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OPEN ECONOMY/ EXTERNAL SECTOR

Open Economy and Closed Economy

Closed Economy: Is the economy that has no economic transactions with the outside world. There are no imports, no exports and no flow of capital to or from the outside world. Thus a closed economy is completely self-sufficient. In reality no nation can have a completely closed economy (essential items like crude oil, pharmaceutical drugs etc. are imported even if economy is largely a closed economy).

Open Economy: Freely engages in economic transactions with the outside world. ‘Freely’ here means without any restriction.

No nation in the world has a completely open economy. Even the most open economies in the world may impose a certain restrictions on the economic transactions with the outside world.

Barriers to Trade

The policy instruments which obstruct trade are called barriers to trade.These are of the following two types:

A) Tariff Barriers

B) Non-Tariff Barriers

A) Tariff Barriers

Tariff means the duty or tax imposed by the government on the import and export of goods.

The tariff on imports increases the price of the imported goods. This makes the imported goods less competitive. As a result the imports are discouraged.

The tariff on exports makes the exported items costlier and hence less competitive in the international market. This discourages the export. Usually export tariffs are raised for certain items when the government wants to discourage their export in order to make those items available in domestic market which otherwise may be exported.

Tariffs are also a source of government revenue.

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B) Non- Tariff Barriers

These are the administrative measures, other than tariffs, imposed by a domestic Government to discriminate against foreign goods in favour of domestic goods. These are of following types:

1) Quotas: is a restriction on the amount of goods that is allowed to be imported into a country. This is usually enforced by issuing import licences.

2) Subsidies: Subsidies like production subsidies and export subsidies given by the government to the exporters helps in making the goods from the country competitive in the international market. It is considered as a barrier to trade because it creates a non-level playing field. Exporters from rich countries who receive such subsidies are at great advantage in comparison to exporters from other poorer countries who cannot afford such subsidies.

Production subsidies: are given by the government to the producers of exportable goods and services. Example: raw materials at low cost, low interest credit, tax concessions etc.

Export subsidies: are given in the post-production stage of exportable goods. Example: transportation subsidies.

3) Health, Sanitary and Safety regulations:

A country can restrict imports by fixing very high standards for the goods that are imported based on health, sanitary and safety considerations. If the imported goods do not meet these standards the imports may be rejected. For example the importing country can fix a maximum limit of pesticide residue on food items that are imported. If pesticide residue is more than the set limit the imports are rejected.

High packaging standards for imported goods will push up the prices and hence will act like a barrier to trade.

4) Local content requirement: The government can make it mandatory that a certain percentage of the parts of the Product to be made domestically.

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Commercial Policy (Trade Policy): Free Trade Vs Protectionism

The Commercial Policy (Trade policy or International trade policy) is the Government policy which governs the trade and commerce with other countries. The commercial policy is concerned with whether the country should adopt the policy of Free trade or of protection.

Free Trade: The policy of unrestricted international trade is known as the policy of Free Trade. There are no barriers to trade and very minimal or no government intervention in trade. Adam smith, also known as the father of economics, advocated the policy of free trade way back in 18th century. David Ricardo is another classical economist who propagated this policy in 19th century.

Laissez-faire is an economic theory that opposed any government intervention in business affairs. It is a French term which in English translates to “leave alone”.

The Global Enabling Trade Report 2016 Co-published by the World Economic Forum and the Global Alliance for Trade Facilitation, the Report features the Enabling Trade Index, which evaluates 136 economies based on their capacity to facilitate the flow of goods over borders and to their destination. It was first published in 2008. The Enabling Trade Index measures the factors, policies and services that facilitate the trade in goods across borders and to destination. It is made up of four sub-indexes:

1. Market access 2. Border administration 3. Transport and communications infrastructure 4. Business environment

The Enabling Trade Index Ranking for 2016

1. Singapore 2. Netherlands 3. Hong Kong SAR 4. Luxembourg 5. Sweden 22. USA 35. China 102.India 110. Brazil 111. Russian Federation 136. Venezuela

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Protectionism: It is a policy of creating trade barriers with an intention of protecting nation’s vital economic interests like domestic industries, employment, commodities etc. It is the opposite of free trade.

Commercial policy has been a topic of heated debate. Let us now discuss the arguments in favour of free trade and protectionism.

Arguments in favour of free trade

1. Gains from Specialization: the countries should specialize in the production of those goods in which it is relatively more efficient and export a part of them and in exchange import those goods from other countries in production of which they are comparatively more efficient. Specialization and trading in this way would achieve a more efficient allocation of resources and a higher level of output and well being.

2. Gains from economies of scale: trade makes it possible for the producers to move beyond the domestic market into the international market and produce at large scale and take advantage of economies of scale by achieving lower cost per unit.

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3. Promotes competition: free trade increases competition in the economy as domestic firms have to compete against foreign firms in order to survive. Domestic firms have to increase their efficiency and are compelled to innovate and improve the quality of their products. Consumers on the other hand get wide range of products at lower prices.

4. Transfer of Technology: Free trade leads to international diffusion of technology. A technology developed by one country is improved by another country and so technology goes on being improved successively.

5. Access to domestically unavailable goods and raw materials: free trade can make available those goods to a country which it cannot produce or produce inefficiently. It also makes available those raw materials which are not available in the country.

6. Improves international cooperation: Free trade makes nations economically dependent on each other. The economic interdependence reduces the likelihood of hostilities between countries. It provides powerful incentives for peaceful solution of disputes.

Arguments in favour of protectionism

1. Infant industry argument: this argument advocates that infant industries should be provided protection from the competition of low priced imports of the mature and well established industries of the developed industrialised countries. The protected environment will allow them to grow, become more efficient and over a period of time they will be in a position to compete with the foreign firms. In the absence of protection they will be wiped out by foreign competition. This argument is explained well by the dictum-‘Nurse the baby, protect the child, and free the adult.’

2. Employment argument: according to this argument protection would lead to an increase in domestic employment or at least save the present domestic employment. Instead of imports, the goods are manufactured domestically and this leads to an increase in employment. If imports are restricted exports can’t remain unaffected. Export industries will face difficulties in procuring raw materials and capital goods and as a result exports would fall and so would the employment in export industries. Also when one country imposes restrictions on imports other countries also retaliate by imposing restrictions on that country’s exports and this leads to fall in exports and fall in employment in export industries.

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3. National defence argument: This argument states that total dependence on foreign goods that are essential for defence purpose or for consumption can be dangerous in times of war or emergencies. By having manufacturing for defence items protected from foreign competition, trade protectionism is necessary for a nation’s existence. Thus the country must protect and develop its defence industry and farming industry even if this means an economic loss to the country.

4. Anti-dumping argument: sometimes protection is required in order to protect the domestic firms against the dumping of goods done by the foreign firms. Dumping is an unfair trade practice in which the producers of a country sell goods in another country at lower prices than those charged at home. The intention of the foreign firm in this case is to drive the competitors out of the market.

5. Protection for conserving the natural resources: unchecked free trade can lead to exhaustion of mineral resources which are very vital for the development of the country.

Balance of Payments (BoP)

The Balance of Payments (BoP) is defined as a systematic record of all economic transactions of a nation with the outside world in a given year. The Transactions here means transactions of the government as well as private entities.

The Bop records are prepared by the central banks of every country as per the format given in International Monetary Fund’s (IMF) BPM-6 manual. (RBI in case of India).

All the figures in BoP are expressed in USD (US dollar).

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Components of BoP

Balance of Trade (BoT) = Exports- Imports (of only visible goods)

Current Account Balance (CAB)= Net Visibles+ Net Invisibles

If CAB is +ve , we call it Current account Surplus. If CAB is –ve, we call it Current account Deficit(CAD).

Capital Account Balance= Net Investmensts+ Net Loans+ Net Banking Capital Overall Balance = Current A/C Balance+ Capital A/C Balance

If Overall balance is +ve, it increases the Forex Reserves

If Overall balance is –ve, it decreases the Forex Reserves

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Current Account Deficit (CAD) is good or bad for the economy?

It depends upon

a) What constitutes your imports? 1. If large part of CAD is due to the import of capital goods and raw materials then we don’t

consider CAD as bad. As these capital goods and raw materials would help in increasing the production and exports.

2. But when CAD is there due to the imports of consumptive products (eg Gold , luxury items etc) then it is bad for the economy as it would not help in increasing the exports even in future.

b) How do you finance your deficit? If CAD is financed through borrowing, it is unsustainable because borrowing leads to high

interest payments in the future. Also attracting capital flows in the form of FPI (hot money) to finance the deficit is risky as

when confidence falls, hot money flow dry up and further there may be flight of capital away from the country leading to rapid depreciation of currency and crisis of confidence.

If CAD is too high and capital inflows are insufficient to meet the deficit then Forex reserves starts depleting and currency starts depreciating. Thus moderate CAD (around 2% of GDP) financed mainly by stable foreign investments (FDI) can be helpful in the long run.

Balance of Payments (BoP) Crisis

If persistent current account deficit (CAD ) prevails and capital inflows are not enough to fund the CAD then Forex reserves starts depleting. A situation may then come when the forex reserves fall to dangerously low levels. The country will then face difficulty in importing even the essential items like crude oil and servicing the external loans. Such economic situation is known as Balance of Payments (BoP) crisis.

Importance of Foreign Exchange reserves

1. Forex reserves help in the import of essential items like crude oil when both current account and capital account are in deficit.

2. Defend rupee if it starts depreciating rapidly. 3. Servicing of external loans. 4. To enjoy favourable rating by sovereign credit rating agencies which helps in borrowing cheap.

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Improved current account balance , robust capital inflows (FDI, FII) drove the forex reserves to an all time high USD 608.99 billion during the week ended 25 june 2021.

In terms of projected imports for 2021-22, the current level of reserves provides cover for less than 15 months (Import cover).

India is the 5th largest reserve holding country in the world after China, Japan, Switzerland and Russia.

BoP during 2020-21

The current account balance recorded a surplus of 0.9 per cent of GDP in 2020-21 as against a deficit of 0.9 per cent in 2019-20 on the back of a sharp contraction in the trade deficit to US$ 102.2 billion from US$ 157.5 billion in 2019-20.

Net invisible receipts were lower in 2020-21 due to increase in net outgo of overseas investment income payments and lower net private transfer receipts, even though net services receipts were higher than a year ago.

Net FDI inflows at US$ 44.0 billion in 2020-21 were higher than US$ 43.0 billion in 2019-20.

Net FPI increased by US$ 36.1 billion in 2020-21 as compared to US$ 1.4 billion a year ago.

External commercial borrowings to India recorded inflow of US$ 0.2 billion as compared with US$ 21.7 billion in 2019-20.

In 2020-21, there was an accretion of US$ 87.3 billion to foreign exchange reserves.