A2 Macro - Growth Development and Global Economy

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A2 Macro - Growth Development and Global Economy

  1. 1. Tutor2u Economics The UK and Global Economy Unit 4 Macro Economics Geoff Riley Spring 2014
  2. 2. - 2 - www.tutor2u.net Geoff Riley acknowledges the help of Mark Johnston, Ben Cahill, Penny Brooks, Liz Veal, Mo Tanweer, Ruth Tarrant, Jim Riley, David Carpenter, Jonny Clarke, Tom White, Oliver Fernie and Bob Nutter in developing resources that have been used in this guide. Study Companion Table of Contents 1. Globalisation......................................................................................................................................... 3 2. Trade ................................................................................................................................................... 8 3. The Terms of Trade (ToT) ....................................................................................................................... 12 4. Protectionism........................................................................................................................................ 14 5. The Balance of Payments (BoP)............................................................................................................... 24 6. Exchange Rates.................................................................................................................................... 31 7. European Monetary Union...................................................................................................................... 44 8. What is Economic Development? ............................................................................................................. 50 9. Millennium Development Goals............................................................................................................... 52 10. Human Development Index (HDI)............................................................................................................. 57 11. Inequality of Income and Wealth............................................................................................................ 61 12. Developing Countries – Similarities and Differences................................................................................... 64 13. Measuring National Income.................................................................................................................... 66 14. Measuring the Standard of Living ........................................................................................................... 72 15. Sources of Economic Growth................................................................................................................... 74 16. Consequences of Economic Growth.......................................................................................................... 88 17. Constraints on Growth and Development.................................................................................................. 92 18. The Prebisch-Singer Hypothesis..............................................................................................................105 19. Productivity – Economic Growth and Development....................................................................................109 20. Competitiveness...................................................................................................................................113 21. Development Strategies........................................................................................................................119 22. Private Sector and Economic Development...............................................................................................124 23. State Intervention – Growth and Development .........................................................................................131 24. Overseas Aid, Remittances and Debt Relief.............................................................................................135 25. Micro Finance, Fair Trade and Tourism....................................................................................................142 26. Macroeconomic Policies and Economic Growth .........................................................................................147 27. Keynesian Economics ............................................................................................................................161 28. Labour Migration Economics ..................................................................................................................164 29. Sustainable Development......................................................................................................................167 30. Growth and Development in China.........................................................................................................172 31. Growth and Development in India..........................................................................................................180 32. Growth and Development in Brazil.........................................................................................................183 33. Growth and Development in South Africa................................................................................................187 34. Growth and Development in South Korea................................................................................................191 35. Growth and Development in the European Union......................................................................................196 36. Economic Developments in the UK Economy..............................................................................................202 37. Development and Global Institutions.......................................................................................................209 38. Unit 4 Economics Glossary.....................................................................................................................211 39. Past Exam Questions for Unit 4 Macro (EdExcel).......................................................................................220
  3. 3. - 3 - www.tutor2u.net Transnational Corporations 51 of the largest economies in the world are corporations. The top 500 TNCs account for nearly 70% of world trade. The Shifting Centre of Global Influence “In 1980, North America and Western Europe produced more than two-thirds of the world’s income, so as a result, in 1980 the world’s economic center of gravity was a point in the middle of the Atlantic Ocean. By 2008, because of the continuing rise of India, China and the rest of East Asia, that center of gravity had shifted to a point just outside Izmir.” Source: Professor Danny Quah, LSE 1. Globalisation The OECD defines globalization as “The geographic dispersion of industrial and service activities, for example research and development, sourcing of inputs, production and distribution, and the cross-border networking of companies, for example through joint ventures and the sharing of assets.” Globalisation is a process of deeper economic integration between countries involving: (1) An expansion of trade in goods and services (2) An increase in transfers of financial capital including the expansion of foreign direct investment (FDI) by trans-national companies (TNCs) and the rising influence of sovereign wealth funds (3) The development of global brands (4) Spatial division of labour– for example out-sourcing and off shoring of production and support services as production supply-chains has become more international. As an example, the iPod is part of a complicated global supply chain. The product was conceived and designed in Silicon Valley; the software was enhanced by software engineers working in India. Most iPods are assembled / manufactured in China and Taiwan by TNCs such as FoxConn (5) High levels of labour migration within and between countries (6) New nations joining the trading system. Russia joined the World Trade Organisation in July 2012 (7) A fast changing shift in the balance of economic and financial power from developed to emerging economies and markets (8) Increasing spending on investment, innovation and infrastructure across large parts of the world Global inter-dependence and shifts in world economic influence  Globalisation is a process of making the world economy more inter-dependent  It is also bringing about a change in the balance of power in the world economy. Many of the newly industrializing countries are winning a rising share of world trade and their economies are growing faster than in richer developed nations especially after the global financial crisis (GFC) Previous waves of globalisation There have seen several previous waves of globalisation: o Wave One: Began around 1870 and ended with the descent into protectionism during the interwar period of the 1920s and 1930s. This first wave started the pattern which persisted for over a century of developing countries specializing in primary commodities which they export to the developed countries in return for manufactures. During this wave of globalisation, the ratio of world exports to GDP increased from 2 per cent of GDP in 1800 to 10 per cent in 1870, 17 per cent in 1900 and 21 per cent in 1913. o Wave Two: After 1945, there was a 2nd wave of globalization built on a surge in trade and reconstruction. The International Monetary Fund was created in 1944 to promote a stable monetary system and provide a sound basis for multilateral trade, and the World Bank to help restore economic activity in the devastated countries of Europe and Asia. Their aim was to promote lasting multilateral co-operation between nations. The General Agreement on Tariffs and Trade (GATT) signed in 1947 provided a framework for a mutual reduction in import tariffs. GATT eventually became known as the WTO. o Wave Three: The most recent wave of globalisation has seen another sharp rise in the ratio of trade to GDP for many countries and secondly, a sustained increase in capital flows between counties
  4. 4. - 4 - www.tutor2u.net What factors have contributed to globalisation? Among the main drivers of globalisation are the following: 1. Containerisation – the costs of ocean shipping have come down, due to containerization, bulk shipping, and other efficiencies. The lower cost of shipping products around the global economy helps to bring prices in the country of manufacture closer to prices in the export market, and makes markets contestable in an international sense. 2. Technological change – reducing the cost of transmitting and communicating information - known as “the death of distance” – a key factor behind trade in knowledge products using web technology 3. Economies of scale: Many economists believe that there has been an increase in the minimum efficient scale associated with particular industries. If the MES is rising, a domestic market may be regarded as too small to satisfy the selling needs of these industries. Overseas sales then become essential. 4. De-regulation of global financial markets: This has included the removal of capital controls in many countries which facilitates foreign direct investment. 5. Differences in tax systems: The desire of trans-national corporations to benefit from lower labour costs and other favourable factor endowments abroad and develop and exploit fresh comparative advantages in production has encouraged many countries to adjust their tax systems to attract foreign direct investment. 6. Less protectionism - old forms of non-tariff protection such as import licencing and foreign exchange controls have gradually been dismantled. Borders have opened and average tariff levels have fallen – that said in the last few years there has been a rise in protectionism as countries have struggled to achieve growth after the global financial crisis. The table below tracks average import tariffs since 1991. Average Most Favoured Nation Applied Import Tariffs (%) 1991 2001 2009 Developing Countries (134 countries) 27.7 13.5 9.9 Low Income Developing Countries (42 countries) 44.4 14.4 11.8 Source: World Bank Fall in Transport Costs / effects of Containerization Entry of new countries into the official world trade system Lower communication costs (broadband/cloud) Decline in tariff and non-tariff barriers to trade Rising Living Standards – growing demand for world products Liberalisation of Domestic Markets – opened up to competition
  5. 5. - 5 - www.tutor2u.net  The breakdown of the Doha trade talks a few years back dashed hopes of a globally based multi- lateral reduction in import tariffs and other trade barriers. In its place there has been a rising number of bi-lateral trade deals between countries and the emergence of regional trading blocs such as NAFTA, MECOSUR and plans for a new Trans-Pacific Partnership (TPP)  Globalization no longer necessarily requires a business to own or have a physical presence in terms of either owning production plants or land in other countries, or even exports and imports. For instance, economic activity can be shifted abroad using licensing and franchising which only needs information and finance to cross borders. Joint Ventures Increasingly we see many examples of joint-ventures between businesses in different countries • BMW and Toyota agreed a partnership in 2011 to co-operate on hydrogen fuel cells, vehicle electrification, lightweight materials and a future sports car. Partnership agreements between competing automakers are becoming increasingly common in the industry as manufacturers seek to pool efforts on costly technologies. • Renault-Nissan’s joint venture with Indian firm Bajaj to produce a £1,276 car • Alliances in the airline industry e.g. Star Alliance and One World • Burger King, the US fast food restaurant chain plans to open 1,000 stores in China through a new joint venture with a Turkish private equity business • Sony and Olympus agreed to form an alliance in September 2012 Our chart above tracks the annual growth of real GDP for the world economy and for developing countries as a group. In nearly every year the developing world has seen faster growth. 2009 marked a difficult year for the world economy with a recession – this was felt most severely in rich advanced countries. Annual % change in world real GDP and real GDP for developing countries World Growth and Developing Country Growth World Emerging & Developing Economies Source: International Monetary Fund, World Economic Outlook 00 01 02 03 04 05 06 07 08 09 10 11 -2 -1 0 1 2 3 4 5 6 7 8 9 Percent -2 -1 0 1 2 3 4 5 6 7 8 9 Developing country growth has out-paced global GDP growth in every year since 1999 1999 – A year of deep recession for many advanced economies
  6. 6. - 6 - www.tutor2u.net What are the Key Gains from Globalisation? (1) Trade enhances the division of labour as countries specialise in areas of comparative advantage (2) Deeper relationships between markets across borders enable and encourage producers and consumers to reap the benefits of economies of scale (3) Competitive markets reduce monopoly profits and incentivize businesses to seek cost-reducing innovations and improvements in what they sell (4) Gains in efficiency should bring about an improvement in economic growth and higher per capita incomes. The OECD Growth Project found that a 10 percentage- point increase in trade exposure for a country was associated with a 4% rise in income per capita (5) Globalisation has helped many of the world’s poorest countries to achieve higher rates of economic growth and reduce the number living in extreme poverty (6) For consumers globalisation increases choice and there are gains from a rapid pace of innovation driving dynamic efficiency benefits What are some of the Risks and Disadvantages from Globalisation? 1. Inequality: Globalisation has been linked to rising inequalities in income and wealth. Evidence for this is a rise in the Gini-coefficient and a growing rural–urban divide in countries such as China, India and Brazil. This leads to political and social tensions and instability as a backlash. 2. Inflation: Strong demand for food and energy has caused a steep rise in commodity prices. Food price inflation (known as agflation) has placed millions of the world’s poorest people at great risk. 3. Macroeconomic Instability: A decade or more of strong growth, low interest rates, easy credit in developed countries created a boom in share prices and property valuations. The bursting of speculative bubbles prompted the credit crunch and the contagion from that across the world in from 2008 onwards. This had negative effects on poorer & vulnerable nations. 4. Threats to the Global Commons: A major long-term threat is the impact that rapid growth and development is having on the environment. Threats of irreversible damage to ecosystems, land degradation, deforestation, loss of bio-diversity and the fears of a permanent shortage of water are afflicting millions of the most vulnerable people are vital issues. 5. Trade Imbalances: Trade has grown but so too have trade imbalances. Some countries are running enormous trade surpluses and these imbalances are creating tensions and pressures to introduce protectionist policies such as new forms of import control. 6. Unemployment: Concern has been expressed by some that investment and jobs in advanced economies will drain away to developing countries as firms switch their production to countries with lower unit labour costs. This can lead to higher levels of structural unemployment. 7. Standardization: Some critics of globalisation point to a loss of economic and cultural diversity as giant firms and global brands come to dominate domestic markets in many countries. 8. Dominant Global Brands – globalisation might actually stifle competition if global businesses with dominant brands and superior technologies take charge of key international markets be it telecommunications, motor vehicles, heavy industrial equipment or digital cameras. Globalisation and the Risk of Financial Contagion In 2007-08, financial crises generated in developed countries quickly spread affecting the poorest and most distant nations, which saw weaker demand and lower prices for their exports, higher volatility in capital flows and commodity prices, and lower remittances. Globalisation and Dynamic Efficiency - China Stimulates Innovation in the West Apple’s iPhone and iPad were both designed and prototyped in California and then produced in China. Chinese manufacturing competition is increasingly capturing low-skill production while simultaneously fostering high-skill innovation in the West. About 15 percent of technical change in Europe in the past decade can be attributed directly to competition from Chinese imports, an annual benefit of almost €10 billion to European economies. Firms have responded to the threat of Chinese imports by increasing their productivity—adopting better IT, boosting R&D spending, and increasing patenting. Source: Von Reenen & Bloom, LSE, Economic Journal 2012
  7. 7. - 7 - www.tutor2u.net Sovereign Wealth Funds (SWF) o Investment funds run by foreign governments, also called ‘sovereign wealth funds’ have been in existence since the 1950’s. China, Singapore, Dubai, Norway, Libya, Qatar and Abu Dhabi have all built up a sizeable surplus of domestic savings over investment. o Norway’s $760bn oil fund is the world’s largest sovereign wealth fund. According to a report in the Financial Times in August 2013, it owns on average about 2.5% of every listed European company o Now some other countries with large reserves of oil and gas are considering setting up their own funds – in 2012, Tanzania announced it is to set up a sovereign wealth fund. Not all have been successful. Nigeria’s has operated an Excess Crude Account the surpluses from which have been largely used to pay off existing international debts. o China established its official sovereign wealth fund China Investment Corp (CIC) five years ago with the aim of earning high returns by investing abroad the dollars China earns from its exports. In January 2012, CIC’s $410bn sovereign wealth fund, bought an 8.68 per cent stake in Thames Water, the water network that serves London. It also has investment stakes in France’s GDF Suez, Canada’s Sunshine Oil sands and Trinidad and Tobago’s Atlantic Liquid Natural Gas Company. o Sovereign wealth funds are already having an important effect on the UK. Singapore's Temasek owns stakes in Barclays and Standard Chartered, while Qatar and Dubai between them own about a third of the London Stock Exchange. The government of Singapore has also built up a 3% stake in British Land. Dubai's sovereign wealth fund, Dubai International Capital (DIC) has invested money in building stakes in UK companies, including Travelodge and the London Eye. o Many sovereign wealth funds have provided an injection of fresh capital for the UK banking system in the wake of the losses sustained from the sub-prime crisis and the credit crunch. The banks have needed to re-capitalize to repair their balance sheets, improve their chances of survival and provide a stronger platform for a recovery in lending to businesses and individuals who need loans. Rising Trade and FDI Flows in the World Economy The chart below tracks the annual value of world trade in goods and services together with the value of foreign direct investment flows. Both have seen a strong trend rise which reflects the rapid process of globalisation. There have been dips – notably in 2001 and in 2008-09 following the global financial crisis. But trade and investment has recovered quite strongly in 2011 and 2012. There is some evidence of a complementary relationship between FDI and trade. For example inwards investment that leads to the building of new factories, hotels, ports, roads and airports helps facilitate trade within and between regions. Foreign direct investment and trade have risen far more rapidly than global output since 1990, with FDI rising faster even than trade. The FDI stock jumped from 9 per cent of world output in 1990 to 33 per cent in 2012; exports of goods and services went from 20 per cent of world output to 31 per cent
  8. 8. - 8 - www.tutor2u.net 2. Trade  Trade is the exchange of products between countries  When conditions are right, trade brings benefits to all countries involved and can be a powerful driver for sustained growth and rising living standards.  One way of expressing the gains from trade in goods and services is to distinguish between static gains from trade (i.e. improvements in allocative and productive efficiency) and dynamic gains (i.e. gains in welfare that occur over time from improved product quality, increased choice and faster innovative behaviour). Gains from Trade – Understanding Comparative Advantage  First introduced by David Ricardo in 1817, comparative advantage exists when a country has a ‘margin of superiority’ in the production of a good or service i.e. where the marginal cost of production is lower  Countries will generally specialise in and export products, which use intensively the factors inputs, which they are most abundantly endowed.  If each country specializes, then total output can be increased leading to an improvement in allocative efficiency and welfare.  Because production costs are lower, providing that a good market price can be found from international buyers, specialisation should focus on those goods and services that provide the best value  In highly developed countries, comparative advantage is shifting towards specialising in producing and exporting high-value and high-technology manufactured goods and high-knowledge services. Example of comparative advantage Usually we take a standard two-country + two-product example to illustrate comparative advantage  Consider two countries producing two products – digital cameras and vacuum cleaners  With the same factor resources evenly allocated by each country to the production of both goods, the production possibilities are as shown in the table below. OUTPUT BEFORE SPECIALISATION DIGITAL CAMERAS VACUUM CLEANERS UK 600 600 United States 2400 1000 Total 3000 1600 Working out the comparative advantage o To identify who should specialise in a particular product, consider the internal opportunity costs o Were the UK to shift resources into supplying more vacuum cleaners, the opportunity cost of each vacuum cleaner is one digital television o For the United States the same decision has an opportunity cost of 2.4 digital cameras. Therefore, the UK has a comparative advantage in vacuum cleaners Quotes on Gains from Trade “According to a recent study, one iPhone has an export value of $150 per unit in Chinese trade statistics but the value added attributable to processing in China is only $4, with the remaining value added assembled in China coming from the United States, Japan, and other Asian countries” Pascal Lamy, Director-General of the World Trade Organisation “The case for free trade is robust. It extends not only to overall prosperity or gross national product (GNP), but also to distributional outcomes, which makes the free trade argument morally compelling as well” “The dramatic upturn in GDP growth rates in India and China after they turned strongly towards dismantling trade barriers in the late 1980s and early 1990s is compelling. “In India, the shift to accelerated growth after reforms that included trade liberalization has pulled nearly 200 million people out of poverty. In China, which grew faster, it is estimated that more than 300 million people have moved above the poverty line since the start of reforms.” Professor Jagdish Bhagwati
  9. 9. - 9 - www.tutor2u.net o If the UK chose to reallocate resources to digital cameras the opportunity cost of an extra camera is one vacuum cleaner. But for the USA the opportunity cost is only 5/12ths of a vacuum cleaner. o USA has comparative advantage in producing digital cameras because its opportunity cost is lowest. Showing the Output after Specialisation DIGITAL CAMERAS VACUUM CLEANERS UK 0 (-600) 1200 (+600) United States 3360 (+960) 600 (-400) Total 3360 1800 o The UK specializes totally in producing vacuum cleaners – doubling its output - now1200 o The United States partly specializes in digital cameras increasing output by 960 having given up 400 units of vacuum cleaners o As a result of specialisation output of both products has increased - a gain in economic welfare. For mutually beneficial trade to take place, the two nations have to agree an acceptable rate of exchange of one product for another. If the two countries trade at a rate of exchange of two digital cameras for one vacuum cleaner, the post-trade position will be as follows: o The UK exports 420 vacuum cleaners to the USA and receives 840 digital cameras o The USA exports 840 digital cameras and imports 420 vacuum cleaners Showing the Gains from Trade - Post Trade Output / Consumption DIGITAL CAMERAS VACUUM CLEANERS UK 840 780 United States 2520 1020 Total 3360 1800 Compared with the pre-specialisation output levels, consumers now have an increased supply of both goods What are the key assumptions behind this theory of trade? This theory of trade based on comparative advantage depends on a number of assumptions: 1. Occupational mobility of factors of production (land, labour, capital) - this means that switching factor resources from one industry to another involves no loss of efficiency and productivity. In reality we know that factors of production are not perfectly mobile – labour immobility for example is a root cause of structural unemployment 2. Constant returns to scale (i.e. doubling the inputs used in the production process leads to a doubling of output) – this is merely a simplifying assumption. Specialisation might lead to diminishing returns in which case the benefits from trade are reduced. Conversely increasing returns to scale means that specialisation brings even greater increases in output. 3. No externalities arising from production and/or consumption – no discussion about the overall costs and benefits of specialisation and trade should ignore many of the environmental considerations arising from increased production and trade between countries. The Growing Importance of Intra-Industry Trade and Supply Chains The standard model of trade focuses on trade between countries. In reality, most trade takes place between businesses across national boundaries – i.e. intra-industry trade. In the last twenty years we have seen huge changes in both the pattern of trade between developed and developing countries. And also the complexity of manufacturing supply chains around the world. Typically for example, a tablet computer or a smart phone will be manufactured in one or two centers but the components will have come from dozens of other countries.
  10. 10. - 10 - www.tutor2u.net The Heckscher-Ohlin Trade Model According to the Heckscher-Ohlin model of trade, countries have a comparative advantage in sectors that make more intensive use of their relatively abundant factors. For example many lower income countries have exports concentrated in primary commodities or lower value-added manufacturing products. What are the Main Sources of Comparative Advantage? Comparative advantage is a dynamic concept meaning that it changes over time. For a country, some of the factors below are important in determining the relative unit costs of production: 1. The quantity and quality of natural resources available for example some countries have an abundant supply of good quality farmland, oil and gas, fossil fuels. Climate and geography have key roles in creating differences in comparative advantage. More recently shale gas revolution is likely to lead to dramatic shifts in the future pattern of world energy production and trade as North America becomes energy sufficient. Severe worries about water scarcity in the future in large parts of the developing world might have hugely significant effects on their ability to export products. 2. Demographics - An ageing population, net outward or inward migration, educational improvements and women’s participation in the labour force will all affect the quantity and quality of the labour force available for industries engaged in international trade. 3. Rates of capital investment including infrastructure: Greater public infrastructure investment can reduce trade costs and hence increasing supply capacity. Investment in roads, ports and other transport infrastructure strengthens regional trade ties. ICT infrastructure is particularly important for countries wanting to build a competitive advantage in information-intensive sectors such as mobile telecommunications, gaming and financial services 4. Increasing returns to scale and the division of labour – increasing returns occur when output grows more than proportionate to inputs. Rising demand in the markets where trade takes place helps to encourage specialisation, higher productivity and internal and external economies of scale. These long-run scale economies give regions and countries a significant cost advantage. 5. Investment in research & development which can drive innovation and invention 6. Fluctuations in the exchange rate, which then affect the relative prices of exports and imports and cause changes in demand from domestic and overseas customers. 7. Import controls such as tariffs, export subsidies and quotas – these can be used to create an artificial comparative advantage for a country's domestic producers. 8. The non-price competitiveness of producers - covering factors such as the standard of product design and innovation, product reliability, quality of after-sales support. Many countries are now building comparative advantage in high-knowledge industries and specializing in specific knowledge sectors – an example is the division of knowledge in the medical industry, some countries specialize in heart surgery, others in pharmaceuticals. 9. Institutions – these are important for comparative advantage and important for growth too. Banking systems are needed to provide capital for investment and export credits, legal systems help to enforce contracts, political institutions and the stability of democracy is a key factor behind decisions about where international capital flows. Comparative advantage is often a self-reinforcing process. o Entrepreneurs in a country develop a new comparative advantage in a product either because they find ways of producing it more efficiently or they create a genuinely new product that finds a growing demand in home and international markets o Rising demand and output encourages the exploitation of economies of scale; higher profits can be reinvested in the business to fund further product development, marketing and a wider distribution network. Skilled labour is attracted into the industry and so on o The expansion of an industry leads to external economies of scale.
  11. 11. - 11 - www.tutor2u.net What are some of the Wider Benefits of International Trade? Many countries have seen a growing share of their GDP directly linked to overseas trade, our chart below tracks data for India, one of the fast-growing BRIC nations. India joined the WTO in 1991. Some of the broader gains from trade in goods and services are: 1. Welfare gains: Supporters of trade believe trade is a ‘positive-sum game’ – all counties engaged in open trade and exchange stand to gain – although the gains from trade may not be equal 2. Economies of scale – trade and increased market size allows firms to exploit scale economies leading to lower average costs of production that might be passed onto consumers 3. Competition / market contestability – trade promotes increased competition particularly for domestic monopolies that would otherwise face little competition. Trade is a spur for higher productivity – a stimulus to higher efficiency across many industries. 4. Dynamic efficiency gains from innovation - trade enhances choice and stimulates product and process innovations bringing better products for consumers and enhances the standard of living 5. Access to new technology and inflows of new knowledge: trade is a mechanism by which countries can have access to new technologies. Trade is a stimulus to the exchange of ideas and inflow of human capital. Openness to trade allows imports of capital equipment at lower prices. 6. Rising living standards and a reduction in poverty - a growing body of evidence shows that countries that are more open to trade grow faster over the long run and have higher per capita income than those that remain closed. Growth through trade directly benefits the world's poor although free trade is not necessarily equitable. The United Nations Development Programme (UNDP) believes that greater openness in trade can be a major factor behind reducing extreme poverty. For example in the case of Cambodia, access to markets is estimated to have contributed to a decrease in extreme poverty from 35% in 2002 to 25.8% in 2010. Prior to joining the WTO, Indian trade as a share of GDP was low by global standards at just 15%. That figure has doubled in the last twenty years
  12. 12. - 12 - www.tutor2u.net 3. The Terms of Trade (ToT) David Ricardo’s theory of comparative advantage explains that if countries specialise in the production of the good/service in which they have a comparative advantage, then all countries can move outside their PPF and gain from trade. How the gains from trade themselves are distributed depends on the actual terms of trade.) The terms of trade measures the rate of exchange of one good or service for another when two countries trade with each other. We calculate the terms of trade as an index number using the following formula: Terms of Trade Index (ToT) = 100 x Average export price index / Average import price index  If a country can buy more imports with a given quantity of exports, its terms of trade have improved. For example, during the commodity price boom, many resource-exporting developing countries experienced increases in their terms of trade. In other words, for the same physical quantity of exports (copper, oil etc.) as before, they could buy more consumer and capital goods from abroad  If import prices rise faster than export prices, the terms of trade have deteriorated. A greater volume of exports has to be sold to finance a given amount of imported goods and services. Typically this leads to a fall in the standard of living because imports of food and technologies are more costly  The terms of trade fluctuate in line with changes in export and import prices. The exchange rate and the rate of inflation can both influence the direction of any change in the terms of trade  A key variable for many developing countries is the world price received for primary commodity exports e.g. the world export price for Brazilian coffee, raw sugar cane, iron ore and soybeans. In our chart below we track what has happened to the terms of trade for Brazil in recent years.  Brazil is a commodity exporter – her terms of trade are sensitive to world commodity prices  After a period of time when the Brazilian terms of trade was declining (1998 through to 2005) the economy then saw a steep increase in the terms of trade index rising from to 125 in 2010  High and rising demand for commodities from Asia—China is now Brazil’s largest trading partner— drove Brazilian export prices to record highs and a strong improvement in her trade surplus in many primary products.  Commodity prices jumped by 75% in real terms between 2001 and 2010, a period during which Brazil’s terms of trade improved by 34%  This has had some second-round consequences damaging for the rest of her economy. One effect has been to cause the Brazilian currency (the Real) to appreciate which has damaged the price competitiveness of many of Brazil’s manufacturing businesses such as steel and vehicle making. A rise in the index shows an improvement in the terms of trade i.e. the ratio of export prices to import prices for Brazil
  13. 13. - 13 - www.tutor2u.net For countries such as Brazil, the commodity boom has led to an improvement in their terms of trade. Next we look at a developing country whose terms of trade have moved in the opposite direction – Nepal. Nepal joined the World Trade Organisation in 2004 and in global terms her exports account for only 0.01% of total world trade. Crucially 70% of her exports are manufactured products and 66% of total exports flow to India (the next highest is 11% to the European Union). Our chart above shows that the Nepalese terms of trade has declined in nearly every year since 2002. A key reason for this has been a trend decline in world prices of manufactured products – a trend linked directly to the effects of globalisation. Nepal is an extremely small economy with little pricing power in world markets. It must compete with huge-scale manufacturers in China and India which puts pressure on Nepalese businesses to reduce their prices to remain competitive in the international market. Another factor causing the terms of trade in Nepal to fall further has been the high cost of imports of essential imports including food and energy which by definition will have a low price elasticity of demand. Our chart below shows the extent of the increase in the value of imports coming into Nepal since 2001. A decline in the index shows that the terms of trade for Nepal have fallen Higher import prices have contributed to the fall in the terms of trade
  14. 14. - 14 - www.tutor2u.net Solar Panel Trade Dispute is Resolved The EU and China have settled a trade dispute over solar panels that upset relations between two of the world’s largest economies and threatened to spread to other industries in a spiral of tit-for-tat retaliation. The agreement will allow Chinese companies to export to the EU single market up to 7 gigawatts per year of solar products without paying import duties (tariffs) provided that the price is no less than 56 cents per watt. Any products sold above the quota or below that minimum price will be hit with anti-dumping duties. The case sparked fears of a wider trade war, with China launching its own investigation into imported European wine and polysilicon and threatening another against European luxury cars. Adapted from news reports, August 2013 4. Protectionism Trade Barriers These include all costs of getting a good to the final consumer other than the cost of supplying the good itself Protectionism - Import Controls  Trade disputes between countries happen because one or more parties either believes that trade is being conducted unfairly, on an uneven playing field, or because they believe that there is one or more economic or strategic justifications for import controls.  Protectionism represents any attempt to impose restrictions on trade in goods and services.  The aim is to cushion domestic businesses and industries from overseas competition and prevent the outcome resulting from the inter-play of free market forces of supply and demand. Protectionism can come in many forms including the following: 1. Tariffs - a tax that raises the price of imported products and causes a contraction in domestic demand and an expansion in domestic supply – for example, the average import tariff on goods entering the Russian economy is 10%, although there will be higher rates for a number of products 2. Quotas – these are quantitative (volume) limits on the level of imports allowed or a limit to the value of imports permitted into a country in a given time period 3. Voluntary Export Restraint Arrangements – where two countries make an agreement to limit the volume of their exports to one another over an agreed time period Transportation costs •Freight costs •Time costs •Customs Delays Policy barriers • Import Tariffs •Non-tariff barriers Internal trade and transaction costs •Information costs •Contract enforcement costs •Red tape
  15. 15. - 15 - www.tutor2u.net 4. Intellectual property laws (e.g. patents and copyright protection) 5. Technical barriers to trade including product labeling rules and stringent sanitary standards. These increase product compliance costs and impose monitoring costs on export agencies in many countries. Huge scale vertically integrated transnational businesses can cope with these non-tariff barriers but many of the least developed countries do not have the some technical sophistication to overcome these barriers. 6. Preferential state procurement policies – where a government favour local/domestic producers when finalizing contracts for state spending e.g. infrastructure projects 7. Export subsidies - a payment to encourage domestic production by lowering their costs. Soft loans can be used to fund the ‘dumping’ of products in overseas markets. Well known subsidies include Common Agricultural Policy in the EU, or cotton subsidies for US farmers and farm subsidies introduced by countries such as Russia. In 2012, the USA government imposed tariffs of up to 4.7 per cent on Chinese manufacturers of solar panel cells, judging that they benefited from unfair export subsidies after a review that split the US solar industry. 8. Domestic subsidies – government financial help (state aid) for domestic businesses facing financial problems e.g. subsidies for car manufacturers or loss-making airlines. 9. Import licensing - governments grants importers the license to import goods. 10. Exchange controls - limiting the foreign exchange that can move between countries. 11. Financial protectionism – for example when a national government instructs its banks to give priority when making loans to domestic businesses. 12. Murky or hidden protectionism - e.g. state measures that indirectly discriminate against foreign workers, investors and traders. A government subsidy that is paid only when consumers buy locally produced goods and services would count as an example. Deliberate intervention in currency markets might also come under this category. Quotas, embargoes, export subsidies and exchange controls are examples of non-tariff barriers Tariffs China joined the WTO in 1991 and since then average import tariffs have been falling on a consistent basis. Our analysis diagram below shows the standard effects of an import tariff on an imported product. The world price before the tariff is Pw and at this price, domestic demand is Qd and domestic supply is Qs. Sustained fall in the average import tariffs on imports into China. But there has been an expansion of non-tariff barriers to trade
  16. 16. - 16 - www.tutor2u.net EU Extends Anti-Dumping Tariffs on Ironing Boards The European Union has extended anti-dumping duties on ironing boards imported from China by five years, but lifted them for these products coming from Ukraine. China used to control around 40 to 45 per cent of the EU ironing board market – but this fell to 15 to 20 per cent when the duties were introduced in 2011. When duties were originally imposed in 2007, imports from China were levied at a top rate of 38.1 per cent. In 2010 the top rate increased to 42.3 per cent for China. Source: News reports, July 2013 Because of the tariff, the import price rises to Pw + T. This causes a contraction in demand to Qd2 and an expansion of supply to Qs2. The result is that the volume of imports falls to quantity M. Tariffs have welfare consequences, one of which is that the welfare of consumers who must now purchase the imported product at a higher price has fallen – there is a deadweight loss of consumer surplus. The effects of a tariff on quantities depend on the price elasticity of demand and price elasticity of supply of domestic businesses that have been given a cushion of increased competitiveness by the tariff. Arguments for Protectionism 1) Fledging industry argument: Certain industries possess a possible comparative advantage but have not yet exploited economies of scale. Short-term protection allows the ‘infant industry’ to develop its comparative advantage at which point the protection could be relaxed, leaving the industry to trade freely on the international market. 2) Externalities and market failure: Protectionism can also be used to internalize the social costs of de-merit goods. Or to correct for environmental market failure in the supply of certain imports. 3) Protection of jobs in home industries and an improvement in a country’s balance of payments 4) Protection of strategic industries: The government may also wish to protect employment in strategic industries, although value judgments are involved in determining what constitutes a strategic sector. This might involve attempting to reduce long-term dependence on certain imports 5) Anti-dumping duties: Dumping is a type of predatory pricing behaviour and a form of price discrimination. Goods are dumped when they are sold for export at less than their normal value. The normal value is usually defined as the price for the like goods in the exporter’s home market. In the short term, consumers benefit from the lower prices of the foreign goods, but in the longer-term, persistent undercutting of Price Output (Q) Domestic Demand Domestic Supply World Price QdQs Pw Pw + Tariff Qd2Qs2 Revenue from Import Tariff M Pw + T Tariff diagram is a key analysis diagram to use when discussing the economic effects of protectionism
  17. 17. - 17 - www.tutor2u.net Protectionism in Brazil The car-making sector is one of Brazil’s largest industries, accounting for 6 to 8 per cent of GDP and about 25 per cent of manufacturing. Like other nations, Brazil values the sector because it generates skilled employment and jobs at suppliers. Fiat, Volkswagen, General Motors, and Ford Motor, South Korea’s Hyundai, Japan’s Nissan, Fiat, Toyota, and China’s Chery Automobile have all invested in Brazil to build car plants. But the Brazilian government has not been slow to use protectionist measures to support this industry. In September 2011 the government raised the taxes on imported cars by 30 percentage points, to between 37 and 55 per cent, in response to surging imports caused by an appreciating exchange rate. The rise in the import tariff hit producers such as Hyundai and BMW that do not yet produce locally, while leaving cars made in Mexico and MERCOSUR countries (including Argentina) eligible to enter the country duty- free. Car imports from Mexico soared as buyers switched to cheaper vehicles, prompting Brazil to impose a three-year import quota regime, restricting the value of imported cars each year to less than $1.5 billion. Adapted from News Reports, autumn 2012 domestic prices might force a domestic industry out of business and allow the foreign firm to establish itself as a monopoly. Once this is achieved the foreign owned monopoly is free to increase its prices and exploit the consumer. Therefore protection, via tariffs on 'dumped' goods can be justified to prevent the long-term exploitation of the consumer. The World Trade Organisation allows a government to act against dumping where there is genuine ‘material’ injury to the competing domestic industry. In order to do that the government has to be able to show that dumping is taking place, calculate the extent of dumping (how much lower the export price is compared to the exporter’s home market price), and show that the dumping is causing injury. Usually an ‘anti-dumping action’ means charging extra import duty on the particular product from the particular exporting country in order to bring its price closer to the “normal value”. Tariffs are not a major source of tax revenue for the Government that imposes them. In the UK for example, tariffs are estimated to be worth only £2 billion to the Treasury, equivalent to only around 0.5% of the total tax take. Developing countries tend to be more reliant on tariffs for revenue. Arguments against Protectionism 1. Market distortion and loss of allocative efficiency: Protection can be an ineffective and costly means of sustaining jobs. a. Higher prices for consumers: Tariffs push up the prices faced by consumers and insulate inefficient sectors from competition. They penalize foreign producers and encourage the inefficient allocation of resources both domestically and globally. b. Reduction in market access for producers: Export subsidies depress world prices and damage output, profits, investment and jobs in many developing countries that rely on exporting primary and manufactured goods for their growth. 2. Loss of economic welfare: Tariffs create a deadweight loss of consumer and producer surplus. Welfare is reduced through higher prices and restricted consumer choice. 3. Extra costs for exporters: For goods that are produced globally, high tariffs and other barriers on imports act as a tax on exports, damaging economies, and jobs, rather than protecting them 4. Regressive effect on the distribution of income: Higher prices that result from tariffs hit those on lower incomes hardest, because the tariffs (e.g. on foodstuffs, tobacco, and clothing) fall on those products that lower income families spend a higher share of their income. 5. Production inefficiencies: Firms that are protected from competition have little incentive to reduce production costs. This can lead to X-inefficiency and higher average costs. 6. Trade wars: There is the danger that one country imposing import controls will lead to retaliatory action by another leading to a decrease in the volume of world trade. Retaliatory actions increase the costs of importing new technologies affecting LRAS.
  18. 18. - 18 - www.tutor2u.net 7. Negative multiplier effects: If one country imposes trade restrictions on another, the resultant decrease in trade will have a negative multiplier effect affecting many more countries because exports are an injection of demand into the global circular flow of income. 8. Second best approach: Protectionism is a ‘second best’ approach to correcting for a country’s balance of payments problem or the fear of structural unemployment. Import controls go against the principles of free trade. In this sense, import controls can be seen as examples of government failure arising from intervention in markets Economic Nationalism o Economic nationalism describes policies to protect domestic consumption, jobs and investment using tariffs and other barriers to the movement of labour, goods and capital o The term gained a more specific meaning in recent years after several European Union governments intervened to prevent takeovers of domestic firms by foreign companies. In some cases, the national governments also endorsed counter-bids from compatriot companies to create 'national champions'. Such cases included the proposed takeover of Arcelor (Luxembourg) by Mittal Steel (India). And the French government listing of the food and drinks business Danone (France) as a 'strategic industry' to block potential takeover bid by PepsiCo (USA The Rise of Trading Blocs and Regional Trade Agreements (RTAs) Over the years tariffs have declined with progress especially marked in developing Asia and in Eastern Europe. But the breakdown of the Doha trade talks has dashed hopes of a globally based multi-lateral reduction in import tariffs and other forms of protectionism. In its place there has been a flurry of bi-lateral trade deals between countries and the emergence of regional trading blocs. For example, the European Union now has over 30 international trade agreements including those with countries such as Colombia and South Korea. Some of these deals are free-trade agreements that involve a reduction in tariff and non-tariff import controls to liberalise trade in goods and services between countries. The most sophisticated RTAs include rules on flows of investment, co-ordination of competition policies, agreements on environmental policies and the free movement of labour. Examples of Regional Trade Agreements (RTAs): The number of RTAs has risen from around 70 in 1990 to over 300 today – this both reflects and reinforces a switch towards greater intra-regional trade most notably between many of the world’s fast-growing emerging market economies. No regional trade agreement is the same.  The European Union (EU) – a customs union, a single market and now with a single currency  The European Free Trade Area (EFTA)  The North American Free Trade Agreement (NAFTA)  Mercosur - a customs union between Brazil, Argentina, Uruguay, Paraguay and Venezuela  Association of Southeast Asian Nations (ASEAN) Free Trade Area (AFTA)  Common Market of Eastern and Southern Africa (COMESA)  South Asian Free Trade Area (SAFTA) created in January 2006 and containing countries such as India and Pakistan  Pacific Alliance – established 2013 – a trade agreement between Chile, Colombia, Mexico and Peru  Trans-Pacific Partnership (TPP) - a proposed free trade agreement being negotiated during 2013 between Australia, Brunei, Chile, Canada, Malaysia, Mexico, New Zealand, Peru, Singapore, the United States, and Vietnam Malaysia and Australia agree a free trade pact Malaysia and Australia have signed a free trade agreement. The agreement, which has been in negotiations since 2005, aims to scrap the majority of export tariffs. It is hoped that the deal will boost trade between the two countries which currently stands at £8bn a year on average Source: BBC news, May 2012.
  19. 19. - 19 - www.tutor2u.net STAGE OF ECONOMIC INTEGRATION NO INTERNAL TRADE BARRIERS COMMON EXTERNAL TARIFF FACTOR AND ASSET MOBILITY COMMON CURRENCY COMMON ECONOMIC POLICY Free Trade Area X Customs Union X X Single Market X X X Monetary Union X X X X Economic Union X X X X X The Economics of a Customs Union The European Union is a customs union. A customs union comprises countries which agree to: o Abolish tariffs and quotas between member nations to encourage free movement of goods and services. Goods and services that originate in the EU circulate between Member States duty-free. However these products might be subject to excise duty and VAT. o Adopt a common external tariff (CET) on imports from non-members countries. Thus, in the case of the EU, the tariff imposed on, say, imports of Japanese TV sets will be the same in the UK as in any other EU country. o Preferential tariff rates apply to preferential or free trade agreements that the EU has entered into with third countries or groupings of third countries. 1. A customs union shares the revenue from the CET in a pre-determined way – in this case the revenue goes into the EU budget fund. The EU receives its revenues from customs duties from the common tariff, agricultural levies and countries paying 1% of their VAT base. Payments are also made through contributions made by member states based on their national incomes. Thus relatively poorer countries pay less into the EU and tend to be net recipients of EU finances. 2. A single market represents a deeper form of integration than a customs union. It involves the free movement of goods and services, capital and labour and the concept are broadened to encompass economic policy harmonization for example in the areas of health and safety legislation and monopoly & competition policy. Deeper economic and business ties requires some degree of political integration, which also requires shared aims and values between nations Trade Creation and Trade Diversion with Customs Unions and Regional Trade Agreements Trade Creation o Trade creation arising from trade deals between countries involves a shift in domestic consumer spending from a higher cost domestic source to a lower cost partner source for example - within the EU - as a result of the abolition tariffs on intra-union trade o So for example UK households may switch their spending on car and home insurance away from a higher-priced UK supplier towards a French insurance company operating in the UK market o Similarly, Western European car manufacturers may be able to find and then benefit from a cheaper source of glass or rubber for tyres from other countries within the customs union than if they were reliant on domestic supply sources with trade restrictions in place. o Trade creation should stimulate an increase in trade between countries that have signed trade agreements and should, in theory, lead to an improvement in the efficient allocation of scarce resources and gains in consumer and producer welfare.
  20. 20. - 20 - www.tutor2u.net Trade Diversion o Trade diversion is best described as a shift in domestic consumer spending from a lower cost world source to a higher cost partner source (e.g. from another country within the EU) as a result of the elimination of tariffs on imports from the partner o The common external tariff on many goods and services coming into the EU makes imports more expensive. This can lead to higher costs for producers and higher prices for consumers if previously they had access to a lower cost / lower price supply from a non-EU country o The diagram next illustrates the potential welfare consequences of imposing an import tariff on goods and services coming into the European Union. o In general, protectionism in the forms of an import tariff results in a deadweight social loss of welfare. Only short term protectionist measures, like those to protect infant industries, can be defended robustly in terms of efficiency. The common external tariff will have resulted in some deadweight social loss if it has in total raised tariffs between EU countries and those outside the EU. The overall effect of a customs union on the economic welfare of citizens in a country depends on whether the customs union creates effects that are mainly trade creating or trade diverting. Price Output (Q) Domestic Demand Domestic Supply Supply price from EU Supply Qd2Qs2 Supply price from outside the EU Qd1Qs1 Trade creation – access to cheaper supplies allows a lower price – which benefits consumers P1 Lower price leads to an expansion of demand and a rise in consumer surplus + a net improvement in economic welfare P2
  21. 21. - 21 - www.tutor2u.net Case Study: Ambitious Plans for an ASEAN Economic Community ASEAN is a trade bloc of 10 nations with an aggregate economic size of $2.3 trillion. Their aim is to establish a fully-fledged economic community (AEC) by the end of 2015. The trading bloc’s diversity – ranging from advanced economies like Singapore to developing countries like Myanmar is an interesting feature – who will be the winners and losers from deeper economic integration in the region? Current members; 10 countries - Brunei Darussalam, Cambodia, Indonesia, Lao People’s Democratic Republic, Malaysia, Myanmar, Philippines, Singapore, Thailand and Vietnam Economic Background to ASEAN  ASEAN is a middle-income region but with big differences in per capita incomes  Countries such as Singapore and Brunei enjoy a very high GDP per capita at around USD 49,000 and USD 39,000, respectively, on par with the top tier of developed-market economies. In contrast, Myanmar and Cambodia have a GDP per capita of just below USD 900.  Region has a population of over 600 million, roughly half that of China’s or India’s and around 9% of the world’s total  GDP of USD 2.3 trillion in 2012 – around 30% the size of China’s, roughly the same size as that of the UK and 25% larger than India’s. ASEAN GDP accounts for 3% of the world’s total  25% of ASEAN trade is intra-regional trade – the aim is to increase this as economic ties deepen and also for a rise in intra-regional FDI flows  China has emerged as the No. 1 trading partner for ASEAN  5 “ASEAN+1” FTAs have been signed, with China, Japan, Korea, India and Australia/New Zealand The basics of a single market / economic community As part of the ASEAN integration plans, barriers to trade in goods and services will be brought down or kept to a minimum. Flows of investment, capital and skilled labour will be facilitated and co-operation in sectors designated as priority integration sectors will be promoted. — Free flow of goods and services — Freer flow of capital and the Free flow of skilled labour — Priority integration sectors — Food, agriculture and forestry This will be added to by establishing regional standards for Competition policy, Consumer protection, Intellectual property rights, Taxation and E-commerce The ASEAN Infrastructure Fund was established with the Asian Development Bank to fund physical infrastructure projects in ASEAN. An example is the building of a new high speed railway between Malaysia and Singapore.
  22. 22. - 22 - www.tutor2u.net The UK Pattern of Trade UK Share in world total exports 2.59 UK Share in world total imports 3.46 Breakdown in economy's total exports Breakdown in economy's total imports By main commodity group By main commodity group Agricultural products 7.3 Agricultural products 10.8 Fuels and mining products 18.7 Fuels and mining products 18.4 Manufactures 72.1 Manufactures 69.1 By main destination By main origin 1. European Union (27) 53.4 1. European Union (27) 51.3 2. United States 13.3 2. China 9.0 3. China 3.0 3. United States 8.1 4. India 1.8 4. Norway 6.0 5. Switzerland 1.8 5. Japan 2.1 Key points on the UK pattern of trade • Well over half of UK merchandise trade is with the other nations of the EU single market • Manufacturing remains a crucial source of UK exports – around 60% of total manufacturing output is exported – the UK is particularly strong in pharmaceuticals, vehicles, high-end engineering products including aerospace • The UK now runs a trade deficit in crude oil and gas • Overall the UK runs a large trade deficit in goods (>£100bn in 2011) and a rising surplus in services (>£75 billion in 2011). • Only 3% of UK exports go to China and less than 2% go to India – one of the key aims of macro policy in the coming years will be to increase the share of UK trade in goods and services that goes to faster-growing areas / regions of the world including the BRIC nations. Percentage of world trade Share of World Trade in Goods and Services Source: Reuters EcoWin 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 18.0 20.0 22.0 Percent 0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 18.0 20.0 22.0 Asian Emerging Nations (Inc China) United Kingdom
  23. 23. - 23 - www.tutor2u.net Britain inside the European Single Market / European Union During 2012 it seemed that the suggestion that Britain might leave the EU single market and renegotiate her trade relationships with other EU countries was gaining support. “Brexit” is the media term used when discussing the costs and benefits of such a momentous decision. There are strongly held views on both sides of this debate. The case for British exit from the European Union Some counter-arguments – the case for staying within the EU single market Free trade •Britain could negotiate new free trade agreements with major EU trade partners and fast-growing emerging countries •Britain would benefit from freeing itself from many of the EU's laws & regulations Budget savings •Leaving the EU would cut our contributions to the EU budget - a UK fiscal windfall •Food prices would possibly be lower if we left the Common Agricultural Policy (CAP) Exports •The UK is Europe’s biggest export market. So Europe needs the UK as a trade partner •The UK would retain greater control over fiscal and monetary policy and also gain more freedom over labour market, competition and environmental policies Free trade • Risk of losing trade benefits of being inside single market, lower per capita GDP • Attractiveness of the UK as a destination for FDI would be diminished • Adopting a position similar to Norway (which is outside of the EU) would mean the UK accepting many EU rules without having a say in their formulation Market Access • UK will lose tariff-free access to its largest export market • London would no longer be the EU’s financial hub • No guarantee that the UK could negotiate an arrangementto Norway or Switzerland Extra costs • Extra costs for businesses as they ajust to new legal frameworks • Europe might decide to retaliate and prevent favourable trade deals with UK • UK’s net spending on the EU is tiny – less than 1% of GDP (about the same as overseas aid) - for small budget savings, the long-run economic cost will be high
  24. 24. - 24 - www.tutor2u.net 5. The Balance of Payments (BoP) What is the Balance of Payments?  The balance of payments (BOP) records all financial transactions made between consumers, businesses and the government in one country with others  The BOP figures tell us about how much is being spent by consumers and firms on imported goods and services, and how successful firms have been in exporting to other countries.  Inflows of foreign currency are counted as a positive entry (e.g. exports sold overseas)  Outflows of foreign currency are counted as a negative entry (e.g. imported goods and services) The balance of payments is made up of these key parts i) The current account ii) The capital account iii) Official financing account (Note: You will need to understand all three for A2 exams, the AS course focused only on current account) Stylised Example of the Balance of Payments The example below refers to a hypothetical country, data is in $ billion Item of the BoP Net Balance $ billion Comment Current Account (1) Balance of trade in goods -25 A trade deficit (2) Balance of trade in services +10 A trade surplus (3) Net investment income -12 Net outflow of income i.e. due to profits of transnational corporations (4) Net overseas transfers +8 Net inflow of transfers perhaps from remittance payments from migrants Sum of 1+2+3+4 = Current account balance -19 Overall – this country runs a current account deficit Financial Account Net balance of foreign direct investment flows +5 Positive net inflow of FDI Net balance of portfolio investment flows +6 Positive net inflow into equity markets, property etc Net balance of short term banking flows -2 Small net outflow of currency from country’s banking system Balancing item +2 There to reflect errors and omissions in data calculations Changes to reserves of gold and foreign currency +8 +8 means that this country’s gold and foreign currency reserves have been reduced Overall balance of payments 0 Key point: If a country is running a current account surplus, this means there is a net inflow of foreign currency into their economic system. From a balance of payments point of view, a surplus on the current account would allow a deficit to be run on the capital account. For example, surplus foreign currency can be used to fund investment in assets located overseas. The balance of payments must balance.
  25. 25. - 25 - www.tutor2u.net Countries with current account deficits can run into difficulties. If the deficit is large and the economy is not able to attract enough inflows of foreign investment, then their currency reserves will dwindle and there may come a point when the country needs to seek emergency borrowing from institutions such as the International Monetary Fund. Trade deficits and the resulting borrowing lead to a rise in external debt. Measuring the Current Account  The current account of the balance of payments comprises the balance of trade in goods and services plus net investment incomes from overseas assets and net transfers.  Net investment income comes from interest payments, profits and dividends from external assets o For example a UK firm may own a business overseas and send back profits to Britain. This is a credit item for the current account o Similarly, an overseas investment in the UK might generate a good rate of return and the profits are remitted back to another country – this would be a debit item in the account  Transfers include overseas aid payments. For the UK the net transfers figure is negative each year, mainly due to the UK being a net contributor to the budget of the EU. As a rich nation, the UK makes sizeable foreign aid payments, close to a target of 0.7% of GDP per year Trade in Goods and Services Trade in goods includes items:  Manufactured goods  Semi-finished goods and components  Energy products  Raw Materials  Consumer goods  (i) Durable goods (washing machines)  (ii) Non-durable goods (e.g. foods)  Capital goods (e.g. equipment) Trade in services includes:  Banking, insurance and consultancy  Other financial services including foreign exchange and derivatives trading  Tourism industry  Transport and shipping  Education and health services  Research and development  Cultural arts Net Exports and Net Imports The table below shows the value of net trade in goods for the UK economy in 2012. It excludes trade in services. Net exports show products where the value of UK exports exceeds the value of imports. This data reveals competitive advantage in a number of manufacturing industries such as pharmaceutical products, aerospace, fertilizers and photographic equipment. The net import column reveals where the UK runs a trade deficit in a specific group of products including crude oil, motor vehicles others than cars (e.g. passenger vans and coaches) and electrical machinery. Net Trade Balances for the UK Economy Net Exports for the UK (value of exports > value of imports) £m Net Imports for the UK (value of exports > value of imports) £m 1 Mechanical machinery £7,910 1 Electrical machinery -£26,388 2 Medicinal & pharmaceutical products £3,381 2 Other miscellaneous manufactures -£13,483 3 Beverages £2,976 3 Crude oil -£9,500 4 Aircraft £2,968 4 Refined oil -£8,170 5 Fertilizers & other chemicals £2,034 5 Road vehicles other than cars -£5,766 6 Toilet & cleansing preparations £1,898 6 Miscellaneous metal manufactures -£2,522 7 Scientific & photographic £1,514 7 Plastics -£1,463 8 Precious stones £1,409 8 Cars -£1,441 9 Works of art £1,275 9 Non-ferrous metals excl. silver -£592 10 Organic chemicals £1,273 10 Iron & steel -£332 Source: Office for National Statistics
  26. 26. - 26 - www.tutor2u.net What does a current account deficit mean? Does it matter? Running a deficit on the current account means that an economy is not paying its way in the global economy. A deficit means a country is drawing in money from elsewhere and, as a consequence, building up corresponding liabilities – i.e. an increase in external debt. Balance of payments and the standard of living  In principle, there is nothing wrong with a trade deficit. It simply means that a country must rely on foreign direct investment or borrow money to make up the difference  In the short term, if a country is importing a high volume of goods and services this is a boost to living standards because it allows consumers to buy more consumer durables  The deficit might also be the result of importing much needed capital equipment that will boost a country’s productive capacity in the long run Especially for a developing country, a trade deficit can bring beenfits. Economists might justify a trade deficit by arguing that poorer nations should be importing capital by running a current-account deficit. Providing productive investments are made, this gives a country the extra capital to drive future GDP growth so it can pay the foreigners back. Balance of Payments and Aggregate Demand 1. When there is a current account deficit – this means that there is a net outflow of demand and income from a country’s circular flow. In other words, trade in goods and services and net flows from transfers and investment income are taking more money out of the economy than is flowing in. Aggregate demand will fall. 2. When there is a current account surplus there is a net inflow of money into the circular flow and aggregate demand will rise. Trade Imbalances The global economy will always have some deficit countries and some surplus countries. But the scale of global trade imbalances has increased over the years and this has created tensions between nations and poses a threat to globalisation. More countries are using managed exchange rates as a way of dealing with growing trade deficits. A Balance of Payments Crisis A BoP crisis occurs when a country cannot pay for essential imports or service its debt (i.e. pay interest), often as a result of currency devaluation; usually preceded by large capital inflows in order to boost growth but then investors get worried about their debt and remove their capital.
  27. 27. - 27 - www.tutor2u.net What are the Key Dangers from running Persistent Trade Deficits? Countries with Trade Surpluses Many countries operate with a trade and current account surplus – good examples are China, Germany, Japan, Norway and several emerging market countries with strong export sectors. A country with a surplus on the current account sees capital outflows of the same amount. This capital is either deposited in banks overseas or used to purchase foreign assets, from government bonds to companies, leading to an increase in the surplus nation’s ownership of foreign assets. A deficit leads to lower aggregate demand and thereforeslower growth In the long run, persistent trade deficits undermine the standard of living Trade deficit can lead to loss of jobs in home-based industries Deficit countries need to import financial capital to achieve balance A trade deficit can lead to currency weakness and higher imported inflation Countries may run short of vital foreign currency reserves A trade deficit is a reflection of lack of price / non-pricecompetitiveness Currency weakness can lead to capital flight / loss of investor confidence
  28. 28. - 28 - www.tutor2u.net “If a currency is weaker another is stronger; if a trade balance is improved another is worsened. There is a zero sum game in currencies/trade balances” Economist Nouriel Roubini What are the Main Causes of Structural Trade Surpluses? There are several causes of a trade surplus and each country will have a unique set of circumstances:  Export-oriented growth: Some countries have set out to increase the capacity of their export industries as a growth strategy. Investment in new capital provides the means by which economies of scale can be exploited, unit costs driven down and comparative advantage can be developed.  Foreign direct investment: Strong export growth can be the result of a high level of foreign direct investment where foreign affiliates establish production plants and then export from this base  Undervalued exchange rate: A trade surplus might result from a country attempting to depreciate its exchange rate to boost competitiveness. Keeping the exchange rate down might be achieved by currency intervention by a nation’s central bank, i.e. selling their own currency and accumulating reserves of foreign currency. One of the persistent disputes between the USA and China has revolved around allegations that the Chinese have manipulated the Yuan so that Chinese export industries can continue to sell huge volumes into North American markets.  High domestic savings rates: Some economists attribute current account surpluses to high levels of domestic savings and low domestic consumption of goods and services. China has a high household saving ratio and a huge trade surplus; in contrast the savings ratio in the United States has collapsed and their trade deficit has got bigger. Critics of countries with persistent trade surpluses argue they should do more to expand domestic demand to boost world trade.  Closed economy – some countries have a low share of national income taken up by imports – perhaps because of a range of tariff and non-tariff barriers.  Strong investment income from overseas investments: A part of the current account that is often overlooked is the return that investors get from purchasing assets overseas – it might be the profits coming home from the foreign subsidiaries of multinational businesses, or the interest from money held on overseas accounts, or the dividends from taking equity stakes in foreign companies. Current Account Deficits and Surpluses Data is measured as a % of GDP, data is 2012, Source: World Bank Global Economic Prospects Deficit Countries (Highest deficit first) % of GDP Surplus countries % of GDP Mongolia -49.5 China 3.1 Niger -22.7 Germany 5.3 Cyprus -22.3 Sweden 6.2 Uganda -14.8 Taiwan, China 8.1 Zimbabwe -12.4 Sub-Saharan Africa Oil exporters 8.8 Jamaica -11.4 Netherlands 9.5 Rwanda -10.0 Asian High-Income NIEs 9.9 Cambodia -9.9 Nigeria 10.4 Middle East & North Africa Oil importers -9.3 Malaysia 11.1 Ghana -8.6 Switzerland 13.9 Kenya -8.2 Angola 16.2 Ethiopia -7.8 Singapore 17.7 Sub-Saharan Africa - Fragile states -6.3 Norway 18.2 Low Income Countries -6.3 Trinidad and Tobago 18.7 Sub-Saharan Africa Oil importers -5.9 Oman 19.1 Portugal -5.0 Gabon 19.6 South Africa -4.6 Azerbaijan 24.9 Sri Lanka -4.4 Saudi Arabia 31.8 India -3.6 Kuwait 39.7
  29. 29. - 29 - www.tutor2u.net Policies / approaches to reduce a persistent current account deficit There are a number of policies that can be introduced to achieve an improvement in a country’s trade balance – some of them focus on changing the growth of demand, others look to improve the supply-side competitiveness of an economy. As with any macroeconomic ‘problem’ effective policies are those that target the underlying causes. 1. Demand management: Reductions in government spending, higher interest rates and higher taxes could all have the effect of dampening consumer demand reducing the demand for imports. This leads to an increase in spare productive capacity which can then be allocated towards exporting. 2. Natural effects of the economic cycle: One would expect to see a trade deficit fall during a recession – so some of the deficit is partially self-correcting – but this does little to address the problems of a structural balance of payments problem. 3. A lower exchange rate: a. The central bank of a country might decide that a lower exchange rate provides a suitable way of improving competitiveness, reducing the overseas price of exports and making imports more expensive b. For those countries operating with a managed exchange rate, the government may decide to authorise intervention in the currency markets to manipulate the value of the currency 4. Supply-side improvements: a. Policies to raise productivity, measures to bring about more innovation and incentives to increase investment in industries with export potential are supply-side measures designed to boost exports performance and compete more effectively with imports. The time-lags for supply-side policies to have an impact are long. b. Policies to encourage business start-ups – successful small businesses with export potential c. Investment in education and health-care to boost human capital and increase competitiveness in fast-growing and high value industries such as bio-technology, engineering, finance, medicine d. Investment in modern critical infrastructure to support businesses and industries involved in international markets 5. Protectionist measures such as import quotas and tariffs are rarely used because of our commitments to the World Trade Organisation and our membership of the European Union. Expenditure- reducingpolicies- designed to control demand and limit spending on imports - squeeze on demand, encouraging rising private sector saving Expenditure-switchingpolicies- designed to change the relative prices of exports and imports - this causes changes in spending away from imports and towards domestic/export production Improvingthe supply-sideperformanceof the economy - to boost competitiveness - economic reform is a long-run strategy Improvingmacroeconomicstability to make a country more attractive to inward investment - investment can raise productivity and increase a country's capacity for exporting Improving Trade Performance in the Short and Long Run
  30. 30. - 30 - www.tutor2u.net Case Study: The UK Balance of Payments The UK current account comprises the trade balance in goods and services; net international income, for instance from dividends and rents; and net payments by governments and international organisations, such as contributions to the EU and overseas aid. Britain has run a current account deficit since 1984. Our trade deficit in goods has increased significantly – surging past £100 billion in 2012. In contrast, Britain now achieves strong surpluses in trade in services but not enough to fully offset the trade gap in goods. Net investment income is usually positive although this dropped sharply in 2012. Our transfers balance is negative largely because of financial commitments to the European Union and also due to the UK being a net donor of overseas aid equal to around 0.7% of her GDP. The balance of payments must balance! So a nation running a current account deficit requires a capital account surplus. The counterpart to Britain’s current account has been heavy inflows of foreign deposits to UK banks and lending by foreign banks to UK residents. Britain’s current account deficit is sustainable in the sense that the country remains attractive to foreign investment and also because it is regarded as having a flexible economy and a floating exchange rate. This makes it possible for the country to achieve a balance of payments adjustment in the years ahead, for example by successfully improving competitiveness and/or having a lower exchange rate to boost sales and profits from export industries. But the persistent current account deficit is also the result of a relatively low savings rate (mirrored by high levels of consumer debt) and some weaknesses in the supply-side of the economy. Annual balances for each component, £ billion Components of the UK BoP on the Current Account Source: Reuters EcoWin 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 billions -125 -100 -75 -50 -25 0 25 50 75 100 £Billion(billions) -125 -100 -75 -50 -25 0 25 50 75 100 Trade in Goods Current account Trade in Services Transfers Investment income
  31. 31. - 31 - www.tutor2u.net 6. Exchange Rates • Currencies are traded in foreign exchange markets and the volume of money bought and sold is huge! Daily foreign exchange market turnover averages over $4 trillion • An exchange rate is the price of one currency in terms of another – in other words, the purchasing power of one currency against another. • Exchange rates are an important instrument of monetary policy – a growing number of countries are intervening in currency markets as part of their economic strategies Measuring the exchange rate Exchange rates are expressed in various ways: o Spot Exchange Rate - the spot rate is the rate for a currency at today’s market prices o Forward Exchange Rate - a forward rate involves the delivery of currency at a specified time in the future at an agreed rate. Companies wanting to reduce risks from exchange rate volatility can buy their currency ‘forward’ on the market o Bi-lateral Exchange Rate - the rate at which one currency can be traded against another. Examples include: $/DM, Sterling/US Dollar, $/YEN or Sterling/Euro o Effective Exchange Rate Index (EER) - a weighted index of sterling's value against a basket of currencies the weights are based on the importance of trade between the UK and each country. o Real Exchange Rate - this is the ratio of domestic price indices between two countries. A rise in the real exchange rate implies a worsening of competitiveness for a country. Value of one Euro, daily closing exchange rate Euro - Sterling Exchange Rate Source: Reuters EcoWin Jan 08 May Sep Jan 09 May Sep Jan 10 May Sep Jan 11 May Sep Jan 12 May Sep Jan 13 May 0.725 0.750 0.775 0.800 0.825 0.850 0.875 0.900 0.925 0.950 0.975 PenceperEuro1 0.725 0.750 0.775 0.800 0.825 0.850 0.875 0.900 0.925 0.950 0.975 Depreciation in the value of sterling v the US dollar Sterling is appreciating here – fewer pounds needed to buy $1
  32. 32. - 32 - www.tutor2u.net Exchange Rate Systems The choice of exchange rate regime is one of the most important that a country can make as part of monetary policy. The main options are: 1. A free-floating currency where the external value of a currency depends wholly on market forces of supply and demand 2. A managed-floating currency when the central bank may choose to intervene in the foreign exchange markets to affect the value of a currency to meet specific macroeconomic objectives A fixed exchange rate system e.g. a currency peg either as part of a currency board system or membership of the ERM II for countries intending to join the Euro. System Main Characteristics Recent UK History Free Floating Exchange Rate The value of a currency is determined purely by demand and supply of the currency Trade flows and capital flows affect the exchange rate under a floating system There is no target for the exchange rate and no intervention in the market by the central bank Sterling has floated since the UK suspended membership of the ERM in September 1992 The Bank of England has not intervened to influence the pound’s value since it became independent Managed Floating Exchange Rate Value of the currency is determined by market demand for and supply of the currency Some currency market intervention might be considered as part of demand management (e.g. a desire for a lower currency to boost exports) Governments normally engage in managed floating if not part of a fixed exchange rate system. Managed floating was a policy pursued in the UK from 1973-1990 Semi-Fixed Exchange Rates Exchange rate is given a specific target. The currency can move between permitted bands of fluctuation on a day-to-day basis Interest rates are set at a level necessary to keep the exchange rate within target range – or direct intervention in the FOREX market Re-valuations are seen as a last resort The UK operated a semi-fixed system from October 1990 - September 1992 when a member of the ERM. Sterling was eventually forced out of the ERM by a wave of speculative selling Fully-Fixed Exchange Rates The exchange rate is pegged and there are no fluctuations from the central rate A country can automatically improve its competitiveness by reducing its costs below that of other countries – knowing that the exchange rate will remain stable Several countries operate with fixed exchange rates or currency pegs. The Ivory Coast Franc is pegged to the Euro, with the French Treasury guaranteeing convertibility. This facilitates exchange rate and price stability. The peg is not threatening international competitiveness given the low inflation rate in the Ivory Coast.
  33. 33. - 33 - www.tutor2u.net Countries with floating exchange rates The Case for Floating Exchange Rates The main arguments for adopting a floating exchange rate system are as follows: 1. Reduced need for currency reserves: There is no exchange rate target so there is little requirement for a central bank to hold foreign currency reserves to use during intervention 2. Useful instrument of economic adjustment: For example depreciation of the exchange rate can provide a boost to exports and stimulate growth during a recession and/or when there is a risk of deflation. A good example of this is Poland whose currency the Zloty depreciated against the Euro in 2009-10 which helped Poland to avoid recession during the global financial crisis. Indeed Poland was one of the few EU countries to avoid a slump during this difficult period. 3. Partial automatic correction for a trade deficit: Floating exchange rates can help when the balance of payments is in disequilibrium – i.e. a large current account deficit puts downward pressure on the exchange rate, which should help exports and make imports relatively more expensive. Much depends on the price elasticity of demand and supply of exports and the price elasticity of demand for imports – see the later section on the Marshall-Lerner condition and the J- curve effect 4. Less opportunity for currency speculation: The absence of an exchange rate target might reduce the risk of currency speculation. Speculators tend to attack weaker currencies where a government is trying to maintain a fixed exchange rate out of line with macro-economic fundamentals. 5. Freedom (autonomy) for domestic monetary policy: The absence of an exchange rate target allows policy interest rates to be set to meet domestic aims such as controlling inflation or stabilising the business cycle. Countries locked into a single currency system such as the Euro do not have the same freedom to manage interest rates to meet their key macroeconomic aims. This has become obvious as one of the limitations of being inside the Euro during the ongoing crisis. Floating exchange rates have their disadvantages – some of these are discussed next when we look at the advantages of fixed systems. One of the main disadvantages is that floating currencies can be volatile which makes doing businesses harder. An unexpected fall in the exchange rate can also be a cause of rising inflation. Sterling Australian Dollar New Zealand Dollar Polish Zloty
  34. 34. - 34 - www.tutor2u.net Countries with Managed Floating Exchange Rates The Case for Fixed Exchange Rates The main arguments for adopting a fixed exchange rate system are as follows: 1. Trade and Investment: Currency stability can promote trade and capital investment because of less currency risk. Overseas investors will be more certain and confident that the returns from their investments will not be destroyed by sudden fluctuations in the value of a currency. 2. Some flexibility permitted: Some adjustment to the fixed currency parity is possible if the case becomes unstoppable (i.e. the occasional devaluation or revaluation of the currency if agreement can be reached with other countries). Some countries are tempted to engage in competitive devaluations and this threatens the outbreak of “currency wars”. 3. Reductions in the costs of currency hedging: Businesses have to spend less on currency hedging if they know that the currency will maintain a stable value in the foreign exchange markets. 4. Disciplines on domestic producers: A stable currency acts as a discipline on producers to keep costs and prices down and may encourage attempts to raise productivity and focus on research and innovation. In the long run, with a fixed exchange rate, one country’s inflation must fall into line with another (and thus put competitive pressures on prices and real wages) 5. Reinforcing gains in comparative advantage: If one country has a fixed exchange rate with another, then differences in relative unit labour costs will be reflected in the growth of exports and imports. Consider the example of China and the United States. For several years China pegged the Yuan against the dollar. Until July 2005 the exchange rate was fully fixed; since then the Chinese have allowed only a gradual depreciation of the dollar against the Yuan. Most estimates indicate that the Chinese currency is persistently undervalued against the dollar. This makes Chinese products cheaper and has led to numerous calls from US manufacturers for the Chinese to be persuaded to switch to a floating exchange rate or to adjust their currency by appreciating against the dollar. Brazilian Real Swiss Franc Japanese Yen Norwegian Krone Ghana - Cedi
  35. 35. - 35 - www.tutor2u.net What economics factors affect the value of a nation’s currency?  In floating exchange rate systems, the market value of a currency is determined by the demand for and supply of a currency  Most currency dealing is speculative but trade and investment decisions also have a role to play Some of the key factors that can affect a currency are as follows:  Trade balances – countries that have strong trade and current account surpluses tend (ceteris paribus) to see their currencies appreciate as money flows into the circular flow from exports of goods and services and from investment income. This increases the demand for a currency and brings about an appreciation in its value. Persistent trade deficits can lead to currency depreciation.  Foreign direct investment (FDI) – an economy that attracts high net inflows of capital investment from overseas will see an increase in currency demand and a rising exchange rate.  Portfolio investment – much currency trading is used to finance cross-border portfolio investment, for example investors putting their funds into stocks and shares, government bonds and property. Strong inflows of portfolio investment from overseas can cause a currency to appreciate  Interest rate differentials - if a country’s interest rates are higher than rates on offer in other countries then ceteris paribus we expect to see an inflow of currency into banks and other financial institutions. The higher the interest rate differential, the greater is the incentive for funds to flow across international boundaries and into the economy with the higher interest rates. Countries offering high interest rates can expect to see ‘hot money’ flowing across the currency markets and causing an appreciation of the exchange rate. There are inevitable risks in shifting funds across international markets. What might happen to the currency if you leave $200,000 worth of cash in a UK bank account? What happens to the value of your investment if sterling depreciates against the US dollar? What are the risks in exchanging a similar value of US dollars and putting it into the UK stock market or into government bonds? Investors often consider the risk-adjusted relative rate of return from different financial investments. Chinese Yuan to the US Dollar China Spot Exchange Rate against the US Dollar Source: Reuters EcoWin 04 05 06 07 08 09 10 11 12 13 6.00 6.25 6.50 6.75 7.00 7.25 7.50 7.75 8.00 8.25 8.50 USD/CNY 6.00 6.25 6.50 6.75 7.00 7.25 7.50 7.75 8.00 8.25 8.50 China ended the fully fixed exchange rate versus the US dollar in July 2005 Managed appreciation of Yuan v US dollar during this period Effectively – a return to the fixed exchange rate from 2008-2010
  36. 36. - 36 - www.tutor2u.net Currency Markets – Demand and Supply in Action Demand and supply charts help to show how a change in the exchange rate can come about. In the left- hand diagram below we see the effect of a rise in Chinese exports to the United States which leads to an increase in the demand for Chinese Yuan and appreciation in the exchange rate. In the right hand diagram we see the effects of the Chinese central bank intervening to lower the Yuan by selling their own currency and buying US dollars. How can a government manage the value of an exchange rate in the currency market? There are various options for a government / central bank that wishes to intervene in the currency market to bring about a change in the external value of the currency • Changes in policy interest rates e.g. lower interest rates to depreciate the exchange rate • Causes movements of “hot money” banking flows Changesin monetarypolicyinterestrates • Direct intervention in the market • Buying and selling of domestic / foreign currencies Directbuying/ sellingin the currencymarket (intervention) • Taxation of foreign deposits in commercial banks cut the profit from hot money inflows / carry trade effect • Controls on the free flow of capital into and out of a country Taxation of overseascurrencydepositsand capital controls Dollar/Yuan Quantity of currency traded Dollar/Yuan Quantity of curren trad Demand for Yuan Supply of Yuan ER1 D2 ER2 Demand for Yuan ER1 D2 ER2 Supply of Yuan S2 with intervention

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