Trade is the mother of money. Why block it?

Foreign Direct Investments and Trade Blocs Blocking Free

and Fair World Trade


This one I did as an assignment for college. Unlike many others, this required some comprehensive research.

Introduction:

The growth of international production is driven by economic and technological

forces. It is also driven by the ongoing liberalization of Foreign Direct Investment

(FDI) and trade policies. In this context, globalization offers an unprecedented

opportunity for developing countries to achieve faster economic growth through

trade and investment. But these Foreign Direct Investments and Trade Blocs

are not helping all the countries grow at the same pace. Many fail to look at the

disadvantages of the same.

Discriminatory trade policy is the defining characteristic of a trade bloc. The different

types of trade blocs or PTAs (Preferential Trade Agreements) can be broadly

distinguished in three categories:

1)a free trade agreement (FTA) where trade barriers among member

countries are removed, but where each member remains responsible for the

determination of its trade policy vis-à-vis non-member countries;

2) a customs union (CU), with liberalised intra-bloc trade, as well as the adoption

of a external tariff structure and trade barriers towards outsiders common to

all members of the CU

3) a common market, which entails a CU with deeper integration between

its members (such as free movements of goods, services and factors of

production, common economic policies, etc.).

Foreign Direct Investment, or FDI, is a type of investment that involves the injection

of foreign funds into an enterprise that operates in a different country of origin from

the investor.

Foreign direct investment (FDI) is an integral part of an open and effective

international economic system and a major catalyst to development. Yet, the

benefits of FDI do not accrue automatically and evenly across countries, sectors and

local communities. National policies and the international investment architecture

matter for attracting FDI to a larger number of developing countries and for reaping

the full benefits of FDI for development. The challenges primarily address host

countries, which need to establish a transparent, broad and effective enabling policy

environment for investment and to build the human and institutional capacities to

implement them.

Although differences in labour costs may sometimes help influence firms’ decisions

to locate abroad, this is far from being the whole story. As the FDI data showed, the

majority of FDI still goes to the advanced countries, in particular the United States

where wages are high relative to those in developing countries.

Host governments sometimes worry that the subsidiaries of MNCs operating in their

country may have greater economic power than indigenous competitors because

they may be part of a larger international organization. This is sometime the case in

Less Developed Countries where MNCs have monopolized the market and raised

prices above those that would prevail in competitive markets, with harmful effects on

economic welfare of the host nations.

FDI can also have an adverse affect on the host country’s balance-of-payments

position is twofold. First, capital flight—the subsequent outflow of income as a

foreign subsidiary repatriates its profit to its parent company. Such outflows show

up as a debit on the current account of the balance of payments. A second concern

arises when a foreign subsidiary imports a substantial number of its inputs from

abroad, which also results in a debit on the current account of the host country’s

balance of payments.

Criticism levied at the operations of MNCs in developing countries was that FDI

could lead to loss of economic independence for the host country.

Based on the objective of import-substitution industrialization (in terms of formation

of Trade Blocs), the rationale was that developing countries could reap the benefit

from economies of scale by opening up their trade preferentially among themselves,

hence reducing the cost of their individual import substitution strategy.

Joining a trade bloc increases the size of the market that a firm can sell to.

Increasing market size will also diminish the market power of individual firms.

By opening up markets, domestic firms will face greater competition. Monopoly

power will fade as a result, and domestic firms will have an incentive to increase

productivity through implementing newer technology or better management. In

situations where partner countries are dissimilar in capital endowments, there may

also exist possibilities for investment. Capital will find the highest return. In general

this is where capital is scarce.

Findings:

MNCs have also encouraged less developed counties to concentrate their

production on raw materials to the detriment of food security. Thus cash crops

production becomes a dominant mode of production there. These productions

received primary attention from MNCs by way of incentives for production that

by far surpassed that of its counterpart—food crop. This practice has led to the

marginalization of women—the main producers of food in such countries.

The determining factor for a particular firm to establish production facilities abroad

or make a Foreign Direct Investment abroad is the prospect of earning higher profit

which induces firms to invest abroad, primarily because of lower labour costs.

Conclusion:

While the empirical evidence of FDI’s effects on host-country foreign trade differs

significantly across countries and economic sectors, a consensus is nevertheless

emerging that the FDI-trade linkage must be seen in a broader context than the

direct impact of investment on imports and exports. The main trade-related benefit of

FDI for developing countries lies in its long-term contribution to integrating the host

economy more closely into the world economy in a process likely to include higher

imports as well as exports. In other words, trade and investment are increasingly

recognised as mutually reinforcing channels for cross-border activities. However,

host-country authorities need to consider the short and medium-term impacts of FDI

on foreign trade as well, particularly when faced with current-account pressures,

and they sometimes have to face the question of whether some of the foreign-

owned enterprises’ transactions with their mother companies could diminish foreign

reserves.

It was argued that the liberalization has led to a substantial increase in intra-industry

trade, but much of the intra industry being horizontal in nature; it did not have a

significant effect on FDI. On the other hand, the trade associated with cross-border

vertical integration had a favourable effect on FDI. Trade liberalization has had a

favourable effect on FDI inflows in Indian manufacturing industries. Lower tariffs

and consequently higher cross border trade has attracted higher FDI into industries.

Foreign equity is attracted into dynamic firms which have higher imports and exports

and relatively new assets. Regions having greater involvement in international trade

are able to attract greater amount of FDI.

Reference List:

Journals:

Websites:

Bliss, C. J. (1994). Economic Theory and Policy for Trading Blocks.
Manchester: Manchester University Press

Paul R. Krugman, Maurice Obstfeld (2008) International Economics:
Theory and Policy

ibid.informindia.co.in
globalization.icaap.org
unctad.org
businessworld.in

-HITA GUPTA

Money Mess

Recession has earned its reputation as a villain in the money world. For investors stock market comes to a standstill, no investment option seems good enough; market sentiments are wounded badly. The pace of other economic activities like consumption, production and even employment fall. This is usually indentified by fall in the Gross Domestic Production for two consecutive quarters. The phase of depression is ultimate disaster in economy. Recession is mostly a temporary phase but when there is depression in an economy there is no hope of recovery. The world faced depression in the 1930s. It initiated in the United States but soon it spread to other countries as well. To uncover these tales of recession and depression which shook the foundation of global economy read further............

Prior facing the atrocities of World War II, nations across the world faced another blow – this was the Great Depression of 1930. This economic world crisis began in 1929 and continued till the early 1940s. Prices of crops fell by 60% and international trade by 50%. Conditions worsened with the drought in the early 1930s hitting the agricultural heart of USA. 

Then nearly 80 years later there came another economic crisis to haunt the world economy. We called this ghost the Late 2000s Recession. Well, it was successful to a large extent in scaring a large portion of investor in the stock market. To be precise this started in December 2007 but the world only realized it severity in September 2008 when the stock market crashed.

Let dig a little deeper and see the full picture......

Why did it happen?

1930: The major culprit of this depression was the stock market crash of October 29 in 1929. Sectors hit the worst were the heavy industries and farming. One of the major perpetrators of this economic crisis was the Keynesian principles. Keynes’ principles suggested that an economy is driven by demand created by the consumers. In a situation of economic crisis, it is the job of the government to increase its public expenditure and reduce taxes which will induce consumers to spend. Another factor to be blamed for the crisis is the protectionist policies adopted by USA and later other countries. Nations which were majorly dependant on international trade were worst hit by a sharp decline in trade after 1930.

2008: The first indicator of this crisis was the Subprime Mortgage Crisis. Subprime Mortgage Crisis is responsible for the collapse of the entire housing sector and later it triggered the collapse of the entire U.S economy. Subprime Loan is the riskiest of all and it is for this reason that banks charge higher interest rate than the prime rate when lending subprime loans; irrespective of the paying capacity of the borrower.

Keynes and Roosevelt

“Wars are good for an economy”. Confused? Well, this is what Keyes suggested to President Roosevelt and it worked. After 1932 when Hoover lost the elections and Roosevelt was elected to be the saviour, he came up with New Deal which had programmes though which people were hired for various projects. Nevertheless, what actually lead to the end of the Great Depression was the bombing of Pearl Harbour and U.S’s involvement in the World War II. For US, both people and industry became essential for the war effort. Men were trained to become soldiers and the women were kept on the home front to keep the factories going for weapons, artillery, ships, and airplanes. Food was grown for both the home front and soldiers overseas.

Bank Failure in 1930s

If not trade policies this must surely catch your attention. Through the 1930s over 9000 banks failed, people lost all their savings and the surviving banks worried about their own survival refused to give loans which reduced expenditure by consumer. Nevertheless, these surviving banks also had to close down because people who had their savings in these banks rushed to withdraw their savings and this excessive withdrawal lead to their closure. This eventually results into reduction in other economics activities of consumption and production. This eventually leads to rise in inventory. Hence, excess workforce was fired!    

Where did the system go wrong?

1930s: Stock prices faced a steep drop with no hope of recovery. Everyone wanted to sell their stocks but no one wanted to buy. Now, the stock market was attributed as a path to bankruptcy. But this was only the beginning. Since many banks had invested their client’s savings in the stock market; the banks had to shut when the stock market crashed.

2008: People primarily borrowed money for buying houses since the housing sector was booming at that time. Thanks to subprime loan that now suddenly anyone could buy a house regardless of their ability to repay. People were buying houses only to sell it later at a higher price – this directed the formation of ‘Speculative Housing Bubble’. Whenever people were unable to repay their loan they would borrow more against the security of their house which was now worth more. In simple words, they went into more debt in order to pay off their debts.   

After effects

1930s: Another major phenomenon of the great depression was the ‘Dust Bowl’. Usually during the time of depression farmers are not hard hit because they are in a condition to feed themselves at least if not the whole country. But this time the farms were hit by both drought and dust storm. Overgrazing and drought left the land without any grass. The topsoil was exposed to the harsh conditions to the dust storms. Small farmers faced another atrocity. They had borrowed amount from banks to purchase tractors for farms but since they was no produce on the farm land to earn from, they failed to repay the banks. The banks foreclosed their farms. Farmer’s family was now not only unemployed but also homeless.

2008: What many failed to understand was that their income wasn’t rising but the price of houses was rising. Many people defaulted to their loan repayment and the housing bubble burst. The price of houses plunged to all-time low because there was over-supply of houses in the market and no buyers. This is when people investing in mortgage backed securities started to panic. Since people no longer wanted to buy these securities, the companies selling this kind of securities were forced to go out of business. And since people did not repay their loans to banks, many banks failed. Investors in stock market started to sell their equity to put this money into safer assets like bonds. Therefore, the value of equity declined and the stock market crashed.

Current Scenario

The official data shows that U.S made a modest recovery and was out of crisis in July 2009. Nevertheless, there are still traces of recession in U.S. A poll was conducted where 50% of the American population said that their country is still in recession. This study is also backed by evidences-  still consumer confidence is low (people are not willing to invest in stock), house prices are still falling, foreclosure and bankruptcies hasn’t bunged, large portion of workforce is still unemployed and food inflation is crying for a check.  

Credit Worthiness??

Great Depression of 1930s, Late 2000s Recession and yet we are not done with economic crisis. The latest economic crisis which may turn into a disaster like the ones we have faced before is the one which made its first appearance in August 2011. U.S and Europe are losing out on their reputation in terms of credit-worthiness and financial system. This in turn has reduced credit lending around the world.

What U.S currently is facing is known as United States debt-ceiling crisis. As the name suggests U.S wants to increase its ‘debt ceiling’ i.e. the maximum amount the federal government can borrow from public through sale of securities from the treasury. This proposal needed acceptance from both the houses of the congress. The bad news for President Barack Obama was that the Republicans did not support this idea and suggested an alternative; that the government should rather reduce its expenses. This did not have adverse effect on the economy but the market sentiments were hurt. People were not even investing in government bonds rather they found metal like gold and silver to be the safest way out of this crisis. Hence, it should come as no surprise that gold touched edge of 26,000 rupees. U.S faced the biggest blow when Standard and Poor downgraded its credit worthiness rating from AAA to AA-plus. This step was taken with regard to rising debt burden. However, this cannot be attributed as an economic crisis but just a close brush from another financial collapse. This should have helped many countries evaluate how prepared they are for another ‘Money Mess-up’. 

-HITA GUPTA