INTERNATIONAL TRADE AND ITS IMPACT ON LOCAL INDUSTRIES
Rangesh Fernando
2 August 2011
Table of Contents
1. Introduction.............................................................................................................3
1.1. Objectives........................................................................................................3
1.2. Methodology....................................................................................................3
1.3. Regulating Trade.............................................................................................3
2. Trade related theories..............................................................................................4
2.1. Free Trade Theory...............................................................................................4
2.2. Mercantilism........................................................................................................5
2.3. Zero-Sum Game..................................................................................................5
2.4. Absolute advantage.............................................................................................5
2.5. Comparative Advantage......................................................................................5
2.6. Heckscher Ohlin Theorem...................................................................................6
2.7. Product Life Cycle Theory by Raymond Vernon................................................6
3. Impact due to governments physical policy changes..............................................7
4.1. Impact on local automobile manufacturer (Micro Cars Limited).......................9
4.2. Impact on car importers and traders....................................................................9
4.3. Impact on the consumer.....................................................................................10
4.4. Impact on the Economy.....................................................................................10
5.0 Conclusion & Recommendations...........................................................................12
6.0. References.............................................................................................................14
Table of Figures
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Figure 1: Economics of Free Trade...............................................................................4
Figure 2: The impact of import duty reduction..............................................................7
Figure 3: The tax system introduced on June 1, 2010...................................................8
Figure 4: The tax reduction on motor vehicles..............................................................8
Figure 5: The impact on economy...............................................................................11
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1. Introduction
Imports and Exports in a country make a significant impact on a country’s economy.
The main areas of concern include; balance of payments, exchange rate, impact on
local industries, comparative advantages for efficient management of resources, etc.
This short report is a brief analysis on the government‘s recent physical policy
changes in its taxation for motor vehicles. The report is an analysis of the impact
towards the local vehicle manufacturer (Micro Cars), vehicle importers/ traders,
consumers and the economy at macro level as a result of the government’s recent
reduction of taxes on imported vehicles and the subsequent increase of taxes again.
1.1. Objectives
Objectives of the assignment are as follows;
To understand how international trade functions and MNC’s operate around the
world.
To evaluate how certain protectionism policies are made by the government
effectively.
To make recommendations to the Sri Lankan government on how to improve and
protect the local industries without jeopardizing the imports and foreign exchange.
1.2. Methodology
The information was collected from websites, published journals, corporate sites,
news paper articles, government approved publications and other types of documents
available on the internet. Also several customers and vehicle importers in Sri Lanka
were contacted personally to gather data. Gathered data was analyzed using both
quantitative and qualitative methods.
1.3. Regulating Trade
The following are some of the mechanisms used by governments throughout the
world to regulate international trade.
Physcal policy adaptations
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Embargos
Quantity restrictions
Request for margins
Exchange control regulations
Sanctions
Aid & Loans
Protectionism policies
2. Trade related theories
2.1. Free Trade Theory
Free trade is the ability for countries to carry goods and services across without the
involvement of the government. As per David Ricardo’s theory of comparative
advantage, both countries will be able to mutually benefit. As the government is not
getting involved in the form of taxes, tariff barriers, non-tariff barriers, protectionism
policies, etc., the pricing in a free trade environment will reflect a true picture of the
demand and supply situation for a product or service.
Source; (James, 2011)
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Figure 1: Economics of Free Trade
2.2. Mercantilism
This is where the government’s involvement is considered as of paramount
importance where international trade is concerned. Here, the government will
regulate the trade by imposing various policies such as monopolization, forbidding
trade of certain goods, export subsidies, promoting research and development or
infant industries of a country, restricting wages, maximizing the use of domestic
resources, limiting domestic consumption, etc.
2.3. Zero-Sum Game
In simple terms this is where the sum of imports and exports amount to Zero. This
happens when all economies try to produce, sell and try to compete with other
countries in all possible ways. This will automatically cut off gains against gives.
In a case where a country increases its exports of a product line, it will increase its
production costs due to rising inflation. Another country will then compete in the
same production line for a better price.
The Zero-Sum Game theory was argued by David Ricardo. The theory of
comparative advantage is now used by economies.
2.4. Absolute advantage
This is where an economy produces more from the same quantum of input. Adam
Smith explained this by using the input of Labour. As labour in different nations can
have different levels of output due to their differing levels of skills, knowledge and
attitude.
2.5. Comparative Advantage
This theory of David Ricardo goes on to say that countries need to focus on
production of items which they are able to produce at a better price than any of the
other and export the surplus. The other products can be imported from countries in
which they are produced most efficiently. This is in order for both countries to
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benefit from trade by focusing on producing items which has the lowest opportunity
cost.
For example, if, using machinery, a worker in one country can produce both shoes
and shirts at 6 per hour, and a worker in a country with less machinery can produce
either 2 shoes or 4 shirts in an hour, each country can gain from trade because their
internal trade-offs between shoes and shirts are different. The less-efficient country
has a comparative advantage in shirts, so it finds it more efficient to produce shirts
and trade them to the more-efficient country for shoes. Without trade, its cost per shoe
was 2 shirts; by trading, its cost per shoe can reduce to as low as 1 shirt depending on
how much trade occurs (since the more-efficient country has a 1:1 trade-off). The
more-efficient country has a comparative advantage in shoes, so it can gain in
efficiency by moving some workers from shirt-production to shoe-production and
trading some shoes for shirts. Without trade, its cost to make a shirt was 1 shoe; by
trading, its cost per shirt can go as low as 1/2 shoe depending on how much trade
occurs.
2.6. Heckscher Ohlin Theorem
Heckscher Ohlin states that a country will export resources which they have in
abundance and will import those which are scarce. This is more accurate when the
resources are broken down to specifics. For example, a skilled labour intensive
country can export its skill and encourage growth of skill in the country. It can import
capital and unskilled labour which is scarce.
2.7. Product Life Cycle Theory by Raymond Vernon
After the failure of Heckscher Ohlin Theory, Raymond Vernon states that during the
initial stages of innovation of a product, all the required resources for the product will
be sourced from the country of origin. Once it’s developed the sales will also be
carried out first in the country of origin before exporting. However, over time even
the production will be carried out in a developing country in which the resources for
production is cheaper and not the one in the country in which the product originated.
For example, personal computers originated from USA. But today it is produced in
China in order to exploit efficient and economical resource utilization.
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3. Impact due to governments physical policy changes
The automobile industry and the taxation regulating it is one of the key income
generators for the government of Sri Lanka. The taxation on motor vehicles is over
300% for top end luxury vehicles. Whilst a tax rate of approx. 200% was imposed on
the medium range and economical range vehicles.
The reduction of taxation on the medium and economy vehicles instantly shot up the
demand for such substantially due to the price elastic nature of demand. This helped
the government to increase their revenues.
According to a senior finance ministry official, Sri Lanka imported over 10,000
vehicles within a period of four months after duty reduction. During first nine months
of the year 2010, the government was able to earn 15 billion rupees on taxes on
vehicle imports. As per in excise duty terms the government earned 9,920 million
rupees compared to 1,995 million rupees in the previous year (Lankanewspapers.com,
2010).
According to statistics of the Motor Traffic Department a total of 359,243 vehicles
were registered in year 2010 which was a 76 percent increase when compared with
the year 2009 (The Democratic Socialist Republic of Sri Lanka, 2011).
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Source; (LMD, 2011)
Figure 2: The impact of import duty reduction
On the social aspect, it enabled the Sri Lankan middle class to obtain their first brand
new vehicle. Especially the Suzuki Marti as this was now at an affordable Rs 800,000
as opposed to Rs 1.3mn prior to the tax reduction.
However, the negative side of this is the large cash out flows towards the global
automobile manufacturers.
The tax system for motor vehicles was as follows.
Petrol Diesel
Engine
Capacity
Old Tariff (%) New Tariff (%) Old Tariff (%) New Tariff
(%)
Below 1000cc 187 90 412 179
1000cc – 1600cc 217 115 510 185
1600cc – 2000cc 299 150 524 271
2000cc – 3000cc 299 150 524 271
Over 3000cc 299 190 524 290
Source; (Adaderana.lk, 2010)
Figure 3: The tax system introduced on June 1, 2010
The tax reduction was applicable to all kinds of motor vehicles.
Category Tax reduction
Three wheelers Excise duty was completely removed.
68% tax was reduced to 40%.
Tax charged on conversion unit was reduced from
40% to 8.5%.
Motor cycles 15% surcharge was completely removed.
Custom duty was reduced from 15% to 5%.
Lorries and trucks Excise duty was reduced by 15%.
Vans Tax was reduced from 180% to 121%.
Diesel Vans Tax was reduced from 281% to 152%.
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Source; (Media Center for National Development of Sri Lanka, 2010)
Figure 4: The tax reduction on motor vehicles
4.1. Impact on local automobile manufacturer (Micro Cars Limited)
Micro Cars Limited is the first local automobile manufacturer that is fully established
in Sri Lanka. The organization was formed recently and hence is still in the latter part
of the introduction stage in its life cycle.
Since this is an industry which is new to Sri Lanka, the government needs to take
measures to protect these infant industries. The government backing is required for a
new company to dilute the entry barriers and to reduce the heat from global
automobile manufacturers.
The high tax rate imposed on imported vehicles enabled Micro to compete in the
market and cater to the lower socio-economic clusters of the society with their fleet of
vehicles’ starting sales price of Rs 350,000/-. The key advantage of the Unique
Selling Proposition for Micro was its ability to compete on price.
However, with the reduction of taxes on imported vehicles, the prices of small
vehicles such as the Suzuki Maruti made a direct impact on Micro’s range of vehicles.
As the buyers opted for the Maruti over Micro due to better brand recognition and
brand credibility carried by Maruti.
It became difficult for Micro to compete on price and was directly in the playing field
with global competition. Hence Micro now lacked its once unique proposition of
being able to compete on price.
When the government again increased the tax levels however, Micro was again put at
ease. However, it had by then already made strategic moves towards producing value
added vehicles such as the Micro Panda to compete with global players in addition to
targeting the lower end of the market.
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4.2. Impact on car importers and traders
At first, when taxes were increase, the importers were unable to reduce their prices of
vehicles as the existing stocks were already taxed paid at, at a higher tax percentage.
The vehicles importer’s association then put pressure on the government and also
agreed to maintain the price until they recovered the tax paid on existing stocks.
The traders on the other hand had to face a consumer demand shift from second hand
and older models to newer models. Thus, the prices of second hand vehicles had to be
reduced due to the inflow of newer vehicles.
However, at an overall level the importers and traders were benefited and their
revenue increased. The increased demand for vehicles resulted in better revenue
generation.
The sudden rise of taxes again however requires the trading activity to provision for
the tax component.
4.3. Impact on the consumer
There was an increase of sales observed in the Hybrid vehicles such as; the Toyota
Prius and the Honda Hybrid range of vehicles as Hybrids were now affordable and
cost effective in its usage.
The middle class citizens were now able to purchase their first new vehicle; as a
Maruti now would only cost Rs 800,000/-.
The consumer that was into second hand vehicles now had the opportunity of
considering a brand new or a reconditioned vehicle. However, the sellers of used
vehicles were faced with the trauma of not being able to recover their money and
obtain the expected sales price as prices are usually on the rise for second hand
vehicles.
4.4. Impact on the Economy
The reduction of taxes pushed the demand up for vehicles; thus, resulting in a higher
number of vehicles being imported to Sri Lanka. This resulted in large outflows of
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Sri Lankan rupees. This inevitable increases the balance of payments gap despite it
being negative already.
With the simplification of the tax system the government was able to expand its
revenue base in order to tighten the budget deficit to 8.8 percent in 2010. But, the
rapid increase in imports with high global prices pushed the trade deficit to 10.5
percent of GDP in 2010 from 7.5 percent in 2009. The total expenditure of the
country was 23 percent of GDP in 2010 (Wickremasinghe & Jayakody, 2011).
Source; Cited in (Wickremasinghe & Jayakody, 2011)
Figure 5: The impact on economy
It also depreciates the value of the rupee. This would then create an impact on the
trading of other industries; especially those that are export/ import oriented.
However on a more societal and well being element and when considering the long
term impact; the penetration of vehicles to the middle class cluster will improve their
lives, their mobility and infrastructure. Thus, the efficiency of this segment will
increase.
This will eventually contribute to the overall development of the economy in the form
of development in infrastructure. Thus, the efficiency of this segment will increase.
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This contributes to the economy in the form of development in infrastructure,
transportation and mobility. It makes the operational activities in a country efficient.
5.0 Conclusion & Recommendations
International trade is one of the key deciding factors for the growth of an economy.
In today’s economic context and in an environment in which world trade is an
inevitable requirement; governments today need to manage an economy in such a way
to maintain a balance of payments surplus.
A country’s resources and factors that are able to deliver a comparative advantage
must be utilized effectively in order to have an advantage over other producing
nations.
When looking into government’s decision of reducing taxation on imported vehicles;
it’s a sole quantitative gain is increase of revenue to the government. But the large
outflow of cash is much more harmful and is damaging to the economy in the long
run as cash outflow increases the trade deficit.
Instead it would be a wise move and beneficial for the economy if the government
increases the duty on imported vehicles in an attempt to support the growth and
establishment of Micro Cars.
Micro is the first and the only Sri Lankan car manufacturer. Automobile production
is a new or an infant industry to Sri Lanka. Hence, government needs to support
Micro and adopt protectionism policies for Micro to stand against global competition.
As in the long run growth of Micro Cars can enhance the technical and managerial
skills with regard to automobile industry in Sri Lanka. It will also give the ability to
tie up with global players to assemble their vehicles and even export high quality
Micro vehicles in order to generate foreign exchange. Thus it will reduce the cash
outflow and in fact, it can result in cash inflows.
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For example, when Kia and Hyundai companies first started their production in
Korea, the government of Korea supported them by imposing duties on imported
vehicles. This way the Koreans had to purchase Kia & Hyundai vehicles for their
requirements. In the short term this would upset the Korean citizen. But today due to
the government backing, Hyundai and Kia is a global automobile giant and is one of
the much sort after brands and renowned for its technical evolvement and quality.
In another instance, government allowed an entrepreneur to start a cab service by
bringing down Tata Nano vehicles from India. The cab service was able to operate
well by giving a comfortable ride to its consumers for an economical price.
This was a short sighted decision. The three wheeler hires were getting hit and thus,
was affecting the livelihoods of many three wheel drivers.
At a broader level, instead of the Tata Nano, the government could have encouraged
the cab service to use the Micro fuel efficient range. This way the community will get
to experience the ride in a micro vehicle and will help promotion of the brand.
Imports and Exports are very sensitive elements of an economy. Especially as it
directly impacts balance of payments, inflation and all the internal trade related
industries.
Hence the government should be very analytical and long-term thinking when making
decisions with regard to international trade.
With regard to the automobile import duty, the government should encourage
consumers to purchase economical range of hybrid vehicles and once produced in the
home country, such as the Micro. Other vehicle purchases should be discouraged
except for motor cycles.
The government further should grow those industries in which Sri Lanka has a
comparative advantage over others. For example, industries such as tea and spices
from Sri Lanka are re-known for its best quality. The Sri Lankan soil has a
comparative advantage to produce better quality over any other country.
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The imports should only be carried out for those items which are most essential and
are too costly to produce in Sri Lanka. This way it will help Sri Lanka to reduce the
trade deficit and eventually a surplus.
6.0. References
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ArticlesBase SC #4825575, 2011. Hybrid cars demand on a rise in Sri Lanka.
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on-a-rise-in-sri-lanka-4825575.html [Accessed 9 June 2011].
Cader, S., n.d. Micro Cars builds first luxury double-decker bus. [Online] Available
at: http://www.nation.lk/2008/08/17/busi7.htm [Accessed 9 June 2011].
Daily News, 2010. Vehicle import duty reduction hailed. [Online] Available at:
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Fernando, P., 2011. Sri Lanka’s economic gains lead to reduction in poverty levels.
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AND 3 WHEELERS. [Online] Available at: http://www.development.lk/news.php?
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