods as well as finished goods are manufactured by their subsidiaries. In MNEs, sales are considered intrafirm when the goods are transferred from one subsidiary to another.
The equilibrium of exchange rate is determined when So and Do intersect. Therefore with reference to the graph, it can be seen that 600 pounds will be traded at $1.60 per pound.
As the equilibrium of exchange rate was determined at $1.60 per pound and now the spot exchange rate is $1.20 per pound, dollar spent per pound has appreciated. Therefore since the exchange rate for the pounds has fallen, the demand for the amount of pounds will increase as investors try to cash in on the lower exchange rate to try to make a profit when they sell it in the future when the exchange rate for the pounds goes up. However, it will also lead to a decrease in the supply for pounds.
The forward rate is the rate of exchange which is used in the settlement of forward transactions and it is stated in relation to the spot rate. When the forward market of a foreign currency is worth more than the spot market it is said to be at a premium and when the forward market is worth less than the spot market is said to be at a discount.
Since the speculator anticipates that the spot rate of the pounds in three months will be higher than the current three-month forward rate of the pound, he go into contract and use his $1 million to buy the pounds and sell it in three month's time when the offer price is higher than the bid price. By hedging on his investments to the current forward rate of $1.50, he will not lose money when lose money when the dollars are converted back to pounds. He can hedge his investment against dollar appreciation or dollar depreciation.
Should the pound's spot rate in three months be $1.60 as compared to the current three-month forward rate at $1.50 per pound, it will mean that for every pound purchased, it will cost an additional of $0.10. The speculator should go into contract and hedge his investments at the forward rate of $1.50 per pound so that he can avoid the foreign exchange risk and hedge against dollar depreciation. Thus he is able to hedge his investment against dollar depreciation. By purchasing his pounds at $1.50 and should he decide to convert the pounds to dollar in three-month time, he will make a profit of $100,000.
Should the pound's spot rate in three months be the same as the forward rate be identical (i.e. $1.50), there will not be any profit nor any lost for the speculator should invest his money in pounds.
Should the pound's spot rate be $1.40 in three month time, this means that it cost less to purchase every pound hence the dollar has appreciated. Since the pounds will be worth less than the price that it is originally bought (i.e. bid price) the speculator should hedge his investments at $1.50 per pound so as hedge against dollar appreciation. To avoid this foreign exchange risk, the investor can contract to sell his expected receipts in the forward market at today's forward rate.
The real interest rate refers to 'an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost offunds to the borrower, and the real yield to the lender.The real interest rate ofan investment is calculated as the amount by which the nominal interest rate is higher than the inflation rate.'
Real Interest Rate = Nominal Interest Rate - Inflation (Expected or Actual)
United States 6% - 3% = 3%
United Kingdom 5% - 4%= 1%
Therefore, the real interest rate for United States is 3%, United Kingdom is 1%.
If United States rise of nominal rate is accompanied by and equal rise rate in inflation rate, this will result of constant real interest rate. In this case rising United States inflation encourage U.S buyers to reach out for low-priced UK goods. This will affect an increase in the demand for more pounds and cause U.S dollar to depreciate. As such, the UK investors will expect the exchange rate in U.S dollar in the pounds, to deprecate together with declining purchase power of the U.S dollar. The higher nominal return of U.S i.e. 6% on the U.S securities will be equalized by the expectation of a lower future exchange rate. Thus UK investment in the United States will be impassive. The higher nominal rates in the United States indicate an increase in the real interest rate.
As United States real interest rate are higher then United Kingdom, we expect to see appreciating currencies. Thus the country will attract investment funds from all over the world.
The expectation of foreign-currency gain makes U.S Treasury bills appear more attractive, and the UK investors will obtain more of them. In this way, prospect expectations of an appreciate of the dollar can be self-fulfilling for current value of dollar.
The UK investor expects the value of dollar to appreciate against pound, in three months exchange value. The long -run determinates of exchange rates will expected to appreciate if there are expectations of United States price level decrease to the UK price level. Hence, U.S productivity will increase relatively to UK productivity, U.S. tariffs will increase the U.S demand for imports will decrease, or the UK demand for U.S exports will increase. Given anticipated gains resulting from an appreciating dollar, UK investment will flow to the United States, which causes an increase in today's value of the dollar in terms of pound.
In the long run, four key factors account for changes in exchange rates: relative price levels, relative productivity levels, preferences for domestic goods and foreign goods, and barriers to trade.
In support of relative price levels, the domestic price level increases in United States but it remain constant in the United Kingdom. This will affect United States consumers to yearn for relative low-priced UK goods, and affect a raise in the demand for pounds. On the other hand, UK consumers purchase fewer U.S goods due to the high-priced U.S goods. Thus this result in an increase in U.S price level and also leads to depreciation of dollar.
Relative productivity level for the long run show that if United States productivity growth is greater then U.K, U.S goods become relatively less expensive. Therefore U.K consumers will demand more goods from U.S; this will lead to an increase supply of pounds. Adding on, if U.S consumer decrease the demand for U.K goods and there will be a reduce demand for pounds.
Subsequently, preferences for domestic goods or foreign goods understand that U.S consumer build up strong preference for U.K goods. This will result a demand for more pounds by the U.S consumers. But this leads to a decrease value for dollar. Summing up, increase demand for imports tends to depreciate in the domestic currency.
The fourth is trade barriers. If assume the U.S government impose tariffs on the products of U.K. The UK goods will tend to increase and U.S consumer will purchase lesser pounds to buy U.K product. For the decrease in demand for pounds leads to the increase value of the dollar. For this reason, trade barriers leads to appreciation of dollar.
In the short run, changes in exchange rates are caused by relative interest rates and expected changes in exchange rates. The decrease in interest rate in U.S and unchanged for U.K interest rate causes U.S investors to have a demand for pounds in order to purchase investments in the United Kingdom. When U.K investors invest less in the United States there will be a decrease in the supply of pounds. Result the dollar will depreciates and pound appreciates.
Economic integration is a process of eliminating restrictions on international trade, payments, and factor mobility. The stages of economic integration are free-trade area, customs union, common market, economic union and monetary union.
'Free-trade area is an association of trading nations in which members agree to remove all tariff and nontariff barriers among themselves. Each member maintains its own set of trade restriction against outsiders, example for this integration is the North American Free Trade Agreement.'
'Customs union is an agreement among two or more trading partners to remove all tariff and nontariff trade barriers among themselves. Each member nation imposes identical trade restrictions against outsiders. The effect of the common external trade policy is to permit free trade within the customs union, whereas all trade restrictions imposed against outsiders are equalized, example for this integration is Benelux.'
As for common market, it is a group of trading nation that authorizes the goods and services among the member nations for free movement. The initiation of common external trade restriction against nonmembers, and the free movement of factors of production across national borders within the economic bloc. The common market represents a more completed stage of integration than a free-trade area and customs union, example for this integration is European Union.
The evolved of economic integration to stage of economic union, which national, social, taxation, and fiscal policies are harmonized and administered by a supranational institution. The task of creating an economic union is much more ambitious than achieving the other forms of integration. Reason being, a free-trade area, customs union, or common market results from the abolition of existing trade barriers but economic union required an agreement to transfer economic sovereignty to a supranational authority. Example of this evolved integration is Belgium and Luxembourg formed an economic union during 1920s.
Monetary union is the unification of national monetary policies and the acceptance of a common currency administered by a supranational monetary authority. U.S. serves an example of a monetary union. Fifty states are linked together in a complete monetary union with a common currency, implying completed fixed exchange rates and the Federal Reserve serves as the single central bank for the nation.
Regional trading arrangement refers to the member nations whom agreed on imposing lesser barriers. Therefore, trade in the group than with nonmember nations. The welfare implications of regional trading arrangement can be analyzed from two perspectives, one of them is the static effects of economic integration on productive efficiency and consumer welfare, resulting from trade creation and trade diversion. Next are the dynamic effects of economic integration, which relate to member nation's long run rates of growth, that stem from greater competition, economic of scale, and the stimulus to investment spending that economic integration makes possible. Due to the small change in the growth rate can lead to a substantial cumulative effect on the national output, the dynamic effects of trade policy changes can yield larger magnitudes than those based on static models. With the combination of the both effects, they can determine the overall gains of losses associated with the formation of a regional trading arrangement.
Before custom union is formed, the consumer surplus is the area of the red triangle, the producer surplus is the area of the green triangle, while the tariff revenue is the area of the black rectangle, thus the triangle a and b is the dead loss.
With the customs union agreement with Germany will lower the price to SG , resulting in the consumer surplus increase, and trade creation effect cause the welfare losses are part of the consumer surplus, which triangle a is the production effect, and triangle b is the consumption effect. Thus the rectangle c is the trade diversion effect, thus cause by the lost benefits from the lower cost suppliers.
The formation of a customs union leads to a welfare increasing trade creation effects and a welfare decreasing trade diversion effect. The overall effect of the customs union on the welfare of its members, so as on the world as a whole, depends on the relative strength of these two opposing forces.
Over long run the dynamic effect influences member nation growth rates. The benefits relate with the customs union's dynamic gains may more than offset any unfavorable static effects. These dynamic gains include economic of scale, greater competition, and a stimulus of investment.
Economies of scale are the access to a larger market allows producers to become more efficient through greater specialization, better equipment, and usage of by-products. Greater competition tends to increase number of producers makes collusion less likely and forces firms to become more efficient. Lastly stimulus of investment is because of increased rate of return and ability to spread research and development costs trade makes greater levels of investment more likely.
The trade creation occurs when some domestic production of one customs union member is replaced by another member's lower cost imports. This increases the welfare because it leads to increased production specialization.
Trade diversion occurs when import from a low cost supplier outside the union are replaced by purchase from a higher cost supplier within the union.
If Country X forms a custom union with Country Z, this is a trade diverting customs union, as now Country X is importing more from the higher cost Country Z, this lead to the world production is reorganized less efficiently. The total volume of trade increase under the customs union, part of this trade (400-250=150 pairs) has been diverted from Country Y to Country Z. This increase in the cost of obtaining these 150 pairs of imported shoes, and the welfare loss to Country X as well as to the world as a whole. This concluded that the formation of a customs union will increase the welfare of its members, and the world if the positive trade creation effect more than offsets the negative trade diversion effect.
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ECO203 International Economics (study guide).Dr. Ho Woon Yee, 2009 South- Western, a part of Cengage Learning.
From Export Promotion To Import Substitution; Comparative Experience of China and Mexico
Shafaeddin, Mehdi and Pizarro, Juan, Institute of Economic Research, Neuchatel University,
UNCTAD, June 2007, http://mpra.ub.uni-muenchen.de/6650/1/MPRA_paper_6650.pdf
China's Trade Surplus Isn't Going Away Soon,Yang Yao, 09.28.09.
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