Question Paper

International Finance and Trade – II (222): January 2005

Section D : Case Study (50 Marks)
• This section consists of questions with serial number 1 -
4.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 80 - 90 minutes on Section D.

Case Study
Read the case carefully and answer the following questions:
1. Evaluate the investment proposal of Bio Pharma GmbH in Germany using the Adjusted Present Value
(APV) technique.
(20 marks)<Answer>
2. Discuss the factors which make evaluation of foreign direct investments different from the evaluation of
domestic investments. Explain how these factors are dealt with in the Adjusted Present Value (APV).
(12 marks)<Answer>
3. What is meant by all-equity discount rate? How is it determined?
(10 marks) <Answer>
4. Explain the concept of exchange risk and how it affects an international project.
(8 marks) <Answer>
Bio Pharma GmbH in Germany is a leading global pharmaceutical company specialized in manufacture of life
saving drugs and other generic formulations based on international standards. The company caters to the needs
of the customers’ worldwide including Malaysia, Indonesia, Thailand, Hong Kong and China. The company
identified that the Asian markets offer huge opportunities for the company’s products because a number of new
drugs are going to be off patent over the next few years. For companies that are among the earliest generic
companies to enter after a drug goes off patent, the rewards can be immense.
It is for this reason, the company is contemplating to setup a manufacturing plant in Hong Kong as it is very
close to the other Asian countries and due to its proximity it can increase its market share. The management of
the company already had a few round of negotiations with the Government officials of Hong Kong, which
evinced interest to get the manufacturing plant and also agreed to offer concessional finance. Currently Bio
Pharma GmbH market its products through a subsidiary in Singapore, which acts as an agent for distribution
and marketing of the company’s product in Asian markets. After the setting up of new plant, the parent
company intends to close the subsidiary in Singapore as the proposed unit can market the products produced in
Hong Kong.
The cost for the project has been estimated at HK$ 450 million in plant and machineries and other facilities and
HK$ 50 million in working capital requirement. The land for the proposed project will be provided free of cost
by the Hong Kong’s Government on lease. The implementation of the project will be started soon and will be
operational after one year. The capacity utilization of the project for first five years has been estimated as
follows:
Year 1 2 3 4 5
Capacity Utilization (%) 50 60 70 80 100
At 100% capacity utilization, the sales revenue at current prices has been estimated at HK$ 2,000 million. The
company currently exports various drugs to Singapore, which are marketed by its subsidiary. For the running
year the export is estimated at HK$ 200 million, which is expected to be grown by 10% annually for next five
years. The net profit margin on such exports is 15%. The export is expected to grow to keep pace with inflation
rate in Hong Kong. When the project will be operational, there will be no need for such exports.
The company has accumulated profits of HK$ 50 million in various banks in Hong Kong, which can be
repatriated to Germany without any constraint. The company is planning to use this fund for the project.
The life of the project can be taken as five years for the appraisal purposes. The value of plant and machineries
and other facilities after five years can be assumed to fetch 10% of the initial investment and working capital
requirement can be realized at 100% of initial amount.
The product mix is expected to remain identical throughout the five years and contribution is expected to be the
50% of sales for all the five years. The fixed cost excluding depreciation is estimated at HK $ 200 million at
the current prices, selling and administration expenses will be expected to be 10% of sales. All the revenues
and fixed costs are expected to go up according to the inflation rate in Hong Kong. The company estimated that
a profit of HK$ 5.00 million at current prices could be repatriated illegally in all the five years of operation,
which will also keep pace with the level of inflation in Hong Kong. The initial investment in plant and
machineries will be depreciated at 20% written-down-value method.
The project would increase the borrowing capacity of Bio Pharma GmbH in Germany by about euro 10 million
out of 80% of which is expected to be used by the company. The Government of Hong Kong has also offered a
concessional loan of HK $100 million at 4% for five years; the comparable loan is available to the company at
6% in Hong Kong. This concessional loan will be repayable in four equal installments starting at the end of
second year. The company faces a borrowing rate of 5% in Germany. The risk free rate of interest in Germany
and Hong Kong are 2% and 3% respectively.
The corporate income tax rate in Hong Kong is 20%, and the same in Germany is 25%. There is a double tax
avoidance treaty in between Germany and Hong Kong, under which full credit is given to German companies
for taxes paid in Hong Kong, provided, the rate, does not exceed the German tax rate of 25%.
The long-term inflation forecasts in Germany and Hong Kong are 2% and 3% respectively. A risk consultancy
firm in Germany has advised the company that in the current year euro will appreciate against Hong Kong
dollar by 1% from the current spot rate of euro 0.1040/HK$, but after that it will follow purchasing power
parity between euro and Hong Kong dollar. The return required by German shareholders of the company is
20%.
END OF SECTION D

Section E : Caselets (50 Marks)

• This section consists of questions with serial number 5 -
11.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 80 - 90 minutes on Section E.

Caselet 1
Read the caselet carefully and answer the following questions:
5. What are the main functions of World Trade Organization (WTO)?
(6 marks)<Answer>
6. Discuss the reasons that prompt a country to impose trade barriers.
(8 marks) <Answer>
7. Explain the key features of the dispute settlement system of WTO.
(6 marks) <Answer>
(August 2, 2004 – Washington, DC) The World Bank welcomes the WTO new agreement on a negotiating
framework for the Doha trade negotiations reached over the weekend. This critical and long awaited step in
the process will help to put the Doha trade round back on track and bring us closer to realizing the
development promise of the Doha Agenda.
All parties – rich and poor countries alike, as well as the WTO Secretariat – are to be congratulated in reaching
this important step in the multilateral negotiations. The agreement lays the groundwork for significant reform
of global agricultural trade. By laying out a map for the future elimination of export subsidies, introducing new
commitments on trade-distorting farm subsidies, and providing for progressive reductions in border protection,
the new framework raises expectations that the world’s poor will have a more equitable playing field in global
markets. The special attention devoted to cotton is particularly important for the least developed countries.
No less important, the framework on non-agricultural market access (NAMA) sets the stage for the pursuit of
meaningful reductions in barriers to manufactured exports from poor countries. And all can benefit from
further efforts of WTO members to liberalize services and facilitate trade, important aspects of the agreement .
As the negotiators know better than all of us, the hard work still lies ahead. Negotiating improved market
access and trade rules that benefit all countries – and especially poor people in developing countries – will
require continued compromise and significant political effort on all sides.
WTO members are encouraged to maintain the new momentum. The stakes are huge. A good, pro-poor deal
that lowers tariff peaks and averages, as well as non-tariff barriers, in both rich and developing countries could
stimulate worldwide increases in income and lift millions out of poverty.
Dispute settlment is the central pillar of the multilateral trading system, and the WTO’s unique contribution to
the stability of the global economy. Without a means of settling disputes, the rules-based system would be less
effective because the rules could not be enforced. The WTO’s procedure underscores the rule of law, and it
makes the trading system more secure and predictable. The system is based on clearly-defined rules, with
timetables for completing a case.
The World Bank will continue to support developing countries in their efforts to make the most of the
opportunities offered by global trade. This includes providing financial support for improvements in ports,
customs, and other trade-related infrastructure, as well as financing for transition costs as countries adopt
reforms to make themselves more competitive. A successful conclusion of the negotiations will help raise the
return to these efforts in the form of more rapid growth and poverty reduction.
Caselet 2
Read the caselet carefully and answer the following questions:
8. Explain the various factors that determine the strength or weakness of a currency.
(7 marks) <Answer>
9. Though floating exchange rate system is widely prevalent across the globe, China continues to follow
fixed exchange rate system. Briefly discuss the reason for not following the floating exchange rate
system by China.
(8 marks) <Answer>
China is one of the few nations which still maintains a government-fixed rate and capital controls. Since the
Asian financial crisis in 1997, Chinese currency has been pegged to the US dollar (the narrow band of 8.28).
Then with the Chinese Central Bank intervention it appreciated around 5-8%. However, with the process of
China’s integration towards global economy, financial convergence calls for full convertibility of the currency
—yuan or the Renminbin (RMB). China is under pressure from the international community to revalue the
RMB amidst growing criticism that it is keeping Chinese exports unfairly cheap (A weaker currency means a
country’s goods are cheaper abroad, boosting exports) at the cost of the manufacturing jobs outside China.
Exporters in the US say the Chinese currency is undervalued, making American goods far too expensive to
compete in China and China-made goods are unfairly cheap for Americans. China is being accused of
manipulating the exchange rate by buying and selling yuan on the international capital markets for a fixed
price. Thereby it effectively discourages a free market value for the yuan.
However, China is up against this criticism. The dragon is under increasing pressure to abandon its currency
pegged to the dollar and float yuan. In the recent past, the global media was repeatedly pointing out that
China’s rapid accumulation of international reserves reflected a growing external imbalance. As the yuan
becoming an important currency in Asia and even globally, the demand for making the yuan fully convertible
is becoming an important issue in the global media.
Going by China’s strong GDP growth rate, America’s biggest bilateral trade deficit with China, and the mighty
economy boasts of a $200 bn trade-dominant current account surplus along with $300-bn FDI with the status
quo of cheap exports, is there scope that the yuan will dominate the global currency market? Prof. Richard N
Cooper disagrees. He predicts that in any case, China cannot float its currency before creating a proper foreign
exchange market, which it has not yet done. This is part of the financial reforms that China still needs to
undertake. Until this occurs, and capital controls are eliminated, the yuan has no chance to dominate the globe
or even the Asian currency markets.
Of late, the debate over revaluing the Chinese currency has been gathering momentum. In the US, this issue
has become politically sensitive. The burgeoning bilateral trade deficit with China and concerns over job
losses to China may have repercussions in the coming US Presidential election campaign. Even in China, the
issue has grown in importance as China tried to formulate a policy to tame growth, emergent inflation and
over-investment in key sectors. Going by this, Zhou Xiaochuan, the Governor of People’s Bank of China
recently announced that China would take steps to develop a “unified” forex trading system to let market forces
play a bigger role in determining the yuan’s value and pave the way for its full convertibility.
The floating of Chinese yuan should be accompanied by deep reforms like recapitulation of banks, and state-
owned companies and curbing debt. Besides, experts recommend replacing the current fixed rate policy with a
floating rate system, which would allow the rate of the yuan to fluctuate according to the market. To avoid the
coming crisis, a floating rate system, which could gradually release risks with market fluctuation, is quite
necessary for the country, so that the current stable economy and the sufficient foreign currency reserves offer
the best opportunity to carry out the reform.
Caselet 3
Read the caselet carefully and answer the following questions:
10. Explain how a weakening or depreciating dollar is advantageous and also disadvantageous to USA.
(8 marks) <Answer>
11. Discuss the reasons for the appreciation of euro.
(7 marks) <Answer>
The launch of the euro offers the prospect of a new bipolar international economic order that could replace
America’s domination since World War II. The global trading system has already been jointly run since the
early days of the European Common Market, which enabled Europe to integrate its commerce and exercise
power equivalent to that of the United States in that domain.
As a result, the creation of a single European currency will be the most important development in the evolution
of the international monetary system since the widespread adoption of flexible exchange rates in the early
1970s. A successful euro will be the first real competitor to the dollar since it surpassed sterling as the world’s
dominant money during the inter war period. As much as $1 tn of international investment may shift from
dollars into euros. Volatility between the world’s key currencies will increase substantially, requiring new
forms of international cooperation to avoid severe costs for the global economy.
Now euro land will equal or exceed the United States on every key measure of economic strength and will
speak increasingly with a single voice on a wide array of economic issues. The euro is likely to challenge the
international financial dominance of the dollar.
The political impact of the euro will be at least as large as these economic effects. A bipolar currency regime
dominated by Europe and the United States, with Japan as a junior partner, will replace the dollar-centered
system that has prevailed for most of this century. A quantum jump in transatlantic cooperation will be required
to handle both the transition to the new regime and its longer-term prospects.
It is mainly because the global economic roles of the European Union and United States are virtually identical.
The EU accounts for about 31% of world output and 20% of world trade (excluding intra-EU transactions). The
United States provides about 27% of global production and 18% of world trade. The dollar, however, maintains
a share of world finance that far exceeds the economic weight of the United States: 40 to 60%, depending on
the category of transactions and whether intra-EU holdings are excluded (as they will be with the creation of
the euro). This total far exceeds the global role of 10 to 40% of the combined European national currencies.
However, the fact has been considered that dollar will probably remain the top currency for the indefinite
future. But the creation of the euro will produce a sharp reduction, and perhaps eventual elimination, of the
present gap in international monetary roles between the United States and Europe. The dollar and the euro are
each likely to wind up with about 40% of world finance with about 20% remaining, for the yen, Swiss franc
and a few minor currencies.
In the longer run, the dollar-euro exchange rates is likely to fluctuate considerably more than the rates between
the dollar and individual European currencies have in the past. Prolonged misalignments could result, with
adverse effects on both Europe and the United States and with consequent intensification of protectionist
pressures on the global trading system.
Economic relations between the United States and the European Union will therefore rest increasingly on a
foundation of virtual equality. The United States will either have to adjust to this new reality or conduct a series
of rear-guard defensive actions that will be increasingly futile and costly—like the British did for many
decades as their leadership role declined. The EU will either have to exercise positive leadership, which it now
can do, or become highly frustrated at home and a spoiler abroad. Therefore, it is essential that the currencies
directly involved and the international financial institutions begin immediately to access the global impact of
new currency euro.
 END OF SECTION E

END OF QUESTION PAPER

Suggested Answers
International Finance and Trade – II (222) : January 2005
Section D : Case Study
1. The expected exchange rate for different periods are as follows:
Current spot euro/HK$ = 0.1040
0.1040
= 0.1030
At time, t=0, euro/HK$ = 1.01
1.02
0.1030 × = 0.1020
t = 1, euro/HK$ = 1.03
1.02
0.1020 × = 0.1010
t = 2, euro/HK$ = 1.03
1.02
0.1010 × = 0.1000
t= 3, euro/HK$ = 1.03
1.02
0.1000 × = 0.0990
t = 4, euro/HK$ = 1.03
1.02
0.0990 × = 0.0980
t = 5,euro/HK$ = 1.03
The adjusted present value is given by :
n
( St C t + E t ) ( 1 − T ) + n D t T n
r Bo T  n
Rt 
∑ ( 1 + ke ) ∑ ∑ + So  CL o − ∑ 
t =1 ( 1 + k d ) ( 1+ kb ) t =1 ( 1 + k c ) 
t t
t =1
t
t =1  
APV = So (Co – Ao) + +
n
It
∑
( 1 + ki )
t
t =1
+
Blocked fund = 0
Initial outlay = 500 × 0.1030 = euro 51.50 million.
Loss of profits from export sales
Year 1 2 3 4 5
Sales (HK$ mln.) 226.6 256.74 290.89 329.58 373.41
Net profit 33.99 38.51 43.63 49.44 56.01
Profit (euro. mln.) 3.467 3.890 4.363 4.895 5.489
Cash flows from operations (HK$ million)
Year 1 2 3 4 5
Sales 1030 1273.08 1529.82 1800.81 2318.55
Contribution 515 636.54 764.91 900.41 1159.28
Fixed cost 206 212.18 218.55 225.10 231.85
Selling & Admn. Exp 103 127.31 152.98 180.08 231.86
PBT 206 297.05 393.38 495.23 695.57
Tax @ 25% 51.50 74.26 98.35 123.81 173.89
PAT 154.50 222.79 295.03 371.42 521.68
Exchange rate (euro/HK$) 0.1020 0.1010 0.1000 0.0990 0.0980
PAT (euro mln.) 15.759 22.502 29.503 36.771 51.125
Less: Loss profit from exports 3.467 3.890 4.363 4.895 5.489
Net cash flow 12.292 18.612 25.140 31.876 45.636
 Terminal cash flow * 9.310
Total cash flow 12.292 18.612 25.140 31.876 54.946
Terminal cash flow = 450 × 0.10 + 50
= HK$ 95 mln.
= 95 × 0.0980 = euro 9.31 million

Present value of total cash flow

= 12.292 × PVIF(20%,1) + 18.612 × PVIF (20%,2) + 25.140 × PVIF (20%,3)
+ 31.876 × PVIF (20%,4) + 54.946 × PVIF (20%,5)
= euro 75.165 million
Depreciation schedule
Year 1 2 3 4 5
Opening balance 450 360 288 230.40 184.32
Depreciation 90 72 57.60 46.08 36.86
Closing balance 360 288 230.40 184.32 147.46
Present value of depreciation tax shield
= 90 × 0.25 × 0.1020 × PVIF(2%,1)+ 72 × 0.25× 0.1010 × PVIF(2%,2) + 57.60 × 0.25 × 0.1000 ×
PVIF(2%,3) + 46.08 × 0.25 × 0.0990 × PVIF(2%,4) + 36.86 × 0.25 × 0.0980 × PVIF(2%,5)
= euro 7.225 million.
Tax shield due to incremental borrowing capacity
= (10 × 0.80) × 0.05 × 0.25 × PVIFA(2% ,5)
= euro 0.4713 million.
Note: In the above two cases discount rate is taken as risk free rate in Germany, assuming that the company
will be able to achieve the projected sales, hence the probability of positive cash flows is high.
Concessionary loan repayment schedule
Year Principal o/s at the Interest Principal Total
payment repayment repayment
end of year
1 100 4 – 4
2 75 4 25 29
3 50 3 25 28
4 25 2 25 27
5 – 1 25 26
Benefits due to concessionary loan
= 0.1030 [100 – {4 × PVIF (6%,1) + 29 × PVIF (6%,2) + 28 × PVIF (6%,3)
+ 27 × PVIF (6% ,4) + 26 × PVIF(6% ,5)}]
= 0.1030 [100 – 93.908]
= euro 0.6275 million.
Illegally repatriated profit
Year 1 2 3 4 5
Profit (HK $ million) 5.15 5.305 5.464 5.628 5.796
Profit (euro million) 0.525 0.535 0.546 0.557 0.5680
3 8 4 2
Present value of illegally repatriated profit
= 0.5253 × PVIF (20%,1) + 0.5358 × PVIF (20%,2) + 0.5464 × PVIF (20% ,3) + 0.5572 × PVIF (20% ,
 4)
+ 0.5680 × PVIF (20%,5)
= euro 1.6227 million.
APV = – 51.50 + 75.165 + 7.225 + 0.4713 + 0.6275 + 1.6227
= + 33.6115 million
As the APV is positive the project may be accepted.
< TOP >
2. The following factors make evaluation of foreign direct investment different from evaluation of domestic
investment :
• Blocked funds
• Loss of exports
• Concessional financing
• Different tax rates
• Restrictions on profit repatriation
• Inflation
• Uncertain salvage value
• Host government incentives
Blocked funds: The parent company might have accumulate some funds in the host country. All the funds
may not be allowed to repatriate because of various controls or taxes. If the parent would like to use these
funds for investment purposes, all the funds can be utilized. In case of domestic investments, no such
problem arises.
APV addresses this problem by reducing the initial capital cost by the difference between the face value of
the blocked funds and net realization by the parent if the funds are repatriated.
Loss of exports : Setting up of a subsidiary can lead to loss of market currently being catered to by the
parent. This is because the subsidiary may serve the market, which is currently served by the parent
company. APV adjusts the operating cash flows of the project for the loss of profit on account of reduced
sales by the parent company.
Concessional financing : The host company may offer concessional finance to FDI to attract capital. This
reduces the cost of the project. APV accounts for this gain by crediting the difference between the face
value of the loan and PV of the repayment obligations to the project.
Difference tax rates: Host country generally taxes the profits repatriated to the parent company. If there
is a double taxation avoidance agreement between the home and host countries, then the tax rate applicable
will be the higher tax rate of the two countries.
Restriction on profit repatriation: The host country may impost restrictions on the repatriation of profits.
APV considers only legally remittable cash flows and extra cash flows by other means are accounted for
separately.
Inflation : While evaluating the international project we have to consider inflation, since variable cost per
unit and product prices generally will rise over time. Inflation can be very volatile from year to year in
some countries and can therefore strongly influence a project’s net cash flows.
Improper handling of this item may lead to inaccurate net cash flow forecasts. The joint impact of inflation
and exchange rate fluctuations on a subsidiary’s net cash flows may produce a partial offsetting effect, from
the view of point of the parent company. Such an offsetting is not exact or consistent because inflation is
only one of many factors that influence exchange rates; there is no guarantee that a currency will depreciate
when the local inflation rate is relatively high. Therefore one has to consider the impact of inflation and
exchange rates on net cash flows while evaluating the international project.
Uncertain salvage value : The salvage value of an overseas project typically has a significant impact on
the project’s NPV. When salvage value is uncertain the parent company may desire to include various
possible outcomes for the salvage value and re-estimate the NPV based on each possible outcome. It may
even estimate the break-even salvage value or break-even terminal value which is necessary to achieve a
zero NPV for the project. If the actual salvage value is expected to equal or exceed the break-even salvage
value, the project is feasible. The break-even salvage value (SV n) can be determined by setting NPV equal
to zero and rearranging the capital budgeting equation. The break-even salvage value is determined as
 follows :

 CFt  n
IO − ∑ (1 + k)
 t 
SVn = 
(1 + k) 

IO = Initial outlay
SVn = Salvage value
CFt = Cash flow in period ‘t’
k = required rate of return on the project
n = life time of the project (number of periods)
Host Government’s incentives : In countries where FDI is welcome, the host country offers various
incentives to increase FDI. Any incentives offered by the host government must be included within the
capital budgeting analysis. For example a low-rate host government’s loan or a reduced tax rate offered to
the subsidiary would increase periodic cash flows. If the host government subsidizes the initial
establishment of the subsidiary, the parent company’s initial investment would be reduced to the extent of
the subsidy provided to the parent company.
< TOP >
3. The various adjustments needed to go from the weighted average cost of capital for the firm to the weighted
average cost of capital for the project makes it a somewhat typical technique to use at times. An alternative
is the use of an all-equity discount rate, k*, that abstracts from the project’s financial structure and that is
based solely on the riskiness of the project’s anticipated cash flows.
To calculate the all-equity rate, we rely on the CAPM:
k* = rf + (rm – rf)
where is the all-equity beta – that is, the beta associated with the unleveraged cash flows.
In reality, of course, the firm will not be able to estimate with the degree of precision implied here. Instead,
it will have to use assumptions based on theory.
If the project is of similar risk to the average project selected by the firm, it is possible to estimate by
reference to the firm’s stock price beta, . In other words, is the beta that appears in the estimate of the
firms’s cost of equity capital, ke:
ke = rf + [E(rm) – rf]
To transform , we must separate the effects of debt financing. This is known as unlevering, or converting a
levered equity beta to its unlevered or all-equity value. Unlevering can be accomplished by using the
following approximation:
= /[1 + (1 – t)D/E]
where t is the firm’s marginal tax rate, and D/E is its current debt/equity ratio. Thus, for example, if a firm
has a stock price beta of 1,1, a debt/equity ratio of 0.6, and a marginal tax rate of 34%, its all-equity beta
equals 0.79 [1.1/(1 + 0.66 x 0.6)].
It turns out that the case of similar risk characteristics is an important one in estimating the foreign project
cost of capital.
< TOP >
4. Foreign exchange risk may be defined as the variance in the domestic currency values of assets, liabilities
and operating incomes attributable to unanticipated changes in exchange rates. Two things have to be noted
in this definition. One, risk may arise due to variability of incomes, assets and liabilities. Two, it is only the
variance that is caused by unanticipated changes that adds to risk, as variance from anticipated changes can
be eliminated through hedging.
Bio Pharma GmbH may face exchange risk due to its international project. If it is making supplies to the
Hong Kong office, denominated in HK $, it will have transaction risk. Similarly, if there are outstanding
receivables and payables between the two, translation risk will arise. Translation risk may also arise due to
other assets and liabilities of the Hong Kong office as well, if Bio Pharma GmbH chooses to consolidate its
accounts. Operating risk any how will exist, as it cannot be eliminated.
< TOP >
Section E: Caselets
 Caselet 1
5. India is one of the founder members of World Trade Organization (WTO). The WTO is based in Geneva,
Switzerland. Its main functions are
(i) Administering trade agreements
(ii) Acting as a forum for trade negotiations
(iii) Settling trade disputes
(iv) Reviewing national trade policies
(v) Assisting developing countries in trade policy issues, through technical assistance and training
programs.
(vi) Cooperating with other international organizations
< TOP >
6. The reasons that prompt a country to impose trade barriers are as follows:
1. Tariffs are a source of revenue for the government.
2. Sometimes compromising on economic welfare becomes essential due to some important national
goals. For example, national security cannot be compromised by opening up the defense sector.
3. The fallacy that a country’s economic condition can be improved only if the country enjoys a trade
surplus, tempts governments to put up trade barriers. This line of thinking stems from the period when
a nation’s wealth used to be measured by the amount of gold it held and any trade surplus or deficit
was settled by transfer of gold. This system, called the gold standard, no longer works now.
4. Free international trade has a few major implications. The first one is factor price equalization. As
international demand for a commodity produced in a particular country grows, the price of the factor
of production which is used intensively for that product, increases in that particular country. At the
same time, demand for the same product produced in other countries reduces, which lowers down the
price of that factor in those countries. Hence, the factors of production which are comparatively
inefficient suffer in terms of reduced compensation. Another implication is that in the event of an
increase in the productivity of one of the factors of production, there is a reduction in the production
of goods which intensively use the other factor. These implications give rise to a demand from those
sectors for protection – of domestic industries, local jobs and the levels of factor prices. These sectors
serve as very powerful lobbying groups for putting up trade barriers.
5. Tariffs are a popular means of retaliation for other countries putting up barriers against domestic
goods.
6. When some foreign producer is found to be dumping some particular good, i.e. selling it at a price that
does not even cover his costs (this may be done to secure a foothold in the market), anti-dumping duty
may be levied.
7. When some foreign country subsidizes its exports (maybe to avoid balance of payments problem), the
importing country may impose a countervailing duty.
8. A nation which is large enough to be able to affect world prices may be able to change the terms of
trade in its favor by levying tariffs. Imposition of tariffs would increase the domestic prices beyond
the international prices, thus reducing domestic demand. If the domestic demand is large enough, then
this fall would induce the world price of that commodity to come down, thus improving the terms of
trade for the large country. In this situation, imposition of tariffs could prove to be an attractive
proposition for the large country, at least in the short-term. In the long-term, other big countries may
also decide to act in the same manner, resulting in a decline in the economic welfare of all the
countries.
9. Trade barriers may be needed to protect an infant industry with tremendous growth potential, if it is
believed that in the long run it would be able to stand on its own and face international competition.
10. Barriers can be used to increase the demand for domestic products (by increasing the price of foreign
goods by imposing a tariff or by restricting their availability with the help of quotas), in order to
increase the domestic employment opportunities, especially during periods of recession.
11. Restrictions may be put in place to reduce expenditure in foreign currency by the citizens in order to
improve the balance of payments situation.
12. Helping the exporters build up world markets can be another reason for putting up of trade barriers.
13. Providing encouragement to local production in order to reduce reliance on foreign producers serves
as a justification for trade barriers.
14. Though a particular industry may not be under any direct threat from advancements in technology in
 other countries, barriers may still be put in place due to externalities and spillover effects. These terms
refer to the phenomenon where a change in technology in a related industry or an outside event
changes the comparative advantage of another industry.
15. Governments may not allow trade with another country due to ideological differences, international
sanctions or other political reasons (for example, the US has not traded with Cuba for a long time).
Economic sanctions can take a number of forms – from embargo (a complete ban on transactions) to
restriction on some particular types of transactions.
< TOP >
7. The WTO’s procedure for resolving trade quarrels under the Dispute Settlement understanding is vital for
enforcing the rules and therefore for ensuring that trade flows smoothly. Countries bring disputes to the
WTO if they think their rights under the agreements are being infringed. A dispute arises when a member
government believes another member government is violating an agreement or a commitment that it has
made in the WTO. The authors of these agreements are the member governments themselves. Ultimate
responsibility for settling disputes also lies with member governments through the Dispute settlement
Body. Judgements by specially appointed independent experts are based on interpretations of the
agreements and individual countries commitments. The system encourages countries to settle their disputes
or differences through consultation. Failing that, they can follow a carefully mapped out, stage by stage
procedure that includes the possibility of a ruling by a panel of experts and the chance to appeal the ruling
on legal grounds.
A procedure for settling disputes existed under the old GATT, but it had no fixed time tables, rulings were
easier to block, and many cases dragged on for a long time inconclusively. The Uruguay Round agreement
introduced a more structured process with more clearly defined stages in the procedure. The agreement
emphasizes that prompt settlement is essential if the WTO is to function effectively. If a case runs its full
course to a first ruling, it should not normally take more than about one year 15 months if the case is
appealed. The agreed time limits are flexible, and if the case is considered urgent (e.g. if perishable goods
are involved), it is accelerated as much as possible. If any country affected by the decision wants to block a
ruling, it has to persuade all other WTO members (including its adversary in the case) to share its view.
Although much of the procedure does resemble a court or a tribunal, the preferred solution is for the
countries concerned to discuss their problems and settle the disputes by themselves. The first stage is
therefore consultations between the governments concerned, and even when the case has progressed to
other stages, consultation and mediations are still always possible.
How long to settle a dispute?
These approximate periods for each stage of a dispute settlement procedure are target figures – the
agreement is flexible. In addition the countries can settle their disputes themselves at any stage. Totals
also are approximate.

Consultations, mediation etc., 60 days

Panel setup and panelists appointed 45 days
Final panel report to parties 6 months
Final panel report to WTO members 3 weeks
Dispute settlement body adopts report (if no appeal) 60 days
(Without appeal) Total 1 year
Appeals report 60 – 90 days
Dispute settlement Body adopts appeals report 30 days
(With appeal) Total 15 months

< TOP >

Caselet 2
8. Factors determing strength or weakness of a currency are explained below.
Interest Rates
Interest rates are important determinants of the exchange rates. In case interest rates are market determined
their impact on exchange rates will be high rather than when they are regulated. Secondly, the long-term
trend in interest rates – rising, declining, stable etc. have a direct effect on the exchange rate.
Balance of Payments
If the BoP of an economy is positive, it reflects growth, competitiveness and such an economy is likely to
have a strong currency. An economy with current account deficit is likely to have a relatively weaker
 currency.
Growth Rate of Economy
The growth of an economy consistently adds strength to the currency. Growth in turn is related to several
other factors such as, exports, GDP, per capita income, etc. This adds further to the strength of the
currency.
Inflation
Moderate inflation is desirable for the growth of an economy. However, it should be maintained within
acceptable levels. Deflation may spell doom for an economy and currency will loose strength. Again
inflation directly determines the appreciation/depreciation of the home currency vis-á-vis the foreign
currency.
Forex Reserves
Depleting forex reserves adds downward pressure on the home currency while comfortable forex reserves
add strength to the currency.
Other Factors
• Government policies and regulatory environment
• Political stability
• Demographics of the economy.
• Government debt/borrowings
• Policies of the central bank
• Literacy, unemployment, etc.
• Type of economy – agrarian, industrial, etc.
• Global competitiveness in trade
• Fiscal deficit.
< TOP >
9. Various arguments against the flexible exchange rates by experts are explained below:
1. Flexible exchange rates cause uncertainty and inhibit international trade and investment:
It is claimed by proponents of fixed rates that if exporters and importers do not know the future
exchange rate, they will stick to local markets. This means less enjoyment of the advantages of
international trade and of making overseas investments, and it is a burden on everyone.
2. Flexible rates cause destabilizing speculation:
A highly controversial argument is that under flexible exchange rates, speculators will cause wide
swings in the values of different currencies. These swings are the result of the movement of “hot
money”. This expression is used because of the lightning speed at which the money moves in response
to news items.
3. Flexible rates will not work for open economies:
This argument begins by noting that a depreciation or devaluation of currency will help the balance of
trade if it reduces the relative prices of locally produced goods and services. However, a depreciation
or devaluation will raise the prices of tradable goods. This will increase the cost of living, which will
put upward pressure on wages. In such a case, a country may as well fix the value of its currency to
the currency of the country with which it trades most extensively.
4. Flexible rates are inflationary:
Rigid adherence to the gold standard involved a constraint on monetary authorities. They had to keep
their money supplies and inflation under control. It is claimed by proponents of fixed rates that
Bretton Woods and dollar standards also involved discipline, since inflation would eventually force
devaluation. This gave the central bank public support for strong action to keep inflation under
control. On the other hand, flexible exchange rates allow inflation to occur without any eventual crisis.
Therefore, there is less motivation for governments to combat inflation.
5. Flexible rates can cause structural unemployment:
After the discovery and development of vast supplies of natural gas off the Dutch coast, the Dutch
Guilder appreciated substantially. This made traditional Dutch exports expensive, causing
unemployment in these industries. The gas industry is far less labor-intensive than the traditional
Dutch export industries, making it difficult for the displaced workers to find alternative employment.
 There are clearly valid arguments on both of the ledger for fixed and flexible exchange rates.
Therefore, in the absence of any new, as-yet-untried dominant approach, we can expect the
international financial system to respond to circumstances. Rising trade imbalances could push the
system towards flexibility, whereas increased volatility from political events could push the system in
the other direction.
< TOP >
Caselet 3
10. A weakening or depreciating dollar is advantageous to USA
The advantages are as follows:
1. U.S. exporting firms find it easier to sell goods in foreign markets
2. Firms in the United States have less competitive pressure to keep prices low
3. More foreign tourists can afford to visit the United States
4. U.S. capital markets become more attractive to foreign investors
The disadvantages are as follows:
1. U.S. consumers face higher prices on foreign goods
2. Higher prices on foreign goods contribute to higher inflation in the United States.
3. U.S. consumers find traveling abroad more costly
4. It is more difficult for U.S. firms and investors to expand into foreign markets.
< TOP >
11. Reasons for the Appreciation of Euro
Recent, developments have shown the substantial appreciation of the euro in the currency market. The
exchange value of 1 euro to dollar at current rates is $1.18850 which is expected to increase in near future.
The four major reasons for the appreciation of euro are:
• The substantial underlying undervaluation of the euro;
• A focus on the euro during the next leg of the fall in the dollar that is inevitable due to America’s huge
and growing current account deficit;
• The beginning of a substantial portfolio shift into the euro as it asserts a major role in international
finance;
• And a pick-up in European growth coupled with an American slowdown.
As a result, it has emerged as a challenge to dollar in the global currency market.
< TOP >
< TOP OF THE DOCUMENT >