INTERNATIONAL TRADE FINANCE

UNIT I
Why International Trade?
• Countries cannot live in isolation.
• They have to mutually share their prosperity, technical know-how and undertake trade in
order to sell their surplus products.
• The world economy is inter-dependent.
• Economic progress of a nation would depend upon its ties with other countries.
• Countries trade with each other when, on their own, they do not have the resources, or
capacity to satisfy their own needs and wants.
• By developing and exploiting their domestic scarce resources, countries can produce a
surplus, and trade this for the resources they need.
• Evidence of trading dates back at least 9,000 years - domestication of pack animals and
the invention of ships
Domestic Trade Vs International Trade

Differences Domestic Trade / Internal Trade International Trade

1. Broader markets Exchange of goods and services Exchange of goods and services
within the nation (Limited market) beyond the nation’s territory (Broader
markets)

2. Mobility in Factor Free to move around factors of Quite restricted or immobility in

of Production production like (land), labor, factors of production
capital and labor capital and
entrepreneurship from one state to
another within the same country

3. Movement of Easier to move goods without Restricted due to complicated custom

Goods much restrictions. Maybe need to procedures and trade barriers like
pay sales tax, etc. tariff, quotas or embargo

4. Usage of different Same type of currency used Different countries used different
currencies currencies
 5. Laws & regulation Uniformity in laws and regulations Each country has its own laws and
regulations

6. Language and Speak same language and practice Communication challenges due to
Cultural Barriers same culture language and cultural barriers

Two Fundamental Principles

Production of goods and services in countries that need to trade is based on two
fundamental principles – analysed by Adam Smith.
1. Division of labour (internationally), means that countries produce just a small range of goods
or services, and may contribute only a small part to finished products sold in global markets.
For ex, a bar of chocolate is likely to contain many ingredients from numerous countries,
with each country contributing one ingredient to the final product.
2. Specialisation - each worker or producer, is given a specialist role – increase in efficiency
and productivity when countries use their scarce resources to produce just a small range of
products in high volume. For example, the Canadian economy which is rich in low cost land is
able to exploit this by specializing in agricultural production. Asian economies including China
have focused their resources in exporting low-cost manufactured goods which take advantage of
much lower labour costs.
How does a country benefit from trade? (Benefits of International Trade)
International trade brings a number of valuable benefits to a country.
1. The exploitation of a country's comparative advantage, which means that trade encourages a
country to specialise in producing only those goods and services which it can produce more
effectively and efficiently, and at the lowest opportunity cost.
Ex: Switzerland has a comparative advantage in the production of chocolate. By
spending one hour producing two pounds of chocolate, it gives up producing one pound of
cheese, whereas, if it spends that hour producing cheese, it gives up two pounds of chocolate.
Switzerland must produce its chocolate and can buy cheese from someone else.

COMPARATIVE ADVANTAGE - CHINA VERSUS ITALY

CHINA
 SHIRTS BICYCLES

Number of Hours to Produce One Unit 1 2

Opportunity Cost (of producing one

½ bicycle 2 shirts
unit)

ITALY

SHIRTS BICYCLES

Number of Hours to Produce One Unit 3 5

Opportunity Cost (of producing one

3/5 bicycle 5/3 shirts
unit)

The Chinese should specialize in the production of shirts (1/2 bicycle) and the
Italians should specialize in the production of bicycles (5/3 shirts).

2. Producing a narrow range of goods and services for the domestic and export market means
that a country can produce in at higher volumes, which provides further cost benefit in terms of
economies of scale.
– For instance, it may be cheaper, to employ labor in a workforce-rich developing
country than in the United States.
– One town in China produces most of the world’s underwear, another nearly all
cigarette lighters.
– Indian information services companies are still clustered in Bangalore.
3. Trade increases competition and lowers world prices, which provides benefits to consumers by
raising the purchasing power of their own income, and leads a rise in consumer surplus.
IMF (Oct 2014) – announced that China's economy, when measured by purchasing
power parity (PPP), surpassed that of the United States (was on top since 1872) to become the
world's largest.
4. Trade also breaks down domestic monopolies, which face competition from more efficient
foreign firms.
 Ex: In 1888 De Beers Consolidated Mines was formed with the sole purpose to be the
owner of all diamond mining operations in South Africa. Discovery of new mines in Russia,
Canada, and Australia ended De Beers monopoly.
5. The quality of goods and services is likely to increase as competition encourages innovation,
design and the application of new technologies. Trade will also encourage the transfer of
technology between countries.
Ex: For many Asian and third world countries, technologies imported from industrialized
countries provided the initial base for industrial development.
6. Trade is also likely to increase employment, given that employment is closely related to
production. Trade means that more will be employed in the export sector and, through the
multiplier process, more jobs will be created across the whole economy.
Ex: Export supported jobs in USA rose from 7.6 million in 1993 to 10.3 million in 2008,
an increase of 2.7 million jobs.
7. Monetary gains to the respective country indulging in trade.
8. More variety of goods available for consumers.
• Ex: Google (1998) provides numerous services for consumers and businesses – Gmail,
Google Chrome, YouTube and Blogger, Android operating system, Google driver-less
car, an artificial intelligence system designed to drive cars without the help of a person,
Chrome OS, which powers Chromebooks, their new Chrome laptops
– Amazon.com is an online retail company - books, e-books, electronics, Kindle e-
book readers and tablets. It is considered the largest online retailer in the world.
– Coca Cola (1886) - in addition to Coca-Cola, there are also 500 additional
brands, including Sprite, Tab, Nestea, Minute Maid, Dasani water, and Powerade.
9. Better quality of goods
10. Competition both at the international level as well as local level.
– Ex: Apple (1977) - Macintosh line of computers, and the Apple iPad, iPod, and
iPhone - rarely follows the innovations of its competitors.
– IBM (1911) - hardware and software for computers - company's annual profits
were at record highs
11. Closer ties between nations
Disadvantages of international trade (or) Arguments against international trade
 • Local production may suffer
• Local industries may be overshadowed by their international competitors
• Rich countries may influence political matters in other countries and gain control over
weaker nations.
• Ideological differences may emerge between nations with regard to the procedures in
trade practices.

Risks in international trade

• Buyer insolvency (purchaser cannot pay);
• Non-acceptance (buyer rejects goods as different from the agreed upon specifications);
• Credit risk (allowing the buyer to take possession of goods prior to payment);
• Regulatory risk (e.g., a change in rules that prevents the transaction);
• Intervention (governmental action to prevent a transaction being completed);
• Political risk (change in leadership interfering with transactions or prices); and
• War and other uncontrollable events.
• In addition, international trade also faces the risk of unfavorable exchange rate
movements
Theories of International Trade
1. Mercantilism
2. Absolute Advantage (Classical) (Adam Smith’s model)
3. Comparative Advantage (Ricardian model)
4. Factor Proportions (or endowments) Trade (Heckscher – Ohlin model)
5. International Product Cycle
6. New Trade Theory
7. National Competitive Advantage
1. Mercantilism (mid- 16th century)
• A nation’s wealth depends on accumulated treasure
– Gold and silver are the currency of trade
• Theory says you should have a trade surplus.
– Maximize export through subsidies
– Minimize imports through tariffs and quotas
 • The theory holds that nations should accumulate financial wealth, usually in the form of
gold (leave aside things like living standards or human development) by encouraging
exports and discouraging imports.
• Flaw: restrictions, impaired growth
2. Absolute Advantage (Classical) (Adam Smith’s model)
• Adam Smith displays trade taking place on the basis of countries exercising absolute
advantage over one another.
• Adam Smith: Wealth of Nations (1776) argued:
– Capability of one country to produce more of a product with the same amount of
input than another country
– A country should produce only goods where it is most efficient, and trade for
those goods where it is not efficient
• Trade between countries is, therefore, beneficial
• Assumes there is an absolute balance among nations
• Destroys the mercantilist idea since there are gains to be had by both countries party to an
exchange
• Questions the objective of national governments to acquire wealth through restrictive
trade policies
• Measures a nation’s wealth by the living standards of its people
3. Comparative Advantage (Ricardian model)
• David Ricardo: Principles of Political Economy (1817)
– Extends free trade argument
– Efficiency of resource utilization leads to more productivity
– Should import even if country is more efficient in the product’s production than
country from which it is buying.
• A country must produce if it is comparatively efficient than import.
• Trade is a positive-sum game
Assumptions and Limitations
• Driven only by maximisation of production and consumption
• Only 2 countries engaged in production and consumption of just 2 goods?
• What about the transportation costs?
• Only resource – labour (that too, non-transferable)
• No consideration for ‘learning theory’
4. Factor Proportions (or endowments) Trade (Heckscher – Ohlin model)
• In the early 1900s developed by two Swedish economists, Eli Heckscher and Bertil
Ohlin.
• This theory has subsequently been known as the Heckscher–Ohlin model (H–O model).
• The results of the H–O model are that countries will produce and export goods that
require resources (factors) which are relatively abundant and import goods that require
resources which are in relative short supply.
 • A country that is relatively labour abundant (capital abundant) should specialise in the
production and export of that product which is relatively labour intensive (capital
intensive)
• The H–O model makes the following core assumptions:
– Labor and capital flow freely between sectors
– The amount of labor and capital in two countries differ (difference in
endowments)
– Technology is the same among countries (a long-term assumption)
– Tastes are the same
• Empirical problems with the H–O model, such as the Leontief paradox, were noted in
empirical tests by Wassily Leontief who found that the United States tended to export
labor-intensive goods despite having an abundance of capital.
• Example: Finland produces ocean cruisers and leather products such as reindeer fur,
mink and fox coats. Lapland, the northern part of Finland, is sparsely inhabited by mostly
Indians who hunt these wild animals. This cold climate or forest is a factor specific in the
leather goods industry. In the urban areas Finns are also engaged in cruise ship building
and Finland exports cruisers to European countries. In addition to well educated workers,
the ship building industry requires a large amount of capital, which is specific to that
industry in that it cannot be used in the leather goods industry. Finnish workers are
mobile between the two industries.
5. New Trade Theory
• New Trade Theory tries to explain empirical elements of trade that comparative
advantage-based models above have difficulty with.
• These include the fact that most trade is between countries with similar factor endowment
and productivity levels, and the large amount of multinational production (i.e., foreign
direct investment) that exists.
• New Trade theories are often based on assumptions such as monopolistic competition and
increasing returns to scale.
• One result of these theories is the home-market effect, which asserts that, if an industry
tends to cluster in one location because of returns to scale and if that industry faces high
 transportation costs, the industry will be located in the country with most of its demand,
in order to minimize cost.
• Although new trade theory can explain the growing trend of trade volumes of
intermediate goods, Krugman's explanation depends too much on the strict assumption
that all firms are symmetrical, meaning that they all have the same production
coefficients.
• Shiozawa, based on much more general model, succeeded in giving a new explanation on
why the traded volume increases for intermediate goods when the transport cost
decreases.
• Role or Contribution of foreign trade in economic development
• 1. Foreign trade and economic development
• Foreign trade plays very important role in the economic development of any country. Ex:
Pakistan exports a lot of agricultural product to other countries and imports the capital
goods from other countries.
• 2. Foreign exchange earning can be used to remove the poverty in most developing
countries and other productive purposes.
• 3. Market expansion (demand factor) increases production and encourages the
producers.
• 4. Increase in investment - encourages the investor to increase the investment to
produce more goods.
• 5. Foreign investment: Besides the local investment, foreign trade provides incentives
for the foreign investment.
• 6. Increase in national income - increases the scale of production and national income
of the country. So GNP also increases.
• 7. Decrease in unemployment – due to rise in the demand of goods domestic resources
are fully utilized.
• 8. Price stability - goods which are in short supply and prices are increasing can be
imported and goods which are surplus can be exported, there by stopping fluctuation in
prices.
• 9. Specialization Each country adopts the specialization in the production of those
commodities, in which it has comparative advantage – so profitable for all.
• 10. Remove monopolies - discourages the monopolies. Where every any monopolist
increases the prices, government allows the import of goods to reduce the prices in the
country.
• 11. Removal of food shortage - India is also facing the food shortage problem. To
remove the food shortage India has imported wheat many times.
• 12. Agricultural development is the back bone in our economy. Every year we export
rice, cotton, fruits and vegetables to other countries - makes our farmer more prosperous.
It inspires the spirit of development in them.
• 13. Import of consumer goods - India and Pakistan imports various consumer goods
from other countries, which are not produced inside the country. Today the shortage of
any commodity can be removed through international trade.
• 14. To improve quality of local products - Foreign trade helps to improve quality of
local products and extends market through changes in demand and supply. Foreign trade
can create competition with the rest of the world.
• 15. External economies - Industries producing goods on large scale in Pakistan and India
are enjoying the external economies due to international trade.
• 16. Competition with foreign producers - improves the quality and reduces the cost of
production.
• 17. Useful for the world peace: Today all the countries are tied in trade relations with
each other. So foreign trade also contributes to peace and prosperity in the world.
• 18. Import of capital goods and technology in the less developed countries has
increased the rate of economic development.
• 19. Import substitution - These countries not only produce import substitute, but also
reduce deficit in BOP of their countries.
• 20. Better understanding - provides an opportunity to the people of different countries
to meet, discuss, and exchange views and ideas related to their social, economic and
political problems.
• 21. Dissemination of knowledge - Ex: Iron and steel industry needs technical
knowledge from foreign countries. Without trade, not only difficult but also too
expensive.
 • 22. Interdependence Foreign trade is responsible for creating economic dependence and
establishing economic interest in the countries having trade relations.
• 23. Factors productivity - productivity of labour and capital and organization increases.
Demand makes them mobile on national as well as international level which helps
underdeveloped countries to develop and maintain a high level of growth of developed
countries.
Balance of Payments
Meaning of Balance of Payments
• Balance of payments is a statement listing receipts and payments in international
transactions of a country.
• Balance of payments accounts are an accounting record of all monetary transactions
between a country and the rest of the world during a specific period of time.
• These transactions include payments for the country's exports and imports of goods,
services, financial capital, and financial transfers.
• Usually, the BOP is calculated every quarter and every calendar year.
• All trades conducted by both the private and public sectors are accounted for in the
BOP in order to determine how much money is going in and out of a country.
• The term ‘balance’ means that it is a balance sheet of receipts and payments having an
accounting balance.
Accounting Equilibrium
• It is based on the concept of double-entry book-keeping where credit balance shows
the receipts of foreign exchange from abroad and debit balance shows payments in
foreign exchange to foreign residents.
• If a country has received / earned foreign exchange, this is known as a credit, and if a
country has paid or given foreign exchange, the transaction is counted as a debit.
• Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities
(debits) should balance, but in practice this is rarely the case. Capital account + Current
account = 0
• Monetary value of exports (receipts from abroad) = credit transaction (+);
• Monetary value of imports (payments to foreigners) = debit transaction (-)
BOP Equilibrium
BOP Equilibrium occurs when a surplus or deficit is eliminated from the BOP.
Balanced BOP: Value of total receipts equals total payments.
BOP Disequilibrium occurs when the two sides of the flows differ in size.
Favorable BOP: Value of total receipts more than total payments
Adverse BOP: Value of total receipts less than total payments
Balance of Trade
• Balance of Trade is the difference between exports and imports.
• When value of exports > value of imports = surplus in BOT
• When value of imports > value of exports = deficit in BOT
International Transactions
• Payments received by a country
– Exports of goods
– Services provided to foreigners such as transportation
– Income received from investments in other countries
– Gifts received from foreign residents
– Aid from foreign governments or residents
– Borrowings from other countries
– Sale of assets to foreign residents
– Investment in the country by foreign residents
• Payments made by a country
– Import of goods
– Services received from foreign residents
– Income payable on investments made by foreigners in the country
– Gifts to foreign governments or residents
– Aid provided to foreign governments or residents
– Lending to foreigners
– Purchase of assets from foreign residents
– Investments made in other countries
Purpose of BOP
1. The BOP is an important indicator of pressure on a country’s foreign exchange rate,
and thus on the potential for a firm trading with or investing in that country to experience
 foreign exchange gains or losses. Changes in the BOP may predict the imposition or
removal of foreign exchange controls.
2. Changes in a country’s BOP may signal the imposition or removal of controls over
payment of dividends and interest, license fees, royalty fees, or other cash disbursements
to foreign firms or investors.
3. The BOP helps to forecast a country’s market potential, especially in the short run. A
country experiencing a serious trade deficit is not likely to expand imports as it would if
running a surplus. It may, however, welcome investments that increase its exports.
Structure of Balance of Payments
• Receipts and payments are compartmentalized into two heads:
– Current account
– Capital account
– Errors & Omissions
• Official Reserves
Structure of Balance of Payments
CREDITS DEBITS
Current A/c: Current A/c:
• Exports of goods (Visible items) • Imports of goods (Visible items)
• Exports of services (Invisibles) • Imports of services (Invisibles)
• Unrequited receipts (gifts, • Unrequited payments (gifts, remittance,
remittances, indemnities, etc. from indemnities etc. to foreigners)
foreigners)

Capital A/c: Capital A/c:

• Capital receipts (Borrowings from • Capital payments (lending to, capital
abroad, capital repayments by, or repayments to, or purchase of assets
sale of assets to foreigners, increase from foreigners, reduction in stock of
in stock of gold and reserves of gold and reserves of foreign currency
foreign currency etc.) etc.)

1. Current Account Transactions: Records the receipts and payments of foreign exchange in
the following ways:
• Current account receipts
– Export of goods – effects the flow of foreign exchange into the country
– Invisibles
– Non-monetary movement of gold
• Current Account payments
– Import of goods – causes the flow of foreign exchange from the country
– Invisibles
– Non-monetary movement of gold
– Invisibles – include receipts and payments on account of
• Trade in services such as travel and tourism, transport, etc.
• Investment income, such as, interest and dividend, etc. and
• Unilateral transfers include pension, remittances, gifts and other
transfers for which no specific services are rendered. They are unilateral
transfers because they represent flow of funds only in one direction, that
is, the direction of payment.
• Movement of gold – may be monetary or non-monetary.
– Monetary movement is the sale or purchase that influences the international
monetary reserves.
– Non-monetary sale and purchase of gold is done for industrial purposes that is
shown in the current account.
• If the credit side of the current account is greater than the debit side – there is a surplus
balance.
• If the debit side of the current account is greater than the credit side – there is a deficit
balance.
• The current account shows the net amount a country is earning balance of trade (net
earnings on exports minus payments for imports), factor income (earnings on foreign
investments minus payments made to foreign investors) and cash transfers.
• So, BOP on current account refers to the inclusion of 3 balances:
– Merchandise balance,
– Services balance and
– Unilateral Transfer balance (gifts)
 • Where, CA: current account, X and M: export and import of goods and services
respectively, NY: net income from abroad; NCT: net current transfers - The net value of
the balances of visible trade and of invisible trade and of unilateral transfers defines the
balance on current account.
• BOP on current account is also referred to as Net Foreign Investment because the sum
represents the contribution of Foreign Trade to GNP.
Structure of Current Account
Transactions Credit Debit Net Balance
1. Merchandise Export Import -
2. Foreign Travel Earning Payment -
3. Transportation Earning Payment -
4. Insurance (Premium) Receipt Payment -
5. Investment Income Dividend Receipt Dividend Payment -
6.Government (purchase Receipt Payment -
of goods & services)
Current A/C Balance - - Surplus (+) or Deficit (-)

2. Capital Account Transactions

• The capital account records all international transactions that involve a resident of the
country concerned changing either his assets with or his liabilities to a resident of another
country.
• Transactions in the capital account reflect a change in a stock – either assets or liabilities.
• Capital account receipts and payments comprise long-term and short-term inflow and
outflow of funds.
• Credit side records the official and private borrowing from abroad net of payments,
direct and portfolio investment and short-term investments into the country. It records the
bank balances of the non-residents held in the country.
• Debit side includes dis-investment of capital invested into the country, the country’s
investment abroad, loans given to a foreign government or a foreign party and the bank
balances held abroad.
 • Long-term transactions involve maturity periods of over 1 year (an individual buying a
long term government bond in another country).
• Long term capital movement includes:
– Investments in shares, bonds, physical assets, etc.
– Amortization (repayment) of capital
• Short-term flows are effected for 1 year or less (a firm or individual that holds a bank
account with another country and increases its balance in that account).
• Short term capital movement includes:
– Purchase of short term securities
– Speculative purchase of foreign currency
– Cash balances held by foreigners
– Net balance of current account
Various Forms of Capital Account Transactions
• Direct investment is the act of purchasing an asset and the same time acquiring control
of it. Ex: The acquisition of a firm resident in one country by a firm resident.
• Portfolio investment by contrast is the acquisition of an asset that does not give the
purchaser control. Ex: Purchase of shares in a foreign company or of bonds issued by a
foreign government or Loans made to foreign firms or governments come into the same
broad category.
Errors and Omissions
• Errors and omissions is a “statistical residue.”
• It is used to balance the statement because in practice it is not possible to have
complete and accurate data for reported items.
3. Official Reserves Account
• Official reserves are held by the monetary authorities of a country.
• Reserves are held in 3 forms: in foreign currency, usually but always the US dollar, as
gold, and as Special Deposit Receipts (SDRs) borrowed from the IMF.
• Foreign currency assets are normally held in the form of balances with foreign central
banks and investment in foreign government securities.
• Reserves do not have to be held within the country.
 • Indeed most countries hold a proportion of their reserves in accounts with foreign central
banks.
• If the overall balance of payments is surplus, the surplus amount adds to the official
reserves account but if the overall balance of payments is deficit, the official reserves
account is debited by the amount of deficit.
Trends in India’s BOP
• India’s BOP position was quite unfavorable during the time of country’s entry into
liberalized trade regime.
• Two decades of economic reforms and free trade opened several opportunities that
reflected in the BOP performance of the country.
• Independent India’s external trade and performance had faced severe threats many a
times.
• The most challenging one was that of 1991.
• The widening current account imbalances and reserve losses contributed to low
investor confidence putting the external sector in deep dilemma.
• During 1990-91, the current account deficit steeply hiked to $- 9680 million while the
capital account surplus was far below at $ 7188 million.
• This led to an ever time high deficit in BOP position of India.
• India initiated economic reforms to find the way out of the growing crisis.
• Structural measures emphasized accelerating the process of industrial and import
delicensing and then shifted to further trade liberalization, financial sector reform and tax
reform.
• Prior to 1991, capital flows to India predominately consisted of aid flows, commercial
borrowings, and nonresident Indian deposits.
• Direct investment was restricted, foreign portfolio investment was channeled almost
exclusively into a small number of public sector bond issues, and foreign equity holdings
in Indian companies were not permitted.
• But this scenario underwent radical changes with the liberalization policies of 1991.
• The post reform period really eased India’s struggles with regard to external sector.
• This is evident from the RBI data summarizing the BOP in current account and capital
account.
• The current account remained almost negative throughout the post reform period.
• However, for the first time since 1991, the current account recorded surplus for the 3
consecutive financial years: 2001-02, 2002-03 and 2003-04.
• Until 2000-01, the current account deficit remained stagnant and stood around $ 5000
million.
• The deficit in current account continued to occur from 2004-05 onwards and the growth
rate was comparatively faster.
• The recent crisis of 2008 affected the trade performance of India in a large way.
• Indian economy had been growing robustly at an annual average rate of 8.8% for the
period 2003-04 to 2007-08.
• Concerned by the inflationary pressures, RBI increased the interest rates, which
resulted in a slowdown of India’s trade flows prior to the Lehman crisis.
• The trade flows, which are one of the important channels through which India was
affected during the recent global crisis of 2008, started to collapse from late 2008.
• Merchandise trade, software exports and remittances declined in absolute terms in
response to the exogenous external shock.