AL - 13 - CHAPTER 9

S. M. Irshad
BA in Social Sciences (OUSL).
MA in Economics (MKU) India. in Progress.
Diploma in Governance, Democratization & Public Policy (CISS).
E-mail – irshad.sahabdeen@yahoo.com
Copyright © S M Irshad 2013. 1

9. Analyses the effects of
International Trade and Finance
on an economy. 9.1 Investigates the basis of International Trade.
 9.2 Analyses the impact of protectionist policies in
international trade.
 9.3 Investigates structure and trends of the
international trade in Sri Lanka.
 9.4 Investigates economic impacts of International
Trade using terms of trade.
 9.5 Prepares a structure of Balance of Payments based
on the contents of Balance of Payments.
 9.6 Investigates economic effects of foreign
transactions using Balance of Payments in Sri Lanka.
 9.7 Investigates the determination and impacts of
foreign exchange rate.Copyright © S M Irshad 2013. 2

 9.8 Investigates effects of foreign
investments in an economy.
 9.9 Investigates the importance of
economic organization for economic co-
operation.
 9.10 Investigate the role of International
financial institutions.
 9.11 Investigates the impact of globalization
on developing countries.

What is International Trade?
 International trade broadly means the
exchange of goods between countries. It is
also known as foreign trade. Goods that are
sold by a country to other countries are known
as exports. Goods that are brought into the
country are known as imports. The deference
between the 2 variables is known as the trade
balance. When a country exports more than it
imports, it enjoys a trade surplus. When its
imports exceed exports, there is a trade deficit.

Why do Countries Trade?
 Countries have different quantities of
resources like land, labour, capital and raw
materials. For example, some countries have
greater resources to produce agricultural
products. Some other countries have
resources that are suitable to produce
industrial goods like cars and ships. So, each
country cannot produce all that it needs.
Therefore, countries are engaged in foreign
trade.

Reasons for Engaging in
International Trade.
 Inadequacy Of Certain Resources: certain
resources available in a country may not be
adequate to produce goods and services for
domestic consumption. This is why Sri Lanka
imports dry fish from Maldives, and some times
rice also from other countries.
 Non Availability Of Certain Resources: another
important reason is the total absence of certain
resources, natural or technological in some
countries. This is why, for example, Sri Lanka
imports oil from middle east and cars from Japan.

 Productivity Differences In Countries: due to
technological reasons or because of a highly
skilled work force some countries have the
capacity to produce more of a good from the
given amount of resources than other countries.
So the country producing bulk of that commodity
would export to the other countries which produce
less. For example, the united states because of its
use of technology produces more wheat than India
from a given amount of land, and hence is able to
export wheat to other countries.
 In any economy, consumers tend to go for quality
goods and services at the lowest possible cost. To
operate efficiently, every form of good should be
produced at the lowest possible opportunity cost.

 Trade take place between countries since the
supply or availability of raw materials, and
other factors of production such as land labour,
and technology are not to be found equally in
all countries. This leads to international
differences in production costs and in the
prices of goods and services in the various
countries.
 Therefore, through international trade countries
supply the world economy with the
commodities they produce relatively cheaply,
while they import from other countries goods
that are made relatively cheaply elsewhere.

Theories of International Trade
 It is important to study the theories of
international economics or trade for a better
understanding of this subject.
 So, there are 3 main theories of international
trade, i.e. absolute advantage theory,
comparative advantage theory and the
Hecksher Ohlin theory on comparative
advantage. These theories are used to
analyze the basis and gains from trade.

Adam Smith:
Theory of Absolute Advantage.
 Adam smith is the other early classical
economists who criticized the mercantilist
views. According to smith, national wealth was
reflected not by the value of precious metals
but by the exchange value of annual product
of land ,labor of country.
 In other words, wealth was reflected in its
productive capacity (its ability to produce final
gods and services) and not by acquiring
precious metals.

Absolute Advantage
 The seeds of the modern international trade
theory come from Adam Smith (1776). The
concept of absolute advantage is the most
important idea put forward by him in this
regard.
 Smith argued that if a country can supply us
with a commodity cheaper than we ourselves
can make it, it is better to buy from them or to
exchange for the produce of our own industry.
Thus international trade helps countries to
acquire their consumption needs more
cheaply.

Absolute Advantage: The
ability of a country to produce
a specific good with fewer
resources (per unit of output)
than other countries. Thus,
according to smith, absolute
cost differences between
countries is the basis for trade.

Labour Theory of Value
 The absolute advantage theory is explained
by smith on the basis of the labour theory
of value. This means that the labour
element in the cost of production measured
in terms of labour time spent, determines
the value of a commodity.
 In other words, goods exchanged for each
other at home involve the same amount of
labour that is expended on producing them.

 Now let us explain how countries specialize
and gain from trade according to the
absolute advantage principle. To illustrate
this, we have to make some assumptions;
 We have only 2 countries say Sri Lanka and
India.
 Two goods say cloth and wheat.
 Labour is the only factor of production and
there is mobility between industries.
 Transport is cost free and that
 The labour requirements for each good an
country are as follows.

Absolute Advantage; Based on
Absolute Cost Differences.
Country Labour Cost of
Production
(labour hours per
unit of output)
Food Cloth
Sri Lanka 5 2
India 4 10

 According to the above table; in the absence of
trade, Sri Lanka will be the cheaper source of
cloth and India cheaper for food. In other words
Sri Lanka has an absolute advantage in the
production of clothe while India has it for food.
 Suppose that under “autarky” each country has
100hours of labour to produce each of the
commodities.(in the absence of trade, they need
to produce both commodities domestically). Thus,
Sri Lanka can produce 2o units of food (100/5)
and 50 units of cloths (100/2) under autarky
situation. Similarly, under autarky system , India
would produce 25 units of food (100/4) and 10
units of cloth (100/10). Now see the table below.

Autarky System; is a
situation in which a
country is completely
self-sufficient and
hence does not want to
trade with another.

Domestic Production; Before
Trade.
Country Units of
Food
Units of
Cloth
Total
Production
Sri Lanka 20 50 70
India 25 10 35
Total World
Production
45 60

 Now you will see what happen to the total
production by entering into trade. As shown in
the 2nd table, since Sri Lanka now produces
only cloth it can produce 100 units of cloth
(200/2), and since India produce only food, it
can produce 50 units of food (200/4).
Country Units of
Food
Unit of Cloth Total
Production
Sri Lanka 0 100 100
India 50 0 50

 So, according to the above table, the total
production of both commodities has been
increased. Assume that 2 countries
exchanged the 2 goods at a rate of 1 to 1. 1
unit of cloth is exchanged for 1 unit of food.
Suppose Sri Lanka needs 50 units of cloth
for domestic consumption. Therefore, rest of
the units of cloth (100-50 = 50) can be
exported to India, and import 50 units of
food.
 Therefore Sri Lanka has absolute advantage
in producing cloths and India has it for
producing food. Copyright © S M Irshad 2013. 20

David Ricardo
Theory of Comparative Advantage.
 The theory of comparative advantage
was presented by David Ricardo in
1817 in his book the principles of
political economy. He stressed that
absolute cost advantages do not
necessarily help 2 countries to gain
from trade with each other.
 Before we begin, lets look at some
assumptions of the Ricardian model.Copyright © S M Irshad 2013. 21

Assumptions;
 Two countries and 2 commodities.
 Labour is the only factor of production and there
is mobility between industries within a country.
 Transport is cost free.
 FOP’s are immobile between countries.
 Level of technology is fixed in both countries and
can be differ.
 Production costs and opportunity costs are
constant.
 No government restrictions for trade.

Comparative Cost;
Comparative Advantage
Country Hours of Labour
Required to
Produce
Cloth (1 yard) Wine (1 barrel)
India 45 40
Sri Lanka 50 60

 Note as shown in the above table, that India has
an absolute advantage in both commodities. India
can produce a yard of cloth with 45 hours of
labour compared to Sri Lanka’s 50 hours.
 Similarly India can also produce a barrel of wine
in 40 hours of labour compared to Sri Lanka’s 60
hours of labour.
 But comparative advantage says that this
condition is sufficient for trade between the 2
countries. Thus Ricardo argued that India could
benefit from trading with Sri lanka since India's
cost advantage is relatively greater in wine than in
cloth. While Sri Lanka’s relative disadvantage is
smaller in cloth. In other words, Sri lanka has
relative cost advantage in cloth.

 As shown in the table, the relative number of hours needed
to produce wine ( 40 in India, 60 in Sri Lanka) is less than
the relative number of hours needed to produce cloth (45 in
India, 50 in Sri lanka). That is 40/60=0.66 and 45/50=0.9;
o.66 is less than 0.9. thus India has greater advantage in
the production of wine than in cloth.
 On the other hand, in Sri Lanka, the relative number of
hours needed to produce one unit of cloth (50 in Sri Lanka,
45 in India) is less than the relative number of hours
needed to produce one unit of wine (60 in Sri Lanka, 40 in
India). That is 50/45=1.1 and 60/40= 1.5, respectively (
absolute advantage is less in cloth).
 thus, Sri Lanka has comparative advantage in producing
cloth. It is necessary to bear in mind our assumption that
labour is the only factor of production. These relative
(comparative ) cost differences enables both nation to
trade. This can be explained through the opportunity cost
of production. Copyright © S M Irshad 2013. 25

The law of comparative
advantage states that
“countries specialize in
producing and exporting
that goods that they produce
at a lower relative cost than
other countries”.

Opportunity Cost of
Production
 The comparative advantage theory is based
on the opportunity cost of production. The
opportunity cost of a good is the quantity of
other goods that must be sacrificed to make
one more unit of that good. So the
comparative advantage says that there are
international differences in the opportunity
cost of goods.
 The opportunity cost tells us about the
relative costs of producing different goods.

 According to the previous example, the
opportunity cost of producing one unit of
wine is lower (0.88) in India; India must give
up 0.88 units of cloth, than in Sri Lanka (1.2).
 Conversely, the opportunity cost of one unit
of cloth is lower in Sri Lanka than India. Sri
Lanka must give up only 0.83 units of wine
to make another unit of cloth, but India must
give up 1.12 units of wine to make another
unit of cloth.
 Thus India has a comparative advantage in
the production of wine and Sri Lanka has a
comparative advantage in cloth.

The Opportunity Cost of
Production
Country Sri Lanka India
Cloth 50/60 = 0.83 45/40 = 1.12
Wine 60/50 = 1.2 40/45 = 0.88

 There are two parts of comparative advantage
which leads a country towards international
trade.
 Static advantage
 Dynamic advantage
 An advantage a country inherits naturally due
to its production and consumption is known as
static benefit. The following factors cause
static advantage to occur;
 Resource endowment
 Differences in the taste of countries
 Returns to scale in production

Arguments Against Free
Trade.
 Free trade is a system leading to economic
gain for both trading partners. It leads to
the maximization of the value of world
production. If we ask whether free trade is
in fact always advantageous to everyone,
the answer is “ not necessarily". then why
is free trade the exception rather than the
general practice? The answer to this
question lies in arguments against free
trade. Now let us examine some of those
arguments. Copyright © S M Irshad 2013. 31

Trade Barriers Favor of
Protectionism
 There are several types of trade barriers or
restrictions on free trade imposed by countries as
part of their commercial or trade policy. There are
several reasons for the arguments against free
trade.
 Infant industries – the need to protect them.
 The practice of dumping
 The need to diversity
 National security
 Restrictions on luxuries
 Revenue collection
 Improving the terms of trade.Copyright © S M Irshad 2013. 32

Infant Industry Argument
 One of the most common arguments for trade restrictions is
the need to protect infant industries. Tariffs is said, they are
needed to allow infant industries to get started. It is generally
agreed that industries learn by doing, and that their costs will
fall as they gain experience. Indeed only by being in
business will firms earn to reduce costs and become as
efficient as foreign competitors.
 Therefore, a tariff protection is needed to protect new or
infant industries against competition from advanced
countries, until the domestic industries are able to compete
with the high quality goods produced by highly experienced
manufacturers. Once the industries have established
themselves and are able to meet foreign competition the
tariffs or protection could be removed. And any competing
with foreign suppliers, domestic firms could improve the
quality of their goods progressively.Copyright © S M Irshad 2013. 33

Dumping
 Some manufacturers adopt various devices to
capture or to establish their markets in other
countries. Dumping generally occurs when
foreign producers sell their goods at lower
price than the marginal cost in their own
country. This can be done either by selling at a
loss or with the assistance of government
subsidies. So if the foreign producer does this
indefinitely, domestic producers will face
difficulties in selling their goods, as they would
not be able to compete with the cheap goods
dumped by foreign suppliers.

 Usually foreign producers continue supplying
goods at lower prices until they drive domestic
producers out of the industry. The foreign
producer is then able to establish a monopoly of
that particular commodity in the world. Once the
foreign supplier achieves this monopoly he is
able to raise prices at will and make good his
earlier losses. The domestic government has
therefore to impose restrictions on free trade to
protect domestic industries. The most efficient
way to protect local producers from this threat is
the productivity subsidy. So the possibility of
dumping is one of the most important arguments
against free trade.

Product Diversification
 The economies of most developing countries
like Sri Lanka rely on a limited rage of
products. Free trade encourage nation's to
specialize in one or a few commodities to gain
from trade. changes in the world demand or
supply can be devastating if a country
specializes in the production of only a few
major products. For instances, Sri Lanka’s
relies mostly on tea and rubber while
Colombia's reliance is on coffee. Drought,
floods or any other disaster can easily wipe
out a year income of these countries.

 So product diversification is one way
of minimizing the risk. To diversify
production, some new industries
should be started domestically. At the
initial stages new these industries
should be protected through tariffs or
any other form of duties on imported
goods. Thus protection may
encourage entrepreneurs to start a
range of industries.

National Security
 Most countries believe that it is important to
develop and preserve industries that are
essential for the security of the nation. Food
and defense equipments include to this
category. A productive subsidy or incentive
rather than the imposition of tariffs would be
the better way of achieving this objective.
Mercantilists in the 17th century used this
argument to justify restrictions on the use of
foreign ships, saying that it will lead to
fostering the growth of a shipbuilding industry
and a navy that will be vital in a time of war.

Restricting Luxuries
 Those who oppose free trade argue that this is
one way of discouraging luxurious living by the
privileged few. Some poor countries believe that it
is wrong to allow a handful of rich people to enjoy
luxuries while the bulk of the people in the country
find it difficult to meet even their basic needs.
Therefore, they argue that the government
should, for reasons of social equity, impose a tariff
on imported luxury goods. Thus a tariff on imports
of luxuries will, on the one hand, reduce their
consumption by raising pricing, and on the other
hand, provide an incentive for domestic producers
to produce substitutes. This is known as import
substitution. Copyright © S M Irshad 2013. 39

Revenue Collection
 Some governments usually use the tariff
schemes as a resource of revenue. In the 18th
century, most government revenue came from
tariffs. However this was found to be not so
good a way of collecting revenue.
 Even today some developing countries adopt
this method to collect revenue on the basis
that administrative costs of raising revenue
through tariffs are lower than the cost of
raising through income tax. But modern
economies do not favor this method of
revenue collection.

Improving the Terms of Trade.
 This is we call the favorable balance of trade.
So if we can export more than we import the
terms of trade will move in our favor, the we
will end up with a larger share of the gains. On
the other hand If we import more than we
export, the opposite will happen and we will
end up with a unfavorable terms of trade. One
way of achieving favorable term of trade is by
placing restrictions on imports, making it more
difficult or expensive for local people, say Sri
Lanka’s to buy foreign products.

 However this kind of strategy could result in
retaliatory measures being taken thus
ultimately affecting all trade. Restrictive
measures need to be fine turned, if
undesirable effects are to be eliminated.

Commercial Policy Instruments
 As you know, trading with another country is
always more difficult and complicated than doing
business in the hoe country. This is because of
differences in language, laws, regulations,
customs duties, and currency differences all of
which complicate transactions. We will discuss
the government policy on international trade, also
known as commercial or trade policy.
 A governments commercial trade policy are
measures that influence international trade
through taxes, subsidies or through direct
restrictions of imports and exports.

Types of Trade Restrictions
 Trade restriction can broadly divided in to 2
main categories.
1. Tariff barriers – a tariff is a tax or duty
levied on the traded commodity as it
crosses a national boundary.
2. Nontariff barriers – these are quantitative
limits or permits imposed on foreign goods
can be imported. Basically import quotas
and licenses.

Import Tariffs
 An import tariff is a duty or tax on the
imported commodity. Import tariffs are
given below;
1. Value added tax – ad valorem tax is a
fixed percentage of the value of the
traded good.
2. Specific tariff – a fixed sum per
physical unit of the traded good.
3. Compound tariff – a combination of
both VAT & specific tariff.Copyright © S M Irshad 2013. 45

Nontariff barriers
 Licenses - A license is granted to a business by the
government, and allows the business to import a certain
type of good into the country. For example, there could be a
restriction on imported cheese, and licenses would be
granted to certain companies allowing them to act as
importers. This creates a restriction on competition, and
increases prices faced by consumers.
 Import Quotas - An import quota is a restriction
placed on the amount of a particular good that can
be imported. This sort of barrier is often associated
with the issuance of licenses. For example, a
country may place a quota on the volume of
imported citrus fruit that is allowed.

 Voluntary Export Restraints (VER) - This type of trade
barrier is "voluntary" in that it is created by the exporting
country rather than the importing one. A voluntary export
restraint is usually levied at the request of the importing
country, and could be accompanied by a shared VER. For
example, Brazil could place a VER on the exportation of
sugar to Canada, based on a request by Canada. Canada
could then place a VER on the exportation of coal to Brazil.
This increases the price of both coal and sugar, but
protects the domestic industries.

Advantages of Protectionism
 Protection of domestic infant
industries form international
competition.
 Establishing self sufficiency.
 Preventing unemployment.
 Preventing dumping.
 Correction of unfavorable balance of
payments.

Disadvantages of
Protectionism
 Contraction of domestic and foreign
markets
 A decreasing national income & the
contraction of foreign trade
 Inefficient industries due to lack of
incentives to reduce cost of
production of domestic goods
 A fall in the production of high quality
goods

World Trade Organization;
International Restrictions
 WTO was established 1st of January in
1995 replacing GATT – General Agreement
on Trade and Tariff. WTO provides a
common institutional framework for the
conduct of trade relations among its
members. This is an independent body,
with each member country having an equal
vote, unlike the IMF and the World Bank
where votes are weighted in favor of rich
countries.

The WTO meet at ministerial
level every 2 years. The 1st
meeting was in Singapore in
December 1996. there they
adopted 3 major changes;
Policy Reviews
Anti-Dumping Actions
Dispute Settlements

Goals of WTO
 Widening of global trade by reducing tariffs
that hamper free trade.
 Promoting free trade for investments which
influence the agricultural trade in the
international trade and intellectual property.
 Removal of non-tariff barriers such as
dumping export quotas and standardization of
products
 Removal of inequalities in trade.
 Acting congruently with international co-
operations including International Monitory
Fund and World Bank.

Trade Pattern & Sri
Lanka What is export ? Sale of goods and services
by a country to other countries in the world is
export trade.
 Ex: Sri Lanka sells tea to USA.
 What is imports ? Purchase of goods and
services by a country from other countries in
the world is import trade.
 Ex: Purchase of motor cars by Sri Lanka from
India

The export structure of Sri
Lanka is as follows.
Agricultural exports
Industrial exports
Mineral exports
Unclassified exports
(According to 2009 CBSL report)

 The above export structure above can
be presented as a percentage as
follows
 Agricultural exports 23.9%
 Industrial export 74.9%
 Mineral exports 1.3%
(According to 2009 CBSL report)
 Examples of exported / export oriented
agricultural goods are as follows.
 Tea, Rubber, Coconut, other
agricultural exports.Copyright © S M Irshad 2013. 58

Examples of exported industrial
goods are as follows;
 Food, beverages and tobacco
 Textiles and Garments
 Petroleum products
 Rubber products
 Ceramic products
 Leather bags and footwear
 Machinery and equipment
 Diamonds and jewelry
 Other industrial goods
Examples of export oriented minerals are as follows;
 Gems
 Other investment exports

The above structure can be
presented as a percentage;
Consumer goods - 18.4.3%
Intermediate goods - 59.9%
Investment goods - 20.5%
Miscellaneous - 1.2%

Examples of intermediate goods
imported are as follows
 Petroleum
 Fertilizer
 Chemicals
Examples of consumer goods imported
are as follows
 Rice, Sugar, Wheat, Milk powder
 Personal motor cars
 Electrical equipments

Examples of intermediate goods
imported are as follows
 Petroleum
 Fertilizer
 Chemicals
Examples of investment goods imported are as
follows
 Machinery and equipment
 Transport equipment
 Building materials

Terms of Trade
 When trade take place the trading partners stand to
benefit. Now the problem is to resolve how these
gains from specialization and trade could be
shared among the countries, trading partners. This
division of gains from trade depends on what we
call the terms of trade. What is meant by the terms
of trade?
 The terms of trade is the quantity of imported
goods that can be obtained per unit of goods
exported. In other words, it is the quantum of goods
that needs the exported to obtain one unit of an
imported good. This in simple term is measured by
the ratio of the price of exports to the price of
imports. Copyright © S M Irshad 2013. 68

 Terms of trade = Index of exports prices
Index of import prices X 100
•Income terms of trade
I = Px * Qx
I = income terms of trade
• Px = export price index
• Pm = import price index
• Qx= export volume index

 Commodity terms of trade can be
calculated by dividing the export price index
by import price index and multiplying it by
100.
 When the terms of trade improves it
facilitates economic development. When
the terms of trade depreciates it is harmful
to economic development. Commodity
terms of trade do not perfectly reflect the
import purchasing power of a country.
 The index prepared to measure the import
purchasing power of export revenue is
known as income terms of trade.

Favorable Balance of Trade
 Terms of trade could be favorable or
unfavorable. Favorable means that
more can be imported per unit of
goods exported than previously. In
other words, a rise in the price of
exports while the price of imports
remains unchanged, indicates
favorable terms of trade. Thus it will
now take fewer exports to buy the
same quantity of imports.

Favorable Terms of
Trade - the more
commodities can be
imported per unit of
goods exported.

Unfavorable Terms of Trade
Similarly, unfavorable terms of
trade means that the country can
import less in return for a given
amount of exports. In other words,
a rise in the price of imported
goods, while the price of exports
remains unchanged, indicates a
fall in the terms of trade.

Unfavorable Terms of
Trade – a country is
able to import less in
return for any given
amount of exports.

 Unfavorable terms of trade implies that
a country must export more to pay for
any given amount of imports. For
instance, in the early 1970s there were
unfavorable terms of trade for oil
importing countries like Sri lanka,
because of the oil price hikes. On the
other hand this sharp rise in oil prices
led to favorable shift in terms of trade
for the oil exporting countries.

Balance of Payments
 The balance of payments is a record of all the
country's transactions with the rest of the world
during a particular period. We have to follow
certain principles in compiling the balance of
payments statements.
 the balance of payments manual prepared by
the IMF is used as a guide world wide. The
balance of payments statement is based on a
double entry system. This applies the rules of
credit and debit.

 If the country earns foreign exchange through
a particular transaction, that recorded as a
credit or a plus item. A transaction that
involves a payment of foreign exchange is
recorded as a debit or a minus item. Following
this method, we can treat export earnings as a
credit entry and import payments as a debit
entry.
 So we can find BOP as a record of all
transactions between residents of a country
and the rest of the world during a specific
period of time. It helps us to understand the
economic relationships between countries.

Components of BOP
 Current account – all international
transactions relating to goods and
services are recorded in the current
account.
This is divided to 4 categories;
1. Trade account
2. invisible account
3. Services
4. Income and current transfers

Trade Account
 This is also called as visible account.
As it records exports and imports of
goods like tea, garments , vehicles
and gems. We identify the difference
between exports and imports as the
trade balance. A trade deficit occurs
when the value of visible imports
exceeds the visible exports. The
opposite results in a trade surplus.

 Invisible account – foreign transactions
relate to things that we cannot see are
recorded here. Port services, tourism,
insurance services. This account contains
following components;
 Services – including sea and air
transportation, travel , telecommunication
services, insurance services and other
business services.
 Income – includes outflows and inflows of
incomes like wages, dividends and interest.
 Current transfers – includes gifts received
from abroad or sent abroad by the privet and
public sectors.

Capital & Financial
Account
 This records inter-country movements
of financial capital like foreign
borrowings, foreign direct investment
and share market investments. This
account consists the following 2
components;
 Capital account- includes capita
transfers and flows of non financial
assets.

Financial Account
 This account includes foreign direct investment – FDI,
portfolio investment, and short term , long term borrowings.
 The FDI is used for purposes like setting up factories' or
providing telecommunication services. Usually the FDI is
coming for enterprises under the board of investment to the
BOP. These capital flows are considered more stable, as
such investors do not tale away their capital at short notice.
Portfolio investments coming to the stock exchange are
short term by nature, as the investors have the facility to
sell their shares instantly in the stock market.
 Borrowing and lending by the government and privet
sectors are recorded separately in the financial account.
The financial account also records the changes in foreign
assets and liabilities of commercial banks. Drawings from
the IMF are also included in this account.

Trade account & trade balance
 The trade account consist of exports and imports
of goods. Moreover, it includes all visible trade
flows into and out of the country imports are
trade flows into the country while exports are
trade flows out of the country. The net difference
between exports and imports of a country is
called the trade balance. Hence, the trade
balance is an indicator of how a country has
fared with respect to these visible trade items
during a given period of time.

 If a country exports more than its imports, that
country is said to have a trade surplus. A trade
deficit occurs where a country has imported
more than its exports. Usually, a trade surplus
is considered a healthy sign, though not
necessarily so as the deficits (if any) also have
to be take into account.
 on the other hand , any trade deficit could be
off-set by surpluses generated in other
components of the balance of payments. There
are some countries which do not have a
significant production base (e. g. Maldives), but
still there may be a surplus in the capital
account or in the services, due to gains
elsewhere.

BOP
Current
Account
Trade
Account
Exports of
Goods
Imports of
Goods
Invisibles
Export &
Import of
Services
Net Interest
Payments
Privet &
Official
Transfers
Capital
Account
Financing
Items

The Overall Balance
 The overall balance is the final balance of payments
position of the country, i.e. the net outcome of the
current and capital accounts. In other words, this
indicates, how a country has fared in its international
transactions during a given period. This overall balance
may be positive (surplus) or negative (deficit).
 If there is a surplus in the overall balance, it indicates
that country has earned more from foreign exchange
than it has paid out to other countries within a given
period. Thus, it leads to an accumulation of foreign
assets by the banking system. On the other hand, if
there is a deficit in the overall balance, indicates that the
country has earned less foreign exchange than it has
paid out leading to a deterioration of the foreign assets
of the country.

Therefore, the trading
performance of a
country is usually
determined by the
overall Balance of
Payments situation.

Monetary Movements
 This is necessarily always equal, and of
opposite sign, to the net balance of payment
figure. Monetary movements, thus represent
the utilization of foreign assets when there is a
deficit in the overall balance. And on the other
hand , it represents the accumulation of foreign
assets when there is a surplus in the overall
balance. However, this item is considered as a
below the line record because it is not included
in the main body of the BOP. See the below
hypothetical BOP record.

Component Debit ( - ) Credit ( + ) Balance
1. Trade account
a) Total exports
b) Total imports
2. Trade balance
500
400
- 100
3. Services
a) Receipts
b) Payments
4. Balance of services
100
300
+ 200
5. Balance of goods & services
(2+4) + 100
6. Transfers
a) Receipts
b) Payments
7. Net transfers
100
200
+ 100
8. Current acc. Balance (5+7)
+ 200
9. Capital account
a) Receipts
b) Payments
10. Capital acc. balance
350
100
-250 90Copyright © S M Irshad 2013.

Credit & Debit Transactions
 All transactions or exchanges whether
domestic or international are posted as
credits or debits.
 International credit transactions – are
those involve the receipts of payments
from foreigners.
 International debit transactions – are
those involve the making of payments
to foreigners.

 Credit transactions are entered with a positive
sign and debit transactions with a negative
sign n the country's BOP account. For
instance, he export of goods and services,
unilateral transfers such as gifts received from
foreigners and capital inflows are entered as
credits with a positive sign because they
involve the receipt of payments from outside.
 Likewise, the important of goods and services
, gifts made to overseas persons and capital
outflows involving external payments are
entered as debits with a negative sign in the
BOP account. The nature of credits and debits
explained further in the below table.

Credits Debits
Current account
1. Tea sales to UK
2. Rubber sales to Japan
3. Garment sales to USA
4. Interest earned on Sri Lankan
loan to Singapore
1. Purchase of oil from Middle
East
2. Purchase of Japanese cars
3. Hotel bills of Sri Lankan
residents in UK
4. Sri Lankan aid grants to India
Capital account
1. Inflows of Singapore
purchases of Sri Lankan hotels
2. Increase in privet foreign
holdings in Sri Lankan banks.
1. Outflows of Sri Lankan
investments to Japanese
mines
2. New long term loans t0 Hong
Kong
3. Increase in Sri Lankan
deposits in Swiss bank
Reserve items
1. Increase in holdings of Sri
Lankan bank deposits
1. Net increase in holdings of
bank deposits abroad by Sri
Lanka treasury

Double Entry System
 What is double entry system or book keeping
method in the BOP account? Usually, the
accounting procedure, in recording a nation's
transitions, is known as the double entry system.
This is a system where by each transaction is
viewed from 2 different sides, as a credit and as
debit of an equal amount.
 In other words, one side is debited to one account,
while other side is credited to another account. In
this manner, all transactions recorded in accounts
as debits and credits will have to balance
automatically. What is the reason for this 2
transaction? The reason is every transaction has 2
sides. For example, when we sell something, we
receive a payment for it. Likewise, we buy
something and we pay for it.

 Suppose that a Sri Lankan firm exports Rs. 50,000
of merchandise, to UK, to be paid for in 4 months.
Thus, Sri lanka first credits these exports for Rs.
50,000 as these exports lead to the receipt of a
payment from UK. On the other hand this
transaction (payment for exports) itself is entered as
a debit.
 The reason is that this receipt represents a short
term capital inflows from SL. This is because UK has
asked to make payments within 4 months. Thus Sri
Lankan exporter is extending credit to, and has
acquired a claim on , the foreign exporter. This in
fact leads to an increase in Sri Lankan assets in UK
and it is a debit. This transaction therefore, is
recorded as follows in a BOP of nation.

Component Credit + Debit -
Exports Rs. 50,000
Short term
capital outflow
Rs. 50,000

Examples of economic effects of a
surplus of BOP are as follows.
 Increase in foreign reserves
 Increase in the time for which foreign
reserves are sufficient for imports
 Expansionary effect on the money supply
 causing an inflation
 Increase in the value of foreign exchange
 Fall in the export competitiveness

Examples of economic effects of
a deficit of Bop are as follows.
A fall in foreign reserves
Concretionary effect on money
supply
Depreciation of exchange rates
Implementation of protectionism
Increase in foreign debts.

Various measures can be taken to
finance a Bop deficit
 Eg: Use of capital and financial a/c
reserves to finance the current a/c
deficit.
 Long term actions are to be taken to
finance overall balance deficit.
 Import substitution
 Export diversification

Foreign Exchange Rate &
Market
 Each nations currency has a value in terms of the
currency of other nations. This is what is meant by
the exchange rte. For instance if you take a US $,
the SL rupee has a value in terms of the $, i. e. 1 $
= Rs. 130, which is the exchange rte of the Sri
Lankan rupee against the $.
 Therefore we can refer to the exchange rte, in
simple terms as the price of foreign currency. When
the currency is the Sri Lankan rupee, the exchange
rates will be the rupee value of other currencies.
Say the $, which would be equal to 130 rupees.

What is Foreign Exchange
Market? The foreign exchange market is the place where
foreign currencies or foreign exchange is bought
both and sold. In other words, individuals, firms
and banks buy and sell foreign currencies or
foreign exchange in the foreign exchange
markets like New York, London, Paris, and
Singapore and Colombo.
 The transaction can be the place where rupees
are bought and sold for other currencies. So
foreign exchange market is a network of banks
and foreign exchange dealers that buy and sell
national currency in exchange for another
national currency.

Exchange Rate
Regimes An exchange rate is the price of one currency
in terms of another. For Sri Lanka, the dollar
exchange rates means the amount of dollars a
rupee can buy. Countries have adopted many
different exchange rate systems from time to
time. They are;
 Fixed exchange rate regime
 Adjustable peg regime
 Crawling peg regime
 Managed floating regime
 Free floating regime

 Adjustable peg system – the exchange
rate is maintained with a margin around
central parity. This parity may be
changed if necessary.
 Crawling peg system – this is an
adjustable peg where the central parity
ay be changed regularly on the basis of
the previous trend in the exchange rate.
 Managed floating system – the
government occasionally intervenes in
the exchange market to stabilize the
exchange rate. Copyright © S M Irshad 2013. 103

Fixed Exchange Rate Regime
 Under the fixed exchange rate regime, national
governments interns to maintain the convertibility
of their currencies at fixed rates. In other words
in this system government announce official
foreign exchange rates. In such a system
decrease in the official exchange rate is called
devaluation while and increase is a revaluation.
 When a county's official foreign exchange rates
(relative to other currencies) is reduced, we say
that the currency has undergone a devaluation.
0n the other hand, if a country's official exchange
rate is increased, it is called a revaluation.

Free Floating
Exchange Rate System
 However the simplest system is the floating
exchange rate system. In this system there is no
government intervention by governments or central
banks in the process of determining the exchange
rate.
 In other words, the foreign exchange rate is
determined by the demand and supply forces like the
price of any commodity in any competitive market.
Thus , the price of foreign currency (exchange rate)
is determined by the interaction of the demand for
and the supply of that currency, which are in turns
determined by a host of other factors.Copyright © S M Irshad 2013. 105

 Clearly, the market clears itself through price
mechanism. Therefore, in the floating exchange
rate mechanism, government do not intervene
at all in the foreign exchange market. the
exchange rate adjusts automatically in response
to the forces of supply and demand and thereby
automatically eliminates payments imbalances.
 Let us tae an example to illustrate how the
exchange rate is determined under the floating
exchange rate system. We can use our familiar
supply and demand curves to illustrate how
markets determine the price of foreign
currencies.

S
D
A60
62
58
0 200 Mns
Quantity of Dollars
Rs./$

 The above figure shows the international exchange
market for rupees and dollars. The vertical axis
measures the rupee price of dollars, while the horizontal
axis measures the quantity of dollars.
 As mentioned above, the demand and supply curves
intersect at point A, suggesting the equilibrium
exchange rate Rs. 60 : 1 $. At this point the quantity of
dollars supplied and the quantity of dollars demanded
are equal to 200 Mns dollars.
 However, any price other than at point A, would not
clear the market. For instance, at Rs. 58 per dollar, the
price of dollar is cheap. In other words, the amount of
rupees that has to be given per dollar has been
decreased (from 60 to 58 rupees). This is called as
Dollar Depreciation .
 On the other hand, if you consider the other side, that is
, f the amounts of rupees that has to be paid per dollar
has increased from 60 to 62 rupees, then this is called
as Dollar Appreciation.

Currency Depreciation
 When a county's foreign exchange rate
declines relative to that of another county, we
say that the domestic currency depreciates
while the foreign currency appreciates.
 In other words, a rupee depreciation occurs
when the rupee losses value relative to foreign
currencies ( ex. $). As we have discussed now,
in the market for rupees and dollars, a rupee
depreciation occurs when Rs/$ rises. For
example, this ratio is 60/1. if this ratio become
62/1, then the rupee has depreciated. That
means this ratio has been increased
(62/1>60/1).

The Factors Affecting Currency
Depreciation
 There are 3 factors that contribute to
depreciation of a currency;
1. When a person visits a country,
2. When a firm import from overseas,
3. When a firm or individual wants to invest in
abroad,
 due to these factors there is a demand for
foreign currency which leads to depreciate
local currency.

 For Example, if investment seem attractive in the
US, because of a spurt in the American
economy, Sri Lankans might invest in the US, the
demand for dollars to invest in the US rises and
the rupee depreciates correspondingly.
 As mentioned in the curve below, the demand for
American dollar shifts to right, because
increasing price of American software. The
volume of activity on the foreign market increase,
and the rupee depreciates. It shows with the
original exchange rate at Rs. 62 / $. With
increased demand for dollars, the value of the
dollars rises from 62 to 65. the quantity of trading
in the foreign exchange ,market also rises.

S
D1
D
50 600
62
65
Million $
Rs./$

 For example, the effects of change in trade also
deprecate currency. If Sri lanka decided to import
curb from the US, or if Sri Lankans travelled less
to US, what would happen to the exchange rate?
 For both cases, Sri Lanka’s demand for foreign
currencies would decrease. Suppose Sri Lankans
travel less to US or decide to curb imports from
US. This would lead to lower imports from America
and decrease the demand for US dollars, shifting
the demand curve to the left D to D1.
 as a result of this, the exchange rate of the dollar
falls to 60 from 62 per dollar. Due to this exchange
rate of the rupee rises. Then a new exchange rate
occur at point E1, where one dollar is exchanged
for 60 rupees.

S
D1
D
40 500
60
62
Amount of $
Rs./$
E 1
E

Currency Appreciation
 An increase in the value of one currency
with respect to another. This means that
one unit of the appreciating currency buys
more units of the other currency than it did
previously.
 While this can be a good sign, as it may
indicate a low rate of inflation, it also makes
exports from the country with the
appreciating currency more expensive,
while making imports less expensive.

 There are several factors affecting the supply of
foreign currency. For example, the supply of foreign
currency increases when foreigners spend in Sri
Lanka, or when goods are exports or when foreign
investments are made. So these factors would lead
to an increase in the demand for rupees and the
rupee would appreciate.
 For example, on the export side, increased
international demand for Sri Lankan exports (i.e.
garments) would causes foreign buyers to increase
the supply of their currencies on the foreign
exchange market. Again Sri Lanka seems attractive
for investments because of a favorable environment
the demand for the rupee rises and the rupee would
appreciate.

S
S1
Rs./$
62
60
50 600 Million $
D

As shown above, an increase in
the supply of foreign currency
causes an appreciation of the Sri
Lankan rupee as the level of
trading in the foreign exchange
market increases. In other words,
in view of the increased demand
for Sri Lankan rupees, the value of
the dollars fell from 62/$ to 60/$.

Foreign Direct Investment
 What is FDI?
 When a firm invests directly in facilities
to produce/or market a product in a
foreign country is called foreign direct
investment.
 Once a firm undertakes FDI, it
becomes a multinational enterprise
(the meaning of multinational being
“more than one country”).

Types of foreign direct investment
 FDI takes 2 main forms;
 Green field investment – which involves the
establishment of a wholly new operation in a
foreign country.
 Acquiring or merging – acquiring or merging
with an existing firm in the foreign country.
Acquisitions can be a minority (where the
foreign firm takes a 10% to 49% interest in the
firms voting stock), majority (foreign interest of
50% to 99%), or full out right stake ( foreign
interest of 100%).

Foreign Portfolio Investment
 FPI is invested by individuals, firms, or
public bodies (e. g. national and local
government) in foreign financial
instruments (e. g. government bonds,
foreign stocks). FPI does not involve
taking a significant equity stake in a
foreign business entity ( I. e. the equity
stake is less than 10%).

Political Ideology Towards FDI
Ideology Characteristics Host-Government
Policy
Implications
Radical Marxist roots.
Views the MNE as an
instrument of
imperialism.
Prohibit FDI.
Nationalize subsidiaries of
foreign owned MNE’s.
Free Market Classical economic roots
Views the MNE as an
instrument of allocating
production to most
efficient locations.
No restrictions on FDI.
Pragmatic
Nationalism
Views FDI as having both
benefits and cost.
Restrict FDI where costs
outweigh benefits.
Bargain for greater
benefits and fewer costs.
Aggressively court beneficial
FDI by offering incentives.Copyright © S M Irshad 2013. 124

Benefits of FDI to the Economy
 Economists who favor the free market view
argue that the benefits of FDI to a host country
so outweigh the cost of that pragmatic
nationalism is a misguided policy. According to
the free market view, in a perfect world the best
policy would be for all countries to forgo in the
investment decisions of multi national
enterprises – MNE’s.
 Those benefits include; Resource Transfer
Effect, Employment Effects, Balance
of Payments Effect and also Effect on
Competition and Economic Growth.

Resource Transfer Effect
 FDI can make a positive contribution to a host
country by supplying capital, technology, and
management sources that would otherwise not
be available and thus boost that country's
economic growth rate.
Capital – many MNE’s, by virtue of their large
size and financial strength, have access to
financial resources not available to host country
firms. These finds may be available from
international company sources, or, because of
their reputation, large MNE’s may find it easier
to borrow money from capital markets than host
country firms would.

Technology – the crucial role played by
technological progress in economic growth is now
widely accepted. Technology can stimulate
economic development and industrialization.
 Technology can be incorporated in a production
process ( the technology for discovering oil,
extracting and refining oil) or it can be incorporated
in a product (personnel computers).
 However, many countries lack the research and
development resources and skills required to
develop their own indigenous product and process
technology. This is particularly true of the worlds less
developed nations. such countries must rely on
advanced industrial nations for much of the
technology required to stimulate economic growth,
and FDI can provide it.Copyright © S M Irshad 2013. 127

Management – foreign management
skills acquired through FDI may also produce
important benefits for the host country. Foreign
managers trained in the latest management
techniques can often help to improve the
efficiency of operations in the host country.
 Whether those operations are acquired or
green field development. similar benefits may
arise if the superior management skills of a
foreign MNE’s stimulates local suppliers,
distributers, and competitors to improve their
own management skills.

Employment Effects
 Another beneficial employment effect claimed
for FDI is that it brings jobs to host country that
would otherwise not be coated there. The
effects of FDI on employment are both direct
and indirect.
 Direct effects arise when a foreign MNE
employs a number of host country citizens.
Indirect effects arise when jobs are created in
local suppliers as a result of the investment
and when jobs are created because of
increased local spending by employees of the
MNE.

BOP Effects
 There are 3 potential BOP consequences of FDI. 1st , when an
MNE establishes a foreign subsidiary, the capital account of the
host country benefits from the initial capital inflow. (a debit will
be recorded in the capital account of the MNE’s home country,
since capital is flowing out of the host country.
 2nd if the FDI is a substitute for imports of goods or services, it
can improve the current account of the host country’s BOP.
Much of the FDI by Japanese automobile companies in the US
and UK, for example, can be seen as substituting for imports
from Japan.
 3rd potential benefit to the host country's BOP positions arises
when the MNE uses a foreign subsidiary to export goods and
services to other countries. There are some striking examples of
this phenomenon.
 In the Czech republic , Skoda, the national automobile company,
was a well established producer and exporter. After it sale to
Volkswagen in 1992, however, exports boomed as the new
owners redirected the company's sales efforts towards the
European union.

Effects on Competition & Economic Growth
 Economic theory tells us that the efficient functioning of markets
depends on an adequate level of competition between producers.
When FDI takes the form of green field investment, the result is to
establish a new enterprise, increasing the number of players in a
market and thus consumer choice.
 In turn , this can increase the level of competition in a national
market, thereby riving down prices and increasing the economic
welfare of consumers. Increased competition tends to stimulate
capital investments by firms in plant, equipments, and research
and development as they struggle to gain an edge over their
rivals.
 the long term results may include increased productivity growth,
product and process innovations, and greater economic growth.
After liberalization in Sri Lanka 1977, the economy has been
expanded by FDI investments in the industries of power projects,
housing schemes and industrial sectors.

Impact of FDI to the Economy
Three costs of FDI concern host
countries. They arise from
possible adverse effects on
competition within the host
country, adverse effects on the
balance of payments, and the
perceived loss of national
sovereignty and autonomy.

Adverse Effects on Competition
 Although we have just outlined in the previous section
how FDI can host competition, host governments
sometimes worry that the subsidiaries of foreign MNEs
may have greater economic power than indigenous
competitors. If it is part of a larger international
organization, the foreign MNE may be able to draw on
funds generated elsewhere to subsidize its costs in the
host market, which could drive indigenous companies
out of business and allow the firm to monopolize the
market.
 (once the market was monopolized , the foreign MNE
could raise prices above those that would prevail in
competitive markets, with harmful effects on the
economic welfare of the host country). This concern
tends to be a relatively minor concern in most
advanced industrialized nations.

Adverse Effects on the BOP
 There are many possible effects of FDI on a
host country's BOP. There are 2 main areas of
concern with regard to the BOP.
 1st as mentioned earlier, set against the initial
capital inflow that comes with FDI must be
subsequent outflow of earnings from the
foreign subsidiary to its parent company. Such
outflows show up as a debit on the capital
account. Some governments have responded
to such outflows by restricting the amount of
earnings that can be repatriated to a foreign
subsidy's home country.

 A second concern arises when a
foreign subsidiary imports a substantial
number of its inputs from abroad, which
results in a debit of on the current
account of the host county's BOP.
 Eg. Japanese automobile assembly
operations in USA, have become a
debit to their economy because they
imports the parts from Japan not
manufactured in USA.

Effects on National Sovereignty and
Autonomy.
 Some host governments worry that FDI is accompanied by
some loss of economic independence. The concern is that
key decisions that can affect the host country's economy will
be made by a foreign parent that has no real commitment to
the host country, and over which host country's government
has no real control.
 A quarter of a century ago this concern was expressed by
several European countries, who feared that FDI by U.S.
MNE’s was threatening their national sovereignty. The same
concern faced in the US with regard to European and
Japanese FDI during the 1980s and early 1990s.
 In Sri Lanka after the war, the situation was crucial for the
government to start the development process in the north
east, but many FDI were started in significant sectors. Such
as infrastructure and health sector.Copyright © S M Irshad 2013. 136

Regional Integration
(Trade Arrangements).
 One of the major aspects of international trading
relations in the post war period (after the WW – II)
has been the development of regional trade
arrangements such as EEC, ASEAN, LAFTA. In
such cases 2 or more countries combine to form a
larger economic region by removing tariffs and other
trade barriers between them, thus ensuring free
trade within the regional group. However, member of
the regional group practice protectionism in the case
of non-member countries by adopting either
common or separate discriminatory trade policies,
thus combining free trade with protectionism. There
are 4 types of economic arrangements. i. e. free
trade area, customs unions, common markets and
economic unions.

Free Trade Area
 In a free trade area member countries
remove tariffs and other trade barriers
between themselves but each member is
free to decide its own tariff, trade
restrictions and commercial policies with
non member countries.
 The European free trade association –
EFPTA and the Latin American free trade
area – LAFTA, are examples of free trade
areas. African Free Trade zone (AFTZ).

Customs Unions
 Member countries of a custom union abolish
all tariffs ad trade barriers among themselves
but they adopt a common external tariff and
commercial policy in the case of non
members.
 Therefore, in a custom union all members act
as a unit in their trade relations with non
member countries. The west Asian custom
union is, perhaps , the best example for this
type of trade practice. Caribbean Community
(CAN), North American Community (NAC)

Common Markets
In a common market both product and
factor markets are integrated. As a
result there is a free movement of
goods, services and factors of
production among member nations of
the common market. Eg: the central
American common market – CACM.
Caribbean Community (CAN), North
American Community (NAC)

Economic Unions
 Beside the integration of product and factor
markets as in the common market, an economic
union involves the harmonization of monetary ,
fiscal and other policies such as the exchange
rate, transportation, industrial and social policies
and so on.
 Thus there is a significant degree of unanimity
among the members of the economic union in the
adoption of a common external tariff and
domestic economic policies. The European
economic community is the best example for this.

Preferential Trade Agreements
 Preferential Trade Agreements (PTA) is an
organization made by countries to exchange
goods and services among member
countries under less trade barriers that are
usually used in trade among non-member
counters.
 European economic union
 Indo - Afghanistan PTS
 NAFTA (North America Free Trade
Agreement)

Economic & Financial Union
 Economic and monetary unions are integration
of countries to maintain free trade among
member countries, This is an integration with
member countries and non member countries to
follow a common policy on trade and free
mobility of labour and capital among member
countries. Examples of economic and Monetary
unions are as follows
 Central African economic and monetary unions
 Western African economic and monetary unions
 European Monetary and economic unions

Full Economic Integration
Full integration (FI) is integration of
countries to maintain free trade
among member countries and non-
member countries of goods and
services and factor of production
and to maintain a unitary marketing
policy, fiscal policy legislative,
executive judiciary and political
policy.

Feature of Economic Integration
 Economic integration whatever its type
on forms, has 3 features.
 The removal of trade barriers between
member nations
 Adoption of discriminatory trade
policies against non member nations
 The common adoption of certain
instruments of economic policy by
member nations.

Benefits of Regional Trade
Arrangements.
 The purpose of regional trade arrangements is
to ensure free movement of goods and factors
of production between nations in a regional
group. This will bring a number of benefits to
the member countries, such as
 A better allocation of resources among member
nations.
 Increased production due to specialization
based on comparative advantage.
 Enhanced volume of trade.

The Objectives of Economic
Integration
 Maintenance of a unitary price by removing
price disparities among countries.
 Provision of goods at lower prices for
consumers through increasing competition.
 Increase in GDP in countries through widening
world trade.
 Bargaining with multilateral trading partners.
 Preserving international competition in the
process of globalization.
 Developing political relations among nations.

 Increased economic efficiency within the
group due to competition among the
members.
 Improved terms of trade of members of the
regional group as against the rest of the
world.
 Improved standards of living of the people
of the member countries of the group due to
availability of better products at lower
prices.
 Creation of better employment opportunities
and higher incomes.

Trade Agreements
 Many Countries enter to trade agreements as
one step towards the economic integration.
There are types of trade agreements;
 Bilateral Free trade Agreements - Bilateral
trade agreements are agreements created by
two countries for trade and monetary
activities.
 Eg. Indo - Lanka Free trade agreement, SL -
Pakistan Free Trade Agreement.
 Multilateral trade Agreements.

The Indo-Sri Lanka Free Trade
Agreement
 Economic relations between Indian and
Sri lanka, which date back to pickup in
the 1990s with the liberalization of the
Indian economy.
 The year 1998 saw the biggest boost in
economic relations when the two
countries signed a bilateral indo-lanka
free trade agreement , which began
implementation in march 2000.

Signing of Indo-Lanka Free Trade Agreement in 1998
Right ; President of Sri Lanka , Chandrika
Bandaranayke
Left ; Prime Minister of India, Athal Bihar Vajpayee

Objectives of ISLFTA
 To promote through the expansion of trade the
harmonious development of the economic
relations between India and Sri Lanka
 To provide fair conditions of competition for
trade between India and Sri Lanka
 In the implementation of this Agreement the
Contracting Parties shall pay due regard to the
principle of reciprocity
 To contribute in this way, by the removal of
barriers to trade, to the harmonious
development and expansion of world trade.

The Advantages of ISLFTA to
Sri Lanka
 Access to a wider market.
 Decrease in the transport cost.
 Decrease in the prices of consumer goods in
the domestic market.
 Advantages of free trade.
 Inflow of more foreign investments to Sri Lanka.
 Ability to face foreign challenges strongly.
 New Industrial products of India can be
purchased at a low price.

Outcome of 9 Years: 1999-2008
1999 2005 2008
SL exports to India 1% 9% 5%
SL imports from
India
8.5% 17% 25%
Import/Export ratio 10.5:1 2.6:1 8.2:1
No of products from
SL
505 1062 869
Type of exports Many primary
products:
pepper, areca
nuts, waste &
scrap, dried
fruit, cloves
Dominated by
vanaspathi &
copper
VA products: insulated
wires & cables, refined
copper products,
rubber gloves, apparel
Rank of export
destination
14 3 5
Ind investment in
SL (% of total FDI)
Less than 2% 16% 14%
154Copyright © S M Irshad 2013.

India-Sri Lanka Trade: 1995-2008
Year Exports
(US$ Mn)
Imports
(US$ Mn)
Trade Balance
(US$ Mn)
Import/Export
Ratio
1995-1999
average
39 509 -470 13.1:1
2000 58.0 600.1 -542.1 10.3:1
2001 72.0 601.5 -529.5 8.4:1
2002 170.5 852.8 -682.3 5.0:1
2003 245.3 1073.2 -827.9 4.4:1
2004 391.5 1439.1 -1047.6 3.7:1
2005 566.4 1835.4 -1269.0 3.2:1
2006 489.5 2172.9 -1690.4 4.4:1
2007 515.3 2610.1 -2094.8 5.1:1
2008 418.3 3443.0 -3024.7 8.2:1
Source: Central Bank of Sri Lanka

38%
30%
11%
5%
5%
4%
4% 3%
Sri Lanka’s main exports to India 2005
Copper & copper products
Vanaspathi
Aluminium products
Electrical machinery & parts
Antibiotics

0
500
1000
1500
2000
2500
3000
3500
4000
US$Mn
Year
India-Sri Lanka Trade: 1999-2008
Exports
Imports

Sri Lanka’s trade
agreements.
Agreement Year Current Status Member Countries
Reciprocal Agreements
APTA 1976 Signed & in effect Bangladesh, China, India, South
Korea, Laos, SL
ISFTA 2000 Signed & in effect India, SL
PSFTA 2005 Signed & in effect Pakistan, SL
SAFTA 2006 Signed & in effect SAARC countries
SATIS 2010 Signed, not yet in effect SAARC countries
BIMSTEC
FTA
2004 Signed, not yet in effect Bangladesh, Bhutan, India,
Myanmar, Nepal, SL, Thailand
Iran-SL PTA 2004 Signed, not yet in effect Iran, SL

Agreement Year Current Status Member Countries
US-SL FTA 2002 Under consultation &
study
USA, SL
Singapore-
SL FTA
2003 Under consultation &
study
Singapore, SL
GSTP 1989 Signed & in effect 43 developing
countries
Non-reciprocal Agreements
EU GSP 1971 Signed & in effect 175 developing
countries
US GSP 1976 Signed & in effect 127 developing
countries

South Asian Association for
Regional Cooperation.

SAARC
 The SAARC was established at the Dhaka
summit in 1985.
 Many issues were discussed under SAARC, and
the south Asian free trade area – SAFTA comes
under the broad issue of economic relations.
 SAARC is one of the recent developments in an
effort to organize a regional alliance among
developing countries. This enable the 8 south
Asian countries, India, Sri lanka, Pakistan,
Bangladesh, Nepal and Maldives, Bhutan,
Afghanistan to collaborate economically and to
collectively face the challenges that arise in the
process of globalization.

Current members & Observers
Current members
 Afghanistan
 Bangladesh
 Bhutan
 India
 Maldives
 Nepal
 Pakistan
 Sri Lanka
Observers
 Australia
 China
 European Union
 Japan
 Iran
 Mauritius
 Myanmar
 South Korea
 United States

South Asian Preferential Trading
Arrangement - SAPTA
 The SAPTA was signed on April 11th 1993.
 this was a result of previous summits and
discussions, and it was only after the report on
trade manufacture and services in SAARC
countries submitted in 1991, that the countries
agreed to form SAPTA with the intention of
developing economic cooperation. This came in
to operation in December 1995.
 The 8th summit held in New Delhi emphasized
the need to expedite the operation of SAPTA
with a view to achieving a free trade area -
SAFTA.

South Asian Free Trade Area
SAFTA
 SAFTA was envisaged primarily as the first step
towards the transition to a South Asian Free
Trade Area (SAFTA) leading subsequently
towards a Customs Union, Common Market and
Economic Union.
 In 1995, the Sixteenth session of the Council of
Ministers (New Delhi, 18–19 December 1995)
agreed on the need to strive for the realization of
SAFTA and to this end an Inter-Governmental
Expert Group (IGEG) was set up in 1996 to
identify the necessary steps for progressing to a
free trade area.

 The Tenth SAARC Summit (Colombo, 29–31 July
1998) decided to set up a Committee of Experts
(COE) to draft a comprehensive treaty framework for
creating a free trade area within the region, taking
into consideration the asymmetries in development
within the region and bearing in mind the need to fix
realistic and achievable targets
 The SAFTA Agreement was signed on 6 January
2004 during Twelfth SAARC Summit held in
Islamabad, Pakistan. The Agreement entered into
force on 1 January 2006, and the Trade
Liberalization Programme commenced from 1 July
2006. Under this agreement, SAARC members will
bring their duties down to 20 per cent by 2009.
Following the Agreement coming into force the
SAFTA Ministerial Council (SMC) has been
established comprising the Commerce Ministers of
the Member States.

The Basic Principles SAFTA
 Overall reciprocity and mutuality of advantages so as to
benefit equitably all Contracting States, taking into account
their respective level of economic and industrial
development, the pattern of their external trade, and trade
and tariff policies and systems;
 Negotiation of tariff reform step by step, improved and
extended in successive stages through periodic reviews;
 Recognition of the special needs of the Least Developed
Contracting States and agreement on concrete preferential
measures in their favor;
 Inclusion of all products, manufactures and commodities in
their raw, semi-processed and processed forms.

The Instruments Involved in
SAFTA
 Trade Liberalization Programme
 Rules of Origin
 Institutional Arrangements
 Consultations and Dispute Settlement
Procedures
 Safeguard Measures
 Any other instrument that may be
agreed upon.

The Objectives of SAFTA
 Removal of trade barriers and facilitation of
trade transactions across boundaries.
 Free and fair trade in member countries after
considering their economic levels and their
economic development patterns and distribution
of benefits of trade among them equally.
 Creation of an effective mechanism to
implement the agreement to appreciate its
activities and to settle disputes among them.
 Establishment of a regional cooperation
programme to spread and increase the benefits
of the agreement in future.

The Issues that Arose in
SAFTA
 Lack of political agreement
in the zone.
 Production of similar goods
by most member countries.
 Administrative and political
barriers.
 Existence of high tariff

North American
Free Trade
Agreement
NAFTA

NAFTA
 Started with Canada and USA in 1989
 Followed with NAFTA in January 1, 1994
 Tariffs reduced in 10 years (99% of goods traded)
 End most barriers on cross border flow of
services
 Removal of restrictions on FDI except in:
 Mexican railway and energy
 US airline and radio communications
 Canadian culture
 Application of national environmental standards
 Protection of intellectual property rights

Benefits of NAFTA
 Enlarges more efficient regional productive base
 US and Canadian firms tap labor-intensive low-
wages
 Mexico receives FDI and employment
 Increases Mexican income to buy US/Canada
goods
 Demand for US/Canada goods increases jobs
 Increases competitiveness of US/Canadian firms

Case against NAFTA
 Loss of jobs to Mexico
 Mexican firms have to compete against efficient
US/Canada firms
 Environmental degradation
 Loss of national sovereignty for all countries
 Creation of a “Northern State” in Mexico

Effects of NAFTA (1993-2005)
 Overall impact has been small but positive
 Trade between NAFTA members increased 250%
 All 3 members experienced productivity gains
 Employment effects of NAFTA have been small
 NAFTA nurtured political stability in Mexico
 Expansion of NAFTA with Chile?

The Objectives of NAFTA.
 Removal of tariff and non-tariff barriers
 Removal of obstacles to investment
 mobility among member countries
 Promotion of trade in the zone
 Improvement of economic co-
corporation among member countries.

Regional Economic Integration in
Asia
 Association of Southeast Asian Nations
(ASEAN)
 Asia-Pacific Economic Cooperation (APEC)

Association of Southeast Asian Nations
(ASEAN)

Association of Southeast Asian
Nations
(ASEAN) Created in 1967
 500 M people with combined GDP of $740 B
 Goal to foster “freer trade” between members and
cooperate in their industrial policies
 ASEAN Free Trade Area (AFTA) by 6 nations formed in
2003
 Progress limited by:
 failure by members to lower tariffs
 members can’t agree to a common external tariff
 1997 Asian financial crisis
 predominance of old, mediocre private conglomerates
 challenge from China and “shift to the north”

Asia Pacific Economic Cooperation
(APEC)

Asia Pacific Economic Cooperation
(APEC)
 Founded in 1990
 21 members that account for:
 57% of global GNP
 46% of global trade
 majority of growth in world economy
 Despite slow progress, if successful, could
become the world’s largest free trade area

Regional Trade Blocs in Africa
 9 trade blocs on the continent
 Many countries are members of more than one bloc
 Progress slow due to political turmoil and deep
suspicion of free trade and impact on poorest nations
 In 2001, reestablished the East African Community
 Kenya, Uganda and Tanzania
 Goal is customs union 24 years after collapse

Regional Trade Blocs in Africa

International Financial
(Monetary) Institutions
 International financial institutions (IFIs) are
financial institutions that have been established (or
chartered) by more than one country, and hence are
subjects of international law. Their owners or
shareholders are generally national governments,
although other international institutions and other
organizations occasionally figure as shareholders.
The most prominent IFIs are creations of multiple
nations, although some bilateral financial institutions
(created by two countries) exist and are technically
IFIs. Many of these are multilateral development
banks (MDB). Copyright © S M Irshad 2013. 185

International
Monetary Fund

What is the IMF?
• The IMF is an international organization of 185
member countries. It was established to promote
international monetary cooperation, exchange
stability, and orderly exchange arrangements; to
foster economic growth and high levels of
employment; and to provide temporary financial
assistance to countries to help ease balance of
payments adjustments.

Why was it
created?
• The IMF was conceived in July 1944, when
representatives of 45 governments meeting in
the town of Bretton Woods, New Hampshire,
in the north-eastern United States, agreed on
a framework for international economic
cooperation.

What does it do?
Surveillance - It is an assessment of economic and
financial developments, which provides a framework
that facilitates the exchange of goods, services, and
capital among countries and sustains sound economic
growth. It consists in, Focusing on assessing whether
countries' policies promote external stability It is to be
remembered that surveillance is a collaborative, candid,
and even handed process between the Fund and its
members
Lending - IMF lending enables countries to rebuild their
international reserves; stabilize their currencies;
continue paying for imports; and restore conditions for
strong economic growth. IMF does not lend for specific
projects. It eases the adjustment policies and reforms
that a country must make to correct its balance of
payments problem and restore conditions for strong
economic growth. 189Copyright © S M Irshad 2013.

Technical Assistance
• It supports the development of the
productive resources of member
countries by helping them to
effectively manage their economic
policy and financial affairs.
• About 90 percent of IMF technical
assistance goes to low and lower-
middle income countries,
particularly in sub-Saharan Africa
and Asia.

The Objectives of IMF
 To act cooperatively with international monetary issues
and growth of international monetary cooperation
through a permanent institute for counseling.
 Assistance necessary for balanced growth and spread
of international trade and to help maintain a high
employment level and real income level.
 Stability in exchange rates.
 To assist create a mutilated payment system for
requirement transactions and of limitations of exchange
rates.
 To provide funds to consolidate the confidence of
member countries and to provide opportunities to
correct unfavorable balance in BOP.
 To reduce BOP imbalances in member countries and to
shorten the period of existence of these imbalances.Copyright © S M Irshad 2013. 191

Types of Loans Provided by IMF
 Extended fund facilities.
 Structural adjustment facilities.
 External structural adjustment facilities.
 Compensatory and contingency
financial facilities.
 Buffer stock financing facilities.
 Oil loan facilities.
 Systematic transformation facilities.

World Bank Briefing
Made up of 5 different organizations
 International Bank for Reconstruction and
Development (IBRD)
 International Development Association
(IDA)
 International Finance Corporation (IFC)
 Multilateral Investment Guarantee Agency
(MIGA)
 International Center for the Settlement of
Investment Disputes (ICSID)

History behind the IMF and
World Bank
 After the Great Depression in the 1930s
there was a need for an organization to
create a system for exchange rate stability
 Uncertainty of the value of paper money (no
longer used the gold standard)
 Countries began cheating other countries in trade
 Countries’ economies affected by WWII
 need for reconstruction in well-developed nations
 need for development in the lesser developed
nations

Bretton Woods Conference
 1940s proposals for monetary system by
Harry Dexter White (U.S.) and John Keynes
(UK)
 establish the value of each currency
 eliminate restrictions and certain practices on
trade
 assistance for post-war reconstruction
 Bretton Woods Conference, New Hampshire,
July 1944 with delegates of 44 nations
 final negotiations of the IMF and the World Bank
took place

World Bank
Made up of 5 different organizations
 International Bank for Reconstruction and
Development (IBRD)
 International Development Association
(IDA)
 International Finance Corporation (IFC)
 Multilateral Investment Guarantee Agency
(MIGA)
 International Center for the Settlement of
Investment Disputes (ICSID)

International Bank for
Reconstruction and
Development
 Founded in 1944 at the Bretton Woods
Conference
 to finance the reconstruction of countries
affected by WWII
 help with development of impoverished
nations
 World Bank’s central institution
 181 member countries

IBRD continued
 Lends to countries with relatively high
per capita incomes
 Money is used for:
 development projects (i.e. highways,
schools)
 programs to help governments change the
way they manage their economies
 Provides technical assistance in projects

The Services Provided by the
World Bank to Sri Lanka;
 Necessary foreign exchanges are provided
as loans under concessionary conditions.
 Patronage to develop technology industrial
knowledge and technical methods
 Co-operation to attract foreign
investments
 Providing the assistance of the world bank
specialists to plan necessary projects to
accelerate development and to supervise
them.

Globalization
“Globalization is a
social, economic and
political process that
brings into contact and
integrates people,
markets, goods and200Copyright © S M Irshad 2013.

Indicators of Globalization
International tourist arrivals
(millions of people)
Foreign direct investment
(billions of dollars)
Internet hosts (millions)
Number of international
organizations (thousands)

Global Commodity Chain

Transnational Corporations
Transnational corporations – also called
multinational or international
corporations – are the most important
agents of globalization in the world today.
They are giant companies that depend
increasingly on foreign labour, sell on
world markets, operate with considerable
autonomy from national governments,
and depend for growth of on new
management skills, design innovations,
and massive advertising campaigns.

TRANSNATIONAL
CORPORATIONS

This graphic illustrates the network of world trade in
1992. The thickness of lines shows the volume of trade
between countries. Colors distinguish regional trading
blocs. Note that most world trade took place within
regional trading blocs, with the United States, Germany,
and Japan at the center of each of the three main blocs.
(Note: The graphic does not include China, which has
become the centre of a fourth trading bloc since the early
90s.)

Main Elements of
Globalization
 Creation of new markets.
 Creation of new equipment.
 Creation of new world
institutions and
organizations.
 Creation of new laws and
regulations.

Globalization as a
Historical Process.
 From 1870 to 1920 huge
improvement in world trade.
 After 1945 with the end of II world
war huge improvement in trade
flows.
 New trend of globalization
developed after 1980.

Main Characteristics of
Globalization
 Huge interdependence.
 Huge improvement in trade and
financial flows
 Internationalization of production
process.
 International mobility of labour
 Economic cooperation among
countries

Driving Forces of Globalization
 Improving in the fields of transport
 Improvement in technology
 Deregulation of global financial
markets
 Change in comparative advantage
among countries
 Locating of various stage of production
in various countries by multi national
corporations
 Removing of protectionist policies
 Economic integrations

Advantages of Globalization
 Increase in the capacity of word trade.
 Increase in production and income.
 Expansion of employment
opportunities
 Increase in foreign direct investments
 Development of new technology
 Various opportunities of consumption
 Creating of quality products due to
competitiveness in production
 Efficiency in information flow

Disadvantages of Globalization
 Widening of international income inequality.
 Environmental problems.
 Creation of threats to the sovereignty of
domestic economic systems.
 Destroying of cultural diversity.
 Creation of economic crisis due to instability
of financial markets.
 Decline in domestic productive fields and
loss of employment opportunities.
 International terrorism.
 Health problems.

Review Questions
1. Why do nation's engage in trade?
2. What is international trade? Why it is
important in modern world?
3. What are the trade theories?
4. Briefly explain absolute advantage
with an example.
5. Briefly explain comparative advantage
with an example.
6. What is meant by autarky?

7. What is free trade and what are the
arguments?
8. Define protectionism and their
protectionists policies.
9. Describe the export and import structure in
Sri Lanka.
10. Define terms of trade with an example.
11. Describe what is BOP and their
components.
12. Define current and capital account?
13. What is the current BOP trend in SL and
why is continuously deficit?
14. How the government correct the BOP
deficit?

15. What is exchange rate and what are
the types of exchange rates?
16. Define devaluation and revaluation.
17. Define currency appreciation and
depreciation.
18. Why countries engage in regional
integration ? What are the types?
19. Describe NAFTA, SAFTA, ISLFTA
and SAARC.

20. Brief the role of IMF, World Bank in
assisting the countries.
21. What are the recent facilities
provided by IMF and WB?
22. Define globalization their driving
forces.
23. What are the effects of globalization?
24. Brief the main features of
globalization.

Past Questions Paper Review
PQPR.
 2000 AL / PART 2 , Q. NO- 4.
 2003 AL / PART 2, Q. NO- 4
 2005 AL / PART 2, Q. NO – 3.
 2006 AL / PART 2, Q. NO – 3.
 2007 AL / PART 2, Q. NO – 3.
 2008 AL / PART 2, Q. NO – 4.

References
 Jayantha, W M.(1998), International Trade and
Financial Relations, Vol. 1. the Open University
Press, Sri Lanka, Nugegoda.
 Lipsy, G. Richard, Colin Harbury, (1992),
Economics, 2nd Edition, Butler & Tanner Ltd.
London.
 Colombage, S. S. (2006), ” Principles of
Macroeconomics", The Open University Press,
Nugegoda, Sri Lanka.
 Lipsy. Richard G. ,(1989), 7th Edition , ” An
Introduction to Positive Economics” Butler &
Tanner Ltd, London.

 Bennett, Roger. (2006) 2nd edition,
International Business. Dorling
Kindersley (India) Pvt Ltd. Pearson
Education – South Asia, India.
 Cateora R, Phillip. (1990) 7th edition,
International Marketing. Richard D.
Irwin Inc. Homewood, Illinois, USA.
 Hill, Charles W. L. (2005) 5th edition.
International Business; Competing in the
Global Marketplace. McGraw-hill/Irwin
Inc. New York.

 Vidhanapathirana, Upali. Ananda. P D J,
”Principles of Microeconomics (2007) 2nd
Edition ,The Open University of Sri Lanka
Press,Sri Lanka, Nugegoda.
 Central Bank Annual Reports 2009, 2010,
2011, 2012.
 Recent Economic Development Reports
from 2008, 2009, 2010, 2011, and 2012.
 Economics and Social Statistics form 2010,
2011, 2012 published by The Central Bank
of Sri Lanka. Copyright © S M Irshad 2013. 219

AL - 13 - CHAPTER 9

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