Export Subsidies

-----------------------------------------------------------------------------------------------------------

Export subsidies

TABLE OF CONTENTS Introduction

3

Research Methodology

5

Chapter 1: What are Export Subsidies?

6

Chapter 2: The US vs. EU

10

Chapter 3: The Effect on Developing Countries

14

Conclusion

19

Bibliography

20

1

INTRODUCTION Export subsidies are incentives provided by the government to producers who export their goods to foreign countries. These producers could be anyone ranging from huge firms to cottage industries to poor farmers with small land holdings. Due to these subsidies the producers have some motivation to produce more goods which leads to increaser in the stockpile. The government either buys the surplus from this supply by itself or provides concessions on tax or factors of production. After this the surplus amount is exported to other countries to strengthen the foreign exchange reserves. Therefore subsidization encourages production activities and also helps in alleviating poverty among small producers. However the problem due to export subsidies occurs when the export price is set way above the domestic price. This is quite unfair to the domestic consumers plus it leads to losses to the producers in the foreign market. To counter this infiltration, the foreign government introduces its own set of subsidies which shall further lead to changes in subsidies by the domestic government to form a kind of repeated game. All these problems get multiplied in a real-life international market since every country is trying to get the best for themselves which leads to disputes. These kinds of problems generally arise between developed and developing nations. Here, the developed country tries to dump all its goods into the small but roaring markets of the developing nations.

2

As for these developing nations, they want to keep their market protected from dumping by the developed countries. Thus both the nations either complain to the WTO or else try to negotiate between themselves. Obviously it is the developing nations who suffer more owing to the fact that they aren’t in a very strong economical or political situation compared to the developed nations. Therefore subsidies have to be carefully monitored and judiciously implemented for actual welfare. This can be done by investments in Research & Development to gain some knowledge about rival firms’ costs to gain the upper hand. This paper shall further elaborate upon the various aspects of export subsidies. The paper also discusses the advantages and disadvantages associated with these subsidies. Finally it deals with some examples of export subsidies in the international market and their consequences upon the various countries.

3

RESEARCH METHODOLOGY AIMS AND OBJECTIVES This aim of this paper is to study the concept of export subsidies by analyzing the European Union’s export subsidies and their effects on developing countries. The underlying objective is to understand the role of export subsidies in international trade practice. SCOPE AND LIMITATIONS This paper undertakes a case study of the European Union’s export subsidies only. Export subsidies of other countries are not dealt with in this paper. However, a theoretical understanding of export subsidies has also been undertaken in order to aid in the case study. RESEARCH QUESTIONS •

What are Export Subsidies?

•

What are the advantages and disadvantages of Export Subsidies?

•

What led to the Peace Clause?

•

How are developing nations affected by export subsidies?

CHAPTERIZATION The paper is divided into three chapters Chapter 1: This chapter describes the general working of export subsidies and the advantages and disadvantages associated with them. 4

Chapter 2: This chapter talks about the US and EU dispute over subsidies. Chapter 3: This chapter elaborates upon the effects of export subsidies on developing countries. SOURCES OF DATA The researcher has primarily relied on secondary sources like books and articles for information. STYLE OF WRITING The researcher has adopted a descriptive and analytical style of writing for this paper. MODE OF CITATION A uniform mode of citation has been followed throughout the paper.

Chapter 1 What are Export Subsidies? In layman terms export subsidies are bonuses granted to producers who export their products to foreign countries. These are granted for various reasons like encouraging firms or individuals like farmers to produce more goods so that consumer demand is totally fulfilled and the surplus is exported, to capture a foreign market by exporting cheap subsidized products to it, and to help poverty-stricken farmers earn a living since through subsidies they are guaranteed some amount of profit since the government bears the burden of loss for them. The government too readily provides these subsidies to exporters so as to increase the country’s foreign exchange reserves and inventory stocks. Subsidizing goods also helps in protecting the domestic producers against foreign competitors and dumping of goods by them. To further understand how export subsidies lead to welfare some economic models have been discussed. The economists Itoh and Kiyono used a model to show that subsidies on marginal goods, i.e. goods which are not exported or exported in minimal quantities can increase welfare in the subsidizing country. According to their model, a subsidy on marginal goods will lead to increase in their production and the supply of non marginal goods would decrease. This in turn, shall lead to increase in the prices of the non marginal goods and increase in the exporter’s terms of trade. Similarly, Feenstra also demonstrated the role of substitutability and complementarity across subsidized goods to 5

increase welfare. According to him, the subsidized exported good should be a stronger substitute for another exported good or a stronger complement for an imported good in the subsidizing country and this increases welfare by improving the terms of trade in the other imported or exported good1 Export subsidies are implemented by the government through various means. The most common ones are tax concessions and reduction in the costs of the factors of production like transport, electricity, raw materials. There are essentially two types of export subsidies:2 1. Specific Export Subsidy: The subsidy provided is based on a fixed sum per unit. For example a specific amount of concession is granted to producers for every unit they export. This gives the producers an incentive to produce more units and export them. 2.

Ad Valorem Export Subsidy: The subsidy provided is calculated as a proportion of the total value exported. For example the total subsidy for a firm is determined as a proportion of the total value of goods exported which is normally quite large.

Therefore well crafted and targeted subsidies can successfully correct imbalances in the market provided that they are withdrawn gradually when their benefits have been realized since they can prove to be quite detrimental in the long run. The domestic consumers are the ones who lose out since the domestic price is far more than the export price.

3

Thus the government should invest in research to gain information as to what

products to subsidize and in what quantities. Research shall also help the government to gain knowledge about foreign firms trying to enter the market. With this information dumping can easily be prevented and these firms can be kept in check.

1

Julian M. Alston, Colin A. Carter and Vincent H. Smith, “Rationalizing Agricultural Export Subsidies”, 75(4), American Journal of Agricultural Economics 1000, 1000 (1993). 2 Paul R. Krugman and Maurice Obstfeld, International Economics 197-198 (Delhi: Pearson Education, 2004). 3 PC Bansil, Agricultural Incentives in India 39 (Bruno Dorin and Thomas Jullien ed., New Delhi: Manohar Publishers, 2004).

6

Once a subsidy has been decided by the government the producers shall export the goods till the domestic price exceeds the foreign price by the amount of the subsidy provided. This can be further explained with the following graph:

7

Due to subsidization the price in the exporting country shall rise from Pw to Ps since more exports would lead to decrease in their own country’s supply. Similarly price in the importing country shall decrease from Pw to Pt since the supply in their markets shall increase. Therefore in the exporting country the producers might earn profits but the consumers shall suffer losses along with the government since it is them who have to bear the brunt of subsidies. In the graph consumer loss is equal to the area – (a + b) and the producer gain is given by the area a + b + c. Meanwhile the government subsidy is calculated as the area of – (b + c + d + e + f + g). Thus the net welfare loss amounts to area of b + d + e + f + g. Therefore it is quite evident that the costs of export subsidies exceed its benefits.4 Export subsidies are also a key factor in international trade disputes since all nations want their markets to be protected against foreign firms. These shall be discussed further in the project.

4

Supra note 2.

8

Chapter 2 The US vs EU Europe had never been a large producer of agricultural goods and had to import many products to meet the consumer demand. Therefore the European Union (EU) decided to take some steps to increase agricultural produce so that they can be self-sufficient when it comes to food stock and also become an exporter of these agricultural products. So the EU formulated a Common Agricultural Policy (CAP) which was initially meant to help out its farmers by buying their products whenever the prices fell below specified support levels. This policy was simple and quite successful as the agricultural produce increased since now the farmers were not afraid of making losses and also many more people started large scale farming. However, this policy too had some drawbacks and so it has been morphed into a massive export subsidy program now. The basic problem with CAP was that the support prices set by EU were so high that the European farmers had too much of an incentive to produce more stock than needed. The gravity of this can be realized from the fact that had this been a free trade situation European countries would have had to import most agricultural products. However due to implementation of CAP, EU was obliged to buy the entire surplus produced by its farmers. Now EU was having problems in storing such huge quantities of perishable goods. At the end of 1985, European nations had a surplus stock of 780,000 tons of beef, 1.2 million tons of butter and 12 million tons of wheat. The European nations realized that exporting is the only profitable way to get rid of this 9

enormous stockpile. Therefore to make exporting possible, CAP was gradually modified into an export subsidy program.5 The working of CAP can be further explained with the help of the following graph:

5

Supra note 2.

10

The graph indicates that the support price under CAP is fixed above both the world price that would prevail in its absence and the equilibrium price without any imports. Thus to export the resulting surplus, an export subsidy is paid which further enlarges the difference between European and world prices. Meanwhile the subsidized exports tend to reduce the world price since an excess amount of cheap products is released into international markets. This loss in the world price leads to further increase in subsidies since more of surplus goods can be sold off at a lower price. Therefore it is quite evident that the combined costs of CAP to European consumers and taxpayers are far more than the benefit to producers. Despite this fact, CAP has hardly been challenged by the European consumers and authorities since the political strength of farmers in EU is quite strong and influential.6 However, CAP has been criticized on the international level. The United States and other food-exporting nations have always demanded a change in EU policy since European export subsidies drive down the prices of their own exports. In fact during the Uruguay round of trade negotiations, the USA initially demanded a complete end to European subsidies by the year 2000. Later, after long negotiations these demands were considerably reduced but even then the opposition by European farmers was so strong that it nearly led to the collapse of these negotiations. In the end EU agreed to cut subsidies by about a third over six years.7

6 7

Supra note 2, at 199. Supra note 2, at 199.

11

Finally these disputes among the EU and USA came to an end when they both agreed to the Peace Clause. As predictable none of the developing countries like India were a party to it since the peace clause prevented these nations from protecting their markets from European subsidized exports. Under the peace clause, EU is provided a subsidy waiver such that the agricultural export subsidies being granted under the EU’s Common Agriculture Policy cannot be challenged till the year 2003. Thus the peace clause proved to be quite beneficial to the European countries and they shall definitely try to extend the provisions granted to them under peace clause in the future. Meanwhile the US too shall not reduce its export subsidies as was believed earlier. In fact it is believed that US would also increase its subsidies under various exemptions granted under WTO.8

8

Devinder Sharma, The Great Grain Drain, 79 (Bangalore: Books for change, 1998).

12

Chapter 3 The Effect on Developing Countries As discussed in the previous sections export subsidies have a lot of disadvantages to them. They lead to consumer losses in the domestic market while the foreign market is flooded with cheap surplus production which leads to losses for the foreign firms. Subsidization also creates imbalances in the market and can lead to losses to the government. Now that subsidies are the norm, therefore most countries are affected by them but the nations which are most affected by such subsidies are developing nations. The WTO has always encouraged free trade through their policies; however these policies prove beneficial only for the developed countries. As for the developing nations, they have to compete with major powers like US and EU who tend to dump their goods into these countries leading to losses for the producers in these developing countries. Since a complete free market is too idealistic a situation to achieve, therefore subsidies are still implemented across the world. Unfortunately it’s the developing nations who lose out since they cannot compete with the highly subsidized goods of the developed nations no matter how much subsidies they implement. Furthermore the developed nations and the WTO have always tried to get the developing nations to decrease their subsidies leading to an open market for exports. The basic problem when it comes to export subsidies arises due to the fact that the export price is set way below the domestic price. As discussed before this is quite unfair to the domestic consumers plus it leads to losses to the producers in the foreign market. To counter this infiltration, the foreign government introduces its own set of subsidies which

13

shall further lead to changes in subsidies by the domestic government to form a kind of repeated game. To understand this situation further, a simple payoff matrix is drawn:

14

The given payoff matrix shows the various payoffs associated with developed and developing countries based on their choices to implement subsidies or not. In the first cell when both nations provide subsidies, the developed nation would obviously have a higher payoff than the developing nation. Similarly in the second cell, the developed nation shall profit more due to subsidization while the developing nation shall suffer losses due to non subsidization. Plus, dumping of goods might also occur in this case. The third cell describes the situation when none of the countries implement subsidies and how both countries shall receive their normal payoffs. Finally in the fourth cell, the developed nation would not be able to capture the market since it does not implement any subsidies while the developing nation shall get a high payoff. From the above discussion, it’s clear that the given game is an example of prisoner’s dilemma. To elaborate further, both the nations have a dominant strategy to implement subsidization since the payoffs associated with it are higher than the payoffs associated with non-implementation of subsidies. However, the optimal strategy lies in the third cell when no subsidies are used by either nation. This justifies the general belief that the market should be left alone and subsidies should be completely scrapped. Though admittedly those would be too drastic a step to be taken at this point of time, but nevertheless it’s a viable option for the future. As a consolation to developing nations an alternative take on this can be the fact that at least their consumers get access to international standard goods at subsidized prices. However if we believe that the tradeoff between this benefit to consumers of the developing nations and the benefit to producers of the developed nations can be justified,

15

it is totally wrong because the benefit acquired by the consumers is too miniscule compared to the mammoth profits acquired by the producers of the developed nations plus the losses suffered by the firms of developing nations. Therefore it is the developing nations which fall prey to the wrath of subsidies. While the developed nations like the US maintain that they plan to phase out export subsidies, what they actually do is replace these producer subsidies by processor subsidies which would be passed back to producers anyways. Since these countries are too strong economically and politically, they cannot be out rightly opposed by other countries on international forums since most of the other countries do depend on these powerful nations for monetary or military aid. Thus these countries implement their trade policies without any strong objections. Moreover these countries want the developing nations to remove their trade barriers so that they can dump their subsidized surplus products into these markets.9 The WTO too has similar plans. It prohibits various kinds of subsidies like government direct subsidies, export bonuses, concessions on factors of production, etc. Plus, export dumping too has been legitimized till quite a large amount. Thus the picture is quite grim for developing nations. Particularly in the agricultural field where countries like India do provide subsidies to farmers, but these are not implemented efficiently and instead of helping poor farmers its actually increasing the wealth of the middlemen and farmers who are already effluent. Obviously the Indian farmers cannot compete with the multinational companies of the developed nations who also get large subsidies in return. These MNCs can easily dump cheap grains into the Indian market which shall lead to destabilization of the market and loss of livelihood to numerous farmers.10 To counter these ill effects of subsidies the government should try and negotiate with WTO and the developed nations to get its point across. Plans should be formulated to attain self-sufficiency in basic sectors. This would also help the economy because even if it’s a free market, free and fair trade would happen in both countries. Proper planning and research on various markets are the need of the hour since firms are unlikely to have complete information about the costs of their foreign competitors. Therefore if the 9

Supra note 8. Supra note 8, at 77.

10

16

domestic government invests in R&D it can intervene in this situation since it would obviously have more information about the costs of the domestic firm than the foreign firm. The domestic government can then implement an export subsidy to signal the competitiveness of the domestic firm. Now a larger export subsidy shall lead the foreign firm to believe that the domestic firm has lower costs and so it shall reduce its output which leads to increase in profits of the domestic firm. 11 Therefore implementation of subsidies should be properly supervised and judiciously implemented provided that its backed up by research and valuable information.

11

David Collie and Morten Hviid, “Export Subsidies as Signals of Competitiveness”, 95(3), The Scandinavian Journal of Economics 327, 327-337 (1993).

17

CONCLUSION After the completion of this project the researcher has come to certain conclusions. Export subsidies do lead to welfare but only if they are supervised properly. Moreover its cons easily outweigh its pros therefore the best strategy is to invest in research and development so that the best plan of action can be chosen keeping the information furnished by research in mind. Are export subsidies really worth taking the troubles associated with them? This is the question being asked on the international level as well. Many disputes over subsidies are taking place all around the world. The most important of them all was the US-EU dispute over EU’s subsidies which finally came to an end with the signing of the Peace Clause which like most other international trade policies was a policy favoring free trade and thus suited for the developed nations. Developing nations are the ones who actually suffer due to these disputes since they do not have the clout in the international circles to enforce their way. Thus these developing nations should formulate a strategy based on research, planning, negotiations and efficient use of subsidies to hold their own against the developed nations. This tussle between the developed and developing nations leads to a sort of repeated game which reinforces the belief that markets should be left alone and subsidies should be scrapped. However, this is too idealistic a view and therefore the governments should rather aim at keeping subsidies to a minimal level.

18

BIBLIOGRAPHY BOOKS: 1.

Paul R. Krugman and Maurice Obstfeld, International Economics (Delhi: Pearson Education, 2004).

2. PC Bansil, Agricultural Incentives in India (Bruno Dorin and Thomas Jullien ed., New Delhi: Manohar Publishers, 2004). 3. Devinder Sharma, The Great Grain Drain, (Bangalore: Books for change, 1998).

ARTICLES: 1. Julian M. Alston, Colin A. Carter and Vincent H. Smith, “Rationalizing Agricultural Export Subsidies”, 75(4), American Journal of Agricultural Economics (1993). 2. David Collie and Morten Hviid, “Export Subsidies as Signals of Competitiveness”, 95(3), The Scandinavian Journal of Economics (1993).

19