Understanding Trade Policies and Government Intervention

1. CHAPTER 3 The political economy of trade and investment

2. Learning objectives • LO 3.1 Describe the policy instruments used by governments to influence international trade and foreign direct investment. • LO 3.2 Evaluate the arguments for government intervention in international trade and foreign direct investment. • LO 3.3 Explain current international trade and foreign direct investment issues, and describe how the World Trade Organization is addressing these issues. • LO 3.4 Compare the different levels of regional economic integration. • LO 3.5 Examine the implications for international business strategies of international trade barriers and the increasing number of bilateral and regional trade agreements.

3. Introduction • What is free trade? • Free trade refers to a situation where a government does not attempt to restrict what its citizens can buy from another country or what they can sell to another country. • Although many nations are committed to free trade, they tend to intervene in international trade to protect the interests of politically important groups.

4. Instruments of trade policy Barriers to trade Table 3.1 Barriers to trade continued

5. Instruments of trade policy Tariffs • A tariff is a tax levied on imports that effectively raises the cost of imported products relative to domestic products. • Specific tariffs are levied as a fixed charge for each unit of a good imported. • Ad valorem tariffs are levied as a proportion of the value of the imported good. continued

6. Instruments of trade policy Subsidies • A subsidy is a government payment to a domestic producer, including: • cash grants • low-interest loans • tax breaks • government equity participation. • Subsidies help domestic producers in two ways: • they help them compete against low-cost foreign imports • they help them gain export markets. • Consumers typically absorb the costs of subsidies. continued

7. Instruments of trade policy Farm subsidies (percentage of gross farm receipts, 1995–97 and 2008–10) Figure 3.1 Support for agriculture in selected OECD and emerging economies (percentage of gross farm receipts, 1995–97 and 2008–10) SOURCE: Data derived from OECD, Agricultural Policy Monitoring and Evaluation 2011: OECD Countries and Emerging Economies, OECD, September 2011, accessed via www.oecd.org/tad/agriculturalpoliciesandsupport/agriculturalpolicymonitoringandevaluation2011oecdcountriesandemergingeconomies.htm on 8 August 2012. continued

8. Instruments of trade policy Import quotas and voluntary export restraints • An import quota is a direct restriction on the quantity of some good that may be imported into a country. • Tariff rate quotas are a hybrid of a quota and a tariff where a lower tariff is applied to imports within the quota than to those over the quota. • Voluntary export restraints are quotas on trade imposed by the exporting country, typically at the request of the importing country’s government. • A quota rent is the extra profit that producers make when supply is artificially limited by an import quota. continued

9. Instruments of trade policy Local content requirements • A local content requirement demands that some specific fraction of a good be produced domestically. • Local content requirements benefit domestic producers, but consumers face higher prices. continued

10. Instruments of trade policy Administrative policies • Administrative trade polices are bureaucratic rules that are designed to make it difficult for imports to enter a country. • These polices hurt consumers by denying access to possibly superior foreign products. continued

11. Instruments of trade policy Antidumping policies • Dumping is defined as selling goods in a foreign market below their costs of production, or as selling goods in a foreign market at below their ‘fair’ market value. • Dumping is viewed as a method by which firms unload excess production in foreign markets. • Some dumping may be predatory behaviour. • Antidumping polices (or countervailing duties) are designed to punish foreign firms that engage in dumping and protect domestic producers from ‘unfair’ foreign competition.

12. Why governments intervene in trade • There are two types of arguments for government intervention: political and economic. • Political arguments are concerned with protecting the interests of certain groups within a nation (normally producers), often at the expense of other groups (normally consumers). • Economic arguments are typically concerned with boosting the overall wealth of a nation (to the benefit of all, both producers and consumers). continued

13. Why governments intervene in trade Political arguments for intervention • Protecting jobs and industries • The most common political reason for trade restrictions is protecting jobs and industries. • Usually this results from political pressures by unions or industries that are threatened by more efficient foreign producers, and have more political clout than the consumers that will eventually pay the costs. continued

14. Why governments intervene in trade Political arguments for intervention • Security • Protecting industries such as aerospace or electronics because they are important for national security is another argument for trade restrictions. • Retaliation • Retaliation is when governments take, or threaten to take, specific actions so that, for example, other countries may remove trade barriers. • Protecting consumers • Consumer protection can also be an argument for restricting imports. continued

15. Why governments intervene in trade Political arguments for intervention • Furthering foreign policy objectives • Trade policy can help build strong relations with other nations. • Trade policy can punish ‘rogue states’ that do not abide by international laws. • Protecting human rights • Trade policy can help advance human rights and political freedom in trading partners (this method has attracted some critics). • WTO accession of China. • Protecting the environment • Carbon tariffs. • ‘Old-fashioned protectionism dressed in green drag’ (The Wall Street Journal). continued

16. Why governments intervene in trade Economic arguments for intervention • The infant industry argument • The infant industry argument suggests that an industry should be protected until it can develop and be viable and competitive internationally. • It has been accepted as a justification for temporary trade restrictions under the WTO. • Critics argue that if a country has the potential to develop a viable competitive position, its firms should be capable of raising necessary funds without additional support from the government. continued

17. Why governments intervene in trade Economic arguments for intervention • Strategic trade policy • Strategic trade policy suggests that in cases where there may be important first-mover advantages, governments can help firms from their countries attain these advantages. • Strategic trade policy also suggests that governments can help firms overcome barriers to entry into industries where foreign firms have an initial advantage. continued

18. Why governments intervene in trade Economic arguments for intervention • Strategic trade policy • The revised case for free trade—Krugman argues that there are two situations where restrictions on trade may be inappropriate: retaliation and politics. • Retaliation and trade war • Krugman argues that strategic trade policies are beggar-thy-neighbour policies that boost national income at the expense of other countries. • A country that attempts to use such policies will probably provoke retaliation. • Domestic politics • Since special interest groups can influence governments, Krugman argues that strategic trade policy is almost certain to be captured by special interest groups within an economy, who will distort it to their own ends.

19. Why governments intervene in FDI Host-country benefits of FDI • Resource-transfer effects • FDI can make a positive contribution to a host economy by supplying capital, technology and management resources that would otherwise not be available. • Employment effects • FDI can bring jobs to a host country that would otherwise not be created there. continued

20. Why governments intervene in FDI Host-country benefits of FDI • Balance-of-payments effects • A country’s balance-of-payments account is a record of a country’s payments to and receipts from other countries. • The current account is a record of a country’s export and import of goods and services. • Governments typically prefer to see a current account surplus than a deficit. • FDI can help a country to achieve a current account surplus. continued

21. Why governments intervene in FDI Host-country benefits of FDI • Effect on competition and economic growth • FDI in the form of a greenfield investment increases the level of competition in a market, driving down prices and improving the welfare of consumers. • Increased competition can lead to increased productivity growth, product and process innovation, and greater economic growth. continued

22. Why governments intervene in FDI Host-country costs of FDI • Adverse effects on competition • Subsidiaries of foreign MNEs operating in a host country may have greater economic power than indigenous competitors. • Adverse effects on balance of payments • With the initial capital inflows that come with FDI must be the subsequent outflow of capital as the foreign subsidiary repatriates earnings to its parent country. • When a foreign subsidiary imports a substantial number of its inputs from abroad, there is a debit on the current account of the host country’s balance of payments. continued

23. Why governments intervene in FDI Host-country costs of FDI • National sovereignty and autonomy • Many host governments worry that FDI is accompanied by some loss of economic independence. • The effect of transfer pricing is an example. • There is a concern that key decisions that may affect the host country’s economy will be made by a foreign parent that has no real commitment to the host country, and over which the host country’s government has no real control. continued

24. Why governments intervene in FDI Home-country benefits of FDI • Balance-of-payments effect • The balance-of-payments benefits from the inward flow of repatriated foreign earnings. • The foreign subsidiary creates demands for home-country exports. • Employment effects • Positive employment effects arise when the foreign subsidiary creates demand for home-country exports. • Reverse resource-transfer effect • Benefits arise when the home-country MNE learns valuable skills from its exposure to foreign markets that can subsequently be transferred back to the home country. continued

25. Why governments intervene in FDI Home-country costs of FDI • Balance-of-payments effects • The current account of the balance of payments suffers from the initial capital outflow required to finance the FDI. • The current account of the balance of payments suffers if the purpose of the foreign investment is to serve the home market from a low-cost production location. • The current account of the balance of payments suffers if the FDI is a substitute for direct exports. continued

26. Why governments intervene in FDI Home-country costs of FDI • Employment effects • The most serious concerns arise when FDI is a substitute for domestic production. • This concern gets expressed in terms such as ‘exporting jobs’ and ‘offshoring’. • If the home country is suffering from unemployment, concern about the export of jobs intensifies.

27. Government policy instruments and FDI Home-country policies • Encouraging outward FDI • Many investor nations now have government-backed insurance programs to cover major types of foreign investment risk. • Financing of FDI. • Elimination of double taxation. • Free trade agreements relaxing restrictions on FDI. • Restricting outward FDI • Virtually all investor countries, including the United States, have exercised some control over outward FDI from time to time. • E.g. Thailand during the Asian Financial Crisis in 1997–98. continued

28. Government policy instruments and FDI Host-country policies • Encouraging inward FDI • Governments offer incentives to foreign firms to invest in their countries. • Incentives are motivated by a desire to gain from the resource-transfer and employment effects of FDI, and to capture FDI away from other potential host countries. • Export processing zones (EPZ) or special economic zones (SEZs). • Restricting inward FDI • Entry and establishment. • Ownership restraints and performance requirements. • Procedural restrictions and discriminatory treatment.

29. Trade and FDI liberalisation • Calls for trade and FDI liberalisation is strong: • Unilateral—not common. • Bilateral—e.g. CER of Australia and New Zealand. • Regional—e.g. NAFTA, 319 in force. • Multilateral—WTO, 156 member countries. • Trade agreement defines the set of rules for the conduct of trade. continued

30. Trade and FDI liberalisation GATT and the WTO • General Agreement on Tariffs and Trade (GATT) was established in 1947, after WWII. • The approach was to gradually eliminate barriers to trade. • GATT provided a set of rules and a means for their enforcement. • The clarification, strengthening and extension of GATT rules and the creation of the WTO in 1995 held out the promise of more effective policing and enforcement of the global trading system. continued

31. Trade and FDI liberalisation GATT and the WTO • The Uruguay Round of GATT negotiations gave the WTO a mandate to extend global trading rules. • The goal was to expand beyond manufactured goods and address trade issues related to services, intellectual property and agriculture. • The WTO encompasses: • GATT • General Agreement on Trade in Services (GATS) • Trade-Related Aspects of Intellectual Property Rights (TRIPS) • Trade-Related Investment Measures (TRIMS) continued

32. Trade and FDI liberalisation GATT and the WTO • Non-discrimination underpins the negotiations and agreements: • Most Favoured Nation principle • MFN requires that if a country and its trading partner has agreed to reduce a trade barrier (usually a tariff), then that same favour must be granted to all other members of the WTO. • National Treatment principle • The national treatment principle requires that national and foreign businesses be treated equally in all areas of trade and investment. continued

33. Trade and FDI liberalisation Unresolved issues and the Doha Round • Substantial work still remains to be done on the international trade and investment liberalisation front four issues on the current agenda of the WTO: • Antidumping policies • Agricultural protection • Enforcement of rules for intellectual property • Tariff protection of non-agricultural products imposed by developing countries. continued

34. Trade and FDI liberalisation Antidumping actions, 1995–2011 Figure 3.2 Antidumping actions, 1995–2011 SOURCE: Constructed by the author from WTO statistics. World Trade Organization, Anti-Dumping, accessed via www.wto.org/english/tratop_e/adp_e/adp_e.htm on 24 August 2012. continued

35. Trade and FDI liberalisation Bound tariffs, agricultural and non-agricultural products, 2011 Figure 3.3 Bound tariffs, agricultural and non-agricultural products, 2011, selected countries—simple averages (per cent) SOURCES: World Tariff Profiles 2011, World Trade Organization (WTO), International Trade Centre (ITC), United Nations Conference on Trade and Development (UNCTAD), 25 October 2011. continued

36. Trade and FDI liberalisation New contexts, new agenda for Doha • Failed in its attempt to be a ‘development’ round. • Expectation that rich countries would reform policies. • Policies centred around developed countries. • Didn’t take into context what was happening in the 2000s: • Economic growth 2002–7 • Global recession post-2007 • Economic, food and energy security. • Doha doesn’t have the capacity to deal with these issues. • Lack of progress with Doha. continued

37. Trade and FDI liberalisation New contexts, new agenda for Doha • Post-2007 governments retreated into protectionism. • Trade barriers were increased. • A move towards a more restrictive investment environment. continued

38. Trade and FDI liberalisation FDI regulatory changes 2000–11 Figure 3.4 FDI regulatory changes 2000–11: liberalising and restricting 2000–11 (per cent) SOURCE: Drawn from data from UNCTAD, World Investment Report 2012, Table III.1, p.76, accessed via www.unctad-docs.org/files/UNCTAD-WIR2012-Chapter-III-en.pdf on 25 August 2012.

39. Regional economic integration The move towards regional economic integration • Regional economic integration (REI) refers to agreements between countries in a geographic region to reduce tariff and non-tariff barriers to the free flow of goods, services and factors of production between each other. • There is a fear that the world is moving towards a situation in which a number of regional trade blocs compete against each other. • Free trade will exist within each bloc, but each bloc will protect its market against outside competition with high tariffs. continued

40. Regional economic integration Levels of economic integration Figure 3.5 Levels of integration, general characteristics continued

41. Regional economic integration Levels of economic integration • Free trade area (FTA): • In a free trade area all barriers to the trade of goods and services among member countries are removed, but members determine their own trade policies with regard to non-members. • Examples of free trade areas include the Closer Economic Relations (between Australia and New Zealand) and the North American Free Trade Agreement (between the US, Canada and Mexico). continued

42. Regional economic integration Levels of economic integration • Customs union: • The customs union is one step further along the road to full economic and political integration. It eliminates trade barriers between member countries and adopts a common external trade policy. • The Andean Community (between Bolivia, Columbia, Ecuador and Peru) is an example of a customs union. continued

43. Regional economic integration Levels of economic integration • Common market: • The common market has no barriers to trade between member countries, a common external trade policy and the free movement of the factors of production. • MERCOSUR (between Brazil, Argentina, Paraguay and Uruguay) is aiming for common market status. continued

44. Regional economic integration Levels of economic integration • Economic union: • An economic union involves the free flow of products and factors of production between members, the adoption of a common external trade policy, and in addition, a common currency, harmonisation of the member countries’ tax rates, and a common monetary and fiscal policy. • The European Union (EU) is an economic union, although an imperfect one since not all members of the EU have adopted the euro. continued

45. Regional economic integration Levels of economic integration • Political union: • In a political union, independent states are combined into a single union. • The EU is headed towards at least partial political union, and the United States is an example of an even closer political union. continued

46. Regional economic integration The case for regional economic integration • The economic case for integration • REI achieves additional gains from the free flow of trade and investment between countries beyond those attainable under international agreements such as the WTO. • Static and dynamic effects. • The political case for integration • By linking countries together, making them more dependent on each other, and forming a structure where they regularly have to interact, the likelihood of violent conflict and war will decrease. • Countries will have greater clout and are politically much stronger in dealing with other nations. continued

47. Regional economic integration The case for regional economic integration • Impediments to integration • While a nation as a whole may benefit from a regional free trade agreement, certain groups may lose. • There are concerns over the loss of national sovereignty. continued

48. Regional economic integration The case against regional integration • Regional economic integration only makes sense when the amount of trade it creates exceeds the amount it diverts. • Trade creation occurs when low-cost producers within the free trade area replace high-cost domestic producers. • Trade diversion occurs when high-cost suppliers within the free trade area replace low-cost external suppliers.

49. Focus on managerial implications Barriers and firm strategy • Trade and investment barriers are a constraint upon a firm’s ability to disperse its productive activities and are likely to raise the firm’s costs above the level that could be achieved in a world without such barriers. Policy implications • MNEs need to be aware of the political sensitivities towards FDI in many host countries when calling for a freer foreign trade and investment regime. continued

50. Focus on managerial implications Opportunities of regional economic integration • REIs create significant opportunities because markets that were formerly protected from foreign competition are opened. • The free movement of goods across borders, the harmonisation of product standards and the simplification of tax regimes, makes it possible for firms to realise potentially enormous cost economies by centralising production in those locations where the mix of factor costs and skills is optimal. • Culture and competitive practices may limit this. continued