Department of Distance Education

Punjabi University, Patiala

Class : B.A. II (Economics) Semester : 4

Paper : Macro Economics and International Economics
Medium : English Unit : 2

Lesson No.
2.1 : International Trade and Theory of Comparative costs
2.2 : Modern Theory of International Trade
2.3 : Terms of Trade And Principle of Reciprocal Demand
2.4 : World Trade Organization (WTO)
2.5 : South Asian Association of Regional Co-operative (SAARC)
2.6 : Balance of Payments
2.7 : Foreign Exchange
2.8 : International Monetary Fund
2.9 : International Bank for Reconstruction and Development
B.A. PART - II ECONOMICS
MACRO ECONOMICS AND
INTERNATIONAL ECONOMICS

LESSON NO. 2.1 AUTHOR : DR. GOVIND KHANNA

INTERNATIONAL TRADE AND THEORY OF COMPARATIVE COSTS

One of the main drawbacks of the Ricardian comparative cost theory was
that it was based on the labour theory of value which stated that the price of a
good was equal to the amount of labour time going into the production of the
good. Gottfried Haberler gave new life to the comparative cost theory by restating
the theory in terms of opportunity costs in 1933. The opportunity cost of a good is
the amount of a second good that must be given up in order to release just enough
factors of production or resources to be able to produce one additional unit of the
first good. For example, supposing that the resources required to produce one unit
of good X are equivalent to the resources required to produce two units of good Y.
Then, the opportunity cost of one unit of good X is two units of good Y. Haberler
made use of opportunity cost curve to express the opportunity cost of one good in
term of the other. The opportunity cost curve can be called as the ‘transformation
curve’ or ‘production possibility curve’. According to the opportunity cost theory, a
country with a lower opportunity cost for a good has a comparative advantage in
that good and a comparative disadvantage in other good.

Haberler makes the following assumptions for his theory.

1. There are only two countries.
2. There are only two commodities in both the countries.
3. There are only two factors of production such as labour and capital.
4. There is perfect competition in both the factor and good markets.
5. Price of each good equals its marginal cost.
6. Price of each factor equals its marginal productivity.
7. Supply of each factor is fixed.
8. In each country, there is full employment.
9. No change in technology.
10. Factors are not mobile between two countries. But within countries, factors are
totally mobile.
11. There is free and unrestricted trade between the two countries
On the basis of above assumptions, production possibility curve indicates the
different combinations of two commodities that a country can produce with the

1. Cannan Edition, 1937, pp. 423

B.A. PART - II 2 ECONOMICS
given factor endowments and technology. The slope of production possibility curve
or opportunity cost curve is determined by marginal rate of transformation (MRT).
MRT is a rate at which marginal unit of good X is substituted for certain units of
good Y.

The opportunity cost curve may be a straight line, convex to the origin or
concave to the origin, depending on whether MRT between X and Y goods is
constant, increasing or decreasing respectively.

n
Ietrnaoitnal

trade between two countries can be analysed under various types of production
possibility curves or opportunity cost curves.

a) Constant opportunity cost and international trade

When MRT between X and Y goods remains constant then opportunity cost
curve will be a falling straight line. If the slopes of opportunity cost curves in two
countries are the same, so that the opportunity cost curves are parallel to each other
(as shown in Figure 2), no trade can be possible. It is because of the fact that in
such cases the cost ratios of two goods in both the countries are equal.

1. Robert Heller : International Trade—Theory and Expirical Evidence, p. 36

B.A. PART - II 3 ECONOMICS

The trade
y is possible only when the slopes of the opportunity cost curves are
different.

1. The theory of International Trade.

B.A. PART - II 4 ECONOMICS
In Figure, PA and QB are the opportunity cost curves of country A and
country B respectively. Under the situation of autarky, if county A produce and
consume at point C at its opportunity cost curve, i.e, PA line then it will have DO
qunatity of good Y and DC qunatity of good X. However, if county B produce and
consume at point E at its opportunity cost curve, ie., QB line then it will have FO
qunatity of good X and EF qunatity of good Y. However, the relatively greater
steepness of PA line shows that country A has a comparative adventage in the
production of good Y, whereas the relatively greater flatter of QB line reveals that
country B has comparative advantage of good X. Therefore, country A will
specialise in the production of good Y and country B will specialise in the
production of good X. If country A produce only good Y then it can produce
maximum OP quantity of good Y at its opportunity cost line PA. Similarly, country
A
B can produce maximum OB quantity of good X if country B produce only good X
at its opportunity cost line QB. Both countries will exchange goods in the ratio
indicated by the dotted international commodity-price line PB.
Suppose country A want to consume both comodities at point H. At this
point, the country A will export PD quantity of good Y and import DH quantity of
good X. After international trade, country A can consume more quantity of good X,
ie., CH (=DH-DC). Similarly if country B want to consume both commodities at
point G then it will export BF quantity of good X and import FG quantity of good
Y. Therefore, the gain from trade for country B will be GE (=GF-EF) quantity of
good Y.

b) Increasing opportunity cost and international trade

If MRT between X and Y goods goes on increasing, then opportunity cost

curve or production possibility curve will be convex to the origin. In Figure 4, AA
represents the production possibility curve of country A and BB in Figure 5, is the
production possibility curve of country B. The comparison of the shape of the
production possibility curves of both countries makes it clear that opportunity cost
of good X, in terms of good Y, is lower in country A and higher in country B. In
other words, country A is better suited for the production of good X and country B
for the production of good Y.

In the case of country A, under the absence of international trade the

country is in equilibrium at E, where the production possibility curve AA tangents
to the country’ indifference curve, i.e, II curve. At this point, country A is
producing and consuming OX quantity of good X and OY quantity of good Y. The
slope of the production possibility curve AA at point E is donated by P aPa line.
Similarly, country B will be in equilibrium at E1 under the absence of international
trade as shown in Figure 5 where the production possibility curve BB tangents to
the country’ indifference curve, i.e, I1I1 curve. At this point, country B is producing
B.A. PART - II 5 ECONOMICS
and consuming OX1 quantity of good X and OY1 quantity of good Y. The slope of
the production possibility curve BB at point E1 is donated by P bPb line. The slope of
PaPa line is relatively flatter than that of PbPb line. This indicates that good X is
cheaper in country A and good Y is in country B.

If both the countries enter into trade with each other, the international price
ratio is most likely to be somewhere in between the pre-trade ratios in both the
countries. In other words, the international price line would neither be as flat as
price line PaPa of country A, nor be steep as the price line P bPb in country B. The
slope of the international price line would be somewhere in between the price lines
of both the countries. In Figure 6 and Figure 7, P iPi represents a possible
international price line. If PiPi represents international price line, country A will
produce at point N where its production possibility curve AA tangents to
international price line PiPi. At this point it will produce more quantity of good X at
the cost of good Y. Country A will expand the output of good X by MN by
contracting the output of good Y by EM. If country A wishes to maintain
consumption of good X at the old level of OX, it can now export MN quantity of
good X and get in exchange ME2 quantity of good Y. Hence, the gain from trade to
country A is equivalent to EE2 of good Y. the country A is now able to be at a
higher equilibrium point E2 on its indifference curve I2I2. In the absence of trade,
this point cannot be reached by country A as it is beyond its production possibility
curve.
B.A. PART - II 6 ECONOMICS

Similarly, under trade, country B would expand production of good Y by TS

by contracting good X output by TE1. If it would like to maintain pre-trade level of
consumption of good Y, it can export TS quantity of good Y and obtain TE3 quantity
of good X and attain equilibrium at point E3 which cannot be reached under the
absence of international trade. The gain to country B will be equivalent to E1E3 of
good X.

In the above analysis, it is assumed that the country A would wish to

maintain the pre-trade level of consumption of good X and the country B the pre-
trade consumption of good Y. But the real situation may be different. Consumption
of these commodities by the respective countries may be less or more than under
the absence of international trade so that community welfare could be maximized.

c) Decreasing opportunity cost and international trade

If MRT between X and Y goods goes on decreasing, then opportunity cost

curve or production possibility curve will be concave to the origin.
B.A. PART - II 7 ECONOMICS

In Figure, AA and BB are the production possibility curves for country A

and country B respectively. In the situation of autarky, production equilibrium of
country A is determined at R point, where its domestic price line EE tangents to its
production possibility
Y curve AA. Similarly, the production equilibrium of country B
is at S point. Under the situation of international trade, the international price ratio
is depicted by AB line. The relatively greater steepness of EE line to international
price line AB shows that country A will specialize in the production of good Y. On
the other hand, the relatively grater steepness of international price line AB than FF
line indicates that country B will specialize in the production of good X. In other
words, country A will export good Y and import good X; whereas country B will
export good X and import good Y. The equilibrium point for both the countries,
determined by tangency between community indifference curve and international
price line will lie somewhere on AB line. Such point will indicate a higher level of
satisfaction than either at R or S, signifying the gain from trade to the both
countries.
Critical Appraisal

The critical appraisal of Haberler‘s opportunity cost theory can be

discussed under two heads namely

1. Superiority over comparative cost theory, and

2. Criticisms.
B.A. PART - II 8 ECONOMICS
1. Superiority over Comparative Cost Theory

Haberler‘s opportunity cost theory is regarded as superior to the

comparative cost theory of international trade formulated by the classical
economists like Adam Smith and David Ricardo. The arguments put for the
superiority are summarized below:

a. Dispenses with the Unrealistic Assumption of Labour Theory of

Value: The classical theory is based on the unrealistic assumption of labour
theory of value. But Haberler‘s opportunity cost theory dispenses with such
unrealistic assumption and is more realistic.
b. Analyses the Pre-trade and Post-trade situations Completely: The
opportunity cost theory analyses pre-trade and post-trade situations under
constant, increasing and decreasing opportunity costs, whereas the
comparative cost theory is based on the constant cost of production within
the country with comparative advantage and disadvantage between the two
countries. Hence, Haberler‘s opportunity cost theory is considered to be
more realistic over the classical theory.
c. Highlights the Importance of Factor Substitution: The opportunity cost
theory highlights the importance of factor substitution in trade theory. It is
vital in the production process especially for a growing economy.
d. Facilitates the Easy Measurement of Opportunity Cost: The opportunity cost
can be measured easily.
e. Explains the time, reason etc. about Trade: The opportunity cost theory
explains why trade takes place or when it should take place, showing how
the gains shared between the countries etc.
f. Explain about the Complete Specialization: It explains when complete
specialization is possible and when it is not possible etc.

2. Criticisms

Haberler‘s opportunity cost theory is also not free from criticisms. It has been
vehemently criticized by Jacob

a. Inferior as a Tool of Welfare Evaluation: Jacob Viner says that opportunity

cost approach is inferior as a tool of welfare analysis when compared to classical
real cost approach. Further he says that the doctrine of opportunity cost fails to
measure real costs in the form of Sacrifices or Disutilities.
B.A. PART - II 9 ECONOMICS
b. Fails to consider Changes in Factor Supplies: Viner further criticizes that
the production possibility curve or opportunity cost theory do not consider
changes in the factor supplies.

c. Fails to consider Preferences for Leisure against Income: Viner also criticizes
the opportunity costs theory on the ground that the production possibility curve
does not take into account the preference for leisure against income.

Unrealistic Assumptions: Haberler‘s opportunity cost theory is based on many

assumptions like two countries, two commodities, two factors, perfect
competition, perfect factor market, full employment, no technical change etc. All
these assumptions are unrealistic because they do not hold in the real world.

Though the Mercantilists, an early school of Economists, were the first

to advocate a series of measures to regulate international trade, it was Adam
Smith who provided the basic principles which influenced thinking on the
subject for a long time. His method was to apply the benefits of specialisation
to the international economy on the assumption that international trade was
no different from internal trade of a country, if trade barriers were done
away with. He wrote in “Wealth of Nations” 1, “It is the maxim of every
prudent master of a family, never to attempt to make at home what it will
cost him more to make than to buy. All of them find it in their interest to
employ their whole industry in a way in which they have some advantage
over their neighbours and to purchase with a part of it whatever else they
have occasion for. What is prudence in the conduct of every private family
can scarce be folly in that of a great kingdom. If a foreign country can
supply us with a commodity cheaper than we ourselves can make it, better
buy of them with some part of the produce of our country employed in a way
we have some advantage.”
Adam Smith thus argued that relative advantage resulting from
absolute differences in costs are the basis for international trade. But it was
Ricardo who formulated the Law of comparative costs, which postulated that
international trade would be possible even where absolute advantage did not
exist. Ricardo’s theory has been considerably refined and developed by later
economists like Senior, Mill and Taussig.
To take a simple example :
Commodity Labour costs of output
Country A Country B
Wheat (Kgs.) 10 8
Cloth (Meters) 20 10
B.A. PART - II 10 ECONOMICS
According to Adam Smith’s theory, trade could have taken place only
if one country produced more of one commodity per unit of labour input
than of the other commodity in which the second country was more
productive. However, in our example, country A can produce more of wheat
as well as cloth per unit of labour than country B. The comparative cost
theorists show that even in such a situation trade would take place. For
though, A has an absolute cost advantage in both, its comparative advantage
is greater in cloth than in wheat. Similarly, B is better placed in the
production of wheat (relative to A) than in the production of cloth. Thus, 20
metres of cloth would buy 16 kgs. of wheat against only 10 Kgs. in A; while
B could obtain 16 metres of cloth by exporting 8 Kgs. of wheat against only
10 in its domestic market. Thus, both sides can make a profit and trade will
go on as long as relative production of wheat drops to 5 kgs. per unit of
labour in B or alternatively, it rises to 16 Kgs. in A. We can restate our
findings as follows :
"A country will tend to export the commodity whose relative cost or
comparative cost of production is lower than it is in the other country. No
international trade will occur if there are no differences in relative
production costs between countries.” 1
Implicit in the above discussion is the Labour Theory of Value and
hence the argument that prices equal labour costs. The labour theory of
value is not generally accepted as valid because labour is neither
homogenous nor the sole factor of production. Labour market consist of
numerous qualitatively different sub-groups known as “non-competing
groups.” Even if labour were indeed homogenous and commended a single
wage rate in a perfectly competitive market, there remains the more
fundamental objection that labour is not the only factor of production. Goods
are produced by various combinations of land, labour and capital, which
may affect both productivity and profitability and, therefore, the structure of
trade. Assumptions of labour theory of value also ignore money cost
differences resulting from productivity differences. Nor does it take into
account the causes underlying wage differences which may not always
reflect real labour costs. Other economists have criticised the comparative
cost theory for ignoring transport costs which can also effect the pattern and
direction of trade. Equally valid criticism has been advanced against the
implicit assumptions of constant costs and constant returns to scale.
We can conceive of trade taking place until a situation is reached
when the ratio of the cost of producing the two commodities at home equals
B.A. PART - II 11 ECONOMICS
this ratio abroad. At this point trade will come to a stop for want of further
gain from it. Obviously, the greater the disparity in cost ratios between the
two countries, the larger is the volume of profitable trade.
It is not within the scope of this lesson to discuss the determinants
and the role of international prices and foreign exchange rates. But it may
be noted, in passing, that the rate of exchange between two national
currencies serves to convert relative cost differences into prices and hence
may be significant to the direction and volume of trade predicted by the law
of comparative costs.
The foreign account explains the classical theory of comparative costs
as formulated by Ricardo and refined by Taussig. However, the theory has
been analysed further and as a result modified and extended. Its modern
versions reject the labour theory of value and restate it in terms of
opportunity costs. This was first done by G. Harberler in 1933. 1
Since every country has a given factor supply and given technology,
at least in the short period, therefore, some of the possible alternative
commodities, which could have been produced, will have to be foregone.
Thus, there is an opportunity cost represented by the next best combination
of commodities which may have been produced but for the scarcity of the
resources. For simplicity of exposition, we assume, as Haberler did that there
are only two factors of production, viz., capital and labour which can be
used to produce wheat and/or cloth. The economic problem is to decide
which of the two, or what combination of the two commodities to produce,
because with a given factor supply, a country’s production possibilities are
necessarily limited. The greater the quantity of wheat that is produced, the
less cloth will be manufactured and vice versa.
B.A. PART - II 12 ECONOMICS

In figures 1 (a) and (b), we have drawn hypothetical linear production

frontier (or possibility) curves for countries A and B. These diagrams show
that with given resources and optimum efficiency country A could produce
either 50 Kgs. of wheat or 0 Metres of cloth or a combination of the two
commodities indicated by the line AB, which shows the marginal rate of
substitution (transformation) between the two commodities. Similarly,
Combination of the two indicated by the curve CD for country B. Since the
curves are linear, opportunity costs and so the rate of substitution
(transformation) is constant. Therefore, 1 Kg. of wheat would exchange for
0.6 Metres of cloth in country A and 1.5 Metres of cloth in country B. It is
apparent that A has comparative advantage in the production of wheat while
B is relatively more efficient in the production of cloth and both the
countries will gain if a specializes in wheat and B in cloth production. This
can be illustrated with the help of the following figure which is derived from
figure 1 (a) and (b).
B.A. PART - II 13 ECONOMICS

The initial consumption level in country B is at point b on the BC

linear function which gives it Oa of cloth and Od of wheat. As trade between
A and B begins the former will specialize in wheat production and latter in
cloth. So B manufactures OB amount of cloth, of which it consumes Oa at
home and exports B a to A in return for ac amount of wheat. Thus it adds
bc to the previous level of wheat consumption which was ab, without any
reduction in consumption of cloth. So B is a net gainer, but A is neither
well off nor worse off. It simply moves from point P (not shown here) on A.
B curve to point C representing a different combination of wheat and cloth
than before, without loss or gain because the movement is along the same
linear constant opportunity cost curve. This example, however, can be easily
reversed to show the gains in favour of A. But international transactions are
seldom based on the sided gain, and it often happens that as trade takes
place between two products at the two domestic rations, represented by the
line BE in our diagram. In this case, the two countries share the gains
under the new terms of trade, the gain to B will be measured by bF and that
of A by Fc.
Thus, to generalize from the above discussion of comparative
(opportunity) costs, trade results from different production functions and/or
commodity exchange ratios between different countries. It leads to
B.A. PART - II 14 ECONOMICS
specialization by each country in the production of commodities in which it
has a comparative (opportunity) cost advantage, and as a result of it, the
combined production of all the commodities grows, enabling each country to
consume more of it than before trade began. The ratio in which goods are
exchanged between countries is known as “terms of trade” and in the
present case they may be described without the intervention of money. The
limit to the commodity terms of trade are set by the domestic exchange
ratios prevailing in the two countries and the actuals are determined by the
force of the internal demand. The terms of trade are relevant not merely for
determining the quantity and pattern of trade between different countries
but also between sectors within the same economy, e.g. between the
agricultural and industrial sectors. The terms of trade between sectors
within an economy determine relative costs, required level of consumption
and the magnitude of import and export trade that can take place. Thus
“internal terms of trade determine the “external” terms of trade and the
environment in which trade takes place.”
It may be noted that we have drawn a straight line curve because we
have assumed constant (opportunity) costs. However, there is no reason that
they must always be constant. If we have increased (opportunity) costs, the
curve would be convex to the origin. It will be concave to the origin, if the
costs are decreasing.
B.A. PART - II 15 ECONOMICS
In the foregoing figure, we display the production possibilities and
gains from specialization based on increasing opportunity costs. The two
curves A, and B, have different slopes because with identical marginal rates
of substitution (transformation) no trade would be possible. The slopes of the
tangents Pa and Pb represent the domestic terms of trade between the two
commodities in the two countries before the trade opens. Country A
produces OW 3 amount of wheat and OC 3 of cloth. B produces OW 1 of wheat
and OC 1 of cloth. It is evident that A has comparative advantage in wheat
and B in cloth production, and it will be mutually advantageous for them to
specialize accordingly.
International prices are determined by the interaction of demand and
supply in the same manner as domestic prices are. Thus the line PP-
tangential to the production possibilities (substitution) curves of both the
countries indicates the equilibrium points at which trade between them
would stablize. It shows that B can profitably decrease its output of wheat
from OW 1 to OW 2, and increase its output of cloth from OC1 to OC 2. Keeping
its domestic consumption of cloth constant and equal to OC 4. It can now
export C 4C2 amount of cloth of A, in return for W 2W 4 equivalent of wheat
imports from that country. On the other hand, A will increase its output to
wheat from OW 3 to OW 4 by reducing its output of cloth OC 3 to OC 4. But its
total consumption of cloth will increase to OC 2 (i.e. OC 4 domestic output +C 4
C2 imports from B). Likewise, in B the consumption of wheat, will rise to OW4
i.e., OW4 (domestic output) + W2 W4 (imports from A). Thus both the countries
are able to obtain and consume more of cloth or wheat, as the case may be,
than they could obtain before trade began. But at the same time both had to
reduce their consumption of other commodity-A had to reduce consumption
of wheat from OW 3 to OW 2 and B of cloth from OC 1 to OC 4. It is, therfore, a
moot point whether the two countries are better off on the whole, or not. The
answer to this question would be that, if the gain from increased
consumption of one commodity at a price lower than what would have
prevailed in the absence of trade, outweigh the loss from reduced
consumption of the other commodity whose comparative costs of production
were higher than country as a whole gains from trade. Thus the final verdict
involves careful weighting to benefits and costs.
So far we have assumed implicity, the absence of transport costs as a
factor in determining comparative (opportunity) costs. We may now relax this
assumption and consider the impact of transport costs (or to give it another
B.A. PART - II 16 ECONOMICS
name-economic distance) on the international trade flows. We may define
transport costs as the difference between the value of the product ex-factory,
and its value at the point of delivery to the buyer consumer. The first impact
of transport costs is to raise the import (FOB) price of the commodities
traded. As a result, there will be a decline in consumption levels of the
imported commodities in the trading countries, which in turn will bring
about a shift in production pattern. Now the countries concerned will have
to reduce their degree of specialization and the volume of trade between
them will be reduced. The transport costs would modify the structure of
their economies because they reduce the differences in comparative
opportunity costs and thereby reduce the gains expected from international
trade. Finally, transport costs do not effect the pattern of trade, except in
cases, where they are so high as to completely nullify comparative
advantages before absorption of transportation costs.
However, this loss of gain can be countered, if we consider the
possibilities of decreasing (opportunity) costs-instead of constant and/or
increasing (opportunity) costs, which we have considered till now. To
analyse the implication of decreasing (opportunity) cost, we again assume
zero transport costs for the sake of simplicity. Transportation costs can be
introduced into the analysis, mutatis mutandis, as indicated in the preceding
paragraph.
B.A. PART - II 17 ECONOMICS
In the above figure, the ANC curve shows the transformation from
increasing to decreasing opportunity cost. While wheat production is
characterised by increasing opportunity costs throughout the stretch of ANB
curve, cloth production is not if it is expanded beyond the critical point N
at which the curve becomes convex to the origin. The country will then gain
significant economies of scale which will alter the commodity terms of trade.
The tangent represents the existing terms of trade giving Oa output of wheat
and Ob output of cloth. Export of wheat equals to dD and import of cloth dT,
while consumption level is given by T which lies outside the marginal
substitution (transformation) curve. But as output moves beyond N towards
C, less and less of wheat would have to be sacrificed for each marginal
increase in cloth output, which is now subject of decreasing costs. Thus
there will be a rapid shift in production. Even if complete specialization does
not take place, the country will gain by extending production of those
commodities in which possibilities of economies of scale exist.
Now we must extend our analysis to cover multilateral trade. So far
we have analysed the theory of comparative costs on a bilateral basis with
commodities. No doubt it is often bilateral but not always so. India’s trading
arrangements with Communist block countries are under bilateral trade
treaties, but that with other countries are generally on a multilateral basis
and so is most of international trade around the world. As such we must
now lift our analysis out of the two country straight jacket and extend it to
explain multilateral trade.
However, this does not mean that we can simultaneously take into
account all the countries of the world with whom a country may have trade
relations in the numerous commodities which it may be manufacturing. For
them by permutation and combination, the number of possible outcomes will
be infinite and it would be practically impossible to find out the precise
direction of world commodity trade, especially for the fact that comparative
costs themselves are constantly changing due to economic and non-
economic factors. We will, therefore, limit ourselves to a group of four major
countries which we known have substantial trade relations, viz., India,
Britain, USSR and USA. By comparing the domestic pre-trade price-ratios
(terms of trade) for any groups of commodities, a ranking in order of
comparative advantages can be derived. The following table gives a
hypothetical ranking in respect of commodities X and Y on the basis of
assumed price rations :
B.A. PART - II 18 ECONOMICS
Country Commodities & Ranking
X Y
Britain 1 4
USSR 2 3
India 3 2
USA 4 1
On the basis of above ranking, it can be seen that the pattern of trade
expected would be something like the following diagram :

The foregoing table and diagram give an idea of the multilateral trade
between four countries. It is possible to analyse the most probable
commodity composition of any single country’s trade with another country
by similar ranking of the various commodities in terms of comparative costs.
Thus, a general approximation can be made regarding the direction and
commodity composition of trade among countries. But more remains to be
known. No mention has yet been made of the factor endowments which
affect comparative cost difference. To this we shall turn in the next lesson.
contrary to Heckscher Ohlin theory. But it ignores differences in
production methods between the two countries.
Thus, though Heckscher-Ohlin theory explains why trade takes place,
it is not accepted by modern economists as a full or complete explanation
of the emerging pattern of trade in manufactured commodities between
countries with similar economic structures. S.B. Linder has addressed
himself to this problem. Explanation of trade pattern from comparative cost
theories down to factor endowment theories have concentrated on the
B.A. PART - II 19 ECONOMICS
analysis of supply side. They have virtually ignored the implications of
demand for international trade. If a country has a buoyant home market for
a certain commodity it guarantees a substantial demand which enables
production to expand with resulting economics of scale, and the possibility
of a surplus over domestic consumption emerging for export. Since
economies with similar structure and more specifically, similar income
levels tend also to be competitive, they offer better prospects for export
performance than dissimilar economies. Hence according to Linder, two
specific conditions must be fulfilled for trade between two countries to grow.
First, the economies of scale in the domestic economies should be such as
to enable costs of production to be reduced so that product becomes
competitive abroad, and secondly, general economic conditions in foreign
markets must be similar to those in domestic market.
In a somewhat different manner Kravis argues that determinant of the
pattern of trade is the elasticity of supply within the trading countries. But
he also argues that in the real world today, the volume and direction of the
trade depends more on tariffs and foreign exchange and the nature of
intervention by the state which regulate foreign trade and influence the
terms of trade, rather than factor endowments and factor intensities.
B.A. PART - II ECONOMICS
(SEMESTER-IV) MACRO ECONOMICS &
INTERNATIONAL ECONOMICS

LESSON NO. 2.2 AUTHOR : DR. GOVIND KHANNA

MODERN THEORY OF INTERNATIONAL TRADE

In the preceding lessons we have discussed the comparative cost basis of
trade between countries. No mention was made therein of factor endowments
which affect comparative cost differences. The theory sought to explain how
comparative cost differences made trade mutually advantageous to the trading
partners but did not offer any hypothesis as to how the pre-trade cost ratios
differ between countries. The modern theory, on the other hand, goes behind
these pre-trade cost ratios and seeks to predict the pattern to trade on the basis
of the characteristics of pre-trade equilibria. Thus, modern theory (Heckscher-
Ohlin) begins where the neo-classical (opportunity cost) theory of comparative
advantage leaves off.
In 1919 Eli Heckscher published a paper on, “The Effects of Foreign Trade
on the Distribution of Income” 1 in which he explained how factor endowments
affect comparative cost differences. Unlike the classical theory, which make
these differences dependent on the productivity of only one factor viz. labour,
Heckscher’s theory, which has been subsequently developed considerably by
Bertil, Ohlin takes a multiplicity of factors into account. It makes the
possibilities and pattern of trade department on these quantitative differences
and the degrees of intensity with which the factors of production are used.
However, Ohlin is of the view that even if two countries are equally endowed,
profitable trade may still be possible between them, because differences and the
degrees of intensity with which the factors of production are used. However,
Ohlin is of the view that even if two countries are equally endowed, profitable
trade may still be possible between them, because differences in demand
patterns could give rise to differences in prices of the products. 2
Differences in demand can be due to different patterns of income
distribution, or the organisation of production activity as well as other
institutional factors. A distinction, must, therefore, be made between physical
abundance of a factor and its cheapness. The latter depends upon a balance
between demand and supply, in which the former, when it outweigh the latter,
can make the balance of comparative advantage against the abundant factor and
1. Ekonomiks Tidsknift vol. XXI (Ap. 497-912) 1919 - Reprinted in Reading in “The
Theory of International Trade” Edition.
2. Inter-regional and International Trade (Harvard University Press), 1935.
20
B.A. PART - II 21 ECONOMICS
in favour of the relatively scarce one. Also, where factor-substitution at the
margin is possible, change in relative factor prices, e.g., a rise in wage rates
may convert the labour intensive goods into capital intensive ones.
Furthermore, factor endowments may themselves be affected by inter-
regional and international trade. Thus, there is a two way interaction between
trade and economic structure of a country and also the distribution of income
which effects the pattern of demand. Heckscher was of the view that free trade
tends to equalize relative return of factors of production.
On the face of it, the theory seems to be quite reasonable and pragmatic.
It suggests that countries which have an abundance of a factor (e.g. labour)
should specialize in the production of those products in which labour intensive
technology may be more efficient, because abundance would make wage rates
and wage costs lower and thus give it a comparative advantage in labour
intensive products. It can then export these products and import capital
intensive product from those countries which have an abundance of capital
relative to labour. Similarly, it could import land intensive products from those
countries which have an abundance of land relative to labour or capital. Thus
each country will end to specialize in the products which utilize the factor of
which it has an abundant supply, and a pattern of trade will emerge such as the
one suggested by the following diagram :-

As shown in the above figure, labour-intensive commodities are exported

from country L to K and N, and capital-intensive commodities flow into country
L and N from country K. Similarly, country N exports land-intensive commodities
to the other two countries. However, as these transactions take place, the
economies of the two countries are gradually changed. As L exports “Labour
B.A. PART - II 22 ECONOMICS
intensive” commodities, more and more ‘surplus’ labour is absorbed and
gradually, real wages rise till what was once an abundant resource becomes
scarce. If real wages rise to the same level as in country K, the initial
advantage completely disappears. Secondly, as the country L imports “Capital
intensive” goods their scarcity is reduced and with growing abundance, their
prices begin to fall. The two processes may go on till the difference between two
countries is bridged. Reciprocal change may take place in the country K, where
“Capital intensive” commodity will become less abundant with consequent rise
in prices and “Labour intensive” commodity may become relatively more
abundant with consequent decline in prices.
Thus, trade between the two countries tends to equalize both factors and
commodity prices and it does so by bringing about corresponding changes in
economic structure which tends to make their economies similar inspite of
dissimilar factor endowment. From this, one should not jump to the conclusion
that if only international trade is freed from all restrictions, as the classicals
wanted, there would come a complete equalization of factor and commodity
prices throughout the world. Such a conclusion would be unwarranted.
Heckscher and Ohlin do not imply complete equalisation, which is impossible in
the real world due to many products, changing techniques and production
functions, differing character of people, geographical factors etc. As such, all
that can be said is that international trade tends to equalize prices, other
things remaining the same.
Another significant aspect of international trade highlighted by
Heckscher-Ohlin’s factor endowment approach to international trade is in
respect of distribution of incomes, which results in shifts in production.
International trade leads to specialization by each country in one of the specific
type of goods, such as capital intensive or labour intensive. As a result, there
is transference of resources and changes in capital/labour ratios in the
production of both commodities in both the countries. If factor prices reflect the
marginal productivities of factors, then in the capital abundant country real
wages will tend to fall and will tend to be redistributed in favour of capital and
against the working classes. The impact in labour abundant country will be the
opposite. In either case regulation of international trade with a view to regulate
distribution of income would be justified. But we shall postpone this question to
a later lesson dealing with commercial policy.
A treatment of international economics shall be incomplete until we deal
with the demand side also, because it is the interaction between demand and
supply which determines the equilibrium of the economy. This can be
demonstrated with the help of the following diagrams, refering to two countries,
which we assume, have identical factor endowments, technologies, production
B.A. PART - II 23 ECONOMICS
functions and therfore, identical production possibility (substitution/
transformation) curves. But tastes and preferences and, therefore, demand
curves (Community indifference curves) are different.
AB curves represents the identical production possibilities of the
countries. Pre-trade price ratios (terms of trade) are represented by tangentical
lines P 1 (Country A) and P 3 (Country B) which have different shapes. The
difference is not due to supply functions, but demand functions which are
represented by the curves D 1 (Country A) and D 3 (Country B). These provide the
basis for gains from trade. As trade begins price ratios (terms of trade) change
and equalize along P2 curve. In country A production and consumption are given
by the coordinates of point S 1 in the pre-trade period. But as price ratios change
to P 2 line, production shifts to the coordinates of point T 1 with consumption
rising to point R 1 on the higher indifference curve D2. The country will be
importing a a 1 equivalent from country B and exporting b 1b2 of the commodity.

Y Y

Similarly, in country B, with price ratios shifting from P3 to P 2 line,

production of the two commodities will shift from the coordinates of S 2 to those
of point T 2 and consumption will advance to point R 2 on the indifference curve
D4. The country B will now import d1d 2 amount of commodity X and export c 0c 1
amount of commodity Y.
Thus the structure of production and consumption are simultaneously
transformed as a result of differences in consumer preferences, and both
countries gain in economic welfare resulting from specialization, improvements
in economic efficiency and increased consumption.
The above is a simplified version of the modern theory propounded by
B.A. PART - II 24 ECONOMICS
Heckscher and Ohlin. Now we take a critical look at its assumptions and
postulates.
Firstly, tastes are largely similar between countries and, therefore,
demand factors are homogeneous and identical. Thus community indifferences,
become possible and differences in pre-trade price ratios are then attributed to
differences, in production possibilities frontiers of the countries involved in
trade. At the same time production possibilities frontiers become a function of
its factor endowments and the production functions of the various commodities
which are assumed to be linear homogenous since the production function are
further postulated to identical in the two countries. Therefore, any differences
in the shape of production possibilities frontiers can be due only to differences
in factor endowments.
With a single technique of production for commodity X, and a single
technique for commodity Y, the two commodities can always be classified
unambiguously into labour-intensive or land-intensive relative to the one or the
other commodity. The only exception to this rule would be the case where the
expansion paths of the two commodities coalesces over the entire range. But
this would then become akin to a single commodity case from our point of view,
and, therefore, outside the purview of the present discussion.
However, usually more than one technique of production is known to
exist for each commodity. In such cases, it is not always possible to
unambiguously classify two commodities in terms of factor intensity. Sometime
it is and sometimes it is not.

In the above diagram, the two techniques of producing commodity X are

given by the co-ordinates of E and F on XX 1 isoquant curve. Similarly, the
coordinates of C and D on the isoquant curve YY 1 give the two techniques for
B.A. PART - II 25 ECONOMICS
producing the commodity Y. If we assume that technique E and F can be
combined (without any interaction between them) to produce one unit of X and
similarly, techniques C and D can be combined to produce one unit of Y, then
it is obvious that one unit of X can be produced by any combination of land and
labour which is between the EF segment of the isoquant XX 1. Similarly, for the
CD segment of the YY 1 isoquant. Thus, it is apparent from their above figure
that commodity Y is labour-intensive relative to X and that commodity X is land-
intensive relative to Y. This follows from the fact that the shaded areas X and
Y do not overlap. However, such unambiguous classification would not have been
possible if the shaded area X and Y overlapped, each wholly or partially. In that
case, the conclusion would depend on the selection of the optimum expansion
paths of the two commodities. The selection of the optimum expansion path
depends upon factor price ratio and the marginal rate of substitution of labour
for land. If both industries pay the same factor prices, the optimum expansion
path would correspond to the identical marginal rates of substitution of labour
for land. But since factor prices are not given to begin with, it is not possible
to decide which commodity is labour-intensive and which is land-intensive.
Hence, commodity Y is defined to be labour-intensive relative to another
commodity X if commodity Y uses more of labour per unit of land than
commodity X for all factor price ratios.
Unfortunately, there exist particular parts of isoquants for which
commodities X and Y cannot be unambiguously ranked in terms of factor
intensity and Heckscher-Ohlin requirements cannot be met.

The diagram alongside represents a case where Heckscher-Ohlin

B.A. PART - II 26 ECONOMICS
condition cannot be met. The isoquant of commodity Y is L shaped while that of
X is smooth. They touch at only one point S through which the line OS, which
defines the expansion path of commodity Y passes. But X expansion path is not
so uniquely defined. It depends on the factor-price ratios. When the factor-price
ratio is the slope of x at point S, then X’s expansion path coalesces with that
of Y. However, for any factor-price ratio lower than x, such as at point N (on XX’
curve, X’s expansion path is flatter than Y’s. This makes Y labour-intensive
relative to X. On the other hand any factor price ratio higher than x (such as
point M on XX’) will make X labour intensive relative to Y. Therefore, in this
particular case, an unequal classification of commodities by factor intensity is
possible. In such cases, known as factor-reversal, Heckscher-Ohlin theorem
becomes very difficult to follow since it is based on the implicit assumption that
commodities can indeed be classified a priori, in terms of factor intensity. When
this implicit assumption is not met, the structure of trade need not coincide
with the pattern implicit in Heckscher-Ohlin theorem.
Similarly, when the ranking of commodities is contradictory between
countries, the logic of Heckscher-Ohlin theorem breaks down because it is
impossible for both countries, to export the commodity which uses more
intensively their abundant factor.
Heckscher-Ohlin theory has been empirically tested by Prof. W.W.
Leontief. But we will be surprised to see the conclusion that “American
participation in the international division of labour is based on its specialisation
in labour-intensive rather than capital intensive lines of production. In other
words, this country resorts to foreign trade in order to economize its capital and
dispose of its surplus labour, rather than vice-versa. This has come to be known
as ‘Leontief Paradox’.
Leontief sought to explain it in terms of superior effectiveness of the
American worker as compared to foreign workers. W. Vanek thought that though
U.S. is capital abundant, it may not be effective in terms of production because
of the relative scarcity of cooperate natural resources. R. Robinson on the other
hand, sought to explore it from the demand side and felt that at high levels of
income, the consumption of capital intensive goods may be so high that a
country may have to import it. While W.P. Travis argued that factor endowment
cannot be the basis of determining trade-patterns is a tariff-ridden world. But as
Ellsworth argued production functions are not identical as between different
countries, especially those at different levels of economic and technological
development, as Ohlin assured. Thus the basic assumption of the theory, is
rarely fulfilled in the real world.
It may be appropriate to mention here, that an Indian economist Dr.
Raghunath Bhardwaj has tested Heckscher Ohlin theory with reference to
B.A. PART - II 27 ECONOMICS
Indian trade. He found that India’s export to the USA are of capital intensive
goods while its imports from USA are labour intensive. This may seem to be
contrary to Heckscher Ohlin theory. But it ignores differences in production
methods between the two countries.
Thus, though Heckscher-Ohlin theory explains why trade takes place, it
is not accepted by modern economists as a full or complete explanation of the
emerging pattern of trade in manufactured commodities between countries with
similar economic structures. S.B. Linder has addressed himself to this problem.
Explanation of trade pattern from comparative cost theories down to factor
endowment theories have concentrated on the analysis of supply side. They
have virtually ignored the implications of demand for international trade. If a
country has a buoyant home market for a certain commodity it guarantees a
substantial demand which enables production to expand with resulting
economics of scale, and the possibility of a surplus over domestic consumption
emerging for export. Since economies with similar structure and more
specifically, similar income levels tend also to be competitive, they offer better
prospects for export performance than dissimilar economies. Hence according to
Linder, two specific conditions must be fulfilled for trade between two countries
to grow. First, the economies of scale in the domestic economies should be such
as to enable costs of production to be reduced so that product becomes
competitive abroad, and secondly, general economic conditions in foreign
markets must be similar to those in domestic market.
In a somewhat different manner Kravis argues the determinant of the
pattern of trade is the elasticity of supply within the trading countries. But he
also argues that in the real world today, the volume and direction of the trade
depends more on tariffs and foreign exchange and the nature of intervention by
the state which regulate foreign trade and influence the terms of trade, rather
than factor endowments and factor intensities.
B.A. PART-II ECONOMICS
Semester - IV MACRO ECONOMICS AND
INTERNATIONAL ECONOMICS
Lesson No. : 2.3 Author: Dr. Manisha

Terms of Trade and Principle of Reciprocal Demand

1 Introduction
2 Types of terms of trade
2.1 Commodity terms of trade
2.2 Gross barter terms of trade
2.3 Income terms of trade
2.4 Single factoral terms of trade
2.5 Double factoral terms of trade
2.6 Real cost terms of trade
2.7 Utility terms of trade
3 Factors affecting terms of trade
4 Theory of Reciprocal Demand
5 Short answer type Questions
6 Long answer type Questions
7 Suggested Books

1 Introduction
The terms of trade refer to the rate at which the goods of one country
exchange for the goods of another country. It is a measure of the purchasing
power of exports of a country in terms of its imports, and is expressed as the
relation between export prices and imports prices of its goods. When the export
prices of a country rise relatively to its import prices, its terms of trade are said
to have improved. The country gains from trade because it can have a larger
quantity of imports in exchange for a given quantity of exports. On the other
hand, when its import prices rise relatively to its export prices, its terms of trade
are same when a country is in trade there are many types of terms of trade which
are as follows:
2.1 COMMODITY TERMS OF TRADE
The commodity or net barter terms of trade is the ratio between the prices
of a country's export goods and import goods. Symbolically, it can be expressed
as T = Px/Pm, where T, stands for the commodity terms of trade, P for price, the
subscript x for exports and m for imports.
To measure changes in the commodity terms of trade over a period, the
ratio of the change in export prices to the change in import prices is taken.
28
B.A. Part-II 29 Economics

where the subscripts 0 and 1 indicate the base and current periods.
Taking 1991 as the base year and expressing India's both export prices and
import prices as 100, if we find that by the end of 2001 its index of export prices
had fallen to 90 and the index of import prices had risen to 110. The terms of
trade had changed as follows:

It implies that India's terms of trade declined by about 18 per cent in 2001 as
compared with 1991, thereby showing the worsening of its terms of trade.
If the index of export prices had risen to 180 and that of import prices to
150, then the terms of trade would be 120. This implies an improvement in the
terms of trade by 20 per cent in 2001 over 1991.
This concept has been used by economists to measure the gain from
international trade.
Despite its use as a device for measuring the direction of movement of
the gains from trade, this concept has important limitations.
Usual problems associated with index number in terms of coverage, base
year and method of calculation arise. The commodity terms of trade are based
on the index numbers of export and import prices. But they do not take into
account changes taking place in the quality and composition of goods entering
into trade between two countries. Another serious difficulty in the commodity
terms of trade is that it simply shows changes in export and import prices and
not how such prices change. The concept of the commodity terms of trade
throws no light on the "capacity to import" of a country. Suppose there is a fall in
the commodity terms of trade of India. It means that a given quantity of Indian
exports will buy a smaller quantity of imports than before. Along with this
trend, the volume of Indian exports also rises, may be as a consequence of the
fall in the prices of exports. The commodity terms of trade also ignore a change
in the productive efficiency of a country.
2.2 GROSS BARTER TERMS OF TRADE
The gross barter terms of trade is the ratio between the quantities of a
country's imports and exports. Symbolically, Tg = Qm/Ox where Tg stands for
the gross terms of trade, Qm for quantities of imports and Qx for quantities of
B.A. Part-II 30 Economics

exports. The higher the ratio between quantities of imports and exports, the
better the gross terms of traded.
To measure changes in the gross barter terms of trade over a period, the
index numbers of the quantities of imports and exports in the base period and
the end period are related to each other.

Taking 1991 as the base year and expressing India's both quantities of
imports and exports as 100, if we find that the index of quantity imports had
risen to 160 and that of quantity exports to 120 in 2001, then the gross barter
terms of trade had changed as follows:

It implies that there was an improvement in the gross barter terms of

trade of India by 33 per cent in 2001 as compared with 1991.
If the quantity import index had risen by 130 and that of quantity
exports by 180, then the gross barter terms of trade would be 72.22. This
implies deterioration in the terms of trade by 18 per cent in 2001 over 1991.
The concept of gross barter terms of trade has been criticised for lumping
together all types of goods and capital payments and receipts as one category in the
index numbers of exports and imports. There are no units applying equal to rice
and to steel, or to export (or import) of capital and the payment (or receipt) of a
grant. It is, therefore, not possible to distinguish between the various types of
transactions which are lumped together in the index.
2.3 INCOME TERMS OF TRADE
Dorrance has improved upon the concept of the net barter terms of trade
by formulating the concept of income terms of trade. This index takes into
account the volume of exports of a country and its export and import prices (the
net barter terms of trade). It shows a country's changing import capacity in
relation to changes in its exports. Thus the income terms of trade is the net
barter terms of trade of a country multiplied by its export volume index. It can
be expressed as on the next page :
B.A. Part-II 31 Economics

Where, Ty is the income terms of trade, Tc the commodity terms of trade

and Qx the export volume index.
A rise in the index of income terms of trade implies that a country can
import more goods in exchange for its exports. A country's income terms of
trade may improve but its commodity terms of trade may deteriorate. Taking
the import prices to be constant, if export prices fall there will be an increase in
the sales and value of exports. Thus while the income terms of trade might have
improved, the commodity terms of trade might have deteriorated. The income
terms of trade is called the capacity to import. In the long-run, the total value of
exports of a country must equal its total value of imports, i.e. PxQx=PmQm or
Px.Qx/Pm=Qm. Thus PxQmlPm determines Qm which is the total volume that a
country can import. The capacity to import of a country may increase if other
things remain the same the price of exports (Px) rises, or the price of imports
(Pm) falls, or the volume of its exports (Qx) rises. Thus the concept of the income
terms of trade is of much practical value for developing countries having low
capacity to import.
But the index of income terms of trade fails to measure precisely the
gain or loss from international trade. When the capacity to import of a country
increases, it simply means that it is also exporting more than before. In fact,
exports include the real resources of a country which can be used domestically
to improve the living standards of its people. Moreover, the income terms of
trade index is related to the export-based capacity to import and not to the total
capacity to import of a country which also includes its foreign exchange
receipts. For example, if the income terms of trade index of a country has
deterierated but its foreign exchange receipts have risen, its capacity to import
has actually increased, even though the index shows deterioration.
2.4 SINGLE FACTORAL TERMS OF TRADE
The concept of commodity terms of trade does not take account of
productivity changes in export industries. Professor Viner has developed the
concept of single factoral terms of trade which allows changes in the domestic
export sector. It is calculated by multiplying the commodity terms of trade
index by an index of productivity changes in domestic export industries. It can
be expressed as:
B.A. Part-II 32 Economics

where Ts is the single factoral terms of trade, Tc is the commodity terms

of trade, and Fx is the productivity index of export industries.
It shows that a country's factoral terms of trade improve as productivity
improves in its export industries. If the productivity of a country's export
industries increases, its factoral terms of trade may improve even though its
commodity terms of trade may deteriorate. For example, the prices of its
exports may fall relatively to its import prices as a result of increase in the
productivity of the export industries of a country. The commodity terms of
trade will deteriorate but its factoral terms of trade will show an improvement.
This index is not free from certain limitations. It is difficult to obtain the
necessary data to compute a productivity index. Further, the single factoral
terms of trade do not take into account the potential domestic cost of
production of import industries in the other country. To overcome this
weakness, Viner formulated the double factoral terms of trade.
2.5 DOUBLE FACTORAL TERMS OF TRADE
The double factoral terms of trade take into account productivity
changes both in the domestic export sector and the foreign export sector
producing the country's imports. The index measuring the double factoral
terms of trade can be expressed as

where Td is the double factoral terms of trade, Px/Pm is the commodity

terms of trade, Fx is the export productivity index, and Fm is the import
productivity index.
It helps in measuring the change in the rate of exchange of a country as
a result of the change in the productive efficiency of domestic factors,
manufacturing exports and that of foreign factors manufacutirng imports for
that country. A rise in the index of double factoral terms of trade of a country
means that the productive efficiency of the factors producing exports has
increased relatively to the factors producing imports in the other country.
In practice, however, it is possible to calculate an index of double
factoral terms of trade of a country. But it has not been possible to construct a
double factoral terms of trade index of any country because it involves
B.A. Part-II 33 Economics

measuring and comparing productivity changes in the import industries of the

other country with that of the domestic export industries
2.6 REAL COST TERMS OF TRADE
This index is calculated by multiplying the single factoral terms of trade
with the reciprocal of an index of the amount of disutility per unit of productive
resources used in producing export commodities. It can be expressed as:

where Tr is the real cost terms of trade, Ts is the single factoral terms of
trade and Rx is the index of the amount of disutility per unit of productive
resources used in producing export commodities.
A favourable real cost terms of trade index shows that the amount of
imports received is greater in terms of the real cost involved in producing export
commodities. But this index fails to measure the real cost involved in the form of
goods produced for export which could be used for domestic consumption to pay
for imports.
2.7 UTILITY TERMS OF TRADE
The utility terms of trade index measures "changes in the disutility of
producing a unit of exports and changes in the relative satisfactions yielded by
imports, and the domestic products foregone as the result of export
production." In other words, it is an index of the relative utility of imports and
domestic commodities foregone to produce exports. The utility terms of trade
index is calculated by multiplying the real cost terms of trade index with an index
of the relative average utility of imports and of domestic commodities foregone.

where u is the index of relative utility of imports and domestically foregone

commodities. Thus the utility terms of trade index can be expressed as:

Since the real terms of trade index and utility terms of trade index involve
the measurement of disutility in terms of pain, irksomeness and sacrifice, they
are elusive concepts. As a matter of fact, it is not possible to measure disutility
(for utility) in concrete terms.
B.A. Part-II 34 Economics

Hence like the single and double factoral terms of trade concepts, the
concepts of real and utility terms of trade are of little practical use. They are
only of academic interest. That is why the concepts of the commodity terms of
trade and of income terms of trade have been used in measuring the gains from
international trade in developed as well as developing countries.
3 FACTORS AFFECTING TERMS OF TRADE
The terms of trade of a country are influenced by a number of factors
which are discussed as under:
1. Reciprocal Demand
The terms of trade of a country depend upon reciprocal demand, i.e. "the
strength and elasticity of each country's demand for the other country's
product". This also relates to the determination of the equilibrium terms of trade.
Suppose there are two countries, India and Bangladesh, which produce
linen and cloth respectively. If India's demand for Bangladesh's cloth becomes
inelastic, the price of cloth rises more than the price of linen, the commodity
terms of trade will move against India and in favour of Bangladesh. On the other
hand, if Bangladesh's demand for India's linen becomes more intense, the price
of linen will rise more than the price of cloth, and the commodity terms of trade
will move in favour of India and against Bangladesh.
2. Changes in Factor Endowments
Changes in factor endowments of a country affect its terms of trade.
Changes in factory endowments may increase exports or reduce them. With
tastes remaining unchanged, they may lead to changes in the terms of trade.
3. Change in Technology
Technological changes also affect the terms of trade of a country. The
effect of technological change on terms of trade is favourable for the country
which has improved its product technically.
4. Changes in Tastes
Changes in tastes of the people of a country also influence its terms of
trade with another country. Suppose Bangladesh's tastes shift from India's
linen to its own cloth. In this situation, Bangladesh would export' less cloth to
India and its demand for India's linen would also fall. Thus Bangladesh's terms
of trade would improve. On the contrary, a change in Bangladesh's taste for
India's linen would increase its demand and hence the terms of trade would
deteriorate for Bangladesh.
5. Economic Growth
Economic growth is another important factor which affects the terms of
trade. The raising of a country's national product or income over time is called
economic growth. Given the tastes and technology in a country, an increase in
its productive capacity may affect favourably or adversely in terms of trade.
B.A. Part-II 35 Economics

6. Tariff
An import tariff improves the terms of trade of the imposing country and
for other country it will be unfavourable.
7. Devaluation
Devaluation raises the domestic price of imports and reduces the foreign
price of exports of a country devaluing its currency in relation to the currency
of another country. The commodity terms of trade will deteriorate only when
export prices fall more than import prices in terms of domestic currency. In
reality, the elasticities of demand and supply for exports and imports of a
devaluing country determine deterioration or improvement in its terms of trade. If
both the foreign demand for exports and home demand for imports are highly
elastic and supplies both to home exports and foreign imports are highly
inelastic to price movements, devaluation leads to an improvement in the
commodity terms of trade.
4. Theory of Reciprocal Demand
Ricardo expounded the theory of comparative advantage without explaining
the ratios at which commodities would exchange for one another. It was J.S. Mill
who discussed the latter problem in detail in terms of his theory of reciprocal
demand. The term 'reciprocal demand' introduced by Mill to explain the
determination of the equilibrium terms of trade. It is used to indicate a country's
demand for one commodity in terms of the quantities of the other commodity it is
prepared to give up in exchange. It is reciprocal demand that determines the terms
of trade which, in turn, determine the relative share of each country. Equilibrium
would be established at that ratio of exchange between the two commodities at
which quantities demanded by each country of the commodity which it imports
from the other, should be exactly sufficient to pay for one another.
To explain his theory of reciprocal demand, Mill first restated the
Ricardian theory of comparative costs. "Instead of taking as given the output of
each commodity in two countries, with the labour costs different, he assumed a
given amount of labour in each country, but differring outputs. Thus his
formulation ran in terms of comparative advantage, or comparative
effectiveness of labour, as contrasted with Ricardo's comparative labour cost."
Assumptions
Mill's theory of reciprocal demand is based on the following assumptions:
1. There are two countries, say, Bangladesh and India.
2. There are two commodities, say, linen and cloth.
3. Both the commodities are produced under the law of constant returns.
4. There are no transport costs.
5. The needs of the two countries are similar.
6. There is perfect competition.
B.A. Part-II 36 Economics

7. There is full employment.

8. There is free trade between the two countries.
9. The principle of comparative costs is applicable in trade relations
between the two countries.
Explanation of the Theory
Given these assumptions, Mill's theory of reciprocal demand can be
explained with this example:
Suppose India can produce 10 units of linen or 10 units of cloth within
one man-year and Bangladesh can produce 6 units of linen or 8 units of cloth
with the same input of labour-time. This is because India has an absolute
advantage in the production of both linen and cloth, while Bangladesh has the
least comparative disadvantage in the production of cloth. This can be seen
from their domestic exchange ratios and international exchange ratios.
Before trade, the domestic cost ratio of linen and cloth in India is 1:1
and in Bangladesh 3:4. If they were to enter into trade, India's advantage over
Bangladesh in the production of linen is 5:3 (or 10:6), and in the production of
cloth 5:4 (or 10:8). Since 5/3 is greater than 5/4, India possesses greater
comparative advantage in the production of linen. Thus it is in India's interest
to export linen to Bangladesh in exchange for cloth. Similarly, Bangladesh's
position in the production of linen is 3/5 (or 6/10) and in the production of
cloth is 4/5 (or 8/10). Since 4/5 is greater than 3/5, it is in the interest of
Bangladesh to export cloth to India in exchange for linen.
Mill's theory of reciprocal demand relates to the possible terms of trade
at which the two commodities will exchange for each other between the two
countries. The terms of trade refer to 'the barter terms of trade' between the two
countries, i.e., the ratio of the quantity of imports for a given quantity of export
of a country. And "the limits to the possible barter terms of trade (the
international exchange ratio) are set by the domestic exchange ratios
established by the relative efficiency of labour in each country."
In India 2 inputs of labour-time produce 10 units of linen and 10 units of
cloth, while in Bangladesh the same labour produces 6 units of linen and 8
units of cloth. The domestic exchange ratio between linen and cloth in India is
1:1 and 1:1.33 in Bangladesh. Thus the limits of possible terms of trade are 1
linen: 1 cloth in India and 1 linen : 1.33 cloth in Bangladesh. Thus the terms of
trade between the two countries will be between 1 linen or 1 cloth or 1.33 cloth.
But the actual ratio will depend upon reciprocal demand, i.e. "the
strength and elasticity of each country's demand for the other country's
product." If India's demand for Bangladesh's cloth is more intense (inelasic),
then the terms of trade will be nearer 1:1. India will be prepared to exchange
one unit of linen with one unit of cloth of Bangladesh. The terms of trade will
B.A. Part-II 37 Economics

move against it and in favour of Bangladesh. Consequently, India's gain from

trade will be less than that of Bangladesh. On the other hand, if India's
demand for Bangladesh's cloth is less intense (more elastic), then the terms of
trade will be nearer 1:1.33. India will be prepared to exchange its one unit of
linen with 1.33 units of cloth of Bangladesh. The terms of trade will move in
favour of India and against Bangladesh. Consequently, India's gain from trade
will be greater than that of Bangladesh.
Mill's theory of reciprocal demand is explained diagrammatically in terms
Marshall's offer curves.
In fig. 13.1, Bangladesh producing only cloth is taken on the horizontal
axis and India producing only linen is taken on vertical axis. The curve OE is
Bangladesh's offer curve. It shows how many units of cloth Bangladesh will give
up for a given quantity of linen. Similarly, OG is the offer curve of India which
shows how many units of Linen India is prepared to give up in exchange for a
given quantity of cloth. The point T where the two offer curves OE and OG
intersect is the equilibrium point at which OC of cloth is exchanged by
Bangladesh of OL of linen of India. The rate at which cloth is exchanged for
linen is equivalent to the slope of the ray OT.

LINEN

CLOTH
Figure 2.1
A change in the demand on the part of one country for the product of the
other country brings about a change in the shape of its offer curve. Suppose
Bangladesh's demand for India's linen increases. Bangladesh might now be
prepared to exchange more cloth for India's linen. Consequently, Bangladesh's
offer curve shifts to the right as OE1 which intersects India's offer curve OG at T1.
Now Bangladesh trades OC1 units of cloth for OL1 units of linen. The terms of
B.A. Part-II 38 Economics

trade, as shown by the slope of the OT1 indicate that they have deteriorated for
Bangladesh and improved for India. This is evident from the fact that Bangladesh
trades CC1 units of cloth for LL1 units of linen. CCl is greater than LL1
Similarly, if India's demand for Bangladesh's cloth increases, India's
offer curve shifts to the left as OG1 which intersects Bangladesh's offer curve
OE at T2. Now India exchanges OL2 units of linen for OC2 units of cloth. The
terms of trade, as shown by the slope of the OT2, indicate that they have
deteriorated for India and improved for Bangladesh.This is clear from the fact
that India exchanges LL2 more linen for CC2 less cloth, i.e. LL2>CC2
But the actual terms of trade will depend upon the elasticity of demand
of the offer curve of each country. The more elastic the offer curve of a country,
the more unfavourable will be terms of trade for it in relation to the other country.
On the contrary, the more inelastic is its offer curve, the more favourable will
be its terms of trade in relation to the other country.
Its Criticisms
Mill's theory of Reciprocal Demand is based on almost the same unrealistic
assumptions that were adopted by Ricardo in his doctrine of comparative
advantage. Thus the theory suffers from similar weaknesses. Besides, there are
some additional criticisms made by Viner, Graham, and others.
1. Mill's theory of reciprocal demand does take into account the domestic
demand for the product. As pointed out by Viner, each country would
export its product only after satisfying its home demand. Thus the
demand curve for India would not be below the line Og until the
domestic demand was satisfied, and the same applies to Bangladesh.
2. According to Graham, Mill's analysis is valid only if the two countries
are of equal size and the two commodities are of equal consumption
value. In the absence of these two assumptions, if one country is small
and the other large, the small country gains the most on both counts:
First, if it produced a high-value commodity, it will adopt the cost ratios
of its big partner; and Second, the two trading countries being of unequal
size, the terms of trade will be fixed at or near the comparative costs of
the large country.
3. Mill's theory is based on the unrealistic assumption of two-countries and
two-commodities. Graham, therefore, favours several commodities, several
countries and complex trade.
4. Graham further criticises Mill for emphasising demand and neglecting
supply in determining international values. According io him, the application
of the reciprocal demand makes it appear that demand alone is of interest.
He maintains that production costs (supply) are also of paramount
importance in international trade. He thus attacked the Law of Reciprocal
B.A. Part-II 39 Economics

Demand "as appropriate only to trade in antiques and old masters."

5. Another weakness of Mill's analysis of reciprocal demand is that it makes
no allowance for fluctuations in incomes in the two trading countries
which are bound to influence the terms of trade between them.
6. Further, the theory is based on barter of trade and relative price ratios. Thus
it 'neglects all stickiness of prices and wages, all transitional inflationary and
overvaluation gaps, and all balance of payments problems'. No wonder, the
theory is abstract and unrealistic. Graham, therefore, regards the theory "in
its essence fallacious and should be discarded."
7. Mill's theory is based on such unrealistic assumptions as two countries,
two commodities, law of constant returns, lack of transport costs, full
employment, perfect competition, etc. These make the theory unrealistic.
Conclusion:
But there is little basis in the criticisms made by Graham which appear
to be flimsy. As pointed out by Viner, "The terms of trade can be directly
influenced by reciprocal demands and by nothing else. The reciprocal demands,
in turn, are ultimately determined by the cost conditions together with the
basic utility functions." The real fault in Mill's analysis is that it
overemphasizes the basic utility functions and neglects the production costs.
5 Short Answer Type Questions
1. Examine critically the various concepts of terms of trade.
2. Distinguish between Gross Barter Terms of Trade and Barter Terms
of Trade or Income Terms of Trade and Net Barter Terms of Trade.
3. Discuss the factors which determine the terms of trade.
6. Long Answer Type Questions
1. Name different kinds of terms of trade. Which of these concepts is
most helpful in indicating 'gains from trade'? And why?
2. Analyse the nature and significance of the principle of reciprocal
demand in the theory of comparative costs.
3. Critically discuss Mill's theory of reciprocal demand in the theory
of comparative costs.
7 Suggested Books
1. International Economics: Bo Soderston
2. International Economics: Kindelberger
3. International Economics: Sadama Singh and Vaish.
 B.A. PART-II 40 Economics

B.A. PART-II ECONOMICS

MACRO ECONOMICS AND
INTERNATIONAL ECONOMICS

Lesson No. 2.4 Author : Dr. Manisha Sharma

WORLD TRADE ORGANIZATION (WTO)

1 Introduction
2 Objectives of lesson
3 Role of World Trade Organisation (WTO)
4 Impact of WTO on Various Aspects of Indian Economy
5 WTO and India's Gain as a Founder Member
6 Fourth WTO Conference and the Doha Declaration and India's Role
7 Conclusion
8 Short answer type questions
9 Long answer type questions
10 Recommended books

1 Introduction
The birth of World Trade Organisation (WTO) on January 1, 1995 holds a great
promise for the entire world economy in respect of international trade. This World
Trade Organisation will administer the new global trade rules estal lishing the rule of
law in international Trade, which amounted to nearly five trillion dollars goods and
services. The latest issue of GATAVTO News (January, 1995) observed that the new
global trade rules were achieved after seven years of negotiations among more than
120 countries and through the WTO agreements and market access commitments,
world income is expected to rise by over 500 billion dollar annually by the year 2005
and annual global trade growth will be as much as a quarter higher by the same year
than it would have been otherwise.
2 Objectives of lesson
In this lesson we will discuss WTO and its impact on Indian economy.
3 Role of World Trade Organisation (WTO)
The World Trade Organisation (WTO) is playing an important role for
administering the new global trade rules in the following manner:
(1) The WTO administers, through various councils and committees, the 28
agreements contained in the final act of the Uruguay Round, plus a number of
plurilateral agreements, including one government procurement.
(2) WTO also oversees the implementation of the significant tariff cuts (averaging
40 per cent) and reduction of non-tariff measures agreed to in the trade
 B.A. PART-II 41 Economics

negotiations.
(3) WTO is a watchdog of international trade, regularly examining the trade regimes
of individual members. In its various bodies, members flag proposed or draft
measures by others that can cause trade conflicts. Members are also required
to notify in detail various trade measures and statistics, which are maintained
by the WTO in a large data base.
(4) WTO provides several conciliation mechanisms for finding an amicable
solution to trade conflicts that can arise among members.
(5) trade disputes that cannot be solved through bilateral talks are adjudicated
under the WTO Dispute Settlement Court. Panels of independent experts are
established to examine disputes in the light of WTO rules and provide rulings.
This tougher streamlined procedure ensures equal treatment for all trading
partners and encourages members to live upto their obligations.
(6) WTO is a management consultant for world trade. Its economists keep a close
watch on the pulse of the global economy and provide studies on the main
trade issues of the day. The secretariat assists developing countries in the
implementation of Uruguay Round results through a newly established
development division and strengthened technical co-operation and training
division.
(7) WTO will be a forum where countries continuously negotiate exchange of trade
barriers all over the world. And the WTO already has a substantial agenda for
further negotiations in many areas.
It can be expected that the WTO is different from and an improvement upon
GATT, on the ground that firstly, the WTO will be more global in its membership than
the GATT. Its perspective membership is already around 150 countries and territories,
with many others considering accession. Secondly, the WTO has a far wider scope
than its predecessor, bringing into the multi-lateral trading system for the first time,
commercial activities like trade in services, the exchange of ideas in the context of
intellectual property protection and investment.
4 Impact of WTO on Various Aspects of Indian Economy
India, being a founder member of the WTO, has been following the WTO
decisions, but as a consequence, certain effects on the Indian economy have become
evident.
WTO and Indian Industry
WTO has been urging India to lower import duties, remove controls on consumer
goods imports, reduce quantitative restrictions, etc. Under the Uruguay Round
Agreement, India offered to reduce tariffs on capital goods, components, intermediate
goods and industrial raw materials to 40% in case our tariffs were above that percentage;
to 25% in case our tariffs were between 25 to 40 per cent and to bind the tariff ceiling at 25
 B.A. PART-II 42 Economics

per cent in case our tariffs were below that percentage. This reduction in tariffs was to be
achieved by the year ending 2000.
Since India scrupulously followed the agreement, the tariffs have been reduced
year after year to conform with the WTO provisions. As the protection afforded by import
duties gradually disappeared, Indian industry had to face increasing competition from
foreign goods. Confederation of Indian Industry (CII), the apex body expressed its
disapproval against duty-free status of capital goods sector. As a result, CII estimated
that indigenous capital goods industry on a conservative estimate lost orders worth
Rs. 5,000 crores from foreign countries.
Not only the entire manufacturing industry is faced with a crisis, even machine
tools industry, gensets and boiler producers are put at a serious disadvantage.
Consequently, imports of finished products are displacing indigenously produced
products. As a result, many industrial units are being closed and cheap imports have
become an important cause of recession in Indian industry. India was maintaining
quantitative restrictions in the form of quotas, import and export licences on 2,700
agricultural commodities, textile and industrial products. United States along with
Australia, New Zealand, Switzerland, European Economic Community and Canada
complained to the WTO Dispute Settlement Machinery that these QRS were inconsistent
with WTO norms. The dispute settlement panel gave its verdict against India. India went
in appeal, but the WTO panel on 23rd August 1999 rejected India's appeal against QRs.
As a result, although India could continue QRs till March 2003, the process was
hastened and QRS on all items were removed. This has opened the floodgates for foreign
consumer goods to enter the Indian market, thereby seriously damaging Indian industry.
WTO and SSI Units
WTO agreements do not discriminate on the basis of size of industries or
enterprises. In the WTO regime, reservations may have to be withdrawn, preferential
purchase and other support measures may not be available and thus SSIs have to
compete not only with the large units within the country, but also with cheap imported
products. SSIs are thus losing their markets to cheap imported products. Consequently,
a very large number of SSI units are becoming sick or have closed down. Thus, the ° SSI
sector which accounts for 40 per cent of manufacturing output, 50 per cent of
employment and over 33 per cent of exports is in jeopardy. Next to agriculture, this
sector- is the principal source of employment accommodating 18 million persons. The
rule of survival of the fittest is being applied to this sector and in their game, only a few
able ones will be able to survive. Dumping of Chinese goods has seriously affected SSI
sector. The real difficultly with the SSI sector is that it does not have adequate resources
to prepare the case for anti-dumping duties in view of the prohibitive costs of
anti-dumping investigation. The SSIs cannot collect detailed information on individual
products required by the antidumping directorate to establish a complete case.
 B.A. PART-II 43 Economics

Consequently, small industries continue to suffer due to such dumping policy.

Not only that, the entry of multinationals in ordinary consumer goods like ice
cream, agarbatti manufacture, food processing, mineral water etc. is also adversely
affecting the SSI sector since these were the traditional areas of this sector. In soft
drinks, the entry of powerful Coca Cola and Pepsi have eliminated practically all small
units engaged in the manufacture of aerated water. MNCs are not interested in hi-tech
products. Rather they prefer low technology, quick profit yielding and large volume
products with regular demand throughout the year. In the name of consumer interests,
MNCs continue to swallow SSIs and eliminate them from the market.
WTO and Agriculture
WTO Agreement on Agriculture stipulated that developed countries would
reduce their subsidies by 20 per cent in six years and developing countries by 13 per
cent in 10 years. But as facts stand today, developed countries tried to circumvent this
agreement by providing Green Box and Blue Box subsidies to support agriculture.
Green Box Subsidies include amounts spent on Government services such as
research, disease control, infrastructure and food security. They also include
payments made directly to farmers that do not stimulate production, such as certain
forms of direct income support assistance to help farmers restructure agriculture, and
direct payments under environmental and regular assistance programmes. This definition
is very wide and includes all types of Government subsidies.
Blue Box Subsidies are certain direct payments made to farmers where the
farmers are to limit production, certain government assistance programmes to encourage
agriculture and rural development in developing countries, and other support on a small
scale when compared with the total value of the products supported 15 per cent or less in
the case of developed countries and 10 per cent or less for developing countries.
India's agricultural imports were of the order of US $ 1.86 billion in 2000-01, but
they increased to $ 2.29 billion in 2001 -02. If the surge continues, then the interests of
Indian farmers would be seriously affected. Economic Survey (2002-03) makes a
forthright statement: "India has considerable flexibility to counter flooding of the Indian
market by cheap agriculture imports through the imposition of tariffs (bound rates)
under WTO. WTO permissible tariff rates are reasonably high: 112 per cent for nuts,
150 per cent for sugar and coffee, 100 per cent for tea and cotton, 70 to 100 per cent for
foodgrains, 45 to 300 per cent for edible oils and 40 to 50 per cent for fruits. Countervailing
duties can also be imposed to counter questionable subsidies given to agriculture
products by the exporting countries apart from having the option of acting under
safeguard provisions to counter the surge of imports. In budget 2001 -02, import duties
were raised for many agri products such as tea, coffee, pulses and edible oils. In 2002-03
budget, the import duties were raised for pulses (from 5 to 10 per cent, tea and coffee
(from 70 to 100 per cent), natural rubber, pepper, cardamom and clove (from 35 to 70
 B.A. PART-II 44 Economics

per cent)." (pp. 174-75) So far India has followed the Agreement on Agriculture very
honestly, but honest implementation should not be treated as a sign of weakness. In
case, the US and OECD countries persist in their nefarious game of protective tariffs,
quotas and subsidies for their farmers, India and other developing countries may be left
with no choice but to retaliate. But this would mean the start of a process which may
result in the decline of globalisation world over.
However, this does not mean that at the domestic level, India has no action to
take to improve its agriculture. In fact, the reform process is guilty of neglecting
agriculture. In agricultural infrastructure, the most important is irrigation. The reform
process emphasized the role of the private sector in promoting irrigation. But the
experience of the Ninth Plan as documented in the Tenth Plan reveals that the private
sector invested in irrigation technologies which were mainly extractive such as tube wells.
But these investments are not sustainable unless appropriate investments are made
in rain-water harvesting and recharging of ground water resources. However, data as
provided by CSO reveals that in gross capital formation in agriculture, the share of the
public sector declined from 33 per cent in 1994-95 to merely 23.5 per cent in 2000-01. In
absolute terms, public sector investment declined from Rs. 4,947 crores in 1994-95
(measured at 1993-94 prices) to just Rs. 3,919 crores in 2000-01. Although private
sector investment improved, but it did not fulfill the functions of rain water harvesting and
recharging of ground water resources.
In boosting agri exports, some success has been achieved, but agri-exports which
reached $ 6,004 million in 2000-01, declined to $ 5,871 million in 2001-02.
Another important area which needs attention is to make agricultural credit
available at lower rates of interest. There is no doubt that the total flow of institutional
credit to agriculture which was of the order of Rs. 31,956 crores in 1997-98 has more
than doubled to Rs. 82,000 crores in 2002-03. This is really heartening, but the rate of
interest charged on loans ranges between 14-18 per cent. This implies that the benefit of
declining rates of interest has not been passed on agricultural borrowers. On account of
the efforts of former Agriculture Minister Mr. Rajnath Singh, the Finance Ministry agreed
to reduce interest on farm loans upto Rs. 50,000 to 9 per cent. This step, though in the
right direction, is still inadequate, moreso, in view of the fact interest on housing loans
has been reduced to 8.5 to 10 per cent, it is imperative on the part of the Government to
bring down interest rates on all agricultural loans— short-term, medium-term and
long-term. Accepting the need to reduce interest rate on agricultural loans, Former
Prime Minister Atal Behari Vajpayee on 27th July 2003 announced: "Crop loans below Rs.
50,000 will be charged nine per cent interest and banks are being asked to charge the
rate of interest below the PLRs for agricultural loans.
5 WTO and India's Gain as a Founder Member
In a country like India, the benefits accruing from being a founder member of
 B.A. PART-II 45 Economics

World Trade Organisation (WTO) are immense. At present, only just five per cent of
our tariff lines remain bound. With the finalisation of the Uruguay Round, about 68
per cent of India's tariff lines covering basically raw materials, components and
capital goods, but excluding consumer goods, petroleum, fertilisers and some
non-ferrous metals would have been bound.
The Government is of the view that it is in the long term interest of India to
have low duties on raw materials, components and capital goods since they satisfy the
production needs of the economy.
Regarding the threat arising out of TRIPs, the Commerce Minister, Pranab
Mukherjee is on record saying that exclusive marketing rights to be provided for
patent holders would in no way dilute the national interest in such crucial areas as
agriculture, drugs and pharmaceuticals as enough safeguards had been built into the
system to.take care of the concern voiced by developing countries including India.
India now stands to gain immensely from the membership of WTO. At the
time the question of this country joining the WTO was broadly under consideration,
the opposition political parties strongly opposed our joining the World body. The fears
expressed by the opposition parties regarding adverse effects of membership on
farmers and the agricultural sector, prices of foodgrains due to withdrawal of food
subsidies which would become obligatory under the terms of membership of t h a t
body and life savings drugs require us to enact have all proved almost groundless.
India being a founder country has already started to assert itself in the meetings of
WTO council.
Although a great deal of misinformation has been spread throughout the
country on the otherwise beneficial aspects of the multi-lateral treaty, but it is to be
seen how far these safeguards built into the system by the Government are sufficient
enough to take care the interest of the masses as well as the country as a whole. But
the ultimate impact of the Uruguay Round and the formation of WTO would depend on
gains in productivity in various sectors resulting from realisation of economies of
scale, technology transfer and increased trade and investment.
Moreover, India is also facing a serious threat from the attempt of the
developed countries to introduce social and environmental clauses in multilateral
trading system and thereby imposing countervailing duty on imports from India and
other developing countries. These type of proposals have shocked the experts of the
developing countries because it will deprive the developing countries of their only
competitive advantage arising out of cheap and abundant labour force.
Gains for India
The Commerce and Industry Minister who represented India at the Doha WTO
Conference succeeded in sending a strong message that India can no longer be ridden
roughshod over by the developed countries, more especially US and the European
 B.A. PART-II 46 Economics

Union. The biggest gain was that WTO chairman declared that negotiations on
Singapore issues-investment, competition, labour standards and environment would
be held only after an "explicit concensus" was reached at the Fifth Ministerial. Such a
concensus may not be easy to emerge even in 2003, keeping in view the reservations
expressed by the developing nations at the Doha Conference.
Another major gain was that instead of opening discussion on new issues, it
was agreed under pressure from India and other developing countries that it would be
more advisable to undertake an exercise on a more complete implementation of Uruguay
Round recommendations. This would involve review of bottlenecks and constraints
arising out of the roadblocks in the way of fulfillment of their obligations by the
developed countries. This would be particularly directed towards the US, Japan and
countries of the European Union to open markets to products in which the developing
countries enjoyed a comparative advantage.
The anti-dumping laws of the US were another painful thorn in the flesh of
countries like India in respect of steel and other allied items of manufacture. This was
taken up strongly by India and other member countries. The pressure built on US was
so strong that the US was forced to promise a toning down of its policies and legislation
pertaining to anti-dumping laws.
Growth of E-commerce and WTO Declaration
The growth in e-commerce has added a new dimension to trade policy which
countries have to take account of by formulating rules to keep abreast of the fast
growing technological developments. The WTO General Council agreed on the
comprehensive working definition of electronic commerce as "the production,
distribution, marketing, sale or delivery of goods and services by electronic means".
Electronic transactions involve three stages namely searching, ordering/making
payment, and delivery of products. Electronic delivery of goods is by far the most
challenging aspect from a policy perspective as such trade is compounding rapidly
without any global regulatory framework and hardly any national or international
legislation.
In recognition of the growing importance of electronic commerce in international
trade, the Second Ministerial Declaration of the WTO at Geneva adopted a declaration
on global electronic commerce on May 20, 1998, which directed the WTO General
Council to establish a comprehensive work programme to examine all trade related
issues arising from electronic commerce. The work programme includes issues like
characterisation of electronic transmission as goods or services or something else:
market access involving the method of application of customs duties to electronic
transmission; classification of digitized products under the existing Harmonized
System (HS) of trade classification; rules of origin; standardisation; development
dimensions involving the effect on revenue and fiscal positions of developing countries
 B.A. PART-II 47 Economics

in future ; etc. The 1998 declaration also included a so-called moratorium stating that
"members will continue their current practice of not imposing customs tariffs on
electronic transmission". The work programme was adopted by the WTO General
Council on September 25, 1998.
6 Fourth WTO Ministerial Conference and the Doha Declaration and India's Role
In the fourth Ministerial Conference at Doha, India played a proactive role in the
deliberations. India preferred a genuine resolution of implementation related concerns,
increased market access in agriculture, sufficient flexibility and clarity under TRIPs for
public health policies and strongly opposed the introduction of non-trade issues like
labour in the agenda. It was able to ensure adoption of an agenda that emphasised
not only trade but also the developmental goals and priorities of developing countries.
It is the insistence of India that forced the WTO to amend its draft resolution at
the eleventh hour even by extending the scheduled time to suit the interests of
developing nations status, particularly, on the issues related to foreign investment,
competition policies and environment. The conference primarily focussed its discussion
on the related issues pertaining to global recession. Accordingly, the Declaration was
also made— "We are determined particularly in the light of global economic slow-down,
to maintain the process of reform and liberalisation of trade policies, thus ensuring
that ,the system plays its full part in promoting recovery, growth and development.
As per the WTO norms, the member nations, out of its obligations, cannot
discriminate against one another's goods and companies without showing any valid
and justified reasons. But due to the violation of rules, most of the developing nations
have failed to reap any benefits of WTO. It is a matter of happiness that in Doha, under
the able leadership of India, the developing nations have been to able redress their
grievances that they have fared much badly than they should have under globalisation
and now the system should be changed to such an extent so that they should realise a
greater share of benefits. Now the agreement so reached does not. give any immediate
relief to the developing nations but the agreement ommits that the WTO members to
negotiate reductions in tariff, especially on products of export interest to developing
countries and the higher level of tariffs applied on goods such as textiles on which the
developing countries have much better competitive strength. Moreover, under the
active pressure of developing countries, the Doha Conference and its declaration also
agreed to include anti-dumping on the WTO agenda.
The mandated negotiations as per Article 20 of the Agreement on Agriculture
commenced in 2000. Considering its importance, India has submitted its
comprehensive proposals in the areas of Domestic Support, Market Access, Export
Competition and Food Security. The proposals keep in view the objectives of protecting
India's food and livelihood security concerns by having freedom for taking all domestic
policy measures for poverty alleviation, rural development and rural employment as
 B.A. PART-II 48 Economics

also to create opportunities for expansion of agricultural exports by securing

meaningful market access in developed countries. India, with a view to garner support
of other developing countries, also co-sponsored two proposals with other countries :
one on market access and another on export credit for agricultural products. It is quite
true that due to higher rate of export subsidies provided by EU, the agricultural prices
in the developed countries have been kept at lower level deliberately thereby depriving
the Third World countries to get the benefits from its agricultural exports. However,
the issue was temporarily resolved by accommodating a clause in the declaration that
the negotiations in this issue would be held "without prejudging" the outcome.
Under TRIPs, India has been seeking greater flexibility and clarity in the
interpretation of the Agreement on TRIPs in order to ensure affordable access to
essential medicines and life saving drugs, in keeping with the public health concerns
of developing countries. India, the African group of countries, Barbados, Bolivia, Brazil,
Dominican Republic, Philippines, Peru, Sri Lanka, Thailand and Venezuela jointly
submitted a paper on TRIPs and Public Health to the TRIPs Council in which India,
along with other co-sponsors had demanded that the WTO should ensure that TRIPs
Agreement does not undermine the right of the WTO members to formulate their own
public health policies and adopt measures for providing affordable access to medicines.
Finally, the Doha declaration affirms that the TRIPs Agreement can and should be
interpreted and implemented in a manner supportive of WTO members right to protect
public health and, in particular, to promote access to medicines for all.
7 Conlusion
A survey of the globalisation policies followed in India reveals that the promised
benefits of globalisation in the form of sharp increase in GDP, exports, foreign direct
investment, reduction of poverty, deceleration of unemployment could not be realised
by India during the 1990s. Globalisation has adversely affected Indian industry, it has
enabled the developed countries to pusrrtheir exports to India at a much faster rate, but
did not facilitate the process of access to international markets; small scale industry
has suffered due to the policy of dumping practised by developed countries, more
especially in consumer goods. The most distressing part of the story is the double
standards practised by the developed countries which manifest in the form of unfair
agreement on textiles; a policy marked by a bias in favour of the farmers of developed
countries as against the poor farmers in India. Developed countries brought forth
spurious environmental and social issues to prevent the exports from India of such
commodities in which the country possessed comparative advantage.
8 Short answer type questions
1. Write a short note on WTO?
2. What are blue box subsidies?
B.A. PART-II 49 Economics

3. What are green box subsidies?

4. Write a short note on Doha meeting
9 Long answer type questions
1. What is the impact of WTO and Indian economy?
2. Explain the role of WTO.
10 Recommended books
Datt and Sundaram : Indian Economy
P.K. Dhar : Indian Economy
Mishra and Puri : Indian Economy
A. N. Aggarwal : Indian Economy
B.A. PART-II ECONOMICS
(SEMESTER-IV ) MACRO ECONOMICS AND
INTERNATIONAL TRADE
LESSON NO. : 2.5 DR. MANISHA

SOUTH ASIAN ASSOCIATION OF REGIONAL COOPERATION (SAARC):

Origin and growth of India’s trade with SAARC

1 Introduction
2 Objective of lesson
3 Objectives and principles of SAARC
4 Organisation of SAARC
5 Features of SAPTA
6 Indo-SAARC trade relations
7 Appraisal of SAARC
8 Achievements of SAARC
9 Problems of SAARC
10 Summary
11 Glossary
12 Short answer type questions
13 Long answer type questions
14 Recommended books

1 Introduction
The modern industrial system rests upon such techniques that can be employed
economically only if the production takes place on a very large scale. This requires
expanding markets on the one hand and increasing purchasing power on the other.
For the fuller exploitation of the production potential of the modern techniques, certain
countries having small internal geographical markets, have attempted to organise
themselves into regional groupings. This is also called economic integration. The
economic integration in the broadest sense means the unification of distinct economies
into a single larger economy. SAARC is one such type of economic integration. This
association was formed by the South Asian countries including India, Bangladesh,
Pakistan, Nepal, Bhutan, Sri Lanka and Maldives in December, 1985.
2 Objectives of the lesson
In this lesson we will discuss about SAARC, its objectives, organisation,
achievements and problems.
3 Objectives and Principles of SAARC
The SAARC has placed before it the basic goal of rapid economic and social
50
B.A. Part-II 51 Economics
development of the countries of the region through the optimum utilisation of the
collective material and human resources.
Objectives: The objectives of the Association, as specified in the Article I of the
Charter of the SAARC are as under:
(1) Promotion of the welfare of the people of South Asia and improvement in the
quality of their life.
(2) Acceleration of economic growth, social progress and cultural development in
the region and provision for all individuals the opportunity to live in dignity
and to realise their full potentials.
(3) Promotion and strengthening of collective self-reliance among the countries of
South Asia.
(4) Making of contribution to mutual trust, understanding and appreciation of
each other’s problems.
(5) Promotion of active collaboration and mutual assistance in the economic, social,
cultural, technical and scientific fields.
(6) Strengthening of co-operation with other developing countries.
(7) Strengthening of co-operation among themselves in international forums on
the matters of common interest
(8) Promotion of co-operation with intranational and regional organisations with
similar aims and purposes.
Principles: The Article II of the SAARC Charter has spelled out the following principles:-
(i) Co-operation within the framework of Association shall be based upon the respect
for the principles of sovereign equality, territorial integrity, political independence,
non-interference in the internal affairs of other states and mutual benefit.
(ii) The co-operation among the members of the Association shall not be substitute
for bilateral and multilateral co-operation but shall be complementary to them.
(iii) The co-operation among the member nations shall not be inconsistent with
bilateral and multilateral obligations.
4 Organisation of SAARC
The organisation of SAARC is comprised of the Summit, SAARC Secretariat,
Council of Ministers, Standing Committee, Programming Committee and Technical
Committees.
The summit is the highest policy making authority of the Association
constituted by the heads of all the member countries. The summit called as the
council meets almost every year in member countries on a rotational basis. If even
one of the head of member state can not attend the meeting, it is not possible to hold
the meeting of the council.
The SAARC Secretariat, co-ordinates and monitors the execution of the activities
of SAARC, services the meetings and serves as the channel of communication between
SAARC and other international organisations. It was set up at Kathmandu (Nepal) on
B.A. Part-II 52 Economics
January 16, 1987. The, SAARC secretariat is headed by the Secretary-General, who
is appointed by the Council of Ministers upon nomination by a member state on the
principle of rotation in the alphabetical order for a fixed period of 3 years. Apart from
the Secretary General, the secretariat includes also seven Directors, one from each
state and the general services staff : The directors are appointed by the Secretary
General: upon nomination by member states for a period of three years. The term of
the directors can be extended, in special circumstances by another three years by
The Secretary General, in consultation with the concerned member states.
Nepal bore the initial cost of the establishment of the Secretariat. The recurring
expenditures on SAARC are shared among the member countries. India contributes
32 percent of the total expenditure followed by Pakistan that contributes 25 percent of
it. Bangladesh, Nepal and Sri: Lanka each accounts for 11 percent and Bhutan and
Maldives each accounts for 5 percent of it.
There is also the Council of Ministers which is constituted by the Foreign
Ministers of all the member states of SAARC. The council of ministers is entrusted
with the responsibilities to formulate policies, to review progress, to decide on further
areas of co-operation, to establish additional mechanisms as deemed necessary and
to decide on other matters of general interest of the Association. The meeting of the
Council of Ministers in held twice a year. It may have an extra-ordinary session, if all
the members states agree to do so.
The SAARC organisation, in addition, includes a Standing Committee, a
Programme Committee and Technical Committees. The Standing Committee is
constituted by the foreign secretaries of the member states. Its responsibilities are to
monitor and co-ordinate programmes, to work out modalities of their financing, to
determine intersectoral priorities, and to mobilise regional and external co-operation.
This committee normally meets twice a year and submits its report to the Council of
Ministers. The standing committee can institute action committees for the
implementation of projects, comprised of more than two member countries. All the
member countries may not have the representation on it.
In order to assist the standing committee, there is a Programme Committee
comprised of senior officials. It is an adhoc body and meets prior to the sessions of the
standing committee. It is entrusted with the tasks of the scrutiny of budget of the
secretariat, to finalise the annual schedule of its activities, to deliberate upon any
other matters assigned by the standing committee, to consider the reports of the
technical committees and SAARC Regional Centres and to submit its comments to the
standing committee. There are at present 12 Technical Committees related to
agriculture, rural development, environment, health, population activities, transport,
communications, science and technology, tourism etc. These committees include the
representatives of all member states. They prepare programmes and projects in their
respective areas. They monitor and execute the activities in their fields and submit
B.A. Part-II 53 Economics
reports to the standing committee through the Programming Committee. There is
rotation of chairmanship of every technical committee among the member countries
in the alphabetical order every two years.
Self check exercise
Q1. What are the main objectives of SAARC?
Q2. Explain the organisation of SAARC.
Q3. Discuss the important features of SAARC.
5 South Asian Preferential Trading Arrangement (SAPTA)
At the Eighth Summit of SAARC held in New Delhi in May 1995, the member
countries unanimously endorsed an agreement known as South Asian Preferential Trading
Arrangement (SAPTA). The ministerial committee recommended that member countries
should complete the process of ratification of SAPTA by November 8, 1995. India ratified
it on September 22, 1995. After its ratification by all the member countries, SAPTA became
operational on December 7, 1995, the tenth anniversary of the formation of SAARC.
Features of SAPTA: The main features of SAPTA are as follows:
(i) Objectives: The main objectives of SAPTA include the promotion of sustenance
of intra-regional trade and economic co-operation among the SAARC nation
through the extension of tariff and other concessions.
(ii) Basic Principles: The basic principles of the arrangement are enshrined in the
Article 3 of the Agreement. According to this Article, all member states of SAARC
will secure benefits equitably on the basis of reciprocity and mutuality of
advantages. In this regard, the respective levels of economic and industrial
development, pattern of their external trade, tariff and trade policies and system
will, however, be taken into consideration. The negotiations related to SAPTA
shall be carried forward step of step, improved and extended gradually in
successive stages. There will be a periodical review of the agreement. The special
needs of the least developed member countries will be taken into consideration
and accordingly preferential treatment will be given to them.
(iii) Scope: The member countries will provide mutual concessions on all products,
raw materials, semi-processed and processed and manufactures. There shall
be trade liberalisation by preferential arrangements concerning tariffs, para-
tariffs and direct trade measures. The trade negotiations of different types for
the liberalisation of trade on preferential terms will be undertaken on product
by product basis, across the board tariff reductions, sectoral basis of preferences,
direct trade measures.
(iv) Special Preferential Treatment for the Least Developed States: SAPTA
provides, apart from other provisions, for certain special preferential treatment
for, the least developed members of the Association. These include:
(a) By assisting them to enlarge their export potential through technical
assistance, setting up of industrial and agricultural projects linked to
B.A. Part-II 54 Economics
co-operative financing and buy-back arrangements.
(b) By establishing the manufacturing and other facilities in the least
developed member states for meeting their intra-regional demand under
co-operative arrangements.
(C ) By the formulation of export-promotion policies, creation of training
facilities in die fields of trade and extending support to export marketing
through export credit insurance, access to market information etc.
(d) By the removal of non-tariff and para-tariff barriers and the provision of
duty free access, exclusive tariff preferences or deeper tariff preferences
for export products.
(e) By the negotiation of long term contracts for the achievement of
reasonable levels of sustainable exports.
(f) By extending special consideration of exports in the application of
safeguard measures from the least developed member countries.
(g) By the adoption of greater flexibility towards the introduction and
continuance of trade restrictions under critical circumstances by the
least developed member nations.
(v) Balance of Payments and Safeguards: The arrangement permits any member
country, faced with serious economic problems including balance of payments
difficulties, to suspend provisionally the concessions allowed to import goods.
In this regard, SAPTA allows the member countries some safeguard measures.
First, if a product, imported from another member country on concessional
terms in such a manner or in such quantities, that causes serious injury to
importing member country, then the latter may suspend provisionally that
concession. Second, to enable a member country to adopt balance of payments
and safeguard measures, the SAPTA Agreement stipulates the provisions for
information, consultation and dispute settlement.
(vi) Unconditional Extension of Negotiated Concessions: Except the concessions
permitted to the least developed countries, all other concessions agreed upon
under SAPTA, shall be extended to all the member nations unconditionally.
(vii) Committee of Participants: SAPTA makes provision for a committee of
participants including representatives from the member countries. The committee
ensures that the benefits of trade expansion arising from SAPTA agreement accrue
equitably to all the member countries. The meeting of the committee takes place
once a year for the review of the progress in the implementation of the Agreement.
(viii) Non-application of the Agreement: In case the preferences have already been
granted or are to be granted by one state to some other member states, and to
third countries through bilateral plurilateral and multilateral trade agreements
and similar arrangements, the previsions of this Agreement shall not apply to
the member states.
B.A. Part-II 55 Economics
(ix) Modification and Withdrawal of Concessions: Any member country that
has extended concessions, may notify the Committee on Economic Co-
operation (CEC) of its intention to modify or withdraw the concession after a
period of three years. For this, the given country will enter into consultations
and negotiations with another concerned country, and if necessary, negotiate
for appropriate compensation. In case the agreement is reached within six
months, the affected member state may be asked by the CEC to modify or
withdraw the concessions. But in the event of a country leaving SAPTA, the
other member shall be free to withdraw all the concessions extended to it.
(x) Withdrawal from SAPTA: Any member country of the SAARC may withdraw
from SAPTA by giving six month’s prior notice to the SAARC secretariat and
also informing other member states.
Self check exercise
Q4. What is full form of SAPTA?
Q5. Discuss the main features of SAPTA.
6 Indo-SAARC Trade Relations
The SAARC, despite several attempts to encourage regional trade under the
regulation of SAARC and the SAPTA, has not taken an effective shape as a regional
trade body because of political problems between Pakistan and India hampering regional
interests. Despite official declarations to transform the SAPTA into an FTA in this region
by 2001, the idea seems unrealistic. India has had problems with FTAs for its neighbours
do not want free trade with a giant neighbour they do not trust or like. Hence,
multilateralism will remain India’s only choice. During the 10 years before SAARC (1975-
1985), India’s exports increased from US$ 160 million in 1975 to US $ 315 million in
1984 registering a compound growth rate of 7.8 percent. During the 10 years after
SAARC inception, India’s exports increased from US $ 277 million in 1986 to US $ 1532
million in 1995, i.e. from eight percent to 30 percent constituting an additional growth
of 22 percent. So, the SAARC has encouraged India’s exports to its member countries.
Since 1991, liberalization too has increased India’s exports to SAARC countries. From
US $ 622 million in 1991, the exports have touched a peak level of US $ 2005 million in
the year 2000, upping the decadal growth from five percent during the 1980-90
liberalisation to nine percent. Similarly, India’s exports to the world during the pre- and
post- liberalisation periods have witnessed an upward trend. On the other hand, India’s
import from the SAARC countries is quite low. It was just US $ 56 million in 1975 and
rose to only US $ 105 million in 1984 and further to only US $ 182 in 1995. The
immediate reform period has shown a decline in India’s imports from the SAARC
registering a low level of US $ 96 in the year 1993 and later picking up only to US $ 363
million in 2000. They have grown at a constant rate of 7 percent before and after
liberalisation. This shows that India is not a good importer for its neighbouring countries.
While the turnover of India’s trade with SAARC members was US $ 382 million in 1985,
B.A. Part-II 56 Economics
it increased to US $ 1714 million in 1995 and further to US $2368 million in 2000.
So, the increase in India’s trade with SAARC members outclasses the rise in its trade
globally, from US $ 24594 million in 1985 to only US $ 94018 million in 2000.
Before liberalization India exported mostly to Pakistan followed by Bangladesh
and Maldives. But after the liberalization Nepal and Maldives became the major export
destinations. The growth rate of exports to Pakistan had fallen considerably until the
substantial boost of 2005. The tremendous decline in the previous years may be
attributed to the tensions between the two nations. But the growth in India’s export to
the entire bloc has increased from 8.61 percent before liberalization to 12.43 percent
after, showing an increase of 3.82 percent. The growth rate of India’s imports from all
the SAARC nations has been negative before and after liberalisation. Nepal is a major
exporter of Indian products with a high growth rate of about 27.5 percent followed by
Sri Lanka (15.4 percent) and Bangladesh (14.7 percent). Though the volume of trade
with the bloc has increased, India does not have a good trading partner within the
bloc. Except Nepal, all other nations have registered a very low growth rate. Overall,
the growth of India’s exports and imports show a growing trade imbalance between
India and its neighbouring South Asian countries.
Steps towards formal economic cooperation were made with the signing of the
SAPTA in 1993. SAPTA did not achieve much in increasing intra-regional trade either.
Intra-SAARC trade, as a percentage of South Asia’s world trade, increased from 2.42
percent ($1.59billion) in 1990 to 4.56 percent ($6.53 billion) in 2001 and marginally to 4.7
percent by 2003, mostly attributed to rapid liberalisation under bilateral trade agreements
and WTO regimes, rather than to SAPTA. The SAPTA failure is also reflected in the skewed
pattern of trade in the region. Since India has not fully integrated into South Asia, this
purely regional agreement did not expand trade much and failed to address high transport
and transaction costs. The idea of a SAFTA was mooted in 2002, and culminated into an
agreement in January 2004. The SAFTA agreement is expected to come into force from
January 1, 2006 on completion of all formalities. (New date is now July1). SAFTA lists
additional measures not included in the SAPTA such as harmonization of standards,
reciprocal recognition of tests and accreditation of testing laboratories, simplification and
harmonization of customs clearance, import licensing, registration and banking procedures;
removal of barriers to intra-SAARC investment etc.
An expansion of intra-regional trade by 1.6 times the current level as proposed
by SAFTA is not possible in the absence of concomitant moves towards investment
and trade liberalization. If this arrangement is to be successful, the political tensions
will have to be kept at bay and India’s role as a leader would have to be enhanced, as
Roy (2004) points out that India needs to take the lead in greater regional integration
since it accounts for 80 percent of the total South Asia GDP.
BIMSTEC (Bangladesh-India-Myanmar-Sri Lanka-Thailand Economic Co-operation)
This agreement includes Bangladesh, India, Sri Lanka, Thailand, Myanmar,
B.A. Part-II 57 Economics
Bhutan and Thailand. The idea of this regional cooperation was first mooted by
Bangladesh, India, Sri Lanka and Thailand at a meeting in Bangkok in June 1997.
The aim, purpose and principles are contained in Bangkok Declaration of June 6,
1997 on the establishment of the Bangladesh-India-Sri Lanka-Thailand Economic
Cooperation (BISTEC).
At a special ministerial meeting convened in Bangkok on 22 December 1997
the Union of Myanmar was admitted to the grouping renaming it as BIMST-EC
(Bangladesh-India-Myanmar-Sri Lanka-Thailand Economic Co-operation). This is
known as Declaration of 22 December 1997. A ministerial meeting in February 2004
welcomed Bhutan and Nepal as new members.
The inter-regional grouping will serve as a bridge between the five SAARC
countries and two ASEAN countries. BIMSTEC will have a greater potential to increase
the trade among member countries by taking advantage of their geographical location
in the region of the Bay of Bengal and the eastern coast of the Indian Ocean. Discussions
have already been held on building a Trans-Asia Highway linking the five countries
and also setting up a BIMSTEC Airline connecting the capitals and important cities
of the member countries.
Held in Bangkok on 7 August 1998, the first BIMSTEC economic and trade
ministers’ meeting termed as the Retreat, decided that BIMST-EC would initially begin
cooperation efforts in six areas. It was agreed that each country would play a lead role
in planning and implementing programmes in each of the areas. The sectors and lead
countries at the inception were:
Trade & Investment Bangladesh
Technology India
Transportation and Communication Thailand
Energy Myanmar
Tourism Sri Lanka
Fisheries Sri Lanka
Recognising that sub-regional cooperation can progress only in inter-governmental
cooperation and coordination, and that the private sector is an engine of growth for
enhancing interaction between government bodies and the private sector representatives
of the five BIMST-EC countries, the BIMST-EC Economic Forum was conceptualized at
a meeting in Dhaka in 1999. The BIMST-EC Economic Forum is a representative group
of both the public and private sectors, formed to discuss ways for achieving the objectives
of BIMST-EC and making recommendations for the ministerial meetings each year.
BIMSTEC covers a population of approximately 1.3 billion and the trade value
between Thailand and other countries in the group exceeded US$3 billion in 2003.
The forum is unique as the only link between South Asia and Southeast Asia, bridging
South Asia’s Look East policy with Thailand’s Look West policy. BIMSTEC can also be
considered as a mechanism to promote opportunities for trade, investment and tourism
B.A. Part-II 58 Economics
between Thailand and South Asia.
BIMSTEC’s objectives stretch from creation of economic and social prosperity
based on equality, to enhancement of mutual benefits in economic, social and
technological aspects. They also involve intra-regional assistance in training, research
and development as well as beneficial cooperation in agriculture, industry, expansion
of trade and investment, improvement in communication and transport, for improving
living standards and cooperation with other international organisations. India’s trade
with the BIMSTEC countries rose by eight percent in dollar terms and six percent
in rupee terms to reach more than $6.6 billion during 2004-05, according to the
findings of the PHD Chambers of Commerce and Industry.
Reflecting good performance of India’s “New Age Sector”, drugs and
pharmaceuticals, there has been appreciable increase in the country’s exports of such
products to the BIMSTEC countries. The growing thaw in Indo-Myanmar relations
has increased pharma exports to Myanmar by over 36 percent. Export of
pharmaceutical products to Bangladesh that stood at $50 million registered a 19
percent growth. While India’s exports to these countries have grown faster, imports
have remained almost stagnant. Having proved its information technology worth to
the world with aggregate software and services exports of over $ 22 billion, Indian
software industry is making steady inroads into the BIMSTEC countries. Though
starting from a very low base, Indian software exports to Sri-Lanka stood at $1.2
million. Similar trends have also been observed for Bangladesh, Thailand, and Nepal.
Member countries should work towards greater air transport liberalization, short-
sea shipping, and trilateral highway linkages among India, Myanmar and Thailand and
between Bangladesh, Myanmar and Thailand, including linkages with other BIMSTEC
countries. Implementation of transport linkages and physical connectivity among the
member countries would generate huge benefits and expedite the trading process.
7 Appraisal of the SAARC:
SAARC is the trade organisation which is being structured by some very poor
countries of the world primarily directed to accelerate the economic and social
development of the South Asia. Four of the member countries of SAARC-Bangladesh,
Bhutan, Maldives and Nepal are included in the least developed countries. Bhutan
and Nepal are land-locked countries. They can have access to the world market through
the ports of India and Bangladesh. The aggregate of exports of India to other SAARC
countries were of the volume of Rs. 6100.98 crore, while its imports from these countries
were of the magnitude of Rs. 1409.22 crore in 1999. The intra-regional trade of these
countries is only 3.4 percent of the total trade of SAARC nations. It is clear that there
is much potential for expanding the intra-regional trade among these countries.
According to Centre for Global Trade Development (CGTD) Report, the South
Asian Preferential Trading Arrangement will give access to a consumer base of over 425
million people in the middle class bracket and permit the accelerated expansion of
B.A. Part-II 59 Economics
the growing points of the economies of all the countries in the region. With imports of
India as 8 percent of her GDP, 34 percent in Sri Lanka and 17 percent in Pakistan,
Bangladesh and Nepal, the intra-regional trade-creation and trade-diversion effects will
certainly unfold great prospects for the development of the entire region. It is expected
that the combined average growth rate of 7 percent per annum would be realised.
8 Achievements of SAARC
Although SAARC has remained besieged with serious political problems since
its inceptions yet it could register some achievements that are as under:
(i) Removal of trade restrictions: The member countries have undertaken some
steps in the direction of reducing quantitative restrictions on imports from one
another and granted some measure of concessions on trade. From August
1998, India removed quantitative restrictions’ off about 2300 items of import
from member countries. Upto August, 2003, India had permitted concessions
to Pakistan on about 370 items. Pakistan, by that time, had allowed concessions
on import of about 340 items to India. The free-trade agreements have been
negotiated by India with Bhutan, Nepal and Sri Lanka.
(ii) Institution of Technical Committees : In order to promote co-operation among
the member countries in the fields of agriculture, rural development,
environment, health, communications, science and technology, transport,
tourism, education and culture, the technical committees for economic co-
operation have been instituted.
(iii) Poverty-Alleviation Programme: SAARC has adopted the strategy of social
mobilisation, decentralised agricultural development, small labour-intensive
industries and human development. The priority has been given to the right
to work and extension of primary education for the poor. SAARC has created
a three-tier mechanism for exchange of information among member countries
on poverty alleviation programme. In this connection, it has received co-operation
from IBRD, UNDP and ESCAP.
(iv) SAARC Funds: In order to render financial assistance to the member countries,
SAARC has instituted two funds-South Asian Development Fund (SADF) and
SAARC, Japan Special Fund (SJSF). The SADF has three windows-window for
identification of development project, window for institutional and human
resource development and window for social and infrastructural development
(v) SAARC Food Security: The SAARC has set up die SAARC Food Security Board
for making a periodic review of the food situation in the region. A reserve of
2.42 lakh tonnes of foodgrains has been created to tide over any emergency in
the member states.
(vi) SAARC Chamber of Commerce and Industry: A SAARC Chamber of Commerce
and Industry (SCCI) has been instituted with its headquarters in Karachi It
has the aim to promote trade and interaction of chambers of commerce and
B.A. Part-II 60 Economics
industry of seven member countries, to organise trade fairs and to negotiate
with other trade organisations for the expansion of intra-regional trade. The
SCCI has played an important role in the formation of SAPTA and promoting
economic and trade co-operation in the region.
(vii) SAARC Agricultural Information Centre (SAIC) : It was established in 1998
and acts as a central information institution on agriculture-related activities
like forestry, fishery, rice, potato, live-stock etc. It assists in the exchange of
information among the seven member countries also about R & D activities.
The information about research and experiments related to agriculture is
published by SAIC and distributed among the member nations.
(viii) Agreements with International Organisations: For facilitating the social and
economic development of SAARC countries, the memorandum of understanding
have been signed with various international organisations including UNCTAD,
UNDP, UNDCP, ESCAP, ITU and Asia Pacific Telecommunity (APT) etc.
(ix) Formation of South Asian Growth Quadrangle (SAGQ) : In early 2000, India,
Bhutan, Nepal and Bangladesh formed the South Asian Growth Quadrangle
with the aim of the development of Nepal, Bhutan, Bangladesh and Eastern
India and the basin of the rivers Ganga, Meghna and Brahmaputra. The
countries of this area will co-operate in the fields of multi-nodal transport and
telecommunications, effective use of tourism, protection from environmental
hazards and increase in trade and investments.
(x) Bilateral Free Trade Agreements: In order to move towards the creation of
South Asian Free Trade Area (SAFTA), some of the countries of the region have
forged the bilateral free trade area agreements. A major development in this
regard has been the signing of the agreement between India and Sri Lanka on
December 28,1998. Under this agreement, India shall permit the import of
1000 items on zero duty from Sri Lanka and the latter shall permit the duty
free import of 900 items. Similar agreements have also been forged by India
also with Bhutan and Nepal.
Self check exercise
Q6. Make a critical appraisal of SAARC.
Q7. What are the achievements of SAARC?
9 Problems: Although SAARC has attempted to move forward over the years,
yet it has been faced with very serious problems and so far it has not been able to
play its assigned role. These problems are as under
(i) Political, ethnic and religions disputes: The major barrier to the co-operation
among the member countries of SAARC has been long-drawn political, ethnic
and religions disputes among the member countries. Pakistan has been insisting
over the years that co-operation in trade and other matters of social and
economic development can not be possible unless India hands over its state of
B.A. Part-II 61 Economics
Jammu & Kashmir to it.
(ii) Lack of complementarity: The member countries of SAARC mostly produce
same type of products. The successful integration requires dissimilarity in
production rather than similarity. Lack of complementarity in the economies of
these countries is having restrictive effect upon the co-operation among them.
(iii) Preference to trade with hard currency areas: Some of the member countries
of SAARC prefer to enlarge their exports to hard currency areas. As a result,
the promotion of intra-regional trade among the SAARC countries has remained
generally neglected. .
(iv) Deficit in Balance of payments: The countries of SAARC including India are
faced with the problem of persistent BOP deficit and consequent shortage of
foreign exchange. They generally have an inclination to restrict imports and
impose tariff and other restrictions rather then abolishing them.
(v) Competition among themselves: There is competition among some of the
member countries in the export of certain products in the international market.
For instance, India and Sri Lanka compete in respect of tea. India and Pakistan
do so in respect of textiles and clothing. There is competition between India
and Bangladesh in respect of Jute. Such a state of affairs tends to discourage
co-operation among them.
(vi) Infra-structural inadequacies: There is a lack of proper development of
transport, communications, institutional arrangements as well as payment
and clearing arrangements in the region. That is a major impediment in the
expansion of intra-regional trade among the member countries.
(vii) Big brother complex: In view of large geographical area and natural, financial,
technical and manpower resources, the countries like Pakistan and Bangladesh
look at India as big brother who will over-swamp their markets with her products.
India is conscious of such complex among the member countries of SAARC
and has been constrained from extending fuller co-operation in the economic
and social development of other countries of the region.
(viii) Low intra-regional investment: The member countries of SAARC look to the
West and international lending agencies for capital resources and are afraid of
seeking investments from India due to irrational reasons. The intra-regional
investment is only one percent of total investment in the region. In contrast,
43 percent of ASEAN investment and 64 percent of EU investment is intra-
regional. The increase in intra-regional investment by the investors of the
member countries will certainly enhance greater co-operation among
member countries of SAARC in the diverse areas.
(ix) Bilateral preferential arrangements: Some member countries of SAARC have
entered into bilateral agreements with one another for extending trade
concessions. In some cases, these concessions are even more than those assured
B.A. Part-II 62 Economics
under SAPTA. Consequently, there is no added attraction for member
countries to await indefinitely the outcome of SAPTA.
(x) Product by Product Approach: The lack of progress in SAARC negotiations so
far has been on account of the product by product approach of the member
countries in the matter of granting trade concessions. Some of the products
included in the lists for trade concessions are actually not traded among the
member countries. The move towards the creation of South Asian Free Trade
Area (SAFTA) can make headway only if the countries adopt a more wide sector-
based rather than product-based approach in the extension of trade concessions.
(xi) Transport problems: Even though there is technical committee on transport,
created by the member countries, yet the transport facilities are still less
developed. The transit duties are also quite high. It is a major impediment in
the creation of SAFTA.
(xii) Trade barriers: Despite the protracted trade negotiations among the member
countries, there are still high tariffs on several commodities. Pakistan and
Bangladesh impose VAT on all imported goods. All the member countries
continue to levy non-tariff barriers such as quantitative restrictions, restrictive
licenses etc. Pakistan has not yet granted Most Favoured Nation (MFN) status
to India, despite the fact that it is obligatory to do so under the WTO Agreement
by the year 2005. Unless the countries become willing to dismantle the trade
barriers, the avowed goal of creating SAFTA will remain a mirage.
Self check exercise
Q8. What are the problems in growth of SAARC?
Q9. What are the problems in the economic integration of the LDC’s?
10 Summary
In this lesson we have discussed the SOUTH ASIAN ASSOCIATION OF
REGIONAL COOPERATION (SAARC) , its objectives and principles, organisation of
SAARC. It is a sort of economic integration for the fullest exploitation of the production
potential of the modern techniques. South Asian countries have tried to organise
themselves into regional grouping. These countries are India, Bangladesh, Pakistan,
Nepal, Bhutan, Sri Lanka and Maldives and they have formed this association in
December, 1985. No doubt, that with this type of integration market is always expanded
and countries can make full utilisation of resources but some problems are always
faced by the concerned countries.
11 Glossary
Bilateral : Two-sided - when trade is going on in two countries
Free trade area : when there is no restriction in trade.
Self reliant : self -sufficiency.
Negotiation : arbitration
B.A. Part-II 63 Economics
12 Short answer type questions
Q1. What is full form of SAARC?
Q2. Why there is a need of economic integration?
Q3. What are the objectives of SAARC?
Q4. Write a note on organisation of SAARC.
Q5. Discuss the problems of SAARC.
13 Long answer type questions
Q1. Discuss the main features of SAPTA.
Q2. What are the achievements of SAARC?
Q3. Critically evaluate the SAARC.
14 Suggested Readings
International Economics : B. Sodersten
International Economics : Sadama Singh and Vaish
International Economics : D. Salvatore
B.A. PART-II ECONOMICS
(Semester-IV) MACRO ECONOMICS AND
INTERNATIONAL ECONOMICS
LESSON NO. 2.6 AUTHOR : DR. H. G. P. SRIVASTAVA

BALANCE OF PAYMENTS
Meaning and Significance
The balance of payments of a country is a statement showing the various
payments to and from the country in a given period, generally a year. All
transactions in a year which give rise to claims by residents of the country on
foreigners and claims by foreigners on citizen of the country are comprised in
balance of payments. Therefore, the balance of payments may be defined in a
statistical sense as an itemised account of transactions involving receipts from
foreigners on the one hand, and payments to foreigners, on the other. Since the
former relate to the international income of a country, they are called "Credits"
and since the latter to international payments, they are called "Debits".
According to the rules of double-entry book keeping, a nation's receipts and
payments for any given period must be exactly equal. Hence in a way, the balance
of payments will always be in equilibrium. In an open economy, however, total
receipts may differ from total payments. The positive difference is termed as
surplus and the negative difference is termed as deficit in the balance of
international payments of a country.
A country's balance of payments serves as its economic barometer. There are,
however, many things which are only partially explained by it. A surplus or a
favourable balance of payments position is not always a sign of the economic
prosperity of a country nor is adverseness or unfavourable balance of payments
position always an indicator of a country's economic insolvency. A balance of
payments deficit is not, in itself, proof, of the competitive inability of a country in
foreign markets. A detailed analysis of the causes and prospects will be necessary to
determine the magnitude of alarm. The longer a deficit continues, however, the more
it would seem to point to some fundamental deficiencies. Likewise, a favourable
balance of payments position need not always make the government of the country
feel complacent. It can happen that a debtor and economically backward nation at the
time of receiving foreign loans might have surplus in its balance of payments.
Generally speaking, the balance of payments exhibit various aspects of a
country's international economic position. In the case of an underdeveloped
country, the balance of payments will reveal the degree of dependence of the
country's economic development on the financial assistance given by the
industrially advanced capital lending countries. The balance of payments help in
analysing or appraising a nation's short-term international economic prospects,
64
B. A. PART-II 65 ECONOMICS

evaluating the extent of its international solvency and determining the

appropriateness of the foreign exchange rate of the money unit of a national
currency. Comparison of a pair of balance of payments covering a given period
shows changes in the country's trading position, that is, in the relative movements
of exports and imports. The information so obtained could clearly be significant for
the determination of trade and commercial policies. The effect of such changes on
employment and production will also be of value to monetary and fiscal policy.
Distinction between Balance of Trade and Balance of Payments
The term 'Balance of Trade' and 'Balance of Payments' are often
interchangeably used leading to confusion. A country's exports and imports
comprise many items both visible and invisible. Invisible items refer to the services
like shipping, banking and insurance services for which payments are made and
received by a country in the sphere of international trade. The merchandise imports
of a country are constituted by the value of goods purchased by the nationals and
government of the country from those of other countries in a given period. These
have to be paid for and necessitate remittance from the country to various other
countries. The country is debtor to this extent. The exports are the value of goods
sold by its nationals to other country and has to receive payments for them from
aboard. The country is creditor on this account. The net amounts the country has to
pay and receive in a given period from its balance of trade. Balance of trade is,
therefore, the difference between merchandise exports and imports of a country.
The balance of payments has a wider connotation and it comprise the total
debits and credits due to all items on account of which a country makes payments
to rest of the world and receives payments from rest of the world. In this way, the
balance of payments includes both the visible and invisible items. The balance of
trade is only a part of the balance of payments. There is no doubt that it is major
part but its significance is limited. We can very well imagine a situation in which
a country's balance of trade is favourable yet its balance of payments may show
deficit and vice versa. Seen in historical perspective, England's balance of trade
was for long unfavourable but her balance of payments used to be favourable
because on account of exports of visible services and interest earnings on her
foreign investments she used to receive payments more from the rest of the world
than she had to pay the rest of the world on account of imports of visible goods.
Components of Balance of Payments
The emphasis in classical ecomomics was on the export and import and on
the whole, little attention was paid to capital movements. In part the explanation
lies in the classical assumption that capital does not move across national
boundaries or is transferred only with hesitation. Today the position has changed.
It is a rule of book keeping to charge, or debit, the owner of an account for
everything he gets and to credit him for everything he gives up. Therefore, the
B. A. PART-II 66 ECONOMICS

debits and credits can be conveniently linked with payments and receipts. Since a
country's exports or the services i.e. shipping, banking or insurance companies
rendered to others are the items it gives up, they are entered in the balance of
payments as credits. One could equally say that these items give rise to receipts,
when this term is used in connection with the balance of payments. Similarly,
since a country's imports or services rendered to its residents by foreigners are
what the country acquires, they are entered as debits. These items also give rise to
payments on the part of the country concerned and the term payments is used in
this sense is a balance of payments.
As an illustration, we give below the Balance of Payments of Country X:
TABLE I—BALANCE OF PAYMENTS OF COUNTRY X
Debits Credits

Current Account
Merchandise imports Rs. 1800 Merchandise exports Rs. 2300
Services Rs. 300 Services Rs. 200
Donation : Official Rs. 100
————— —————
Rs. 2200 Rs. 2500
————— —————
Capital Account
Short-term Short-term
Capital (Private) Rs. 500 Capital (Official) Rs. 450
Long-term capital Rs. 500 Gold exports Rs. 250
————— —————
Rs. 3200 Rs. 3200
————— —————

It will be seen from the table I, that the most important way in which a
country can acquire foreign currency is by exporting merchandise. This comes to
Rs. 2300. The value of merchandise imports is Rs. 1800/-. These two items relate
to Country X's visible trade and the difference i.e. 500/- indicates the balance of
trade. If a country exports more goods than it imports, it is said to have a favourable
balance or surplus in its balance of trade. Here country X's balance of trade is
favourable. The next item in order of importance relates to services rendered to
foreigners during the period in question or to the services received by the citizen
of the country. In the former case it gives rise to receipts whereas in the latter it
entails payments. Shipping services are significant under this heading because
both exports and imports of merchandise have to incur costs of transportation.
Other types of earnings under this heading are interest and dividends which
B. A. PART-II 67 ECONOMICS

citizens of the country earn on investments abroad. Such payments are regarded
as payments made by foreigners for current services which they derive from capital
in question. Investment income is included in the current account since it is
associated with a service; the use of one's capital. It gives rise to the payments for
the country which has borrowed or in which foreigners own income-earning
property; it is a source of receipts to a lending or investing country. Tourism
constitutes another example and income earned from X this source comes under
the same heading. Other payments falling under this heading are those for
banking and insurance services which are necessary components of modern trade
and commerce. The item of services in table-I figures both on the credit and debit
side, it is 300/- on the debit side Rs. 200/- on the credit side.
Donations differ from ordinary business transactions, such as are included in
the current accounts, in that they do not reflect an exchange of goods or services for
money. They involve no quid pro quo. A person or government transfers
commodities or services or money to some other persons or government and
receives nothing in exchange. The category of donations in a nation's balance of
payments includes a wide variety of transactions : military aid, economic aid,
technical assistance, etc. Frequently, the term "unilateral transfers" is applied to
these transactions to indicate their one sided character. In table I, the value of
donations shown on the debit side comes to Rs. 100.
Even though the country X had a surplus in its balance of trade, this might be
offset by items on other accounts. Country X has a deficit of Rs. 100 in its balance of
services and a deficit in its balance of unilateral transactions to the extent of Rs.
100. When we take into account these heads, we arrive at the balance of current
account, which is large concept than the balance of trade. This is because it takes
into account the balance of trade, the balance of services and the balance of
donations or unilateral transfers. The balance of current account need not be equal
but can show a surplus or a deficit. In table I, Country X has a surplus in its balance
of current account to the tune of Rs. 300.
The balance of current account is a very valuable concept because it reveals
the flow aspect of a country's international transactions. We could say that all the
goods and services produced within the country during the time period in
question and exported are entered on the credit side of the balance of current
account and all the goods and services imported and consumed with in the
country during the same period are entered on the debit side of the balance of
current account. Thus it can be observed that all the international transactions
entering a country's system of national accounting should be listed on the
country's balance of current account. It is therefore clear that all items of a flow
nature find a place in the balance of current account whereas all those items
which exhibit changes in stock are entered in the balance of capital account.
B. A. PART-II 68 ECONOMICS

Reverting back to Table I, we find that since country X's receipts from the
export items exceed payments for imports items and donations, X is said to have
surplus on current account. The difference between a country's exports and
imports, including broadly all current account items, in its international
investment i.e. X's surplus on current account, is the basis for an improvement in
its capital position vis a vis the rest of the world.
The surplus or the deficit has to be settled. If a country has a surplus on the
balance of current account, the country has spent less in abroad during the period
than it has earned. A way to settle this is by a transaction on the capital account.
The country can increase its stocks to an amount equal to the surplus on the
balance of current account. This can be done, for example, by lending aboard, i.e.
by buying a loan instrument to the value of Rs. 300 abroad, by purchasing assets
or by increasing its reserves of foreign currency.
Balance of Payment Concept
Three fundamentally different ideas are simultaneously called by the same
name. For the sake of clearer understanding, it is necessary to distinguish each
one of them from the other two. What is indiscriminately termed as the balance of
payments may refer to one of the following balance :
1. The Market Balance
The market balance of payment is a model of given situation in the foreign
exchange market, characterised by the effective demand and supply of foreign
exchange at given exchange rate, and at alternative, hypothetical rates. This is an
exante concept for use in the analysis of the foreign exchange market, with major
emphasis on the effects which changes in the exchange rate might have upon the
amounts of exchange effectively demanded and supplied.
The dollar deficit in a country's market balance of payments may be
tentatively defined as an excess of dollar amount effectively demanded at the
given exchange rate by would be purchasers (who are not restricted by specially
adopted or discretionary government control measures) over the dollar amounts
supplied at the exchange rate by would-be sellers (who are not motivated by a
desire to support the exchange rate.)
The market supply is by no means confined to transactions on income
account, i.e. to the proceeds from sales of exported goods and services (and certain
donations). It includes all those transactions on capital account (and donations)
which are not the result of deliberate efforts to satisfy the effective demand. Long
term capital imports i.e. direct investment by foreigners and the proceeds from the
sale of securities to foreigners, are unquestionable components of such a balance
of payments. Every supply and demand analysis has several time aspects. It
pictures a situation prevailing at a particular time and expected to last for a
B. A. PART-II 69 ECONOMICS

definite period of time, it deals with quantities offered or demanded per unit of
time, and it expresses the variability of those quantities in response to changes in
the price with a certain time interval allowed for the adjustment. The significance
of time aspect is great, particularly in relation to policy decisions. For instance, if
excess demand for foreign exchange is expected soon to give way to excess supply;
the problem of the dollar shortage is surely quite different from what it would be if
no change was expected in the foreseeable future.
It makes no sense to recast the market balance of payments for a future period
into which the present market conditions can hardly continue, unless, we believe that
we know the future market conditions. Thus , the market balance of payments refers to
a given exchange rate under given conditions of supply and demand.
2. The Programme Balance
The programme balance of payments is a statement of sources and uses of
foreign funds, expected or planned over a future period of one or more years based
upon the nation's capital and consumption requirements and on a programme of
meeting an excess of requirements over resources by recourse to foreign finance
expected or sought. This also is an exante concept, not for analysis but for use in
planning, forecasting, or negotiating with major emphasis not on what is
effectively demanded but on what is felt to be desirable with reference to some
expected norm. A dollar deficit in a country's programme balance of payments may
be defined as an excess of dollar amounts needed or desired for some specified
purposes (assumed to be important with reference to some accepted standards)
over the dollar amounts expected to become available from regular sources.
The existing foreign exchange rate is not as essential for the programme
balance as it is for the market balance of payments. The amounts of dollar
effectively demanded and supplied will vary if the price of dollars changes, but the
amounts of the dollar needed or desired for certain national purpose may be
entirely independent of the price of the dollar. Further it is in the assumptions
about the level of incomes that the difference between market balance and
programme balance of payments is most striking. An increase in money and real
income will be most striking. An increase in money and real income will most
likely increase a dollar deficit in the market balance. But decrease, a dollar deficit
in the programme balance. In the market, the dollar-gap will be widened at a given
exchange rate because people can buy much more and thus more goods will be
imported and fewer goods made available for exports. In the programme, the dollar
gap will be narrowed because people produce more, thus fewer goods need be
imported and more goods may be made available for exports.
Generally, policy measures are undertaken to deal with deficit in the
balance of payments; but, in a sense one should really not speak of policies
"dealing" with a deficit in a programme balance of payments. This is not a deficit
which first "exists" and than is "dealt with". Instead, it is a deficit which is
B. A. PART-II 70 ECONOMICS

programmed when there is a possibility of financing it. There is no sense in

drawing up a programme balance with a dollar deficit.
3. The Accounting Balance of Payments
The accounting balance of payments is a record of all transactions, real and
financial, which have taken place over a past period of one or more years between
the country's residents and the residents of other Countries, the record being kept
in the form of double-entry book keeping with each credit (debit) entry balanced by
an offsetting debit (credit) entry. This is an ex post concept based on statistical
information and estimates for use chiefly in the description of past developments,
and perhaps also in the appraisal of the present position of one nation in relation
to others. Although every body agrees that the accounting balance of payments
necessarily balances, many choose to present it as showing a surplus or deficit in
some meaningful sense.
Thus a dollar deficit in a country's accounting balance of payments may be
defined as an excess of dollar amounts entered on the debit side of certain
accounts in the annual record of its international transactions over the dollar
amounts entered on the credit side of the same accounts, the accounts being
selected from the foll, necessarily balancing statement in order to throw light upon
problems connected with market or programme balances of payments. The
apparent puzzle of a balance in the accounting sense, and also of a deficit, leads
us to the realm of equilibrium and disequilibrium in the balance of payments.
The concepts of balance of current account and the balance of capital
account are of a great significance. The former shows the flow aspect of country's
international transactions whereas the latter lists all items expressing changes in
stocks. The balance of current account which includes the merchandise exports,
and imports, services and donations need not be in equilibrium. It may show a
deficit or a surplus and, therefore, a transaction on capital account has to take
place in order to cover the difference. The movement of capital plays an important
role in settling the differences and the movement of capital itself is dependent on
a broader economic perspective. Thus, the different concepts of balance of
payments are designed to serve different objectives.
B.A. PART-II ECONOMICS
Semester-IV MACRO ECONOMICS AND
INTERNATIONAL ECONOMICS
LESSON NO. 2.7 AUTHOR : DR. H. G. P. SRIVASTAVA

FOREIGN EXCHANGE

Economic stability, international as well as domestic, presupposes stability

in the value of money as one of the essential requirements. Foreign exchange
covers all the means and methods by which the claims expressed in terms of one
currency are converted into another currency and the rate at which exchanges
take place. The money of a country circulates freely as medium of exchange and
measure of value only in that country but it cannot be used in a foreign country. A
mechanism of foreign exchange is, therefore, necessary for making payments
possible between countries. The term foreign exchange comprises the methods by
which the currency of one country is exchanged for that of another, the causes
which make such exchanges necessary, the forms in which such exchanges are
conducted and the rates at which the exchanges are effected.
Demand and Supply
The forces of demand and supply determine the market price of a commodity
and exactly the same conditions apply in the case of the price of a currency i.e. the
exchange market. When there is an increase in the demand for a foreign currency
without a change in its supply, its price in terms of the domestic currency rises. If at
any time, there is a rush on the banks, in the home country dealing on foreign
exchange for the purpose of a foreign currency, say, dollars, the banks find their
balances in the U.S.A. getting depleted and they try to meet the situation by selling
dollars at a higher price. If, on the other hand, the banks find that their dollar balances
are larger than usual and there is not much demand for that currency, the balance
between demand and supply is restored by lowering the price of dollars in terms of
domestic currency. Thus the demand for and supply of a currency in the exchange
market of a country determines its price in terms of the domestic currency.
What are the factors influencing the demand for and supply of foreign
exchange? The demand for and supply of foreign exchange is in the final analysis
nothing else than the demand for and supply of foreign goods and services; the
former is derived from the latter. The supply of foreign exchange results from the
"Credit" items in the balance of payments, while the demand for foreign exchange
results from "debits". Therefore, to know what constitutes credit and debits is to

71
B. A. PART-II 72 ECONOMICS

know the sources of the demand and supply of foreign exchange, as shown in the
following list :
Supply (Credits) Demand (Debits)
1. Commodity exports 1. Commodity imports
2. Services rendered to foreigners 2. Services rendered by foreigners.
(e.g. shipping and freight)
3. Travel expenditure by foreigners 3. Travel expenditure by nationals abroad
4. Interest and dividends on foreign 4. Interest and dividend on domestic
securities owned here. securities owned by foreigners.
5. Remittances and charitable 5. Remittances and charitable
contributions by foreigners. contributions by residents.
6. Government expenditures by 6. Government expenditures by home
foreign nations. Government.
7. Imports of long-terms capital 7. Exports of long-terms capital (i.e.
(i.e. exports of stocks and bonds import of foreign stock and bonds,
to home country by foreigners, domestic country making direct
foreign direct investments here and investments aboard, and loans to
foreign loans to home country). foreigners)
8. Imports of short-terms capital 8. Export of short-terms capital (i.e.
(i.e. increase of foreign owned bank increase of domestic bank balances
balances in the home country). abroad).
9. Gold Exports 9. Gold imports.

It is a recognised practice to put 1, 2, 3, 4, 5 and 6 on both sides in the category

of current transactions, 7 and 8 in capital movements and 9 in gold movements. Of all
the items, exports and imports have predominant position; it is usually the single
largest source of the demand for and supply of foreign exchange. We must, however,
remember that the quantitative significance of any one item differs from country to
country. If a country has a deficit in its current account as a result of an excess of
visible and invisible imports over similar exports, it must experience an adverse
balance of payments in the sense that it is paying off the debts by drawing on its
foreign exchange reserves, by exporting gold, or by borrowing on short term from
creditor countries-in short, by giving foreigners' claims on its currency. Conversely a
favourable balance of payments, means that a surplus country (on current account)
must be accumulating claims on foreign currencies. It is not difficult, therefore, to
explain the relation between the balance of payments and the exchange rate.
Since an increase in a country's claims on another country's currency
means an increase in the supply of that currency on the first country's foreign
exchange market, the domestic price of that currency tends to decrease, thus
appreciating the external value of the creditor country's currency. When the
B. A. PART-II 73 ECONOMICS

creditor country's currency appreciates in value such a country becomes a dear

market in which to buy and eventually exports decline. This is likely to wipe out a
favourable balance of payments, cheaper the domestic currency relative to other
currencies and thereby restore equilibrium. A deficit country, on the other hand,
is likely to have a weak exchange-rate position since an increase in foreign claims
on its currency means an increase in the demand for foreign exchange relative to
supply to cause a decline in the external value of its currency. It is now clear that
change in the demand for and the supply of a foreign currency occurs because of
variations in the payments which the nationals of the country have to make and to
receive from foreigners.
Exchange Rate and Foreign Exchange Market
The rate of exchange between two countries is the price in the home
currency for one unit of the money of foreign country payable in that country, or
more simply the price of the money of one country expressed in the money of the
other. It is generally quoted in two ways :
1. One unit of the foreign currency to so many units of the domestic
currency,
or
2. A certain number of units of foreign currency to one unit of the
domestic currency or for instance, we can say
1
£ 1 = Rs. 15 or Re. 1 = £ = i.e. Re. 1 = 1 $. 4 d
15
The market for a commodity comprises the buyer and sellers of that
commodity. Similarly, the buyers and sellers of foreign currency, in the form of
credit instruments, constitute the foreign exchange market. There are various
institutions operating in the foreign exchange market whose primary business is
to deal in foreign exchange e.g. banks, discount houses, exchange brokers, etc.
While there are others who enter the market in subsidiary capacity e.g. traders in
merchandise or buyers and sellers of foreign securities.
We have to remember that prior to World War-II, foreign exchange markets
functioned freely but the situation has changed thereafter because most of the
countries have introduced wide-ranging exchange controls measures. At present,
the authorities fix exchange rates, consciously allocate the foreign currency
available to importers, require exporters to sell their foreign exchange earnings to
specified dealers and regulate borrowing and lending. The foreign exchange
markets as they existed in pre-World War-II times, do not function today.
Methods of Fixation of Rate of Exchange
The external value of money or the domestic price of foreign currencies on
the foreign exchange market is determined diversely under different monetary
B. A. PART-II 74 ECONOMICS

standards and the way in which it is determined affects domestic and

international economic welfare differently. It is, therefore, necessary to examine both
the theoretical basis and the practical implications of various international currency
systems. There are three typical monetary standards, namely, (a) the gold standard,
(b) the paper standard and (c) the mixed standard, the International Monetary Fund'.
(a) Mint Par of Exchange
It seems useful to begin with a definition of gold standard. A country is said
to be on the gold standard (i) When its monetary authority is committed to a policy
of buying and selling gold at a fixed price in unlimited amounts. (ii) When the
purchasing power of a Unit of its currency is kept equal to the purchasing power of
a given weight of gold and (iii) when the external value of its currency is fixed
through the medium of gold. Practically all major trading nations were on gold in
the above sense before 1931 and gold served as a principal international means of
payment and as an important reserve of international liquidity.
The gold standard enables exchange rates between currencies to be stable.
The normal rate of the par of exchange then depends on the gold values of
currencies. Since gold has the same value in all gold standard countries, the rate
based on it tend to remain unchanged. There are small fluctuations on either side
but these take place within narrow and well-defined limits because of the
possibility of people making remittances in gold.
The method of ascertaining the rate of exchange by comparing the metallic
contents of the currencies of different countries is called the Mint Par Theory of
exchange. A simple example will make it clear. Suppose we want to find out rate of
exchange between England and America-assuming both of them to be on the gold
standard. We know that the weight of the British Sovereign is equal to 113.0016 grains
of fine gold. The weight of the American golden eagle (which is equal to $ 10) is equal to
232.2 grains of fine gold. The weight of one dollar comes to 23.22 grains of fine gold.
113.0016
Therefore £ 1 = = $ 4.8665. Hence the London-New York or
23.22
Sterling-Dollar Mint Par of Exchange is £ 1 = $ 4.8665.
By similar comparisons, the Mint Pars between two countries using the same
metal their standards of value can be calculated but it must be understood that any
Mint Par is merely a theoretical measurement of the value of one standard coin in
terms of another standard coin. It takes no account of practical variations in the
weight or fineness of actual coins due to wear and tear and is purely arbitrary basis
of comparison. It is a theoretical rate of exchange based on the laws of the two
countries which prescribe the weight of fine gold contained in the respective coins.
Even when gold is available, the traders prefer to settle their debits through
exchange bills purchased from bankers. If the bills drawn on a particular country
B. A. PART-II 75 ECONOMICS

are exactly equal to the bills drawn by this country upon foreigners, there is no
difficulty. The debits are offset by credits such a condition, however, seldom exists.
In actual practice, sometimes a country imports more than what it exports and
sometimes its exports largely exceed its imports, so that the price of the bills of
exchange varies in accordance with their supply and demand. Let us take an
example to show how it all happens. X in New York has sold a consignment of steel
to Y in London. Before it is detached from New York the steel becomes represented
by a bill of London 'X' draws a bill of exchange on 'Y' for the amount, that is, he
instructs 'Y' to pay a definite sum at a definite time. It may be according to the
terms of bargain, payable 'at sight' or in the three months time. This bill of
exchange and the bill of lading are sold by 'X' to a New York banker who sends
them to his London Agent from whom 'Y' obtains 'the bill' of lading enabling him to
get the steel by accepting or by actually paying the bill. The New York banker thus
has at his disposal credit in London.
Now suppose another businessman 'Z' in U.S.A. owes money to somebody in
England. He goes to New York Banker (who has credit in London) and wants a draft
payable in London. The banker knows very well that if his client did not get the bill
he shall have to ship the required amount of gold and incur the cost of
transportation and insurance into the bargain, that in addition to spending
$4.866 for every, £ 1 he will have to spend .024 cents per sovereign. He therefore,
quotes for his bill any price between $ 4.866 and 4.89 (4.866+ .024). He cannot
demand a price higher than $ 4.89 for every £ 1) because otherwise 'Z', the American
debtor, will think it worthwhile to undergo the risk and expense of shipping gold.
The highest point to which the price of bills can go is called the Upper Special Point
of the Gold Export Point. The actual rate of exchange will be different from mint par
but it will vary between $ 4.866 and 4.89 depending on the supply and demand of
bills. When the demand for the bills of exchange is less than their supply, their
prices fall. The lowest price to which it can fall is determined by deducting the cost
of commission, insurance and freight from the mint par and is called the Lower
Special Point or the Gold Import Point. Thus the rate of exchange cannot fall below $
4.842 (4,866-.024) for every pound. It will be clear that the rate of exchange between
two countries on the gold standard is determined by the Mint Par and the rate thus
determined fluctuates between the upper and lower specie points depending upon
the extent of mutual indebtedness measured by the supply and demand of bills.
(b) The Purchasing Power Parity Theory
Suppose there are two countries on gold standard and one unit of the
currency of one is equal to one of that of the other or the par rate of exchange is
unity. If both of them resort to inconvertible paper money and the former doubles
the quantity of currency in circulation while the latter quadruples it, the price
level in the former will be half of that of the latter. The rate of exchange, therefore
B. A. PART-II 76 ECONOMICS

will be 1:2 in accordance with their price levels. The rate of exchange obtained by
comparing price-levels of two countries is called the purchasing power parity.
The essence of this theory is that we judge the value of a foreign currency to
us by its command over goods and services. Purchasing Power is indicated by the
general level of prices so that if prices in a foreign country are higher compared
with our own the money of that country will not go very far and we, therefore,
expect to get more of its money in exchange for our own. In other words, the value
of the unit of one currency in terms of another is, in the long run, determined by
the relative values of the two currencies indicated by their respective purchasing
powers over goods and services.
Gustav Cassel, J. M. Keynes and others used the purchasing power parity
theory after World War-I to show that the fall in the external value of some
European currencies was largely the result of the post-war inflation in Europe. The
theory is also useful in demonstrating the consequences of a possible discrepancy
between the internal and external purchasing power of a national currency. The
concept of over-valuation and under-valuation are based on purchasing power
parities. There are a number of limitations of the purchasing power parity theory:
Firstly, we know that the calculation of the purchasing power parity depends
upon index numbers of prices. Since index numbers are merely indications of
average rise or fall in prices, the rate of exchange calculated by means of purchasing
power parity theory frequently deviates from the existing rate of exchange.
Secondly, the theory suffers from its failure to take into consideration the
elasticities of reciprocal demand. By the elasticity of reciprocal demand is meant by
responsiveness of one country's demand for another country's exports with respect to
price or income. As far as the price elasticity of demand for exports, the price change
which is relevant here might be considered to be due to exchange depreciation or
appreciation, not to general price movements. With international price movement
remaining constant, whether the external value of a national currency will change
depends, on the responsiveness of the foreign demand for a nation's total exports to a
slight change in that nations export prices in terms of foreign currencies. Needless to
say, in the longer period the elasticities of the reciprocal demand can change
significantly as a consequence of change in international consumer tastes.
Thirdly, although Keynes concentrates on short-term speculative capital
movements, long term capital movements may have an equally important effect on
exchange rates. Short-term speculative capital movements, otherwise known as
"capital flight", may arise from a desire to make a profit or avoid a loss on exchange
fluctuation as in the case of "hot money", or from a desire for safety and security as
in the case of "refugee capital". The new exchange rate resulting from capital
movements has nothing whatsoever to do with general price movements of changes
in purchasing power parities.
B. A. PART-II 77 ECONOMICS

(c) Pegged Rate of Exchange

The International Monetary Fund is substitute for the old gold standard and an
alternative to both a system of completely free exchange rates and a system of extreme
exchange control. It is a mixed standard embodying within itself some features of the
gold standard and the paper standard.
The Fund requires that the par value of a member-country's currency be
expressed in terms of gold as a common denominator or in terms of U.S. dollar of the
weight and fineness in effect on July 1, 1944. We must bear in mind that this
requirement is for accounting purpose, not for the purpose of maintaining stable
exchange rates as under the gold standard. If, for example, the dollar sterling
exchange rate is fixed at $ 4.08= £1 as an expression of the relative gold weights of the
dollar (0.889 gram) and the pound (3.581 grams), as was initially set by Fund, it by no
means precludes the possibility that the rate may be altered as domestic and
international conditions necessarily change.
In order to facilitate multilateral trade among member countries the Fund bars
“competitive exchange alterations” and requires each member country to "maintain
orderly exchange arrangements with other members". In other words, the Fund
thereby hopes to avoid the disadvantage of a laissez-faire exchange rate policy as well
as the disadvantage of unalterable exchange rates, in short, to achieve managed
exchange stability. To implement this exchange arrangement, the Fund provides for a
10 percent adjustment upwards or downward, in the external value of a member-
country's currency without prior approval of the Fund and for a more than 10 percent
adjustment with the Fund's consent all for the express purpose of correcting a serious
disequilibrium in a member country's balance of payments. This is an important
concession to exchange flexibility which is impossible under either the gold standard
or the paper standard. Under gold standard, exchange flexibility of any kind is out of
the question, while under the paper standard, exchange flexibility is in the habit of
degenerating into disorderly, discriminatory competitive exchange depreciation.
The international monetary system has been under a serious strain since
August 1971. The official price of gold was raised by U.S.A. from $ 35 to $ 38 per fine
ounce i.e. 8.57 recent. This meant a devaluation of the dollar in gold by 7.89 percent.
The dollar, however, continued to remain inconvertible. The exchange parities of
many other currencies were realigned and their values in the dollar were revised
upwards. Another important change that was effected was an increase in the range of
exchange fluctuations from 10 percent to 2.25 percent on either side of the parities.
The exchange could, thus fluctuate within a span of 4.5 percent instead of 2 percent
as before. This will give greater scope to the balance of payments to change without
causing any serious concern to the Fund authorities to do anything about it.
Exchange rates will, thus, have greater flexibility without losing any of their stability.
B.A. PART-II ECONOMICS
Semester-IV MACRO ECONOMICS AND
INTERNATIONAL ECONOMICS
LESSON NO. 2.8 AUTHOR : DR. M. L. SHARMA

INTERNATIONAL MONETARY FUND (IMF)

The collapse of gold exchange standard in the 1930s, competitive exchange
depreciation, exchange restrictions, wide fluctuation in the exchange rates,
discriminating trade policies and general uncertainty about the medium of
international exchange were some of the factors responsible for economic instability
and decline in world trade in the post world war period. The lack of co-operation in
matters of trade and payments was the main problem in the field of international
economic policy. The international community was, therefore, in search of a substitute
for the gold standard, and an alternative to both a system of completely free exchange
control. It was also considered desirable to evolve an international monetary system
which could reconcile the autonomy of internal economy with the discipline of
international mechanism of payments. A conference was, therefore, organised in 1944
under the auspices of the United Nations at Bretton Woods in U.S.A. The conference was
attended by the representatives of 44 countries. Many experts contributed to the Bretton
Woods Agreement but the major influence was exerted by Lord Keynes and Harry
Dexter White. The final agreement, however, was based on the plan propounded by
Harry Dexter White, under secretary of the U.S. Treasury. As a result of the Bretton
Woods Agreement, the International Monetary Fund (IMF) was set up in 1945.
Objectives of IMF
The International Monetary Fund started functioning on the Ist of March,
1947, with the following objectives :
(1) To promote international monetary co-operation amongst the various
member countries.
(2) To facilitate the expansion and balanced growth of international trade
and to contribute thereby to the promotion of high levels of employment
and real income.
(3) To promote exchange stability to maintain orderly exchange arrangements
among members, and to avoid competitive exchange depreciation.
(4) To assist in the establishment of multilateral system of payments in
respect of current transactions between members and in the elimination
of foreign exchange restrictions which hamper the growth of world trade.
(5) To give confidence to the members by coming to their timely rescue by
giving them short period monetary resources to help them tide over the
temporary maladjustments in their balance of payments without resorting
to measure destructive to national or international prosperity.
78
B. A. PART-II 79 ECONOMICS

(6) To shorten the duration and lessen the degree of disequilibrium in the
international balance of payments of members.
The above mentioned objectives, as embodied in the Articles of Agreement
clearly indicate the obligations of the International Monetary Fund. These
objectives indicate that they shall be required to regulate monetary relationship
among member countries in accordance with the 'Code of good conduct' and also
to provide finance to members facing balance of payments deficit.
Organisation of IMF
The total membership of IMF was only 40 at the time of its inception on March
1, 1947. In September, 1966 the IMF had a total membership of 135. Now the
memebership is of 181 countries. The Capital resources of the IMF consists of the
total of the quotas allotted to member countries. The quota of a member country is
based upon its importance as measured by the value of her foreign trade, gross
national product, gold and foreign exchange reserves and certain other related
factors. Each member country is required to contribute its quota both in terms of
gold as well as in its national currency. Each member has to pay its quota in gold
either 20 percent of the quota or 10 percent of its entire gold and dollar holding,
whichever is less. The aggregate of quota amounted to $ 7.5 billion on Ist March,
1946. In September, 1976 the aggregate quotas are counted to $ 43 billion. Since
one unit of SDR is now held equivalent to $ 1.08571, therefore, the aggregate quota
of $ 43 billion amounts to SDR 39 billion.
The IMF has also appointed certain Central banks as its gold depositories
where members can deposit gold to the credit of IMF. The gold and the national
currencies deposited with the IMF are the properties of the IMF. The IMF utilizes
its gold holdings to acquire Dollars and other currencies for its operations. The
IMF holds two kinds of accounts with the Reserve Bank of India's A/C No. 1 and A/
C No. 2. The A/C No. 1 is the major account in which the portion of India's IMF
quota subscription and other payments in rupees are credited and through which
all the major transactions with the IMF involving purchase of foreign currencies
(sale of rupees) are routed. For day-to-day use, the IMF maintains A/C No. 2 with
the Reserve Bank of India. This is a very small current account. Deposit in A/C No.
2 produces the impact on the supply of money in India.
There are two bodies to run, the management of the IMF-(1) The Board of
Governors, and (2) The Board of Directors. Every-member country appoints one
Governor and one alternate Governor. The alternate Governor participates in the
meeting in the absence of the Governor. The Board of Governors formulates the
general policy of the IMF. Thus, the Board of Governor is a decision-making body of
IMF. There are 21 members in the Board of Directors. The Board of Directors has to
carry out the day-to-day working of the IMF. The chief executive of the IMF is the
Managing Director. The head office of the IMF is at present located at Washington.
B. A. PART-II 80 ECONOMICS

Functions and Working of the IMF

The following are the main functions of IMF :
(1) Determination of Exchange Rates : The very first article of the IMF
agreement stipulates that one of the functions of the IMF is to promote exchange
stability. The IMF adopted the 'par value' system of determining the exchange rates
for member countries. Under the 'par value' system each member country is
required to define the value of its currency in terms of weight of gold as a common
denominator or in items of the United States dollar of the weight and fineness in
effect on July 1, 1944 which was $ 35=one ounce of gold of 0.995 fineness. The
initial par value of the Indian rupee, established with the IMF on December 18, 1946
was 0.268601 gram of fine gold or 30.2250 U.S. cents. In other words, the exchange
rate determined in the terms of par value was Rs. 3.30=1.00. When all the member
countries express the values of their currencies in gold or Dollars, it becomes easier
for the IMF to fix the foreign exchange rate of the concerned countries.
(2) Management of Exchange Stability : In order to facilitate multilateral
trade among member-countries, the IMF bars "competitive exchange alteration" and
requires each member-country to "maintain orderly exchange arrangements with
other members". It does not mean that the IMF favours a fixed exchange rate system.
As a matter of practice and principle, the IMF is against the floating exchange rate
policy. The IMF believes in the merits of stable exchange rate policy. In order to
achieve the goal of exchange stability, the IMF provides for a 10 percent adjustment,
upward or downward in the external value of a member-country's currency without
its prior approval, and for a more than 10 percent adjustment with its prior consent.
It must, however be pointed out that the adjustment in the external value of the
currency is permitted only for correcting a fundamental disequilibrium in a
member-country's balance of payments. The downward adjustment in the external
value of the Indian rupee was made when the rupee was devalued on September 18,
1949 and again when the rupee was devalued again on June 6, 1966. Thus, the IMF
seeks to manage the stability of exchange rate. It must, however, be pointed out that
from December 18, 1975 the IMF has allowed' the fluctuation in the exchange rate
of member's currency within a wider margin of 2.25 percent in place of old margin of
1 percent, in either direction of the parity relationship.
(3) Establishment of a multilateral system of payments and elimination of
Foreign Exchange restrictions : Article I (IV) of the IMF agreement indicates that
IMF shall operate assist in the establishment of multilateral system of payments in
respect of current transactions between members and in the elimination of foreign
exchange restrictions which hamper the growth of world trade. In order that this
objective may be achieved, Article VIII provides that no member-country may,
without the approval of the IMF, impose restrictions on the making of payments or
transfers for current international transactions or engage in discriminatory
B. A. PART-II 81 ECONOMICS

currency arrangements or multiple currency practices. It is also stipulated that the

monetary authority of each member country shall convert any balances which another
member-country's monetary authority has acquired from or needs for current
transactions, into gold or into currency of that member-country. In short, all the
member-countries shall abolish restrictions upon current payments, avoid
discriminatory currency practices and promote convertibilities of foreign held balances,
would ensure that a member country would be free to use payments surplus with any
other member-country to pay for its deficit with a third country. As a result, multilateral
system of payments will be established and trade volume will be increased.
(4) Lendings to members to cover up deficits in Balance of Payments : The
IMF's resources consist of a common pool of gold and currencies, which in turn
consist of an aggregate "quotas" paid in or payable by its member-countries. The
IMF lends to a member country which is in need of a short-term credit to settle
current deficit in its balance of payments. The deficit country "borrows", the
necessary fund in exchange for its IOUs It implies that a deficit country buys the
needed foreign exchange from the IMF with its own currency. If the short-term
credit thus acquired helps the deficit country to overcome its adverse balance of
payments, the country is required to 'repurchase' its own currency in exchange for
gold or 'convertible currencies'. As a result, the IMF is protected against quick
depletion of its scarce currencies (e.g. dollar resources.) It must, however, be
pointed out that a member-country can buy foreign exchange from the IMF upto
an amount equal to 25 percent of its quota in any given year. However, the
currency of a member-country with the IMF at any time should not exceed 200
percent of its quota. Let us suppose, as an example, that the quota of member
country is $ 100 million comprising $ 25 million in gold and $ 75 million in its
own national currency. If this country wishes to obtain some foreign currency
from the IMF, it can not secure foreign currency of the value greater than $ 122
million. The IMF charges rate of interest which varies between 0.5 and 2.5 percent.
It also levies service charges to the extent of 0.75 percent on its loans. These
drawings of the member-countries from the IMF are conditional.
(5) Dealing with the problem of ‘Scarcity of Currencies’ : The currency of a
member-country is said to be 'scarce' if its supply is less than, its demand. If a
country sells its goods to other countries but does not buy from them, then the other
countries are not able to acquire the currency of the former. As a result the currency
of the export-surplus country becomes scarce in relation to demand. Dollar for most
of the times, has been a scarce currency. The IMF can deal with the problem of
dollar scarcity in two ways, namely, (a) by increasing its supply of dollars through
purchase of dollars with its gold, and (b) by declaring the dollar to be a 'scarce
currency'. If the IMF's gold assets are enough to buy all the dollar needed by deficit
members, then it will not have to ration its scarce dollar holdings among the dollar-
B. A. PART-II 82 ECONOMICS

needing members. Fundamentally, however, it is more important to correct a

sustained disequilibrium between those members whose currencies are 'scarce' and
those whose currencies are not scarce, because that is what gives rise to a general
scarcity of the former's currencies. This suggests that the burden of responsibility
should not rest on the shoulders of deficit countries alone.
(6) The Special Drawing Rights : Under the original articles of the IMF, it had
powers to lend sums to member countries. But this lending was conditional, and it
was repayable. The unprecedented growth in international trade in the post war era
has posed a serious problem of international liquidity. The introduction of special
drawing rights (SDRs) by the IMF was an important step in improving international
liquidity. The plan for SDRs was approved in September, 1967 and was introduced
in 1969. The essence of these Special Drawing Rights (SDRs) is that they create a
new international reserve assets. They can be used unconditionally by the
participating countries, and they are not packed by any assets.
Unlike existing IMF, drawing rights, SDRs are not created by countries
contribution of gold and currency to the IMF and once drawn they do not have to
be paid back to the Fund. The peculiarity of the new drawing rights is that they
would not be treated as borrowing as the existing claims on IMF are. The SDRs are
sometimes nicknamed 'paper Gold'. They could be used as gold in as much as they
would be the ultimate resource for purchasing other currencies. They are not
pieces of paper like bank notes or Treasury Bills. They are simply entries in a
special account kept by the IMF. The SDRs are allocated to each member country
in exchange for usable foreign exchange in proportion to its IMF quota. They can
only be transferred to another member country for usable foreign exchange. It
means they can not be spent directly on goods and services. In short, SDR is an
international medium of exchange and store of value.
By the end of 1976, 121 members were participants in the SDRs. The
allocations of SDRs were made at the beginning of 1970, 1971, 1972. The total
SDRs allocated during this period amounted to SDR 9.3 billion. On 4th January,
1979 the IMF decided to make a fresh allocation of total of SDR 12 billion. India
was entitled to receive SDR 3.6 billion out of the total SDR 12 billion.
(7) Expert Advice to the Member Countries : Along with financial help, the
IMF also grants technical assistance to the member-countries. The experts and
specialists of the IMF render valuable help to the member-countries in solving their
complicated economic and monetary problems. In fact, the under-developed
countries have been helped in the formulation of their monetary, and exchange
policies. Thus, the IMF helps the member-countries to stabilize their economies.
IMF and Under-developed Countries
The stable exchange rate system was set up in the Bretton Wood System. The
developing countries have been favouring stable exchange rate system because it
B. A. PART-II 83 ECONOMICS

is in the interest of such countries. These countries face often adverse balances of
payments problem. The stable exchange rate system with the support of
international liquidity is better arrangement because they are in a better position
to pursue the development programmes under such an international monetary
system. In 1976, under-developed countries had deficits in their balance of
payments of the order of $ 3.2 billion, whereas in 1973 the deficits were of the tune
of $ 10 billion. The developing economies, therefore, want an adequate supply of
international liquidity to meet the adverse balance of payment. The total SDRs,
created and allocated from 1970 and 1972 stood at $ 3 billion. The under-
developed countries were allocated SDRs to the tune of $ 1.9 billion out of the total
SDRs of $ 9.3 billion. Thus, the allocations of SDRs to under-developed countries
had been much less as compared to their requirements.
The adverse balance of payments position of under-developed countries has
also been affected further by rise in oil prices. In order to meet the situation
created by rise in oil prices and its consequent effect on balance of payments, the
IMF created an ‘Oil Facility Arrangement’. The total contribution to the ‘Oil
Facility’ has been SDRs 6.5 billion. Share of developing countries in the borrowing
out of the capacity worked to be only 37 percent. Though the ‘Oil Facility’ of 1975
gave some relief to the under-developed countries yet the scheme has not
benefitted much owing to insignificant amount of facility. These countries had to
drop some of the projects envisaged under the development plans.
The world economic development in 1971 was characterised by the
realignment of major currencies. Currency floats became the order of the day. It
led to the demise of the 'Par Value' system enshrined under IMF agreement. It
must however, be pointed out that most of the under-developed countries did not
make resort to floating currency system. They have been supporting the case for a
fixed exchange rate system because of the relative absence of uncertainty about
exchange rate under this system. In short, the IMF has not succeeded in safeguarding
the interests of under-developed countries. The deficits in balance of payments,
adverse terms of trade, rising bill of oil imports, uncertainty of the inflow of aid,
availability of SDRs and fluctuations in the exchange rates suggest that the IMF
should evolve suitable policies to suit the interests of developing economies.
Critical Appraisal of the Policies of IMF, with special reference to Triffin Plan
Robert Triffin predicted the breakdown of the international monetary system
evolved at the Bretton Woods. His prediction recorded in his classic book 'Gold
and the Dollar Crisis' proved true with the advent of 1990s.
The International Monetary System under the auspices of the IMF has been
making reliance in a major national currency—the United States dollar. This is
clear from the fact that the dollar was chosen as a common denominator in terms
of which all exchange rates were in fact defined and readjusted from time to time.
B. A. PART-II 84 ECONOMICS

The dollar was regarded as the main component of international reserve

accumulation by all countries other than the United States. As a result, the dollar
came to be used as the main instrument for central bank interventions in the
exchange markets and for the settlement of balance of payments surpluses and
deficits. But at the same time gold formed the basis of the monetary system
institutionalised in the form of the IMF because of the convertibility of dollar into
gold. This meant in practice, that the growth of international reserves becomes
more and more by product of the United States balance of payments deficits. As a
result, the deficits in the balance of payments of the United States make its
indebtedness to foreign central banks (dollar balance). The United States was
required to convert the dollar balance of foreign central Banks into gold.
This system worked reasonably well as long as the deficits in the balance of
payments of the United States did not exceed the normal needs for growth of world
reserves. The accumulation of dollar balances by foreign central banks over 1950-
1969 was of the order of $ 14.5 billion. As a matter of fact, 95 percent of the overall
deficits of the United States balance of payments were financed by the acceptance
of American IOU's as international reserves by other countries. In 1971, the
position was such that the world having acquired dollar balance for more than the
American gold reserves finally lost its confidence in the dollar as the principal
reserve currency. This forced U.S.A to abrogate convertibility of dollar into gold on
August 15, 1971. The countries having surplus balance of payments have to adopt
the floating rate system because of the inflationary implications of rising dollar
balance with them. In short, the inconvertibility of the dollar and the generalised
adoption of floating rate in the basic contravention of the Bretton Woods
agreement were the manifestations of the total breakdown of the international
monetary system institutionalised in the form of the IMF. Gold has been dethroned
from its position of constitutional head of the international monetary system. Thus
we see comes true Triffin's prediction : “Man-made credit reserves will continue to
displace and will eventually replace gold reserves just as man-made credit money
has long replaced gold money in even every national monetary system, the world
over”. He has criticised the use of gold as a component of international liquidity
on the ground that for a long time the monetary stock of gold has been rising more
slowly than the volume of world trade. It is significant to point out than even
though the IMF evolved in 1969, SDRs as an international liquidity, the fixation of
its value in terms of gold proved ineffective. In accordance with the
recommendations made by the C-20 (The Committee of Twenty), the SDRs was
delinked from gold in July 1974.
Triffin has given a proposal for reform of the international monetary system.
He has advocated the centralization of reserves and establishment of an
international reserve-creating institution. He suggests to adopt the model of
B. A. PART-II 85 ECONOMICS

domestic monetary system and establish some form of an international reserve

creating institution to perform tasks to those of domestic central banks.
A new international monetary system was born on January 8, 1976 as a
result of the conference of the C-20. The Old, Bretton Woods monetary system had
collapsed on December 18, 1971, when the dollar was devalued. Thus basic
features of the new monetary system are as follows: Firstly, the new monetary
system has now given legal recognition to the floating of currencies in the foreign
exchange market of the world. Secondly, the new monetary system instituted a
Special Trust Fund with the sale proceeds of gold stock of the IMF. This fund was
intended to be utilized to help the developing countries to meet chronic
imbalance in their balance of payments. However, the assistance from this fund
shall be given only to those developing countries whose per capita income was less
than $ 360. Thirdly, the quotas of the member countries in the capital resources of
the IMF had been increased by 33 percent under the new system. Fourthly, the
paper gold i.e. SDRs has been declared as the principal reserve asset of the
international monetary system.
The above discussion clearly brings out that the IMF succeeded in achieving
such objectives like exchange rate stability, convertibility of a new currency and
multilateral payments system. But it could work satisfactorily only in the first two
decades of its existence. The reliance on one national currency dollar and
convertibility of dollar into gold, enshrined under the IMF agreement, brought a
halt and ultimately collapse of the Bretton Woods system in the beginning of
1970s. Triffin has always been against the introduction of gold in the edifice of
international monetary system. Fortunately in the amended 1976 international
monetary system the yellow metal has been dethroned from its position of the basis
of the international monetary system.
B.A. PART-II ECONOMICS
Semester-IV MACRO ECONOMICS AND
INTERNATIONAL ECONOMICS
LESSON NO. 2.9 AUTHOR : DR. I. A. QUREISHI

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT (IBRD)

Introduction
The International Bank for Reconstruction and Development, better known as
the World Bank, established at the same time as the International Monetary Fund, to
tackle the problem of international investment. Since the IMF was designed to provide
temporary assistance in correcting balance of payments difficulties, an institution
was also needed to assist long-term investment purpose. Thus, IBRD was founded in
1944 and began its operation in 1946 for promoting long-term investment loans on
reasonable terms. The Second World War had given a severe blow to global trade by
disrupting the world economies. The economy of England was completely destroyed
while Germany had been totally ruined. France and other countries had also suffered
on a large scale. Economic reconstruction was the immediate need of war-torn
Europe. Besides, the task of re-building the war-shattered economies of European
countries. Another problem which required urgent attention was the problem of vast
economic inequalities between the developed and developing countries. The entire
continents of Asia, Africa and Latin America were immersed in increasing poverty. The
widening gap in the living standards of the rich and poor nations breeded social
unrest and political upheavals which had the potential of originating the flames of
war, once again. It was realised that the only way to ensure lasting world peace was by
eradicating poverty in the underdeveloped economies through economic
development of these countries. To solve this problem, the Bretton Woods Conference
decided to establish the International Bank for Reconstruction and Development.
Functions
IBRD is an inter-governmental institution, corporate in form, the capital
stock of which is entirely owned by its members.
The main functions of the Bank are :
(i) to assist in reconstruction and development of the economies of its member
governments by facilitating investment of capital for productive purpose;
(ii) to promote foreign private investment by guarantees or through
participation in loans and other investment by private investors;
(iii) where private capital is not available on reasonable terms, to make loans
for productive purpose out of its own resources, or out of the funds
borrowed by it; and
(iv) to promote the long-term balanced growth of international trade and the
maintenance of equilibrium in balance of payments by encouraging
86
B. A. PART-II 87 ECONOMICS

international investment for the development of the productive

resources of member countries.
A little reflection will reveal that the objectives of the IMF and IBRD are
complimentary. Both aim at increasing the level of national income and standard
of living of the member nations. Both serve as lending institutions, the IMF for
short-term and the IBRD for long-term capital. Both aim at promoting the balanced
growth of international trade.
Organisation of the Bank
Any country is eligible for membership of the Bank if he subscribes to the
Charter of the Bank. The Bank has a Board of Governors, Executive Directors, a
President and other staff. All powers of the Bank are vested in the Board of Governors
consisting of one governor and one alternate appointed for five years by each
member. Each governor has the voting power which is in proportion, to the financial
contribution of the government which it represents. The voting power of the big
shareholders outweigh the voting power of the smaller ones. The U.S.A. has 25.66
percent of total votes while the U.K. has 10.31 percent. The Board of Governors meet
once a year. This annual meeting is an important occasion for informal exchange of
views at high level on major international financial and monetary issues.
The initial authorised capital of the world bank was 10 billion; subscribed by
its members in accordance with their economic growth. The United States of
America is the largest subscriber, followed by the United Kingdom; India is the
fifth-largest subscriber. Each country's quota is divided into three parts :
(i) Two percent of the subscription is payable in gold or U.S. dollars and is
freely available for lending;
(ii) 18 percent of the subscription is payable in member's own currency and
is available for lending with the consent of the member whose currency
is involved; and
(iii) The remaining 80 percent of the subscription is not payable for lending but
is subject to call as and when required to meet the Bank's obligations.
The subscribed capital of the bank is increased as a result of the
enhancement of its sources in the form of increases in member's subscription and
also due to the increase in membership. The principal purpose of increasing World
Bank's capital resources is to increase its ability to lend for financing projects for
economic development.
Aims
The fundamental aims and objectives of the Bank are :
(i) To provide a catalyst by which production may be generally stimulated
and private investment encouraged;
(ii) To encourage necessary action by the member governments to ensure
that the Bank's loans will actually prove productive; and
B. A. PART-II 88 ECONOMICS

(iii) To initiate development plans and to see to it that the Bank's resources
are used wisely from the standpoint of the world.
The World Bank is more than the usual type of lending institution. Its concern is
primarily to ensure that its loans make the greatest possible contribution to increasing
the production, raising the living standards and opening opportunities for further
investment in the borrowing member country. Recently, the scope of Bank's assistance
to the members has been considerably widened. In its early years, most of the Bank's
leading was for "hardware" projects which simply added to the physical assets of the
economy like dams; roads and power plants. Now Bank is also lending for "software",
like education, population planning, urbanisation, water supply and sewerage.
Granting of Loans
In the granting of loans and their administration, there are four stages involved.
The first stage may be characterised as exploratoty discussion and preliminary
investigation. At this stage, there are discussions between a Mission sent by the Bank
and the prospective borrower about the latter's ability to repay the loan.
If the Mission is satisfied with preliminary investigation then the second
stage of investigation of the specific project starts. The Mission investigates the
specific project in its technical, financial and administrative aspects whether the
project plans have been properly drawn, whether the required local capital would
be entrusted to capital management, etc.
If the second stage of technical investigation is satisfactory, the third stage of
negotiation of the terms of loans starts. This involves determination of the part of total
investment to be provided by the Bank; the interest rate, the period of the loan and
securing of several assurances and guarantees for safeguarding the interests of Bank.
The final stage is that of the administration of the loan which is a special
feature of the Bank loans. The Bank representatives visit the borrowing country
and check the end use to which the funds are put, in order to determine that this
use conforms to the loans agreement.
Guiding Principles of the Bank
In its lending operation, the Bank is guided by certain guidelines which
have been formulated on the basis of the Articles of Agreement.
In the first instance, the Bank should assess properly repayment prospects of
the loans. For this, it should consider the availability of natural resources and
existing productive plant capacity to exploit the resources and operate the plant
and the country's past debt record.
Secondly, the Bank should lend only for specific projects which are
economically and technically sound and of high priority natures.
Thirdly, it is the Bank's policy to maintain continuing relations with
borrowers so as to check the progress of the projects and to keep in touch with
financial and economic development in the borrowing country.
B. A. PART-II 89 ECONOMICS

The rate of interest charged by the Bank is based on the rate which it would
itself have to pay to borrow money at the time the loan is made plus one percent
commission charge which is allocated to a special reserve. Since July 1976, a new
lending formula provides for a positive spread 0.5 percent between the Bank's own
borrowing cost and the interest charged on its loans granted after that date.
Accordingly, in July 1976, the interest rate on Bank loans was fixed at 8.9
percent. The interest rate was gradually reduced to 8.2 percent.
The bank has advanced loans for specific development projects in the field of
agriculture, electric power, transport, telecommunication, industry, population,
planning, water supply, project preparation, urban development and education.
The Bank has lent to current borrowers a cumulative total amount of 51,51,692
million (upto 20 June, 1979), for financing various development projects, the main
beneficiaries were the developing countries. During the nine year period (1971-
79) the Bank lent a total of 3,019.2 million to the 'core' less development countries
with annual per capita income below $ 296. Bank's loans are long-term loans
granted on the conventional rate of interest for projects of economic priority.
An intermediate financing facility was created in 1975-76 to enable the
Bank to provide development assistance on terms intermediate between those of
the Bank and IDA. The total amount of loans advanced by this 'Third Window'
amounted to $ 600.4 million by the end of fiscal year, 1979.
A majority of IBRD's loans have gone to developing countries for development
projects. These loans were meant for the creation and development of infrastructure
projects in the developing countries in Africa, Asia and Western Hemisphere. More
than 30 percent of the total loans assistance has been given for the development of
electric power projects. About 22 percent of the total amount had been utilised for
providing transportation and telecommunication facilities. About 22 percent of the
total cumulative loan amount has financed the development of agriculture and rural
development projects. Rest of the loan assistance has been given for the development
of education, project preparation and technical assistance, population planning,
water supply and sewerage. Region wise, about 7 percent of the total amount has been
given to South Asia and about 30 percent to Europe, Middle East and North Africa,
about 20 percent has gone to East Asia and Pacific region countries. Africa claimed
about 13 percent while, Latin America and Caribbean territories have shared about 30
percent of the total loan assistance provided by the Bank.
The substantial growth in the lending activities of the Bank would not have
been possible without a corresponding expansion in its resources. The paid in capital
of the bank during the past 35 years has risen to more than four fold. Besides the
increase in its capital resources, the Bank has also borrowed funds on a mass scale by
successfully floating loans in the international financial markets. Investors or about
hundred countries hold the security of the Bank which has been established in the
B. A. PART-II 90 ECONOMICS

money markets of Belgium, Canada, Germany, Italy, Netherlands, Switzerland, U.K.

and U.S.A. and thirteen pertroleum exporting countries including Saudi Arabia.
World Bank and India
In addition to the conventional loans which it has made available for
development projects, the Bank has made sincere efforts to secure outside assistance
from developed countries for under-developed countries. The Bank has taken the lead
in organising and coordination mechanism for a number of developing countries
which receive assistance from several bilateral and multilateral sources. It has helped
in the establishment of International development Association from which under-
developed countries can borrow in hard currencies without being worried to repay in
the same currencies. Another contribution of the World Bank was the amendment to
the charter of International Finance Corporation to enable it to provide equity to
private industrial undertakings in underdeveloped countries. These developments
have helped the developing countries to effectively implement their development
plans. The Bank's lending to least-developed among the developing countries
increased from the low annual average of 204.2 million during 1974-75 to 550
million in 1978-79. Moreover, lending has been in favour of agriculture and rural
development transportation and industrial sectors where development is vital for the
development of member countries. India is a founder member of the Bank and holds a
permanent seat on the Bank's Board of executive directors. In view of the
achievements, the role of the Bank has been commendable. The proof of its popularity
is the rapid increase in its membership. The bank has sent several missions to India to
assess country's development programmes and also for field surveys of various
projects. The Bank has appointed a resident representative in New Delhi who remains
in close contact with the government of India in regard to the country's development
plans and the projects.
India is the largest single borrower of the Bank. In the thirty year period
(1949-79) the Bank has lent 26456 million in 57 loans. Of this loan assistance,
over 50 percent was given for the improvement of transportation. Power claimed
about 20 percent of the total loan assistance. Industry's share came to about 29
percent of the total loan assistance given by the bank of India.
India has gained from assistance given to it by the Bank. It was due to its
concerted efforts that a consortium of twelve lending western countries known as
'Aid India Club' comprising of the U.K., U.S.A., West Germany, Japan, France,
Canada, Italy, Sweden, Austria, Belgium, Netherlands and Holland was formed.
But, much more significant is the involvement of the Bank in India's
development programmes. The proof of the massive assistance of 5,472 million
which she received from the members of the consortium for development
programmes during the Third Five Year Plan and the non project aid of $ 3,700
million would never have been made available without the support of the Bank.
B. A. PART-II 91 ECONOMICS

Apart from providing the massive assistance, the Bank also paid the foreign
exchange amounting to $ 862,000 for improving the transport of coal in India. In
1965 the Bank helped in financing a survey of transport in the eastern region in
order to enable the Government to formulate a transport investment programme for
the Fourth and Fifth Five Year Plans (1966-76).
The Bank also gave a loan of $ 39 million in 1971 and 1972 to the Punjab
Agricultural Project to boost farm production. Projects financed with the help of the
Bank have strengthened the Indian economy.
The International Development Association affiliate of the Bank had also lent
a total of 6750.2 million in 12 soft credits for various development projects upto
June 30, 1970. This shows that the World Bank Group has granted massive loan
and credit assistance of more than 9 million to India for the planned economic
development of the country's economy.
Critical Appraisal
The 'modus operandi' of the Bank has been criticised in various grounds.
Firstly, it is alleged that the Bank charges a very high rate of interest on its loans even
when the loans given by it are guaranteed by government of the borrowing member
countries and there is no risk of loss of capital. There is truth in it because the latest
loans that India has received from the Bank bear interest of over 8 percent. The Bank
must remember that it was created to be an active instrument in the establishment of
lasting international economic peace by making it possible for the economically
weaker nations to become stronger by mobilising their resources. This purpose of the
Bank can be fulfilled only when the rate of interest charged by it is low enough for all
countries to enable them to take loans from the Bank more frequently.
Secondly, the Bank's insistence on the repaying capacity of a borrowing
country before granting the loan is faulty. The repaying capacity follows rather
than proceeds the utilisation of the loan. It is created as the projects financed by
loans materialise. Trying to estimate repaying capacity before granting the loans
betrays lack of judgement on the part of the Bank.
Thirdly, the Bank is non-political and non-partisan financial institution. It is
expected to treat all members equally, being enjoined not to discriminate against
some and in favour of others in the granting of loans. However, in practice loans
have not been given purely on economic considerations. It is only recently that the
economically backward countries of Asia and Africa have caught the eyes of the
Bank and even now these areas are not getting the attention they need. The Third
World countries taken together have the largest population and unexploited
economic resources. On the contrary, Europe and Western Hemisphere are small of
both from population and area consideration and even then they have received huge
amounts or loans. All this cannot be explained on economic consideration alone.
Fourthly, the Bank is still far from playing an effective role in reshaping the
B. A. PART-II 92 ECONOMICS

economic structures of member countries, because the amount of financial help

given by it falls far short of the vast requirements of resources needed for
accelerating the process of economic development.
Inspite of these shortcomings, evaluating the Bank's role we should not forget
the limitations within which the Bank works. The Bank is largely instrumental in
quickening the tempo of economic development projects, it has financed a large
number of them which have proved quite successful. In future, the Bank will be in a
stronger position to render financial assistance to the member countries with its
increased capital resources and the active co-operation of its affiliates.....International
Development Association and International Finance Corporation.
BOOKS SUGGESTED
1. A.E.A. : Readings in the Theory of International Trade.
2. C.P. Kingleberger : International Economics.
3. C.S. Barla, H.S. Aggarwal : International Economics.
4. B.O. Sodersten : International Economics.
5. Vaish and Sudama Singh : International Economics.
B. A. PART-II 93 ECONOMICS

LONG ANSWER TYPE QUESTIONS

1. What do you mean by balance of payments ? Briefly discuss the measures
adopted to correct adverse balance of payments with reference to India.
2. "The balance of payments is always balanced". How then do we talk
about a surplus or a deficit in the balance of payments of a country?
3. Critically examine the various theories for the determination of the rate
of foreign exchange.
4. Discuss the various factors that bring about fluctuations in the rate of
foreign exchange.
5. Explain the functions of the IMF. How far the IMF has succeeded in
achieving its objectives ?
6. What is SDRs ? How for the IMF has succeeded in dealing with the
problem of international liquidity through SDR's ?
7. Discuss the role of IMF in the context of developing countries.
8. What are the features of new international monetary system ? How far
the new monetary system has accommodated the ideas to Triffin Plan ?
SHORT ANSWER TYPE QUESTIONS
1. Why did the International Monetary System of Bretton Woods
breakdown in 1970-71 ?
2. What do you mean by SDR's ?
3. What do you mean by Mint Par of Exchange ?
4. Differentiate between Balance of Payments and Balance of Trade.

Type Setting By :
Computer Lab, Dept. of Distance Education, Punjabi University, Patiala.