International trade and finance
Why do we trade?
• Concepts of absolute and comparative
advantage.
Additional example (1)
Assume that Zepo and Lepo are both producing non-food
consumables and food. Assume that both countries have
15000 minutes per month available to produce the two
kinds of products. The maximum units of the two kinds of
products that Zepo can produce per month are
respectively 2000 metric tons of non-food consumables
and 2500 metric tons of food. The maximum units of the
two kinds of products that Lepo can produce per month
are respectively 1000 metric tons of non-food
consumables and 3 000 metric tons of food. Complete
the following table and answer the questions that follow.
Additional example (2)
Country Minutes taken to produce 1 metric ton of product
Non-food Food
Zepo 7.5 6
Lepo 15 5
Assume the following monthly consumption
patterns (in metric tons) before trade takes
place.
Country Non-food consumables Food
Zepo 700 1200
Lepo 100 400
Assume that the price ratio is 1:1 and that the
two countries would trade 800 metric tons of
non-food consumables for 800 metric tons of
food
Additional example (3)
• Opportunity cost ratios
Non-food Food
Zepo 6/7.5 = 0.8 7.5/6 = 1.25
Lepo 5/15 = 0.33 15/5 = 3
Additional example (4)
• Thus Zepo will produce food production & Lepo will specialise in
non-food production.
• Zepo will produce 2500 metric tons of food. It will export 800 tons
to Lepo and its own consumers will have 1700 tons available for
local consumption.
• Lepo will produce 1000 tons of non-food. It will export 800 tons to
Zepo and its own consumers will have 200 tons available.
• Gains from trade: Zepo’s consumers can consume an additional 100
tons of non-food (700-800) and an additional 500 tons of food
(1200 – 1700). Lepo’s consumers can consume an additional 100
tons non-food (100-200) and an additional 400 tons of food (400-
800).
International trade
• Concept of revealed comparative advantage =
country has an advantage in those products
where the country’s share of world exports in
that particular product is greater than the
country’s share of total world exports.
International trade
• Thus revealed comparative advantage in product B (10% >
3%). Also RCA index = divide market share in that product
by total share of world exports (10% / 3% = 3.3) If RCA > 1 =
revealed comparative advantage in that product.
• Also use market penetration index = indication of direction
in which country’s advantage is moving = if value of exports
of particular product is growing at faster rate than value of
world exports of that product = country is gaining a greater
advantage in that product compared to most other
countries.
• Porter = sources of comparative advantage = i) factor
conditions ii) demand conditions iii) firm competitiveness
iv) networks in value chain = not static and can change over
time.
International trade
Trade restrictions
• Concepts of free trade & protectionism.
• Tariffs: Ad valorem tariff, specific tariff &
composite tariff
International trade
• Quotas, non-tariff barriers (NTBs) & export subsidies.
• Reasons for restrictions: i) cheap imports not good for
local producers ii) dumping iii) infant industry
argument iii) tariffs generate revenue for state iv)
national importance of some industries.
• Institutions that promote international trade: i) WTO II)
UN (UNICEF or UNCTAD), World Bank, IMF.
• Economic integration: Preferential trade area ii) Free
trade area iii)Customs union iv) Common market v)
Economic and monetary union.
• SA part of SACU, BRICS, SADC, AU, G20
International investment (1)
• Two main categories: i) portfolio investment & ii)
foreign direct investment (FDI)
• Portfolio investment = financial assets (shares,
bonds)
• FDI = real assets (multi-national companies
putting up factory in SA).
• Globalisation = geographical distance becomes
less important in the establishment and
maintenance of international economic, political
and socio-cultural relations.
International investment (2)
Characteristics of country’s financial markets
most important determinant for attracting
portfolio investors = care about i) liquidity of fin
markets (how easy it is to se fin assets without
significant loss of value ii) depth of fin markets
(how easy it is to sell large quantities of fin
assets without significant loss of value) iii)
variety of fin assets and quality of fin market
regulation (such as security of property rights
and fin reporting requirements).
International investment (3)
Dunning’s main motives of firms investing in foreign
countries (FDI).
• i) Market-seeking
• ii) Resource-seeking
• iii) Efficiency-seeking
• iv) Strategic asset-seeking
International investment (4)
• Main types of risk for FDI = economic risk and political
risk.
• Avenues for FDI = i) greenfield investment (investor
builds or expands facilities in host country) ii)mergers
and acquisitions (local firm transfers some or all of its
assets to a foreign firm & iii) joint ventures ( local firm
and foreign firm join forces in creating a new firm).
• In order to attract FDI: i) reduce economic and political
risks ii)lower taxes or tax concessions iii) various types
of subsidies iv) low interest loans or loan guarantees v)
various types of zones.
Balance Of Payments (BOP) (1)
BOP (2)
• Merchandise exports & imports = excludes services.
• Other receipts = services
• Current transfers = donations or remittance of
income to relatives in other countries.
• Terms of trade = average price of a country’s exports
divided by the average price of country’s imports
Foreign exchange (1)
• Direct quotation: 1$ = R11.57
• Indirect quotation: R1 = $0.09
• Cross rates: Say R15=1$ and €3=1$ thus R/€ exchange
rate is 15/3 = 5 thus R5 = 1€
• Spot market (spot exchange rates).
• Floating exchange rates
• Appreciation of Rand: R12=1$ to R8=1$
• Depreciation of Rand: R8=1$ to R12=1$
• Fixed exchange rate = devaluation if pegged exchange
rate weakens and revaluation if pegged exchange rate
strengthens.
Foreign exchange (2)
Trade, capital flows & exchange rates
• Depreciation of local currency good for exports but bad for imports.
• Appreciation of local currency good for imports but bad for exports.
• Depreciation of local currency could harm a country and reduce its
attractiveness to foreign investors: Say US investor invested $100m in SA
while exchange rate was R4=1$ thus investment worth R400m. If investor
wants to withdraw this R400, but Rand depreciated to R5=1$, the investor
will only get out $80 (400/5).
• Balance sheet effect: Depreciation increases value of a country’s foreign
debt. Say SA local assets is R50m and the firm borrows $10m from US
bank at exchange rate of R4=1$. Thus firm still solvent because value of
net assets is R10m (50m-40m). But say now R7=1$ the loan will be worth
R70m ($10m x 7) and net asset – R20m.
• Forward market (forward exchange rate) = take out a forward contract to
buy foreign currency at a fix exchange rate to be delivered at a future date.
Foreign exchange (3)
• Say SA importer needs to pay a US supplier $1000 in 6 months from
now. Say spot rate is currently R5/$ and importer scared that
Rand/$ exchange rate will depreciate. Goes to ABSA and fix forward
rate at R5.50/$. At end of 6 month will pay R5500 for $1000. Say
spot rate at end of 6 months is R10/$ thus importer did hedge
against that risk.
• Currency speculation = buying & selling of currencies on foreign
exchange market in order to make a profit.
• Arbitrage in general = occurs when one makes a risk-free profit by
trading same asset on different markets. Occurs when the same
asset is traded on different markets at different prices. Example say
gold traded in London for $400 per fine ounce and at same time in
Hong Kong at $410 per fine ounce. Thus buy gold in London and sell
immediately in Hong Kong. Effect = gold price will increase in
London and decrease in Hong Kong.
Foreign exchange (4)
• Arbitrage in currency markets = possible if i) differences in spot rates in
different markets occur ii) inconsistency in cross rates and iii) differences
in forward rates and future spot rates.
• i) Say spot rate in Jhb = R7.01/$ but R6.95/$ in London. Thus buy $100 in
London (cost is 100 x R6.95 = R695) and then sell the $100 in Jhb for R701
(100xR7.01). Thus profit = R6.
• ii) Say cross rates in Jhb is R7/$ and ¥105/$. Implies that R1 = ¥15. But
somewhere cross rate is R1/ ¥14. Thus take R700 and buy $100 (700/7).
Sell $100 for ¥1050 (100x105) and then sell the ¥1050 for R750 (1050/14).
Thus profit of R50 (750 – 700).
• Say current spot rate = R5/$ and 6-month forward rate is R4/$. Thus
market expects an appreciation of rand over 6 months. You feel that Rand
will depreciate over next 6 months. Thus take R400 and buy $100 on
forward market. Say after 6 month the spot rate is R6/$. Thus take the
$100 (for which you paid R400) and immediately sell it on spot market for
R600 (spot rate is R6/$).
Foreign exchange (5)
Determination of exchange rates
Foreign exchange (6)
• Shifts that would cause the rand to depreciate: i)increase in supply of foreign currency ii)
decrease in demand for foreign currency iii) increase in the demand for Rand iv) decrease in
the supply of rand.
• Shifts that would cause the rand to appreciate: i) decrease in supply of foreign currency ii)
increase in demand for foreign currency iii) decrease in demand for rand iv) increase in
supply of Rand.
• Factors that could cause curves to shift (ceteris paribus): i) trade (exports & imports ii) capital
flows (inflow & outflow) iii) expectations (positive & negative) iv) inflation (higher inflation =
value of currency depreciates. Purchasing power parity = an exchange rate should change to
ensure that you buy exactly the same amount of products in both countries = say R8/$ and
means that R8 should buy the same amount of products as $1 can buy in USA. Say price in SA
is R40 and average price in USA is $5= correct exchange rate must be R8/$ (40/5). Say no
inflation in USA but 10% inflation in SA = average price in USA still $5 but price in SA now R44
= SA rand will then tend to depreciate to R8.80/$ (44/5). But say real spot rate is R7/$ then
rand is overvalued and if real spot rate is R10/$ the rand is undervalued v) interest rates =
increases in interest rates should result in appreciation of rand in short term = higher interest
rates causes inflation to fall and more inflow of portfolio investment = interest rate parity =
exchange rate will change to keep returns on fin assets equal between countries.
Foreign exchange (7)
Managing foreign exchange risk
• Three types of foreign exchange risks:
• i) transaction risk = caused by time lags between commitment to a
transaction and actual payment in the foreign currency= say firm
buy inputs in a foreign currency but only pays for inputs in 3 months
= if foreign currency appreciates before date of payment firm have
to pay more than expected.
• ii) structural risk = caused by mismatch between cash inflows and
outflows due to exchange rate movements (exports and imports)=
platinum mine pays cost in SA rand but sells output overseas in say
USA$ = sudden appreciation in rand means that when they convert
$ earnings into rand they my not be able to cover their cost.
• iii) portfolio risk = when firm operates in many different countries =
profitability can deteriorate dramatically due to exchange rate
movements.
Foreign exchange (8)
• Hedging against risk through forward contracts = not free
as banks will charge you a premium = best suited to
manage transaction risk if transactions are easy to identify
and time lags known.
• Manage structural risks = i) for future payment in a foreign
currency, borrow money in that currency = allows it to lock
in the exchange rate at the time of borrowing ii) if firm has
a large market in another country, it could establish a
subsidiary there, and so eliminate the exchange rate risk it
faces within that country.
• Portfolio risk = hedging inadequate and too expensive =
better to borrow in the currency of each country that the
firm operate.