Current Economic Scenario: Trade And Investment Issues

Current Economic Scenario Module 3: Trade and Investment Issues

Rupa Chanda ESS

Outline of Module 3 • • Concepts, frameworks, and debates • India’s trade and investment context and recent developments • Indian manufacturing: prospects and challenges • Globalization of India’s services: Prospects and challenges • Special Economic Zones • WTO and India • Regional and bilateral agreements and India •

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Concepts, Frameworks, Debates in International Trade

Globalization, Trade, and Investment Flows: Debates, Concepts, Frameworks • • Trade and investment flows are integral to globalization process • • Important engines of growth and key to integration with world markets • • World economy grew at average annual rate of 3.2% since 2000, large part driven by rapid growth in key emerging economies • • Shifting balance of power evident in recent years towards emerging economies, especially in Asia • • Developing country exports in world exports up from 20% in 1970 to 43% today • • Growing role of some developing countries as investors, holders of forex reserves • – •

Waves of globalization in different periods

Debate and key questions • • Globalization has sparked a debate about: – impact on jobs in developed countries, especially low skill jobs and wages – – relocation of production to developing countries and hollowing out in the developed world – – role of technology, demographics, government policies in shaping future balance of economic power • • Some fundamental questions need to be addressed: – Is globalization as reflected by growing trade and investment participation of developing countries in world markets, a zero sum game? – – Is export growth of countries such as India and China at the expense of developed country producers? – – Or is this a win-win game whereby growing economies are not only suppliers of manpower but also a source of demand for the developed world and new markets for investment as they open up further? – – Is trade and globalization of production helping create multiple engines of growth for world economy? – 

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Answers to above will determine: – – Course of trade and investment policies in the developing and developed world • whether protectionism surge in the West • whether large emerging economies benefit from globalization and continue to open up – – What happens if there is a slowdown in high income countries and whether policy shifts towards protectionism – – Whether multilateral trade negotiations succeed or fail – – What happens with regional and bilateral arrangements – –

Concepts and frameworks in International Trade • • Considerable evolution in thinking on international trade – Key underlying concept has been comparative and later competitive advantage – Explains why countries trade in what they do, why businesses chose to locate production where they do, how global firms operate, how trade and investment decisions inter relate • • Thinking shifted from – Mercantilism – Absolute advantage (Adam Smith) – Comparative advantage (David Ricardo) based on labour productivity – Comparative advantage based on resource endowments – Dynamic comparative advantage, evolving with product life cycle – New trade theory (role of market structure and strategic intervention) – Competitive advantage (Porter diamond and role of policies and firm strategies) –

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• All post mercantilist theories see trade as a win-win and not zero sum game, makes possible increased consumption possibilities, static and dynamic welfare gains – But adjustment costs, distributional effects with gainers and losers – Role of government to redistribute gains to losers 

• More recent theories give greater role to government, firm strategy, and market structure in shaping competitiveness unlike earlier theories stressing laissez faire approach 

New trade theory • • Trade provides expanded markets and enables economies of scale, lower unit costs, greater variety of products – Industries with high fixed costs, learning effects • • Market structure and scale economies affect trade pattern – World market supports only few firms in some industries – Exports/dominance in such industries due to first mover/early entrant advantages, not endowments (commercial jet aircraft industry) – Later entrants hurt by high fixed costs • • New source of comparative advantage – economies of scale and learning effects – • Policy implications – Role for selective government intervention – Strategic/pro active trade policy – Govt. assist firms to overcome/get first mover advantages • Boeing-spinoff from US govt’s military program funding • Airbus-helped by European govts’ subsidies – Role of entrepreneurship, innovation in getting first mover advantages 

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National competitive advantage • • Why countries fail or succeed in international trade? – Japan in autos, Switzerland in precision instruments • • What gives rise to competitive advantage? – 4 important characteristics affect environment where local firms compete – These characteristics create or impede competitive advantage • • Porter diamond • 

1. Factor endowments • Basic: natural resources, climate, location, demography • Advanced: skilled labour, infrastructure, research facilities, technical knowhow • Basic factors give initial advantage, reinforced and enhanced by investing in advanced factors • Overcome disadvantages in basic factors via investments in advanced factors 

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2. Demand conditions • Customer needs • Pressures for innovation, quality, features in home market – Japanese camera industry, Scandinavian cellular phone equipment industry – 

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3. Related and supporting industries

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Benefits of investment in advanced factors supported by related, supporting industries – Fabricated steel products industry in Sweden • Ball bearing and cutting tools • Related to strength in specialty steel industry – US semiconductor industry • Supported dominance in PC, other advanced electronics products – Switzerland’s dye industry • Related to success in pharmaceuticals – Germany’s advantage in sewing machine needles and textile machinery • Related to competitive advantage in high quality cotton, wool, synthetic fibres production

4. Firm strategy, rivalry, structure • • Management ideologies of firms (Japanese and German vs. US) • Increased domestic competition leads to – greater efficiency – innovation – better quality – lower costs – more investment 

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4 parts mutually reinforcing

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Govt can influence each part through: • Subsidies to improve endowments – Policies to improve capital markets – Policies to improve educational attainment – Policies to foster competition – Encourage supporting and related industries – Regulations, antitrust laws, tax policies, etc.

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Implications for business

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1. Locational implications • • Different countries with different advantage in activities • Dispersion of production along relative efficiency lines – Laptop computers • Basic R&D and product design in US and Japan, skilled labour requirements • Manufacture of standard electronic components (mem chips) in Singapore, South Korea, semi-skilled and skilled labour • Manufacture of advanced components (microprocessors, display screens) in US, Japan, advanced, capital intensive, highly skilled labour • Assembly in Mexico as labour intensive, low skilled, cost pressures • – Pattern of production and trade explained by: • Factor endowments • Productivity • Government policies • Market structure • Costs • 

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2. First-mover implications • • Early entry into industry to be globally competitive – LCD screens for laptop computers (Toshiba and NEC) – Japanese investment in this technology in 1980s • 3. Policy implications • • Industry lobbying for/against protection – Import quotas on auto, steel, textile imports into US – Pressure by Apple and IBM in 1991 to revoke tariff on US imports of Japanese LCD screens • • Invest in advanced production factors – Train workers, R&D investments • • Lobby government for strategic interventions – education, infrastructure, research, domestic competition • • 

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Trade Policy: Rationale, Instruments, Strategies

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Political, economic, social arguments for and against protection – Political arguments • • Protect vested interest groups, voters, lobbies, sensitive sectors/industries (agri, textiles, auto)- Capture theory • • National security reasons – Aerospace, advanced electronics, semiconductors, defence-related industries • • Retaliate against foreign competition to bargain for better terms, open markets • • Force countries to play by rules of international trade- sanctions, punitive tariffs • • Foreign policy goals • Social arguments • • Consumer protection • • Welfare-social/environmental concerns about exporting country

Economic arguments • • Infant industry argument – Temporary protection via subsidies, quotas, tariffs – Remove protection once industry matures, on even playing field 

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Strategic policy grounds – Selective govt intervention to ensure 1st mover advantages • Promote desirable sectors where high value added, higher wages, superior technology, positive externalities • Help industries appropriate returns via subsidies and protection • Invest in research to establish competitive advantage – Government support to overcome entry barriers-catch up argument

• • Protection to correct market failures • • Could strategic policy result in trade retaliation and trade wars? –

Problems with protection • • Consumption and production distortions • • Inefficiencies in resource allocation • • Welfare losses to society- static and dynamic effects • • Protection tends to be self-perpetuating, creates vested interests • • Retaliatory, beggar-thy-neighbour policies • • Trade wars • • Dictated by influential lobbies not national interest Market failures better addressed by domestic rather than trade policies 

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Trade Policy Instruments • • Tariffs • Quantitative restrictions • Voluntary export restraints • Export subsidies and taxes • Countervailing duties • Antidumping measures • Local content requirements • Administrative regulations • Technical and other standards 

Impact of tariff

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Tariff results in net decline in welfare due to efficiency losses in production and consumption – Decline in consumer surplus – Increase in domestic producer surplus – Tariff revenue use and redistribution important – Dead weight loss to society

• • At margin, rupee lost and rupee gained may not be valued equally • Losses could be greater if account for income distribution effect • • Estimates of welfare costs due to tariffs – Sugar, luggage, textiles and apparel, ceramics, tiles • Saved 200,000 jobs in these protected industries • Cost consumers $32 billion in higher domestic prices • Including tariff revenue, net cost to economy of $10.2 billion per year in 1980s • Spent $50,000 for every job saved • True cost even higher due to inefficiencies, waste, resource allocation • – Japanese economy protects foodstuff, cosmetics, chemicals • Average cost to Japanese consumer of $890 per year from higher domestic prices •

Impact of QR

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Estimates of welfare losses due to QRs – – Licenses for US sugar imports • Estimated net loss from US sugar import program of $580 million per year • Concentrated gains to producers • Losses dispersed at $6 per person • Subsidy of $90,000 per worker • Cost of $50,000 per job saved – Import rationing cost India 7.3 percent of GDP in 1960s

• • VERs are a special case of QRs where give right to sell to foreign country – – Import quota of 1.68 million Japanese vehicles per year in 1981, raised to 1.85 million vehicles per year in 1985 • Domestic producers benefited from higher prices, limited competition • Japanese auto manufacturers benefited from higher prices in US market • Estimated loss to US economy of auto VER- $ 1 billion per year, 1981-85 – MFA in textiles •

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Local content requirements – Specific fraction of good be produced in home country (value or quantity terms) – Developing countries use LCRs to shift manufacturing base from simple assembly to local manufacturing – Used by US in auto industry to force Japanese companies to buy local parts

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Administrative policies – Customs procedures, red tape • Exports of Dutch tulip bulbs to Japan • Imports of videotape recorders into France

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Technical and other standards – Specifications for consumer safety, health, environmental reasons – Labelling, packaging, testing, certification requirements

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Export subsidies – Payment to firm or individual (low interest loans, cash handouts, direct promotional expenditures, tax credits) – Industrial countries: • subsidies of over $300bn per year to agricultural sector, 25-30% of value of production • EU’s CAP massive export subsidy program with price guarantees for agri products –

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Countervailing duties – Used to counter subsidies – Offset decline in export price due to export subsidy

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Dumping – International price discrimination – Predatory dumping-favour foreign buyers till foreign competition eliminated, then raise price

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Antidumping duties – Retaliate against dumping – But need to establish: • material injury to domestic producer • deviation from normal price • Then impose punitive duty to counter dumping margin

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State trading corporations – Import and distribution restricted to public enterprises

Trade policies

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Import substitution – Limit imports of final manufactures, develop indigenous industry – Over time turn to intermediates – Protect via tariffs and quotas

• • But ISI countries experienced – Poor growth and export performance – Inward orientation and limited scale – Inefficient resource allocation, did not reflect comparative advantage – Higher input costs for export industries – Infants never matured and protection persisted – Distorted incentives for production – Complex protection systems with wide range of protection – Income inequalities worsened – Rent seeking behavior •

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Export promoting industrialization – Encourage export growth, export-led growth – Low average rates of protection – Export subsidies, credit allocation, exchange rates to favour export oriented industries

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Evidence on trade policies and economic performance

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• Cross-country evidence shows countries focusing on international competitiveness with targeted strategic industrial policy interventions fared best 

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Empirical evidence shows strong correlation between growth and trade strategies – – Openness more conducive to growth, income convergence, technological convergence – – Closed economies have depressed and less profitable investment, higher input and capital costs, lower total factor productivity – – 1% rise in trade share to GDP raises income per capita by 0.34% (World Bank) – – Outward oriented trade strategies more conducive to employment creation, equitable income distribution

• Overall, trade theory states that free trade is for the most part superior to protection • • Free trade is a win-win game, always possible to compensate the losers by redistributing from the gainers • • Tariffs are superior trade policy instruments than quantity based instruments or domestic regulations used to control trade • • But reality is far more complex, protection and intervention in trade are common • • Trade and investment policies are driven by political economy realities and constraints rather than pure economic welfare considerations

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Application of these concepts, frameworks, and debates to India

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Use concepts of comparative and competitive advantage and new trade theory to understand:

• – Recent trends in India’s trade and investment flows – – Where India may have gained from being a first mover, where lost out – – How policies in India and abroad are enhancing or hurting India’s advantage – – What distortions have arisen due to intervention – – Why India has an edge in knowledge and skill-intensive manufacturing and certain services but not in standardized low cost large volume production – – What are the political economy constraints to trade and investment liberalization in India – – How do considerations of comparative/competitive advantage and other political economy concerns influence India’s multilateral, bilateral, regional engagements