Please explain how trade and investment affect economic and social development.
ID: 1202701 • Letter: P
Question
Please explain how trade and investment affect economic and social development. Provide an example of a country that had economic and social development from trade and investment. Also provide an example of a country that receives little to no trade and/or investment and is economically less developed.
Explain and discuss Theory of Absolute Advantage. How does it differ from the Theory of Comparative Advantage? You may pattern it from your text or other sources, but you are required to make up your own example to show understanding. Please be sure to cite your sources.
Does it make sense for the Gilley family (or any family) to strive to only “buy American”?
Why should managers regularly monitor the BOP of the country in which their business operates? Use the US and China as the example for your response.
Explanation / Answer
Factors affecting economic and social development
First, we review what is known about development, both social and economic. The perspective that we take upon this is closely similar to the view that we advance elsewhere about the fundamentals behind economic growth anywhere: that this is a manifestation of the working of a complex series of interlocking systems, of which the economic component is an essential part. There is, however, a long way to go in the development of these systems. In purely economic terms, the poorest 80% of the world's populations created around 2.6% of the tradable wealth in 1960. By 1980, this had fallen to 1.1%, and appears to be around 0.9% of all value added at the turn of the century. Today, around 1.2 billion people inhabit the wealthy nations, but around the same number live on less than US$1 per day. About the same number lack access to safe water and twice as many live without adequate sanitation. Achieving anything resembling catch-up is, evidently, some way off. Success stories such as Singapore and Hong Kong stem from a rich history of complex institutions, human resource and the pursuit of the best. However, the key limits to creating a more complex framework within which to generate wealth seems limited more by internal institutional issues than by factors such as capital or human resource.
Second, we consider the relationship between development and sustainability. We do this in the light of the growth in population, which will rise from something over 6 billion in 2000 to, perhaps, 8 bn by 2020. The relations between the poor and the rich will be closer-coupled than ever before in history. The relationship will remain lopsided insofar as wealth, power and access to knowledge will also be asymmetrical. Each will, however, want things of the other and both will have the capacity to do the other harm.
There are various ways of segmenting the situation in which people finds themselves: by income and by attitude, by age and by nationality. We discuss some of these approaches elsewhere. However, how we think about divisions often define our approaches to solutions. Economic differences around the world are typically thought about in national terms: that country A is richer than country B. We collect statistics which re-enforce this view. However, it may well be that the nation is the wrong focus, and that we need to think in a more subtle way in order to see what is going on.
In the period up to the industrial revolution - and, indeed, probably to the middle of the C19th - social class was the key discriminator. A Chinese mandarin and British country squire may each have enjoyed a standard of living which was closer to the other than it resembled that of their nation's peasantry. Since around 1840, however, national wealth has become sharply more differentiated, and the most effective segmentation has been that of political boundaries: the mean and statistical way points by which wealth was distributed amongst - say - Americans became increasingly distinctive when compared to most of the rest of the world. Whether co-incidentally or not, this event coincided with the growth of national identity and nationalism. Per capita incomes are thought to have differed between nations by, at most, a factor of three in 1820. This had risen to 35:1 in 1950, 44:1 in 1970 and 72:1 in 1992. The disparity is around 100:1 in 2000.
A century ago, 'development' was seen as something extraordinary, and poverty the norm. Today, the wealthy world spends around a third of its income on internal poverty relief, and there is a growing tendency to view poverty as something to be eliminated. Great progress has indeed been made: in the twenty years since 1980, the proportion of stunted children in the poor world fell from 47% to 37%, according to the UNDP, whilst those with access to safe water rose from 13% to 71%. Life expectancy in the poor nations has risen by 10 years and adult literacy has also risen, from about half to three quarters of the population. School enrolment has risen by similar proportions.
On the negative side, people are still treated as property in many parts of the world and there may be more de facto slaves alive than ever before in history. Around 100 million children live on the streets and about the same number, in settled accommodation, have no access to schooling. There are about quarter of a billion child labourers at work, often under extreme conditions. Some 1.2 million girls are used in prostitution and 300,000 children are currently fighting as soldiers. Six million have been injured in armed conflicts during the 1990s.
Sub-Saharan Africa has grown less rapidly than its population since 1950, and its citizens are thus individually poorer than they were half a century ago. Forest have been felled, mines exhausted and the natural wealth lessened in this period. Asia, by contrast, was of a similar wealth to Africa in 1950. Its economic wealth per capita has increased substantially. Studying this, the World Bank was able to show a pervasive influence of institutions and social organisation in what had happened. Africa had failed to organise itself to grow its capabilities and to extend its options. Asia had, in part, succeeded in doing this. The next section reviews what this may have entailed
South Korea's economic situation was widely regarded as hopeless after the devastation of the Korean War, but it too has turned into another Asian economic miracle—South Korea now challenges Japan for a share of the export markets in the United States and other countries. The economies of Taiwan and Hong Kong are in such great shape that even mainland China (the country they were once part of) views them with great respect. Malaysia and Singapore are also cited as examples of economic success stories. Malaysia had only half of the per capita income of Chile as recently as 1963; only 25 years later Malaysia had caught up to Chile. While these success stories have grabbed public attention, one must also notice that many Asian, African, and Latin American economies continue to languish in utter poverty. Moreover, the financial crises of the late 1990s in many Asian countries, formerly considered miracle economies, have added a note of caution in judging economic development successes too fast. After all, Brazil's early development promise failed to materialize.
While referring to underdeveloped countries many different terms are used. The terms used are intended to describe the stage of development of these countries in comparison to those that are more developed. As a result, the terms used are almost always in pairs. The most dramatic way of referring to the two sets of countries is to make a distinction between backward and advanced economies, or between traditional and modern economies. As the term "backward" carries a negative connotation, it is rarely used these days. It is much more popular to put all countries of the world on a continuum based on the degree of economic development. Using this criterion, several pairs of terms are employed in distinguishing countries with different degrees of economic development—developed and underdeveloped countries, more developed and less developed countries (the latter are often simply referred to as LDCs), developing and developed economies. As the terms "less developed countries" and "developing countries" embody a sense of optimism, their use has become commonplace. Developed countries are also referred to as industrialized countries. Countries that have recently developed are referred to as the newly industrialized economies.
Sub-Saharan African countries also face external trade barriers, such as high import tariffs, which make it difficult if not impossible for their products to compete in important markets. Programmes designed to support African exports are often too complicated or restrictive to be used effectively. Rules of origin about proof of where different products (and all their components or ingredients) come from and complicated health and safety requirements are two examples of barriers that often put African products and producers at a disadvantage. In addition, rich countries often pay subsidies to their own producers, giving them an unfair advantage in the global marketplace. In 2013, agricultural subsidies in countries that are part of the Organisation for Economic Co-operation and Development (OECD) reached $253 billion. This is more than nine times the amount of aid that donors from the same body provided to sub-Saharan Africa that same year.
Sub-Saharan Africa’s rapidly growing population makes job creation an absolutely vital issue. Over the next 20 years the number of Africans joining the working age population (ages 15-64) will exceed that from the rest of the world combined. The IMF estimates that the region will need to create about 18 million new jobs per year until 2035 to absorb the growing labour force.
Absolute advantage is the ability of a country, individual, company or region to produce a good or service at a lower cost per unit than the cost at which any other entity produces that good or service. Entities with absolute advantages can produce a product or service using a smaller number of inputs and/or using a more efficient process than another party producing the same product or service.
Here are some examples of how absolute advantage works:
An entity can have an absolute advantage in more than one good or service. Absolute advantage also explains why it makes sense for countries, individuals and businesses to trade with one another. Because each has advantages in producing certain products and services, they can both benefit from trade.
For example, if Jane can produce a painting in 5 hours while Kate needs 9 hours to produce a comparable painting, Jane has an absolute advantage over Kate in painting. Remember Kate has an absolute advantage over Jane in knitting sweaters. If both Jane and Kate specialize in the products they have an absolute advantage in and buy the products they don't have an absolute advantage in from the other entity, they will both be better off.
Absolute and comparative advantage are two important concepts in international trade that largely influence how and why nations devote limited resources to the production of particular goods. Though the global economy is highly complex, the economics of food production offer a straightforward illustration of both of these key concepts.
Though it is not economically feasible for a country to import all of the food needed to sustain its population, the types of food a country produces can largely be affected by the climate, topography and politics of the region. Spain, for example, is better at producing fruit than Iceland. The differentiation between the varying abilities of nations to produce goods efficiently is the basis for the concept of absolute advantage.
If Japan and the United States can both produce cars, but Japan can produce cars of a higher quality at a faster rate, then it is said to have an absolute advantage in the auto industry. A country's absolute advantage or disadvantage in a particular industry plays a crucial role in the types of goods it chooses to produce. In this example, the U.S. may be better served to devote resources and manpower to another industry in which it has the absolute advantage, rather than trying to compete with the more efficient Japan.
The focus on the production of those goods for which a nation's resources are best suited is called specialization. Given limited resources, a nation's choice to specialize in the production of a particular good is also largely influenced by its comparative advantage. Whereas absolute advantage refers to the superior production capabilities of one nation versus another, comparative advantage is based on the concept of opportunity cost. The opportunity cost of a given option is equal to the forfeited benefits that could have been gained by choosing the alternative. If the opportunity cost of choosing to produce a particular good is lower for one nation than for others, then that nation is said to have a comparative advantage.
Assume that both France and Italy have enough resources to produce either wine or cheese, but not both. France can produce 20 units of wine or 10 units of cheese. The opportunity costof each unit of wine, therefore, is 10 / 20, or 0.5 units of cheese. The opportunity cost of each unit of cheese is 20 / 10, or 2 units of wine. Italy is able to produce 30 units of wine or 22 units of cheese. Italy has an absolute advantage for the production of both wine and cheese, but its opportunity cost for cheese is 30 / 22, or 1.36 units of wine, while the cost of wine is 22 / 30, or 0.73 units of cheese. Because France's opportunity cost for the production of wine is lower than Italy's, it has the comparative advantage despite Italy being the more efficient producer. Italy's opportunity cost for cheese is lower, giving it both absolute and comparative advantage.
Since neither nation can produce both items, the most efficient strategy is for France to specialize in wine production because it has the comparative advantage and for Italy to produce cheese. International trade can enable both nations to enjoy both products at reasonable prices because each has specialized in the efficient production of one item.
The balance of payments (BOP) is the method countries use to monitor all international monetary transactions at a specific period of time. Usually, the BOP is calculated every quarter and every calendar year. All trades conducted by both the private and public sectors are accounted for in the BOP in order to determine how much money is going in and out of a country. If a country has received money, this is known as a credit, and if a country has paid or given money, the transaction is counted as a debit. Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits) should balance, but in practice this is rarely the case. Thus, the BOP can tell the observer if a country has a deficit or a surplus and from which part of the economy the discrepancies are stemming.
The BOP is divided into three main categories: the current account, the capital account and the financial account. Within these three categories are sub-divisions, each of which accounts for a different type of international monetary transaction.
The Current Account
The current account is used to mark the inflow and outflow of goods and services into a country. Earnings on investments, both public and private, are also put into the current account.
Within the current account are credits and debits on the trade of merchandise, which includes goods such as raw materials and manufactured goods that are bought, sold or given away (possibly in the form of aid). Services refer to receipts from tourism, transportation (like the levy that must be paid in Egypt when a ship passes through the Suez Canal), engineering, business service fees (from lawyers or management consulting, for example) and royalties from patents and copyrights. When combined, goods and services together make up a country's balance of trade (BOT). The BOT is typically the biggest bulk of a country's balance of payments as it makes up total imports and exports. If a country has a balance of trade deficit, it imports more than it exports, and if it has a balance of trade surplus, it exports more than it imports.
Receipts from income-generating assets such as stocks (in the form of dividends) are also recorded in the current account. The last component of the current account is unilateral transfers. These are credits that are mostly worker's remittances, which are salaries sent back into the home country of a national working abroad, as well as foreign aid that is directly received.
The Capital Account
The capital account is where all international capital transfers are recorded. This refers to theacquisition or disposal of non-financial assets (for example, a physical asset such as land) and non-produced assets, which are needed for production but have not been produced, like a mine used for the extraction of diamonds.
The capital account is broken down into the monetary flows branching from debt forgiveness, the transfer of goods, and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets (assets such as equipment used in the production process to generate income), the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance taxes, death levies and, finally, uninsured damage to fixed assets.
The Financial Account
In the financial account, international monetary flows related to investment in business, real estate, bonds and stocks are documented. Also included are government-owned assets such as foreign reserves, gold, special drawing rights (SDRs) held with the International Monetary Fund (IMF), private assets held abroad and direct foreign investment. Assets owned by foreigners, private and official, are also recorded in the financial account.
The Balancing Act
The current account should be balanced against the combined-capital and financial accounts; however, as mentioned above, this rarely happens. We should also note that, with fluctuating exchange rates, the change in the value of money can add to BOP discrepancies. When there is a deficit in the current account, which is a balance of trade deficit, the difference can be borrowed or funded by the capital account.
If a country has a fixed asset abroad, this borrowed amount is marked as a capital account outflow. However, the sale of that fixed asset would be considered a current account inflow (earnings from investments). The current account deficit would thus be funded. When a country has a current account deficit that is financed by the capital account, the country is actually foregoing capital assets for more goods and services. If a country is borrowing money to fund its current account deficit, this would appear as an inflow of foreign capital in the BOP.
Liberalizing the Accounts
The rise of global financial transactions and trade in the late-20th century spurred BOP and macroeconomic liberalization in many developing nations. With the advent of the emerging market economic boom - in which capital flows into these markets tripled from USD$50 million to $150 million from the late 1980s until the Asian crisis - developing countries were urged to lift restrictions on capital and financial-account transactions in order to take advantage of these capital inflows. Many of these countries had restrictive macroeconomic policies, by which regulations prevented foreign ownership of financial and non-financial assets. The regulations also limited the transfer of funds abroad.
With capital and financial account liberalization, capital markets began to grow, not only allowing a more transparent and sophisticated market for investors, but also giving rise to foreign direct investment (FDI). For example, investments in the form of a new power station would bring a country greater exposure to new technologies and efficiency, eventually increasing the nation's overall GDP by allowing for greater volumes of production. Liberalization can also facilitate less risk by allowing greater diversification in various markets.
The Bottom Line
The balance of payments is divided into the current account, capital account, and financial account. Theoretically, the BOP should be zero.
China’s balance of payments: current and capital accounts now pulling in different directions
Posted on 18 September 2012 by Simon Taylor • 3 Comments
Every country’s economic relations with the rest of the world are summarised in the balance of payments. This is divided into the current account, which records the flows of trade and income, and the capital account, which records the flows of financial assets and liabilities. Usually countries have a deficit on one and a surplus on the other. China has been unusual in recent years in having a surplus on both, which explained the very strong growth of foreign reserves. But the capital account surplus has now become a small deficit. This is consistent with the view that the foreign reserves, which have stopped growing, might shrink in future. It is also a signal of capital flight from China – the rich taking their money out for fear of the future.
The balance of payments
We have got so used to the relentless rise of China’s foreign exchange reserves that it ought to be news that they are no longer rising, being roughly stable recently at about $3 trillion. In fact China experienced an outflow of capital in thesecond quarter of 2012. The future appreciation of the renminbi can no longer be taken for granted. To explain what’s going on we need a bit of background theory on the balance of payments (BoP).
The BoP for any country is a record of its economic transactions with the rest of the world. Unless a country is a total autarky, meaning it is self sufficient or at least it chooses to have no dealings with the rest of the world, then it will have inflows and outflows of resources. (North Korea today and Albania during the 1980s are rare examples of near-autarky.)
Those resources are classified by economists into: i) goods, services and net income payments & receipts; and ii) financial resources. The first group of resource flows is captured in the current account and the second in the capital account.
The current account is often what people refer to when they say that a country has a balance of payments surplus or deficit. Germany, for example, routinely runs a current account surplus because it has a remarkably strong export industry. It imports things too but not to the same extent.
The UK and US have for several years run current account deficits, importing more than they export. Note that exports and imports here refer not only to physical (“merchandise”) trade but include services such as tourism, investment income and travel. The UK has had a deficit on its physical trade for many decades, at least until North Sea oil and gas came on stream, but most of the time it more than offset this with a surplus on the “invisibles” trade, meaning services and net investment income.
A country can’t run a current account deficit indefinitely because it has to be paid for, either by running up debts or by running down assets. Neither of these can be done forever. That’s why the current account is often the focus of attention in the balance of payments analysis. Here is the US position in the last decade.
China has had a high current account surplus for many years, mainly driven by high export growth. This chart from the latest IMF Finance and Development shows the structure of the current account.
China’s once huge, but declining surplus on goods dominates the current account. Services trade has been regularly in a small deficit and flows of income swing between deficit and surplus over time. All of these surpluses and deficits must have counterparts in the rest of the world. China’s surplus on goods trade means an equally sized deficit among its trading partners, particularly the US.
The capital account
But the capital account matters too. A country may be a net recipient or payer of capital. If foreign investors are optimistic about a country’s prospects they may invest by purchasing shares or buying companies outright or by buying the government’s bonds. All of these represent an inflow of capital. This means a capital account surplus, in these cases of a benign kind.
But a country may borrow abroad to finance deficits and attract a capital inflow that does not reflect good economic prospects, merely a financial gap. Many Latin American countries ran large capital account surpluses in the late 1970s by borrowing from the big American banks. This was to allow those countries (chiefly Mexico, Brazil and Argentina) to keep their economies growing despite a huge rise in the cost of imported oil after the OPEC price hike of 1973-74. The US government encouraged the banks to keep lending, to maintain economic growth and stability in the western hemisphere. But after the second sharp rise in oil prices in 1979-80 following the Iranian Revolution, the level of debt became dangerously high. The US Federal Reserve put up interest rates to combat high inflation in the US and in doing so drove those countries into default in 1982, precipitating the Latin American debt crisis of the 1980s.
The Latin American example shows how the two accounts are frequently linked economically. A capital account surplus pays for (finances) a current account deficit. If the deficit reflects the import of machinery and equipment that will raise future growth, this is good and sustainable. If it merely funds the import of consumption goods, it may not be.
Equally a persistent current account surplus country like Germany has a capital account deficit, meaning that it routinely exports capital by providing loans and funding to countries that want its exports. Some of this funding went to Italy and Spain, which ran (and still run) trade deficits with Germany. So Germany was directly helping to finance the trade imbalances it now complains about.
Many countries restrict capital flows. In the jargon, their capital account is not fully convertible. Economic theory and history provide a lot of reasons for having a relatively free current account, because free trade is often – though not universally – good for an economy. There is no such presumption in favour of a free capital account. Premature opening of East Asian countries’ capital accounts is widely seen as an important cause of the Asian financial crisis of 1997 (see herefor a recent argument against India liberalising its capital account).
Netting the capital and current accounts
The overall balance of payments is the sum of the capital and current accounts. The sense in which the two balance each out depends on the country’s exchange rate regime. In the rich countries which let their currencies float entirely according to market forces, the overall demand and supply for foreign currency are equalised through the price – the exchange rate. So the capital and current accounts must in total sum to zero (other than quite significant data errors). The US, UK, Eurozone and Japan (most of the time) don’t try to influence their exchange rates.
Most emerging economies do manage their exchange rate by intervening in the foreign exchange market. Any surplus of supply of foreign exchange over demand, whether from a current account or capital account surplus, would tend to push the price of the domestic currency up relative to foreign currencies. If this is not what the government wants, it instructs the central bank to fill the gap by absorbing that surplus foreign exchange supply. How? It buys the foreign exchange with printed domestic money. It thereby acquires foreign exchange reserves. This has been the Chinese case for a decade.
In the opposite case of trying to keep the exchange rate up, because there is a surplus of demand of foreign currency, the central bank can use its reserves to fill the gap, preventing what would otherwise happen, a fall in the value of the domestic currency versus foreign currencies.
Why manage the exchange rate? It is one of the most important prices in the economy and rapid changes can have a destabilising effect on the country. So many countries intervene regularly to influence the daily exchange rate. Some try to fix it completely against say the US dollar (as in Hong Kong) or against a basket of currencies (Singapore).
In sum, the relationship is:
Current account + capital account + net change in foreign reserves = zero
In floating exchange rate countries the net change in reserves (*) is zero and the two accounts are brought into balance by changes in the exchange rate. In managed or fixed exchange rate countries any imbalance between the current account and capital accounts is met by raising or lowering reserves. If reserves are zero and there is an overall deficit the country has no choice but to let the exchange rate fall, or restrict capital flows and risk a black market in foreign exchange.
China
China’s decision to prevent the renminbi being pushed up in value against foreign currencies is what explains its massive foreign exchange reserves. The upward pressure has resulted from a combined current and capital account surplus, as shown in this chart from JPMorgan’s economists.