International Trade, Balance of Payments and Exchange Rate

Why countries trade

Absolute advantage (Adam Smith): a country should export the good it can produce with fewer resources than its partner.

Comparative advantage (David Ricardo): even if one country is better at producing everything, both gain when each specialises in the good for which its opportunity cost is lower.

Worked example. Output per worker per day:

India has the absolute advantage in both goods. Nepal gives up less cloth for each unit of tea (0.5 against 1), so Nepal has the comparative advantage in tea. India gives up 1 tea per cloth against Nepal's 2, so India has the comparative advantage in cloth.

Trade barriers

• Tariff: a tax on imported goods. It raises the domestic price and gives the government revenue.
• Quota: a limit on the quantity or value of imports. It restricts supply directly and gives no tariff revenue.
• Non-tariff barriers: licences, standards, subsidies and similar measures.

World Trade Organization (WTO)

The WTO began on 1 January 1995, replacing the General Agreement on Tariffs and Trade (GATT), and is based in Geneva. Its basic principles include most-favoured-nation (MFN) treatment, under which a concession given to one member must be extended to all members, and national treatment. Nepal's accession was approved at the Cancun Ministerial Conference in September 2003, and Nepal became the 147th member on 23 April 2004, the first least developed country to join through the full accession process.

Balance of payments (BOP)

The BOP is a systematic record of all economic transactions between residents of a country and the rest of the world in a period. In the IMF manual (BPM6) it has three main accounts:

Balance of trade covers goods only. Nepal usually runs a large trade deficit, and remittances, recorded as transfers in the current account, are the main inflow that offsets it.

Example: exports 200, imports 900, net services -50, net primary income +30, net transfers +800. Current account = -700 - 50 + 30 + 800 = +80, a surplus despite a trade deficit of 700.

Exchange rate regimes

• Fixed (pegged): the central bank sets the rate and defends it with its reserves.
• Floating (flexible): demand and supply in the market set the rate.
• Managed float: market-determined with occasional central bank intervention.

Under a fixed rate, an official cut in the currency's value is devaluation and an official rise is revaluation. Under a floating rate, the market terms are depreciation and appreciation.

Nepal's peg with the Indian rupee

Nepal Rastra Bank fixes the rate of the Nepali rupee against the Indian rupee at NPR 160 per INR 100 (NPR 1.60 per INR 1). According to NRB, pegging with the Indian currency began in 1960 and the present pegged regime has operated since 1993, when the current account was made fully convertible. Rates against other currencies such as the US dollar are market based, so the NPR to USD rate moves mainly with the INR to USD rate.

The peg gives price and trade stability with Nepal's largest trading partner. Its cost, shown by the impossible trinity (trilemma), is that a country cannot have a fixed exchange rate, free capital movement and an independent monetary policy all at once.

Exam pointers

• Absolute advantage: Adam Smith. Comparative advantage: David Ricardo, based on opportunity cost.
• Tariff is a tax on imports; quota is a quantity limit.
• Remittances are in the current account (transfers), not the capital account.
• Devaluation is an official act under a fixed rate; depreciation is a market fall.
• NPR is pegged to INR at 1.60; other rates are market based.
• Nepal: 147th WTO member, 23 April 2004. WTO established 1 January 1995.