Topic Area 4: International Economics ,Sub-Topic Area 4.1: International Trade,Unit1:International Trade Theories
Key unit competence: Learners will be able to analyse the importance
of international trade to the development of the
By the end of this unit, I will be able to:
⦿ Explain the different terminologies used in international trade.
⦿ Discuss the advantages and disadvantages of international trade and its
⦿ Differentiate between absolute advantage and comparative advantage
theories of international trade.
⦿ Assess the gains from international trade basing on its forms.
⦿ Analyse the determining factors of comparative advantage theory.
⦿ Use calculations from production schedule to explain the theory of
⦿ Analyse the applicability of the comparative advantage theory in LDCs/
⦿ Advocate for efficient use of available resources to increase gains from
the international trade.
1.1. Meaning of International Trade
Mutangana, a business man in Muhanga sells his produce in different districts in Rwanda like Muhanga, Kigali, Rubavu, Nyagatare and other different parts. He also crosses borders
and sells to outside countries like Tanzania, Uganda, Kenya and others. Mutangana also buys some commodities he cannot produce himself from different parts of the country and from
outside the country. Basing on the above case study on Mutangana’s business, analyse
his business actions and share as a class about the following:
(i) How you would call the act of selling and buying by Mutangana.
(ii) What economic term you would call the act of selling and buying of commodities within the country by
(iii) What economic term you would call the selling and buying of commodities between or among countries by Mutangana.
(iv) How nations can get commodities they cannot produce on their own.
(v) ………… are commodities bought from other countries while……. are commodities sold to other
(vi) What you think distinguishes trade within Rwanda and trade between Rwanda and other countries.
International trade is the exchange of capital, goods, and services across international borders or territories, which could involve the activities of the government, companies and individuals. In most countries, such trade represents a significant share of Gross Domestic Product (GDP). While international trade has been present throughout much of history, its economic, social, and political importance has been on the rise in recent centuries. It is the presupposition of international trade that a sufficient level of geopolitical peace and stability are prevailing in order to allow peaceful exchange of trade and commerce to take place between nations.
Trading globally gives consumers and countries the opportunity to be exposed to new markets and products. Almost every kind of product can be found on the international market: food, clothes, spare parts, oil, jewelry, wine, stocks, currencies and water. Services are also traded: tourism, banking, consulting and transportation. A product that is sold to the global market is an export, and a product that is bought from the global market is an import. Without international trade, nations would be limited to the
goods and services produced within their own borders.
1.1.1 Differences between international trade and domestic trade
International trade is, in principle, not different from domestic trade as the motivation and the behaviour of parties involved in a trade do not change fundamentally regardless of whether trade is across a boarder or not. International trade constitutes those activities involving the exchange of goods and services across national boundaries. It differs from domestic trade in the following aspects.
Use of Currency
Transactions in domestic trade involve the use of one currency, normally the national currency or legal tender. For example, in Rwanda’s domestic trade, it is the Rwandan francs which must be used for buying whatever is being sold. For international trade though, various currencies may be involved. For instance, if a Rwandan businessman wants to import cars from Japan, the Japanese exporter, who may not be interested in the Rwandan francs, would demand to be paid in Japanese yen or any other hard currency like the US Dollar.
Trade within a country is not subjected to barriers restricting the movement of goods internally. Goods produced in Rusizi are expected to have free movement to be sold anywhere in Rwanda. On the contrary, movements of goods across national boundaries are subjected to varying degrees of restrictions — tariffs, quotas. Goods involved in international trade have to pass through designed customs posts.
Goods exchanged in domestic trade tend to be more standardised than goods in international trade. For instance, they are legally all measured either in metric or imperial standard measurement. If they are vehicles, they may have to conform to either being left-hand or right-hand drive vehicles. Hence,
local production is for a standardised market. But this need not be the case in international trade, where the producers confronted with different markets may have a variety of different standards for different markets to fulfill.
The paper work involved in domestic trade is normally less voluminous compared to that involved in international trade. There is hardly any paper work involved in the domestic trade.
International trade is typically more costly than domestic trade. The reason is that a boarder typically imposes additional costs such as tariffs, time costs due to boarder delays and costs associated with country differences such as language, the legal system or culture.
Mobility of factors of production
Factors of production such as capital and labour are typically more mobile within a country than across countries. Thus international trade is mostly restricted to trade in goods and services, and only to a lesser extent to trade in capital, labour or other factors of production. Trade in goods
and services can serve as a substitute for trade in factors of production. Instead of importing a factor of production, a country can import goods that make intensive use of that factor of production and thus embody it.
1.2 Forms of International Trade
Shyaka, a bee farmer from Rwanda, secured market for his honey in Tanzania just like Neema, a cosmetics producer from Tanzania, also secured market for her cosmetics in Rwanda and there has been exchange of their commodities between the two countries for a long period of time. However, Rwanda has gone ahead to secure market for Mr. Shyaka’s honey in various countries in the world, both developed and developing countries. This has created peace and harmony between Rwanda and
the partners in trade.
From the research carried out about international trade in activity 1 in this unit, and using Shyaka and Neema’s example, in the case study above, in activity 2, how would you express the following?
(a) The term used to explain trade between Rwanda and Tanzania and the trade between Rwanda and more countries.
(b) The commodities being exchanged in figure 1 (d).
(c) What are the examples of goods and services that Rwanda exchanges with other countries?
(d) Why do you think it is necessary to create and maintain peace and harmony between or among countries trading amongst themselves?
There are majorly two forms of international trade, namely;
(a) Bilateral trade; this is the exchange of commodities between two countries. For example, trade between Rwanda and Tanzania is an example of bilateral trade.
(b) Multilateral trade; this is the exchange of commodities among more than two countries.
1.3 Terminologies Used in International Trade
(i) Exports: These are commodities sold from one country to other countries.
(ii) Imports: These are commodities that are bought from other countries and brought to a particular country.
(iii) Export trade: This is the selling of commodities from one country to another.
(iv) Import trade: This is the buying of commodities from other countries and brought to a particular country.
(v) Visible trade: This is the exchange of commodities that involve only goods. i.e. exchange of tangible or physical commodities between or among countries.
(vi) Invisible trade: This is the exchange that involves only services. i.e. exchange of intangible commodities like education, insurance, health, tourism, etc.
(vii) Entrepot trade: This is the type of trade where goods are imported by a country for purposes of re-exporting them to another country.
(viii) Balance of trade: This is the relationship between visible exports and visible imports. The relationship can be positive, thus favourable balance of trade or negative,
thus unfavourable balance of trade.
(ix) Vent for surplus: This refers to the theory which emphasises increased exploitation of domestic idle resources so as to increase exports or foreign exchange hence increasing a country’s GDP.
(x) Open economy: This is an economy which is involved in international trade.
(xi) Closed economy: This is an economy which is not engaged in international trade at all.
(xii ) Gains from trade: These are advantages which accrue from international trade.
1.4 Need for International Trade
As seen in Activity 2 of this unit, Rwanda exchanges goods and services between or among different countries. In pair, think, share and make presentations to the class giving reasons you think Rwanda had to join international trade.
It is important to note that if all nations had all the goods they require, wereequally efficient, and had unchanging tastes, there would be no need for international trade. Since it is impossible to have all such situations in any one country in the world, there is need for international trade between or among individuals, companies and governments of different countries and this is due to the following reasons;
Differences in natural resource endowments
Different countries have differences in factor resource endowments because Mother Nature has not been equally kind to every region or country in the world in her distribution of resources. Since different countries have different types of natural resources and of which are non-transferable, like climate,
minerals, oil, etc., and in differing quantities, it is important to participate in international trade to acquire and enjoy the benefits of these resources. This helps a country like Rwanda to preserve her natural resources for environmental sustainability since she can get such commodities outside the country than over exploiting and exhausting the little available nonrenewable resources.
Lack of self-sufficiency
A country may be producing a commodity but not in sufficient quantities that it requires, and hence a need for international trade to overcome the shortage. For instance, Rwanda produces sugar but not in sufficient quantities, hence the need to import it. On the contrary, some goods cannot be found in the
country at all may be due to lack of natural resources, capital and skilled labour. On top of that, a country may want to get better quality or standard commodities which she cannot produce as a result of lack of skilled labour or technology to produce them. It’s the role of the government to avail standard or better commodities for its citizens for better standards of living. Therefore, such a country may engage in international trade in order to acquire the goods it cannot produce.
Need to dispose-off surplus
A country may produce a commodity in excess of what can be consumed by the domestic market. Where the economic exploitation of the resource or commodity requires a larger market than the domestic market, international trade will develop in order to avoid wastage. Similarly, in a situation where
a country possesses a resource it does not demand at all but is demanded by other countries, the country would exchange its resources so as to acquire what it needs from other countries. This is known as the vent-for-surplus cause of international trade.
Lack of co-operant factors
A country may be well endowed with natural resources but unable to exploit them either for its own direct utilisation or for exchange to acquire what they need from other countries. This may be due to lack of skills, technology, capital, etc. Exploitation of such resources would inevitably make the
country to engage in international trade so as to acquire the vital missing co-operant factors. With international trade, standardised commodities are required in the world market, therefore, if such co-operant factors miss in a country, production won’t meet world standards which earns it less from
international trade. This makes it a pressing issue for such a country to join international trade to acquire such required factors and meet international standards for the gains from international trade.
Differences in skills
Different people have different skills that may be natural or acquired by training which results into production of different products. The desire for those products beyond one’s productive capacity leads to international trade. For example, Rwanda has for long lacked indigenous skilled manpower thus
has been hiring expatriates to be used in different sectors of the economy. This has promoted skills development among the indigenous population who work with such experts, a reason behind “made in Rwanda campaign” since most Rwandese have emulated such skills from the expatriates and can apply
them in their home country. This has promoted pride and fraternity among the citizens of the country as they consume their own made commodities.
Differences in technology
Nations have differences in technology that enable them to produce different goods and hence international trade arises. For example, Rwanda joined international trade to acquire a better technology to exploit her natural resources, increase production, expand employment opportunities for her
population and improve their welfare. This has enabled Rwanda to achieve some of her objectives of development; like achieving sustained economic growth, reducing unemployment and improving standards of living of people thus promoting confidence in the government, togetherness, unity and love
for the country by the citizens.
Differences in tastes or demand
International trade might also arise because of differences in tastes. With development, people’s standards of living increase and they may demand for not only high quality products but also for a wider variety of goods and services. Thus, even if one country can produce a certain commodity,
importation may still take place due to people’s desire for a better quality product from abroad. This connects with the idea of competitive forces and the exercise of choice. In a free market economy, consumers are free to choose which goods to buy. A foreign good may be more appealing. This
is not necessarily a matter of it being cheaper, but may simply reflect the consumer’s tastes.
International trade might arise out of the need to minimise the costs of production. It is always wise for one to purchase a commodity if one finds it economical/cheaper to buy than to produce. Thus, when one country finds it cheaper to consume imported goods and services than consuming
those domestically produced, it would be engaged in international trade. Some countries may be able to produce given commodities but at relatively higher costs than others may. Therefore, those countries at a relative cost disadvantage may initiate and engage in exchange relations with those countries having a relative cost advantage so as to minimise their costs. This is exchange based on comparative cost advantage.
Need to acquire foreign exchange
Some countries trade because they want to acquire foreign exchange to finance development. Many African countries export their produce to earn foreign exchange. Where domestic revenue isn’t sufficient to meet recurrent and development budgets, a country joins trade to exchange her commodities through exports to get revenue to supplement the local sources.
Need to strengthen political ties
Sometimes, international trade may arise simply to promote political ties between the trade participants or to extend a form of political ideology from one country to another. Two similarly ideologically disposed countries may promote trade between themselves even when it is not necessary. However, it would have been advantageous to one country to trade with another country, which is not ideologically favourable. This promotes international unity, peace and harmony which increases the gains from international trade by different countries since it is easy to access markets worldwide.
Need to increase competition and efficiency
Countries need to join international trade in order to increase competition and efficiency between or among themselves. This lowers prices and reduces local monopolies who might cheat consumers through high prices. Competition avails a variety of commodities of good quality since a certain standard has to be met to get market for a country’s commodities. This promotes the culture of standardisation among producers so as to maximise their profits through producing what is required by international standards.
Need to reduce subsistence sector
Countries participate in international trade to produce for the market through exporting their commodities which reduces on the subsistence sector and its negative effects. For example, Rwanda participates in international trade with the development goal of transforming the economy from subsistence
production to a monetary one. This promotes commercial production and reduces subsistence production. It has also created and expanded employment opportunities to most people thus reducing income gap in the economy. In this case, all people see themselves as important citizens
to the economy as the government facilitates them in transforming from low income subsistence status to high status commercial production, thus increasing love and general peace in the country.
Need to promote employment opportunities
International trade promotes employment directly or indirectly i.e. those involved in handling international trade at border posts, collecting taxes, checking standards and those producing for exports.
Vent for surplus
Countries need international trade in order to exploit their idle resources so as to increase their export level and provide employment. International trade widens market, avails skills and techniques of production, all these increase the capacity to exploit resources by a nation. Nations should, properly and
efficiently utilise idle resources to compromise environmental sustainability, especially with the non-renewable resources. Otherwise, there could come up global warming which affects the entire world directly or indirectly.
Need for specialisation
Countries prefer to specialise in few commodities in which they are efficient so that they can maximise output and preserve resources. Thus, international trade arises due to the fact that a country would exchange what it produces efficiently for what it cannot. This avoids wastage of resources, little foreign exchange and time in producing a commodity a country is not good at. Therefore, a country has to specialise in production of a commodity where it incurs less real costs or opportunity cost and exchange with others who produce what she cannot produce due to incurring high real or opportunity cost.
1.5 Arguments for International Trade
Basing on Activity 3 of this unit, having seen that Rwanda has participated in international trade since time immemorial, agree together as a class on opposing and proposing sides, and debate on the view that “Rwanda’s participation in international trade has been more beneficial than harmful to her economic development”.
International trade is a basic feature of economic activities in every country. Nearly every country in the world seeks to participate in international trade. Ideally, participation in international exchange confers several benefits or advantages to the participants and these may include among others the
• It permits and fosters international specialisation in order to maximise output and costs of production. This therefore leads to increased national income, savings, investment and employment opportunities
for the participating countries.
• It overcomes shortages, i.e. if a country engages in international trade it overcomes such shortages brought by for example natural disasters.
• Market expansion: i.e. international trade widens markets for the participating countries e.g. LDCs are assured of markets for their raw materials. This has encouraged LDCs to move from subsistence
production to a monetary one.
• Vent for surplus: International trade enables a country to utilise her resources thus full utilisation of resources due to assured markets.
• International trade provides an opportunity to a country to sell a surplus of products and to make use of available land and labour. Many countries have products, which are surplus to their own requirements.
It is only by exporting these products that they have any value at all. Without trade, the land and the labour used in their production would be idle. International trade therefore gives the country the opportunity to sell these products and to make use of the available land and labour.
• International trade stimulates competition and forces home producers to become more efficient which leads to a culture of standardisation thus better quality, lower prices and more output.
• It leads to introduction of new ideas, technologies, knowledge and skills, entrepreneurship and social change. Thus the dynamic effects of trade stimulate economic development in the long run.
• International trade provides revenue to the government from import and export duties. This revenue can be used to finance different development activities in the economy, of which revenue would not
be enough had there not been international trade.
• Creation and maintenance of employment: i.e. once countries specialise in production of certain goods for export, it follows that there will be employment in those sectors. This increases incomes of people and raises their purchasing power thus promoting more investments in the country.
• Promotes cultural and political ties between or among countries since there is understanding among trading partners which creates global peace and harmony among countries.
• International trade avails a wide variety of commodities which increase the choice of consumers and their standard of living.
• It increases capital inflow: i.e. foreign exchange which it can use to pay off its foreign debts, pay contributions to international organisations and carry out development programmes.
• It enables a country to get relief supplies by importing from other countries e.g. in case it is hit by emergencies like drought, floods and earthquakes.
• It enables factor mobility which promotes exchange of ideas and information thus increase in labour efficiency, solves unemployment problems and brings about development in the long run.
1.6 Arguments against International Trade
Despite the above mentioned advantages of international trade, it comes
with several demerits which include among others the following;
• It encourages dumping which causes price instabilities in the domestic country/market. It also reduces the spirit of love for the locally made commodities which kills domestic production capacity by local
producers. This is because most of the dumped commodities are either cheaper or of high quality than the home made commodities. This affects the development path of the country where commodities
• Development of local industries is retarded i.e. local industries may be outcompeted by more efficient foreign firms and this leads to increased unemployment and worsens the living standards of people
in the domestic economy.
• If a country trades with another that is affected by inflation, it may result into imported inflation on the importing country.
• Loss of social economic and political independence because MDCs always dictate unfair trading terms to LDCs.
• Loss of culture through demonstration effect as consumers of imported goods adapt to foreign consumption habits and cultures. People change towards the imported commodities with a view that they are better than theirs. This reduces love for their country as they reject consuming its locally made commodities.
• International trade may result into over exploitation of domestic resources due to wider markets.
The desire to serve the wider market leads to the cutting down of forests, draining marsh lands, poaching etc. all which are anti-environmental protection and preservation and anti-environmental sustainability.
• Dangerous commodities may find their way into the country e.g. guns, drugs etc. which may worsen the health and the standard of living of people.
• BOP position may worsen where import expenditure may exceed export revenue. People, due to demonstration effect, free flow of goods and services in the country. This may lead to import expenditure exceeding export earnings thus worsening the BOP position of the country.
• It may limit employment opportunities in the country by the domestic people who are outcompeted by foreigners who might have superior skills over locals.
1.7 Limitations of International Trade
Having seen the reasons countries would want to participate in international trade in Activity 3 of this unit, and the expected benefits from it, what do you think would limit a country like Rwanda from
participating fully in international trade?
A number of both social, economic and political factors can hinder a country to participate fully in international trade. These factors are either internal or external and can be avoidable or inevitable. These include among others the following:
1. Rapid depletion of exhaustible natural resources: It could lead to a more rapid depletion of exhaustible natural resources. As countries begin to increase their production levels, natural resources tend to get depleted with time and it could pose a dangerous threat to the future generation.
2. Import of harmful goods: Foreign trade may lead to importation of harmful goods like cigarettes, drugs, etc., which may harm the health of the residents of the country.
3. It may exhaust resources: International trade leads to intensive cultivation of land. Thus, it has the operations of law of diminishing returns in agricultural countries. It also makes a nation poor by giving
too much burden over the resources.
4. Over specialisation: Over specialisation may be disastrous for a country. A substitute may appear and ruin the economic lives of millions.
5. Danger of starvation: A country may depend mainly on foreign countries for its food. In times of war, there is a serious danger of starvation for such countries.
6. One country gains at the expense of others: One of the serious drawbacks of foreign trade is that one country may gain at the expense of others due to certain accidental advantages.
7. May lead to war: Foreign trade may lead to war, different countries compete with each other in finding out new markets and sources of raw material for their industries and frequently come into clash. This
was one of the causes of the First and Second World War.
8. Language diversity: Each country has its own language. As foreign trade involves trade between two or more countries, there is diversity of languages. This difference in language creates a problem in foreign trade.
9. Differences in laws and regulations: i.e. different countries have different laws and regulations that govern trade that do not coincide with laws of other countries. This makes it hard for traders from
different countries to cope with those laws from other countries thus hindering international trade.
10. Competition to domestic producers: Since goods are not only exported but also imported, people are usually attracted to foreign goods and prefer to buy them instead of goods that have been produced within the nation. Domestic producers face a loss due to this.
11. Cost incurred for exporting: A lot of costs on transportation facilities has to be incurred when goods are exported to other countries.
12. Too much dependence: When countries develop a habit of importing certain kinds of goods from another country they usually reduce the amount of production of the same good within the country so if the country that exports has a problem and is unable to export goods then the country that imports the goods will suddenly face a shortage of those goods.
13. Differences in standards of measurement: Different countries use different weights and measures.
14. Lack of standard currency to exchange commodities: There is no convenient means for buyers and sellers to exchange commodities since they both have different currencies. Exchanging to convertible
currencies may distort the relative prices.
15. Inadequate information about goods available, their prices, quality etc. which hinders smooth international trade.
16. Trade barriers which governments normally impose on flow of
international commodities like tariffs, quotas, foreign currency, selfsufficiency etc. all limit international trade.
1.8 Rwanda’s International Trade
1.8.1 Rwanda’s total trade
In 2014, Rwanda’s total trade increased by 3.4 percent to 2,356.6 millions USD from 2,278.9 million USD registered in 2013. Exports increased by 4.9 percent from 622.0 million USD in 2013 to 652.2 million USD in 2014. During the same period, imports increased by 2.8 percent from 1,658.0
million USD to 1,704.4 million USD.
Source: Rwanda Regulatory Authority and National Institute of Statics of Rwanda
1.8.2 Rwanda’s imports
Rwanda’s imports increased by 2.8 percent to 1,704.4 million USD in 2014 from 1,657.0 million USD in 2013. Rwanda’s imports in 2014 were dominated by electrical machinery, nuclear reactors, boilers, mechanical appliances; pharmaceutical products, vehicles, cereals, mineral fuel, salt,
animal or vegetable fats and iron and steel which accounted to 53.4 percent of the total imports. The main sources of Rwanda’s imports were EAC, EU, China, India and United Arab Emirates which contributed 78.4 percent of the total imports.
Source: Rwanda Regulatory Authority and National Institute of Statics of Rwanda
1.8.3 Rwanda’s domestic exports
Rwanda’s domestic exports decreased by 5.7 percent from 480.2 million USD in 2013 to 453.1 million USD in 2014. The main domestic exports included ores, slag and ash; coffee, tea, mate and spices; products of milling industry, raw hides and skins; iron and steel and natural or cultured pearls; which accounted to 84.2 percent.
Source: Rwanda Regulatory Authority and National Institute of Statics of Rwanda
1.8.4 Rwanda’s re-exports
The share of Rwanda’s re-exports to total exports increased from 22.8 percent in 2013 to 30.5 percent in 2014. The value of re-exports went up by 40.4 percent from 141.7 million USD in 2013 to 199.1 million USD in 2014. The main re-export products included mineral fuels, nuclear reactors, cereals,
animal and vegetable fats and motor vehicles and electrical machinery which accounted to 85.6 percent of the total re-exports in 2014.
Rwanda’s re-exports to the EAC Partner States increased by 4.2 percent from 86.3 million USD in 2013 to 89.9 million USD in 2014. The main re-exports to EAC region were mineral fuels, fats and vehicles.
Source: RRA and NISR
Figure 9 above is a graph showing Rwanda’s re-exports to total
exports between 2010 to 2013.
1.9 Theories of International Trade
There are different theories of international trade as put forward by different economists trying to explain the gains from international trade between or
among countries involved. There are two basic principles or theories of international trade, and these include the following;
• Theory of absolute advantage
• Theory of comparative advantage
1.9.1 Theory of absolute advantage
Using your knowledge from the research on international trade theories in Activity 1 of this unit, analyse the case study below and share ideas with the class;
Given the same conditions, Gicumbi farmers in Rwanda can produce 1000 tons of maize and 500 tons of Irish potatoes while Kabale farmers in Uganda can produce 800 tons and 2000 tons of maize and irish
If trade is to take place between the two groups of farmers in both countries, they must specialise so as to have effective exchange.
(a) Which theory of international trade is portrayed in the case study above?
(b) What does the theory state?
(c) Which of the farmers should specialise in which commodity and why?
(d) Describe how the two countries would benefit using them theory of absolute advantage.
Meaning of absolute advantage
This theory, put forward by Adam Smith, was developed to explain the gains from international trade as a result of specialisation between countries. The law of absolute advantage states that “Given two countries and same amount of resources, a country is said to have an absolute advantage over
another in production of a given commodity if it can produce that commodity more efficiently at a lower input cost”. According to Adam Smith, the lawof absolute cost advantage for international trade, operates in such a way
that countries will benefit if one of them has an absolute (cost) advantage in producing one commodity while the other has an absolute (cost) advantage in producing the other commodity.
A country that can produce a good at a lower cost than another country
is said to have an absolute advantage in the production of that good.Absolute advantage is therefore the ability of a country to produce more of a commodity than its competitors using the same amount of resources.
When two countries have absolute advantages in different goods, there are gains from trade to be reaped. According to the absolute cost advantage doctrine of Adam Smith, each country produces those goods whose production is specially suited on account of its climate, fertility of its land and its natural resources, and acquired capacity of its people, such as plants, buildings, means of transport, education and health. It will concentrate on the production of such commodities, producing more than its requirement, getting the surplus exchanged with goods and commodities from other
The principle of absolute advantage involves comparing the quantities of a specific product that can be produced using the same quantity of resources in two different countries. For example, Rwanda is said to have an absolute advantage over Uganda in the production of tea when an equal quantity of
resources can produce more of tea in Rwanda than in Uganda. Suppose that Rwanda has an absolute advantage over Uganda in one product, while Uganda has an absolute advantage over Rwanda in another, this is a case of reciprocal absolute advantage. This implies that each country has an absolute
advantage in one product. In such a situation, the total production of both countries can be increased (relative to a situation of self-sufficiency) if each specialises in the product in which it has an absolute advantage.
Assumptions of absolute advantage
There are two main assumptions underlying the principle of absolute
• Labour is the only factor of production;
• Labour is mobile within the country but immobile between countries.
Given the above assumptions, an exchange of goods will occur (assuming a two-country two-commodity case), if each of the two countries can produce one commodity at an absolutely lower labour cost of production than the other.
Let us take a two-country two-commodity case. e.g. Rwanda and Uganda producing tea and rice respectively:
Table 1: Reciprocal absolute advantage production schedule.
This information can be represented using a production possibilities curve
Basing on the information from the table and graph above,Rwanda will confine itself to the production of tea since it has an absolute cost advantage in producing tea. Through specialisation
it will produce tea in larger quantity than its home requirement, getting the surplus exchanged for rice from Uganda. Similarly,
Uganda will specialise in the production of rice and, will exchange part of it for tea from Rwanda.
Thus, both countries would have more of both products by trading among themselves, through the application of the principle of division of labour, producing only that product in which each has an absolute advantage over the other. After specialisation, the total production of tea is 100 tons and
that of rice is 120 tons.
On the other hand, given equal quantity of resources, one country can produce both commodities better than another. Thus one country can have absolute advantage in production of both commodities than the other. This indicates a case of non-reciprocal absolute advantage.
Table 2: Non-reciprocal absolute advantage between Uganda and
Rwanda production schedule.
The above information can be illustrated on the graph as below;
From the above information in the table and graph, it can be seen that if Uganda decided to produce only tea, it would produce100 tons and if it decided to produce only rice, it would produce only 150 tons. Similarly, if Rwanda decided to produce only tea, it would produce only 80 tons, and if it decided to produce only rice, it would produce 70 tons. Each country has several possible
combinations of tea and rice it can produce as shown along the production possibilities curve.
Because the production possibilities frontier for Uganda is above that of Rwanda, it means that Uganda has absolute advantage over Rwanda in production of both tea and rice. In this case of non-reciprocal absolute advantage, gains from trade can be realised when countries specialise basing on the opportunity cost of producing each commodity. This is explained by the theory/principle of comparative advantage.
1.9.2 The theory of comparative advantage
Research from the library, the internet or any other economics sourceabout international trade theories, and critically analyse the case study below and share your views as a class.
Given the same conditions, Gicumbi farmers in Rwanda can produce 1000 tons of carrots and 2000 tons of oranges. While Kabale farmers in Uganda can produce 800 tons and 1500 tons of carrots and oranges respectively. If trade is to take place between the two groups of farmers in both countries, they must specialise so as to have effective exchange.
(a) Which theory of international trade is portrayed in the case study above?
(b) Which farmers should specialise in which commodity and why?
(c) State the theory of comparative cost advantage.
(d) Critically analyse the applicability of the theory of international trade to Rwanda’s economy.
Meaning of comparative advantage
The theory of comparative advantage was advanced by David Ricardo in 1817. It followed Adam Smith’s theory of absolute advantage and said that even in the absence of absolute cost advantage, international trade was possible. He postulated that even where one country had an absolute
advantage in the production of both commodities, both countries would benefit, if the first country concentrated only on the production of the most advantageous commodity, leaving the second country to produce the other commodity. Comparative advantage is the ability of a country to produce
a commodity at a less opportunity cost than another. Thus a country has a comparative advantage over the other when it incurs less opportunity cost than the other in the production of a given commodity.
The theory thus states that “Given 2 countries and 2 commodities, with a given amount of resources, a country should specialise in producing a commodity where it has a least opportunity cost compared to the other country”. The specialising country would benefit from trade if it exchanges the surplus of its products for other products in which it has a higher opportunity cost.
Assumptions underlying comparative cost advantage The theory of comparative cost advantage is based on the following assumptions:
• Labour is the only factor of production.
• All labour is homogeneous and freely transferable from one commodity to another.
• The cost ratios between two commodities remain constant.
• Trade takes place between two countries and in two commodities.
• There are no transport costs and no restrictions on trade.
• There is perfect mobility of the factors of production within a country
and perfect immobility internationally.
• The theory assumes constant technology.
• Constant returns to scale.
• The exchange rates of the two countries remain the same.
• The two countries have a double coincidence of wants with barter system of trade.
• Tastes and preferences between the two countries don’t change.
• There is full employment of factors of production.
• There is free trade between two countries.
Uganda has an absolute advantage in the production of both commodities, Tea and Rice over Rwanda. Uganda has the absolute advantage in Tea (5:4) and it has an absolute advantage in Rice (4:3). However, if we examine the domestic opportunity cost ratios, it is clear that each country has a relative
or comparative advantage in the production of one commodity.
To get to know of which country should specialise in what, we must calculate the opportunity cost of one commodity for the other. This is done by the formula;
In Rwanda, the domestic opportunity cost ratio is such that only 7.5 tons of rice must be given up for each ton of tea produced. The opportunity cost of producing one ton of tea is 0.133 tons of rice. However, in Uganda, the domestic opportunity cost ratio is such that 8 tons of rice must be given up
for each ton of tea produced. The opportunity cost of producing one ton ofrice is 0.125 tons of tea.
Rwanda therefore has a comparative advantage in the production of tea since for each ton of tea that is produced fewer rice is sacrificed than in Uganda. Similarly, Uganda, has a comparative advantage in the production of rice, since, for each ton of rice that is produced; less tea is sacrificed than
in Rwanda. For each ton of rice produced, Uganda must sacrifice 0.125 tons of tea, whereas in Rwanda, for each ton of tea, 7.5 tons of rice must be sacrificed. If now Uganda concentrates on rice and Rwanda on tea, then the two countries are bound to benefit assuming that the value of one ton of rice is the same as that of one ton of tea.
After specialisation, the situation looks as indicated in the table below. The assumption is that resources have doubled in each country.
The production of tea has reduced by 2 and the production of rice has increased by 20 tons. On the average, however, the two countries have benefited by 18 tons of rice in terms of value, assuming the price of 1 ton of tea is equal to that of 1 ton of rice.
Relevance/applicability of the comparative cost advantage
• LDCs have tended to specialise in producing primary products where they have a least opportunity cost e.g. Rwanda exports raw materials.
• LDCs still have barter trade arrangements among themselves.
• LDCs use labour intensive technology while MDCs use capital intensive technology so the assumption of no change in technology is realistic.
• There is some degree of mobility of factors of production among LDCs especially labour.
• LDCs import manufactured commodities where they have a high opportunity cost.
• There are some cases of free trade among LDCs especially in economic integrations.
Criticisms/limitations of the comparative cost advantage
Though the theory of comparative advantage appears to explain the basis of choice for a country in terms of what to produce, what to export and import from others, it has been criticised by a number of writers on the following accounts:
Two-country and two-commodity model
The model deals only with the situation in which trade takes place between two countries and in two commodities. This is a hypothetical situation which does not exist in real life. We are aware of the fact that international trade takes place between more than two countries and in more than two commodities. The world of only two countries producing only two commodities is a very unrealistic assumption. The real world is made up of a large number of countries engaged in production of a wide range of
Differences in tastes
The theory assumes that people all over the world have similar tastes. But this is untrue. People belonging to different levels of income have different tastes. In addition, the tastes also change according to the growth of an economy and with the opening of world markets and development of trade relations.
Role of technology is neglected
The theory does not recognise the role of technological innovations in international trade. It’s however known that technological changes help in decreasing the cost of goods and increasing their supply not only in interregional trade but also in international trade.
Assumption of complete specialisation
The theory rests upon the assumption that there is complete specialisation or division of labour. In the real world, complete specialisation is not possible. Let us take an example of two countries — one small and the other large in terms of total output. The small country can specialise in the production of
one good, but the large country will have to produce both goods, because the small country can neither supply the full requirements of the larger country nor can it absorb the surplus output of the larger country. Another situation could be when the two commodities are not of comparable values i.e. one commodity is of high value and the other of a low value. The country producing a high value commodity can specialise but it will not be profitable for the country producing a low-value commodity to specialise.
Assumption of free trade is unrealistic
It is wrong to assume the existence of free world trade. Countries do not always trade freely with each other. History provides ample evidence of the fact that different countries have imposed different restrictions on the free movement of goods to other countries from time to time. There are
political, social or strategic reasons why governments will not permit free trade. Tariffs, quotas, exchange controls and other restrictions are imposed on trade. These restrictions have certainly affected the volume and direction of imports and exports. The existence of such restrictions on trade clearly
limits the scope for specialisation between countries.
No consideration for transport costs
In his theory, Ricardo has shown no consideration for transport costs, which play an important role in determining the profitability and pattern of international trade. However big the difference between the cost ratios of the two commodities entering into trade may be, if it is narrowed down by the high cost of transporting the commodities, trade may not occur. The existence of transport costs gives rise to another class of goods besides those entering
into trade, known as ‘domestic goods’. Some writers have, therefore, suggested that the cost of production should include the transportation cost.
The prevalence of perfect competition in international trade is also anunrealistic assumption. The conditions of perfect competition cannot be achieved in the real world.
Equal efficiency of all factor inputs
The assumption that all units of factors of production are equally efficient is too simplistic. It is very difficult to find factors of production, which are equally efficient.
Perfect factor mobility
The theory assumes that countries can shift resources from the production of one good to the production of another good. In practice, there is likely to be a certain amount of factor immobility, which prevents this, especially in the short run.
Assumption of constant costs
The theory assumes the operation of the law of constant costs or returns. The assumption is entirely unrealistic. In practice, the usual rule in the production of goods is the operation of the law of increasing costs or diminishing returns, that is, beyond a certain point additional output can be obtained only at an increasing per unit cost. When the production takes place under the operation of this law, the cost ratios in both countries will not remain constant.
Coincidence of needs
The theory assumes coincidence needs. e.g. Uganda must want Rwanda’s tea, and Rwanda must want Uganda’s rice. This, however, may not be true in reality. For one reason or another, the cheapest source may not appeal to the customer country such that the customer prefers to buy from an expensive source. It should also be noted that two different currencies are used. However, the theory mentions nothing about them.
Equal costs in the countries
It is possible that the two countries may incur the same cost in the production of a certain commodity. In such a case, it is hard to find which country should specialise in a particular commodity.
The principle of comparative advantage has been criticised by LDCs on the grounds that if adhered to, it would perpetually commit them to being producers of raw materials. This might condemn them to eternal poverty. The present international economic structure is divided into the rich and the poor
nations. The rich nations are the industrialised ones while the poor ones are the producers of primary products. The poor nations therefore believe that if they are to escape from the vicious cycle of poverty, they must industrialise. Unfortunately, the theory of comparative advantage places their advantage
in the production of primary products which are faced with low prices and unfavourable terms of trade. MDCs have a comparative advantage in the production of manufactured goods which are faced with high prices and favourable terms of trade. This therefore implies that LDCs will forever remain poor.
Benefits of comparative cost advantage
• It encourages competition and improvement in efficiency. This reduces costs of production.
• It encourages specialisation and exchange.
• It increases global output of commodities.
• It encourages economic cooperation and free trade among countries.
• It encourages mass production and reaping of economies of scale.
• It discourages duplication of industries i.e. setting up of industries
which already exist in other countries.
• It widens market for exports.
• It enables countries to get commodities which they cannot produce.
• It enables countries to get foreign exchange.
• Specialisation results into effective utilisation of resources some of
which would be idle.
Factors that determine 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: Some countries have an abundant supply of good quality farmland, oil and gas, or easily accessible fossil fuels. Climate and geography have key roles
in creating differences in comparative advantage. More recently the whale gas revolution in the United States and elsewhere is leading to shifts in the future pattern of world energy production and trade as
North America becomes more 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 transpor 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 markets where trade takes place helps to encourage specialisation, higher productivity and internal and external economies
of scale. These long-run economies of scale can give regions and countries a significant unit cost advantage.
5. Investment in research and development which can drive innovation and invention.
6. Fluctuations in the exchange rate which 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. 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 specialising in specific knowledge sectors – an example is the division of knowledge in the
medical industry, some countries specialise in heart surgery, others in pharmaceuticals – health tourism is becoming more important.
9. Institutions: These are important for comparative advantage an 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.
ཀྵཀྵ Absolute advantage: The ability of a country to produce a good or a service at a lower cost per unit than the cost another produces the same good or service.
ཀྵཀྵ Bi-lateral trade: Trade between two countries.
ཀྵཀྵ Comparative advantage: The basis of trade between nations where opportunity cost of producing the good is lower than the opportunity cost of producing the same good or service in
other trading nations.
ཀྵཀྵ Exports: Goods/services produced within a country and sold to other countries.
ཀྵཀྵ Export incentives: Favourable conditions put in place to boost exports of a country.
ཀྵཀྵ Export potential: The amount of unused resources in a country that can be exploited for the external market e.g. forest, mineral etc.
ཀྵཀྵ Imports: Imports are goods/services which are produced in other countries and brought into one country.
ཀྵཀྵ Import surplus: A situation that exists when the value of imports exceeds that of imports (unfavourable trade balance).
ཀྵཀྵ Individualism: This is a belief that individuals are the best judges of their own interests.
ཀྵཀྵ Invisible commodities: Items that are not tangible and these are services e.g. insurance, tourist expenditures etc.
ཀྵཀྵ Invisible trade: Trade in services e.g. tourism, education, banking etc.
ཀྵཀྵ Multi-lateral trade: Trade among several countries. International Trade Theories 39
ཀྵཀྵ Trade gap: This occurs when the quantity of imported goods exceeds that of visible exports. It is the amount by which visible imports exceed visible exports.
ཀྵཀྵ Unrequited exports: These are exports that do not earn any foreign exchange. Such exports arise out of a debt owed by a country to another. i.e. used to pay off the debt.
ཀྵཀྵ Vent-for-surplus: This explains the view that exploitation of idle domestic resources for exports can lead to national income.
ཀྵཀྵ Visible trade: Trade in goods.
• International trade
• Forms, and terminologies used
• Advantages, disadvantages and limitations
• Theories of international trade
• Absolute advantage
• Comparative advantageFiles: 2
Key unit competence: Learners will be able to describe the terms of
trade in LDCs.
By the end of this unit, I will be able to:
⦿ Differentiate between income and barter terms of trade.
⦿ Describe the nature of terms of trade in LDCs.
⦿ Identify factors for improving terms of trade in LDCs.
⦿ Demonstrate the terms of trade and balance of trade in LDCs through
calculations and make interpretation.
⦿ Analyse the ways of improving terms of trade in LDCs.
⦿ Assess the causes and consequences of changes in terms of trade.
⦿ Take part in improving terms of trade in LDCs/Rwanda.
2.1 Meaning of Terms of Trade
Using the case study below, visit the library, the internet or any other economics source and research about terms of trade. Using the gained knowledge, share and discuss as a class the questions that follow.
In 2015, Rwanda exported her coffee to Japan and in turn imported cars from there. The price of coffee per ton was 800 dollars while that of a car was 1,700 dollars. The following year i.e. 2016, coffee prices in the world market fell by 20% while that of cars remained constant.
(a) What economic term do we call the relationship between Rwanda’s export prices and import prices?
(b) Calculate the terms of trade for Rwanda in 2015 and 2016 respectively.
(c) Describe the nature of terms of trade of Rwanda in 2015 and 2016 respectively. Support your answer.
(d) How can terms of trade be expressed?
Terms of trade (TOT) refers to the relative price of exports in terms of imports. It is the ratio of export prices to import prices. It can be interpreted as the amount of import goods an economy can purchase per unit of export goods, i.e. import purchasing power of exports. For example, if an economy
is only exporting coffee and only importing cars, then the terms of trade are simply the price of coffee over the price of cars. In other words, how many cars can you get for a unit of coffee? Since economies typically export and import many goods, measuring the terms of trade requires defining price
indices for exported and imported goods and comparing the two.
A rise in the prices of exported goods in international markets would increase the terms of trade, while a rise in the prices of imported goods would decrease the terms of trade. For example, countries that export oil
will see an increase in their terms of trade when oil prices go up, while the terms of trade of countries that import oil would decrease.
An improvement of a nation’s terms of trade benefits that country in the sense that it can buy more imports for any given level of exports. The terms of trade may be influenced by the exchange rate because a rise in the value of a country’s currency lowers the domestic prices of its imports but may
not directly affect the prices of the commodities it exports.
Terms of trade is the ratio of a country’s export price index to its import price index, multiplied by 100. The terms of trade measure the rate of exchange of one good or service for another when two countries trade with each other.
Basically, TOT is Export Price over Import Price times 100. If the percentage is over 100% then an economy is doing well (Capital Accumulation) thus favourable terms of trade. When this persists year after year, a country is said to have improving terms of trade.
If the percentage is under 100% then an economy is not doing well (more money going out than coming in) thus unfavourable terms of trade. When this persists year after year, a country is said to have deteriorating terms of trade.
2.2 Forms of Terms of Trade
Terms of trade are categorised into two, namely;
1. Barter/commodity terms of trade
2. Income/monetary terms of trade
a) Barter/commodity terms of trade
Barter / commodity terms of trade is the relationship between export prices and import prices, i.e. the ratio of average price index of exports to the average price index of imports. Symbolically, it can be expressed as:
Taking 2012 as the base year and expressing Rwanda’s both export prices and import prices as 100, if we find that by the end of 2015 its index of export prices had fallen to 80 and the index of import prices had risen to
120. The terms of trade had changed as follows:
It implies that Rwanda’s terms of trade declined by about 33.33 per cent in
2015 as compared to 2012, thereby showing worsening of its terms of trade.
If the index of export prices had risen to 150 and that of import prices to 130, then the terms of trade would be;
This implies an improvement in the terms of trade by 15.2 per cent in 2015
Limitations of barter terms of trade
Despite its use as a device for measuring the direction of movement of the gains from trade, this concept has important limitations.
1. Problems of index numbers
Usual problems associated with index numbers in terms of coverage, base
year and method of calculation arise.
2. Change in quality of product
The commodity terms of trade are based on the index numbers of export and import prices. But they do not take into account the changes taking place in the quality and composition of goods entering into trade between two countries. At best, commodity terms of trade index show changes in the relative prices of goods exported and imported in the base year. Thus
the net barter terms of trade fail to account for big changes in the quality of goods that are taking place in the world, as also new goods that are constantly entering in international trade.
3. Problem of selection of period
The problem arises in selecting the period over which the terms of trade are studied and compared. If the period is too short, no meaningful change may be found between the base date and the present. On the other hand, if the period is too long, the structure of the country’s trade might have changed
and the export and import commodity content may not be comparable between the two dates.
4. Cases of changes in prices
Another serious difficulty in the commodity terms of trade is that it simply shows changes in export and import prices and not how such prices change. As a matter of fact, there is much qualitative difference when a change in the commodity terms of trade index is caused by a change in export prices
relative to import prices as a result of changes in demand for exports abroad, and ways or productivity at home. For instance, the commodity terms of trade index may change by a rise in export prices relative to import prices due to strong demand for exports abroad and wage inflation at home. The
commodity terms of trade index do not take into account the effects of such factors.
5. Neglect of import capacity
The concept of the commodity terms of trade throws no light on the country’s “capacity to import”. Suppose there is a fall in the commodity terms of trade in Rwanda, it means that a given quantity of Rwandan exports will buy a smaller quantity of imports than before. Along with this trend, the volume of Rwandan exports also rises may be as a consequence of the fall in the prices of exports. Operating simultaneously, these two trends may keep Rwanda’s capacity to import unchanged or even
improved. Thus the commodity terms of trade fails to take into account a country’s capacity to import.
6. Ignores productive capacity
The commodity terms of trade also ignore a change in the productive
efficiency of a country. Suppose the productive efficiency of a country
increases, it will lead to a fall in the cost of production and in the prices of its export goods.
The fall in the prices of export goods will be reflected in the worsening of its commodity terms of trade. But, in reality, the country will not be worse off than before. Even though a given value of exports will exchange for less imports, the country will be better off. This is because a given volume
of exports can now be produced with lesser resources, and the real cost of imports, in terms of resources used in exports, remains unchanged.
7. Not helpful in Balance of Payment disequilibrium
The concept of commodity terms of trade is valid if the balance of payments of a country includes only the export and imports of goods and services, and the balance of payments balances in the base and the given years. If the balance of payments also includes unilateral payments or unrequired exports
and or/imports, such as gifts, remittances from and to the other country, etc., leading to disequilibrium in the balance of payments, the commodity terms of trade is not helpful in measuring the gains from trade.
8. Ignores gains from Trade
The concept of commodity terms of trade fails to explain the distribution of gains from trade between a developed and under-developed country. If the export price index of an underdeveloped country rises more than its import price index, it means an improvement in its terms of trade. But if there is an equivalent rise in profits of foreign investments, there may not be any gain from trade.
b) Income/monetary terms of trade
This refers to the ratio of the value of exports (revenue from exports) to the price index of imports. This index is calculated by dividing the index of the value of exports by an index of the price of imports. This is called the
“Export Gain from Trade Index.”
A rise in the index of income terms of trade implies that a country can import more goods in exchange for its exports. A country’s income terms of trade may improve but its commodity terms of trade may
deteriorate. Taking the import prices to be constant, if export prices fall, there will be an increase in the sales and value of exports. Thus while the income terms of trade might have improved, the commodity
terms of trade might have deteriorated.
The income terms of trade is called the capacity to import.In the longrun,
the total value of exports of a country must be equal to its total value of imports. Thus determine which is the total volume that a country can import. The capacity of a country to import may increase, other things
remaining the same if;
(i) the price of exports rises,
(ii) the price of imports falls,
(iii) the volume of its exports rises.
Thus the concept of the income terms of trade is of much practical value for developing countries having low capacity to import.
Criticisms of income terms of trade
The concept of income terms of trade has been criticised on the following counts:
1. Fails to measure gain or loss from trade
The index of income terms of trade fails to measure precisely the gain or loss from international trade. When the country’s capacity to import increases, it simply means that it is also exporting more than before. In fact, exports include the real resources of a country which can be used domestically to
improve the standards of living of its people.
2. Not related to total capacity to import
The income terms of trade index is related to the export based capacity to import and not to the country’s total capacity to import which also includes its foreign exchange receipts. For example, if the income terms of trade index of a country have deteriorated but its foreign exchange receipts have risen, its capacity to import has actually increased, even though the index shows deterioration.
3. Inferior to commodity terms of trade
Since the index of income terms of trade is based on commodity terms of trade and leads to contradictory results, the concept of the commodity terms of trade is usually used in preference to the income terms of trade concept for measuring the gain from international trade.
2.2.1 Limitations of terms of trade
• Terms of trade should not be used synonymously with social welfare, or even Pareto economic welfare. Terms of trade calculations do not tell us about the volume of the countries’ exports, only relative
changes between countries. To understand how a country’s social utility changes, it is necessary to consider changes in the volume of trade, changes in productivity and resource allocation, and changes
in capital flows.
• The price of exports from a country can be largely influenced by the value of its currency, which can in turn be largely influenced by the interest rate in that country. If the value of currency of a particular country is increased due to an increase in interest rate, one can expect the terms of trade to improve.
However, this may not necessarily mean an improved standard of living for the country since an increase in the price of exports perceived by other nations will result in a lower volume of exports. As a result,
exporters in the country may actually be struggling to sell their goods in the international market even though they are enjoying a (supposedly) high price.
• In the real world of over 200 nations trading hundreds of thousands of products, terms of trade calculations can get very complex. Thus, the possibility of errors is significant.
2.3 Nature of Terms of Trade for LDCs
Imagine a situation in a country where export prices are persistently lower than her import prices year after year, share your views with the rest of the class explaining:
(a) The likely causes of such an incident in Rwanda.
(b) What you think could be done to improve the terms of trade in Rwanda.
Most LDCs have unfavourable and deteriorating terms of trade. The following are the main reasons for unfavorable and declining terms of trade of less developed countries:
2.3.1 Causes of deteriorating terms of trade in LDCs
Nature of product
The less developed countries are mainly primary producing countries. Their exports mostly include primary products and their imports include capital goods. On the contrary, the developed countries produce and export manufactured goods. Thus the terms of trade between the primary products and manufactured products are generally determined against the former and in favour of the latter.
Effect of technical progress
Industrial countries keep the whole benefit of their technical progress, whereas the primary producing countries transfer a part of the fruits from their own technical progress to the industrial nations. Money incomes and prices have risen more rapidly than productivity in industrial countries,
whereas in the primary producing countries, the gains in productivity have been distributed in the form of price reductions. This has led to the deterioration of terms of trade of the primary producing countries.
Different market conditions
Export prices in the industrial countries do not fall as a result of technical progress because the manufacturers operate under monopolistic conditions in the product market; and they do not operate under competitive conditions in the factor market, i.e., labour market is dominated by trade unions. Thus,
the benefit of the improved technology is not transferred to the consumers in poor countries.
The producers in the poor countries, on the other hand operate under competitive conditions both domestically and internationally. Thus, as a result of technical progress in these countries, prices fall and the benefits flow to the consumers in the rich countries.
Price movements through business cycles
The prices of primary products rise sharply in the prosperous periods and fall in the downswing of the business cycle. In contrast, although manufacturing prices rise in the upswing of the
cycle, these do not fall so much in the depression because of the rigidity of industrial wages and price inflexibility due to monopolistic conditions. Thus, over successive cycles, the gap between the prices of the two groups of commodities has widened, and the primary producing countries have suffered an unfavourable movement in their terms of trade.
Disparity in demand
Declining terms of trade of the less developed countries is also due to longterm disparity in the demand for manufactured and primary products.
In the industrial countries, the income elasticity of demand for primary products is inelastic (i.e., less than one), while in the poor countries, the income elasticity of demand for manufactured goods is more elastic (exceeds one).
This is because, as incomes rise, the proportion of expenditure on food declines. Thus, the demand for food increases less rapidly than the rise in income and the demand for raw materials is restricted by competition from synthetic or man-made substitutes.
The less developed countries use backward technology as compared to the developed countries. As a result, their relative productivity is low, cost ratios are high, and price structure is also relatively high. This leads to the adverse terms of trade for the poor country, placing it at a disadvantageous bargaining position.
High population growth
Most of the less developed countries experience overpopulation and high population growth. As a result, there is high internal demand for the goods and low exportable surplus. Moreover, the import demand of these countries is highly inelastic. This causes their terms of trade to fall.
Lack of import substitutes
Poor countries are greatly dependent on the advanced countries for their imports and have not developed import substitutes. On the other hand, the advanced countries are not so much dependent on the poor countries because they are capable of producing import substitutes. Thus, the poor countries
have weak bargaining position in the international trade.
High transport costs
Rwanda being a land locked country and without cheap air or railway links to regional or international markets make it difficult for trade development in the country.
Lack of adaptability
Unlike, the advanced countries, the less developed countries cannot quickly adapt their supply of goods which are high in demand and whose prices are
rising. The reasons for this are: backward technology, market imperfections, immobility of factors of production, etc. Thus, the terms of trade of less developed countries tend to deteriorate and
these countries fail to reap gains by increasing their supplies of exports during inflation.
Similarity of products
Most LDCs produce more less the same products which leads to limited market among themselves. They therefore tend to increase their export shares to MDCs by reducing prices, yet they have to continue importing manufactured goods from MDCs which are highly priced.
Most LDCs lack a considerable manufacturing sector as a result of political instability and insecurities. This reduces the volume of manufactured commodities that would be exported.
Lack of diversification in production in LDCs
Most LDCs depend on a few traditional cash crops like tea, coffee, cotton tobacco, sisal, cocoa etc. which limits the amount of income they get from exports compared to developed countries that export to LDCs a wide variety of manufactured goods.
2.3.2 How to improve terms of trade for LDCs
Most LDCs face unfavourable terms of trade, an indication that LDCs do not favourably enjoy the benefits of international trade. LDCs should adopt any of the following policies in order to improve their terms of trade so as to enjoy more benefits from international trade.
Carry out adequate market research
LDCs should carry out market research so as get enough information to widen markets for their commodities. For example in Rwanda, the opportunity of having research institutions e.g. ISSAR, KIST, IRST have done a number of researches in Agriculture and Scientific technology. Many of these researches are market oriented and enables us to access new clients and overcome supply constraints domestically, regionally and internationally.
Human resource development
LDCs should develop a strong human resource through education and training so as to reduce expenditure on imported labourforce which is always expensive. For example, availability of skilled and semi-skilled labour in the country allows different types of people to be employed in many of the
existing sectors and then lead to economic development.
Promote peace and security
Due to instabilities in most LDCs, there is always fear by investors both local and foreign, therefore LDCs should ensure peace and security in all parts of their countries, for example, the prevailing peace and security in Rwanda presents a strong opportunity for trade development as the business men carry out their activities without fear of robbery or any other security risk.
In most LDCs, there is financial indiscipline like corruption and embezzlement of government funds which normally affects productive sectors thus less productive capacity. In LDCs economies, trade is favoured
by the existence of good governance, for example in Rwanda, especially with the establishment of ombudsman, it has helped in fighting against corruption in all sectors which has promoted transparency and efficiency thus increased gains from trade.
Promoting regional integration and economic cooperation
LDCs should form economic groupings and trade among themselves in order to avoid exploitation by MDCs. For example, Rwanda is already a member to regional and international bodies like East African Community (EAC), Common Market for Eastern and Southern Africa (COMESA) and its free trade area and is able to access the whole market without any barriers to trade. Rwanda is also ready to benefit from various blocks like Economic Community for Central African States (ECCAS), African Growth
Opportunity Act (AGOA), African Union (AU), World Trade Organisation (WTO), European Union (EU), bilateral trade arrangements, etc. This offers Rwanda an opportunity for easy access to foreign markets.
Public - Private sector partnership
LDCs should promote the development of private sector so as to promote efficiency in production and increase the exploitation of idle resources which increases export volume. The government’s commitment to private sector development makes it an opportunity for trade development, as there are initiatives of creating conducive environment for trade thus increasing gains from international trade.
Legal task force
Different countries have different laws governing trade/business in their economies; this however limits opportunities to investment and trade.
Therefore, there should be an effort made on the establishment of business
legal reform task force mandated to reform all business laws; this will create
conducive legal environment for trade by both local and foreign investors
and will increase the gains form international trade among LDCs.
Financial task force
There should be establishment of financial sector task force with the mandate of solving all problems in the financial sector. This helps avail easy and cheap credit facilities to potential investors and business class which boosts their productive levels thus increasing the export base.
There should be establishment of the trade points which will provide all trade related information; this becomes an opportunity as trade information will be easily obtained in one place. This attracts different investors from within and outside the country’s economy thus promoting production directed towards export and or reducing import expenditure.
Permanent trade fair ground
LDCs should enhance the establishment of permanent national and international trade fair grounds which creates an opportunity for trade development as it will give business men a chance of regular expositions
which will help them in the sell and advertisements of their products.
Business Development Centres (BDS)
Business development centres (BDS) should be established. This will facilitate easy coordination of business activities in rural areas.
Export processing zone
Establishment of export processing zone which facilitate trade development in particular and development in general. This helps transform LDCs commodities into finished products so as to increase the export value and gains from trade as well.
Producer cooperatives and associations
LDCs should form producer cooperatives and associations to bargain for higher prices for their exports. Governments should take initiative in cooperatives development so as to create an opportunity for trade
development. From a strong cooperative movement, trade is improved.
Population control measures
LDCs should take up strong measures to control population growth e.g through family planning campaigns. Population control can increase on the level of exports.
Diversification of domestic production
LDCs should diversify their production so as to reduce dependency on few traditional exports where terms of trade are unfavourable and keep on fluctuating.
Import substitution strategy
LDCs should adopt import substitution strategy so as to minimise import expenditure.
There should be the development and use of intermediate technology to reduce expenditure on expensive capital.
2.4 Balance of Trade
We have seen in Unit 1 Activities 1 and 2 that Rwanda exports and imports goods and services from different parts of the world. Using the knowledge gained and your own analysis, share among yourselves
about the following;
(a) What economic term is given to the difference between export and import of goods in a country.
(b) What economic term is given to the difference between export and import of services in a country.
(c) When is the balance of trade of a country said to be favourable and or unfavourable.
(d) What distinguishes balance of trade from balance of payment.
2.4.1 Meaning of Balance of Trade
Balance of Trade (BOT) is the difference in value over a period of time between a country’s imports and exports in tangible or visible commodities, usually expressed in the unit of currency of a particular country. The balance of trade denotes the difference of imports and exports of a merchandise
of a country during the course of a year. The trade balance is identical to the difference between a country’s output and its domestic demand (the difference between what goods a country produces and how many goods it buys from abroad; this does not include money re-spent on foreign stock,
nor does it factor in the concept of importing goods to produce for the domestic market).
The balance of trade is part of a larger economic unit, the balance of payments (the sum total of all economic transactions between one country and its trading partners around the world), which includes capital movements (money flowing to a country paying high interest rates of return), loan repayment, expenditures by tourists, freight and insurance charges, and other payments.
If the value of exports of a country over a period exceeds its value of imports, the country is said to have a favourable balance of trade, or a trade surplus. Conversely, if the value of total imports exceeds total value of its exports over a period, an unfavourable balance of trade, or a trade deficit, exists. A favourable balance of trade indicates good economic condition of a country.
A continuing surplus may, in fact, represent underutilised resources that could otherwise be contributing towards a country’s wealth, where they are to be directed toward the purchase or production of goods or services. Furthermore, a surplus accumulated by a country (or group of countries) may have the potential of producing sudden and uneven changes in the economies of those countries in which the surplus is eventually spent.
Generally, the developing countries (unless they have a monopoly on a vital commodity) have particular difficulty maintaining surpluses since the terms of trade during periods of recession work against them; that is, they have to pay relatively higher prices for the finished goods they import but receive
relatively lower prices for their exports of raw materials or unfinished goods.
The balance of trade forms part of current account on the BOP, which includes other transactions such as income from the net international investment position as well as international aid. If the current account is in surplus, the country’s international asset position increases correspondingly. Equally, a deficit decreases the country’s international asset position.
Table 1: Difference between Balance of Trade and Balance of Payments
2.4.2 Factors that can affect the balance of trade
• The cost of production (land, labour, capital, taxes, incentives, etc.) in the exporting economy vis-à-vis those in the importing economy.
• The cost and availability of raw materials, intermediate goods and other inputs.
• Exchange rate movements.
• Non- tariff barriers such as environmental health or safety standards.
• The availability of adequate foreign exchange with which to pay for imports.
• Prices of goods manufactured at home (influenced by responsiveness of supply).
• Multilateral, bilateral and unilateral taxes or restrictions in trade.
2.4.3 Rwanda’s balance of trade
In 2014, the Rwandan economy recovered from the slowdown experiencedin 2013 recording a growth of 7.0 percent against a growth of 4.7 percent recorded in 2013.
Agriculture sector grew by 5.0 percent and contributed 1.6 percentage points to the overall GDP growth. Activities in the industry sector grew by 6.0 percent and contributed 0.9 percentage points to the GDP growth. The service sector increased by 9.0 percent and contributed 4.3 percentage
points to the GDP growth.
Rwanda recorded a trade deficit of 116.57 million USD in November 2016. Balance of trade in Rwanda averaged -216.59 million USD from1998 until 2016, reaching an all-time high of -100.62 million USD in October 2016 and a record low of -1268.30 million USD in December 2012.
The figure above shows Rwanda’s trade balance for the year 2016
Rwanda’s exports remained dominated by traditional products such as coffee, tea and minerals like tin, colton, wolfram and cassiterite. Rwanda’s main exports partners are China, Germany and United States. Rwanda imports mainly food products, machinery and equipment, construction materials, petroleum products and fertilisers. Main imports partners are Kenya, Germany, Uganda and Belgium.
2.4.4 Calculations of balance of trade
(a) Calculate visible balance for both years and interpret the answer.
(b) Calculate invisible balance for both years.
(c) Calculate the net capital inflows for both years.
(d) Determine the net transfers.
(e) Calculate the current balance.
(f) Assuming there are no errors and omissions, what is the balance
on monetary account in both years (M and N).
Table 3: Study the table below and answer the questions that follow;
(a) Calculate visible balance for both years and interpret the answer.
(b) Calculate invisible balance for both years.
(c) Calculate the net capital inflows for both years.
(d) Determine the net transfers.
(e) Calculate the current balance.
(f) Assuming there are no errors and omissions, calculate the
balance on monetary account in both years (A and B) and
interpret your results.
2.4.5 Causes of changes in the terms of trade
Think of a situation where a country’s terms of trade in some years are favourable and unfavourable in others, from the knowledge acquired on terms of trade in Activity 1 and 2 of unit 2, share your views in your class discussions about:
(a) The possible causes of changes in the terms of trade for LDCs.
(b) The resultant consequences of changes in the terms of trade on balance of trade.
Causes of changes in terms of trade in the short run and long-run include:
The terms of trade is the price relationship between a country’s exports and imports and will, therefore, be influenced by all the factors which determine the prices of imports and exports.
Fluctuations in exchange rates
In the short-run, changes in relative prices of imports and exports will be caused by fluctuations in exchange rates, particularly where countries operate a floating exchange rate system. Exchange rate instability may be caused by changes in trade, capital flows, interest rates, speculation, inflation and
use of foreign currency reserves by the government. You will recall that a depreciation of the exchange rate causes import prices to increase and export prices to decrease, while an appreciation causes the
Fluctuation in the prices of commodities
Also in the short-run, there may be considerable fluctuation in the prices of commodities which will affect the terms of trade. This is particularly true for agricultural commodities, the supply of which is often affected by drought, floods, diseases, etc. Given that the demand for and supply of
these commodities is highly inelastic, the change in supply will cause a proportionately greater change in price.
In the longer term, changes in the terms of trade are likely to be determined by those factors which exert a long term influence on the demand for, and supply of, a country’s exports and imports.
For the developing countries, who export mainly primary goods and import manufactured goods, their export prices have tended to fall over time due to a combination of increased supply of and reduced demand for their exports.
Development of synthetic substitutes, e.g. plastics
This has lessened the demand for several raw materials from LDCs thus
affecting their terms of trade.
Low income elasticity of demand for primary commodities
As real world incomes have grown, the demand for primary commodities has increased less than proportionately.
The developing countries, despite producing at lower cost, have found it difficult to break into the markets of the richer countries. As farmers they are often heavily subsidised and, in the case of the European Union, protected by a common external tariff.
Modern microchip technologies have enabled products to become smaller, e.g. the personal computer, and this has necessitated less use of raw materials and caused demand to fall.
Price inelastic demand for exports of primary commodities
Compounding the problem of falling export prices, demand for primary commodities tends to be price inelastic, such that decreases in prices bring about less than proportionate increases in the quantity demanded.
Change in factor endowments
Changes in factor endowments may increase exports or reduce them. With tastes remaining unchanged, they may lead to changes in terms of trade. Suppose there is an increase in Rwanda’s supply of factors of production
with constant change in tastes, its productive capacity would increase thus terms of trade would move towards Rwanda against Kenya.
Devaluation raises the domestic prices of imports and reduces foreign price of exports of a country devaluing its currency relative to the currency of another country.
An import tariff improves the TOT of the imposing country, for example if a tariff is imposed on Rwanda’s tea by Kenya, the changes in terms of trade are in favour of Kenya. Since the quantity of exports of Rwanda reduce as a result of tariff by Kenya is greater than the quantity of imports by Rwanda,
the terms of trade definitely move in favour of Kenya.
The raising of a country’s national product or income overtime (economic growth) affects the terms of trade of a country. Given the tastes and technology in a country, an increase in its productive capacity may affect favorably or adversely its terms of trade. As a result of economic growth, a
country exports less that will bring much imports in the country.
Changes in tastes
Changes in tastes of people in a country also affect a country’s TOT with another country. Suppose Kenya’s tastes shift from Rwanda’s tea to its own coffee, in this situation, Kenya would export less coffee to Rwanda and its demand for Rwanda tea would also fall. Thus Kenya’s terms of trade would
improve. On the contrary, a change in Kenya’s taste for Rwanda’s tea would increase its demand and hence terms of trade would deteriorate for Kenya.
Changes in technology
As technology changes, terms of trade of a country increase or decrease respectively, for example, if Rwanda uses poor technology compared to Kenya, the terms of trade would be in favour of Kenya against Rwanda. This is because Rwanda would export less and import more in return from
Kenya. However, if Rwanda’s technology advances, it will be better off as it exports more of its tea hence improving the terms of trade.
2.4.6 Consequences of changes in the terms of trade on balance of trade
The terms of trade is the index of export prices divided by index of import
prices Px/Pm (*100)
An improvement in the terms of trade means that export prices are increasing faster than import prices. Therefore, there will be a fall in exports and an increase in quantity of imports. Therefore, it is likely that with lower exports the current account deficit (trade deficit) will get worse, i.e. bigger deficit.
However, it relies on the Marshall-Lerner Condition. If the Marshall-Lerner condition is satisfied, then an improvement in the terms of trade will worsen the current account.
The Marshall Lerner condition states that if demand for exports and imports is relatively elastic i.e. PED x + PED m >1, then an increase in terms of trade will worsen the current account (balance of trade).
Sometimes elasticity of demand varies over time. In the short term demand is often inelastic; in the longer term demand becomes more elastic. Therefore, we can often see a “J Curve effect”, where an improvement in terms of trade worsens current account in short term but improves in the long term.
If a country experiences deterioration in the balance of trade (value of imports increase faster than value of exports), then it may impact upon the terms of trade.
A deterioration in the balance of trade means a country is importing more than exporting. Therefore, more currency will be leaving a country. This would mean an increase in supply of franc and lower demand. Therefore, it is likely to cause devaluation. This would mean cheaper exports and more
expensive imports. We say this would be deterioration in the terms of trade.
However, other factors may be affecting the terms of trade. For example, it depends on whether there is a strong inflow on other aspects of the balance of payments like the trade in services of financial account (capital flows).
Also other factors can affect exchange rates like confidence, speculation and
relative interest rates. Therefore, in the short term a change in the balance
of trade doesn’t necessarily affect the terms of trade although in the long term it probably will.
ཀྵཀྵ Balance of trade: The difference between the value of visible and invisible exports and imports.
ཀྵཀྵ Barter terms of trade: The ratio of the quantity index of exports to the quantity index of imports.
ཀྵཀྵ Deteriorating terms of trade: When a country experiences unfavourable terms of trade for continuous years.
ཀྵཀྵ Favourable terms of trade: This refers to where a country’s export prices are higher than her import prices.
ཀྵཀྵ Income terms of trade: The ratio of income earned from exports to the price of imports.
ཀྵཀྵ Terms of trade: The measure of import purchasing power of a country’s export or the relationship between the price of a country’s export and its expenditure on imports.
ཀྵཀྵ Unfavourable terms of trade: This is when a country’s import prices are higher than her export prices.
ཀྵཀྵ Visible balance: Is difference in value of a country’s physical imports and exports over a period of time.
• Terms of trade
• Forms of terms of trade
• Nature of terms of trade in LDCs
• Improving terms of trade
• Balance of trade
• Meaning and calculations
• Causes of changes in terms of trade
• Consequences of changes in terms of trade on balance of trade
Key unit competence: Learners will be able to analyse the impact of free
trade and trade protectionism in an economy.
By the end of this unit, I will be able to:
⦿ Distinguish between free trade and trade protectionism.
⦿ Discuss the impact of free trade and trade protectionism on an economy.
⦿ Identify the objectives and tools of commercial policy in Rwanda.
⦿ Evaluate the impact of free trade on Rwanda’s economy.
⦿ Analyse the need for trade protectionism in Rwanda and the likely
⦿ Assess the tools of trade protectionism.
⦿ Choose the appropriate trade system for economic development.
Suppose Rwanda trades with the rest of the world freely and easily without any hindrance. Agree together as a whole class over 2 sides, (opposing and proposing sides), debate on the motion that; “Free trade should be adopted between or among countries if they are to gain more
from international trade”.
3.1 Meaning of Free Trade
Free trade refers to the unrestricted purchase and sale of goods and services between or among countries without the imposition of constraints such as tariffs, duties, and quotas. It is a policy followed by some international markets in which countries’ governments do not restrict imports from, or
exports to other countries. In this case, government does not discriminate against imports or interfere with exports by applying some tariffs (to imports) or subsidies (to exports).
According to Adam Smith, the term “free trade” is used to denote “the system of commercial policy which draws no distinction between domestic and foreign commodities and, therefore, neither imposes additional burdens to the latter, nor grants any special favour to the former”.
In other words, free trade implies complete freedom of international trade exchange. In this situation, there are no barriers to movement of commodities among countries and exchange can take its perfect natural course.
3.1.1 Advantages of free trade
Free trade is the term given to trade between nations that takes place without the imposition of barriers in the form of tariffs, quotas or other measures by governments or international organisations. Free trade is
generally considered by economists to be beneficial to interntional trade by encouraging competition, innovation, efficient production and consumer choice etc. Its advantages include among others the following:
• Greater welfare: Free trade avails consumers in a particular country with a wider choice of goods, as they find imported as well as domestic goods on display in the shops. Thus Free trade permits large varieties of consumption goods and improves consumer’s welfare.
• Domestic businesses may also have a chance to reduce costs by buying imported raw materials from abroad or importing new technology without restriction.
• Both individuals and businesses may have access to imported products that do not exist on the domestic market and would not be available without international trade.
• Comparative cost advantage: Free trade is the natural outcome of comparative advantage. It permits an allocation of resources, and manpower in accordance with the principle of comparative
advantage which is just an extension of division of labour i.e. it boosts specialisation between or among countries involved where countries may boost their production by specialising in those industries for which their opportunity cost is lower than for their competitors.
• By engaging in free trade, countries may then export those goods or services that they are most efficient in producing and import the items which other countries may produce more efficiently.
• By concentrating on certain industries, it may be possible for countries and the firms operating in their territory to build up economies of scale that lower their costs and boost productivity.
• Generally, larger organisations may compete more efficiently on the international market by keeping control over their costs of production and managing their supply chain to reduce transport and inventory
• Competition: Free trade increases competition as domestic industries must compete with foreign firms in the same industry as well as other firms in their own country. This compels domestic industries to look for ways to keep costs down by operating more efficiently and gives them
an incentive to innovate and look for improved products, processes and marketing methods.
Thus, this constant search for new ideas and technology induces domestic producers to become more alert and improve their efficiency which enables them to compete on the international market.
• More factor earnings: Under free trade, factors of production will also be able to earn more, as they will be employed for better use i.e. optimally utilised. Hence, wages, interest and rent will be higher under
free trade than otherwise.
• Cheaper imports: Free trade procures imports at cheap rates thus favouring customers through reduced prices in the market.
• Enlarged market: Free trade widens the size of the market as a result of which greater specialisation and a more complex division of labour becomes possible. This brings about optimum production with costs reduced everywhere, benefiting the world as a whole.
• Restricted exploitation: Free trade prevents growth of domestic monopolies and consumer’s exploitation from abroad.
• Free trade encourages the development of efficient entrepreneurs in given countries due to fear of competition, in order to maintain and improve their methods of production and this reduces their costs of
• It promotes international cooperation among countries and mutual understanding. This helps to improve on the atmosphere of peace and good will in the world hence increasing the volume of international trade.
• It widens tax base in the economy as a result of variety of goods and services produced and exchanged.
• It reduces administrative costs of protectionism such as enforcing quotas, foreign exchange control, subsidies etc.
• It eliminates possibilities of trade malpractices like smuggling with its negative effects e.g. reduction in government revenue through taxes.
• It increases employment opportunities since there is free movement of factors of production.
3.1.2 Disadvantages of free trade
• Free trade involves some risks for a country because the international market conditions are out of the control of any government and are often unpredictable and liable to fluctuation.
• As the terms of trade change, a particular industry in a country can fall into decline, resulting in factory closures and unemployment. The labour market is not fully flexible, and workers may have difficulty
retraining for other industries or moving to other locations to find work. Structural unemployment may therefore cause problems for a country’s economy.
• A country may become too dependent on the export of a particular commodity; this leaves the economy vulnerable to fluctuations in the price of that commodity. This is often the case with former colonies
that were compelled to cultivate a limited number of crops such as cereals or mine for a particular metal.
• The price of agricultural products or minerals on the global market fluctuates greatly with changes in international supply and demand which are outside the control of the producer countries.
• The distribution of income between or among countries may be more uneven as a result of free international trade, because some countries will take advantage of natural resources, skilled workforce
or economies of scale to sell their goods and services internationally on favourable terms.
• Within each particular country, free international trade may increase the gap between rich and poor because those who benefit most from international trade may be the rich elites who own the main assets of the country.
• For individual firms trading internationally, the business risks are increased. They are exposed to the risk of falls in demand as a result of changes in taste or fashion and problems resulting from the introduction of new technology or more efficient processes by their international
competitors. Credit risks can be high and the cost of borrowing may increase unexpectedly, making such firms uncompetitive.
• Countries often need to become part of a larger trading bloc to obtain favourable terms of trade internationally, but such economic benefits may come at the cost of a loss of sovereignty, as important decisions affecting the national economy are made by the international trading
bloc rather than by its individual members.
• The inflow of international goods into a country may cause other problems such as an erosion of the national culture.
• A country with unfavourable BOP finds it difficult to overcome this situation under free trade.
• Free trade may encourage interdependence and discourage self-reliance or sufficiency. But in the matter of defence each country should have self -reliance and self- sufficiency as far as possible.
• Competition induced under free trade is unfair and unhealthy. Backward countries cannot compete with advanced countries. i.e. Local infant industries are out-competed by cheap imported products from abroad since they cannot compete favourably with MDCs.
• Free trade may worsen terms of trade for LDCs as it may prove advantageous to developed and technologically advanced countries.
• It reduces tax revenue from imports and exports since there are no tariffs on them.
• It may lead to importation of undesirable commodities in the country which have adverse effects on consumers since there is no check on production and trade of various harmful goods. This undermines the health conditions of local people.
• It leads to dumping of out dated and poor quality commodities and reconditioned technology into the country.
• It may encourage brain drain and capital outflow/flight from LDCs to MDCs.
3.2 Trade Protectionism
1. Use the library or the internet or any other economics source and make more research on international trade, and using the acquired knowledge, analyse the following scenario;
Rwanda exchanges different commodities between and among different countries all over the world.
However, it is not all the time, that she exchanges with other countries at her wish. At times there are restrictions on her imports and exports e.g. through tariffs, quotas, standardisation measures,
border checks, embargos/sanctions, total ban, import and exportmlicenses, bureaucratic delays etc. This limits the number of commodities entering or leaving the country respectively. Basing
on the above scenario, discussion the following:
(a) What economic term is given to international trade with restrictions?
(b) Why do you think countries need to restrict their trade with others?
(c) Identify examples of trade barriers mentioned above that can be imposed on international trade.
(d) What other policy measures can countries use to restrict trade with other countries in international trade?
3.2.1 Meaning of trade protectionism
Trade protectionism refers to the different forms of barriers imposed on international trade to influence the flow or volume of commodities exchanged. It is a commercial policy of safe guarding the national interests through restrictions on international trade. It is used to regulate the inflow
and outflow of commodities between or among countries involved in international trade so as to allow fair competition between imports and goods and services produced domestically.
The doctrine of protectionism contrasts with the doctrine of free trade, where governments reduce as much as possible the barriers to trade.
3.2.2 Reasons for trade protectionism
• To protect infant industries against unfair competition from low cost products from abroad. Infant industries normally produce at high costs and their products are of poor quality and thus need to be protected from cheap and high quality import goods.
• To discourage dumping through tariffs on cheap and expired commodities into the country.
• To increase employment opportunities at home by reducing imports and stimulating domestic demand for local products which contains local industries in operation so that they can keep providing employment.
• To reduce external economic dependence and promote self-sufficiency e.g. through establishment of import substitution industries to produce formerly imported commodities to ensure self-reliance in the economy.
• To increase government revenue through import and export duties, of which revenue can be used to finance government programmes.
• To prevent importation of undesirable commodities and thus protect the health of citizens. e.g. ban of certain drugs, food staffs etc. on health grounds.
• To check imported inflation by increasing tariffs or prohibit importation of commodities facing hyper inflation.
• To encourage full utilisation of domestic resources especially for import substitution industrial strategy.
• To improve on the BOP position of a country i.e. restrictions may be imposed on imports in order to reduce them and improve BOP of a country because it would reduce foreign exchange expenditure abroad thus improving the BOP position of a country.
• For security purposes e.g. a country may impose restrictions like embargo or total ban on importation of strategic commodities like firearms, military hardware etc. to maintain security in the country.
• For retaliation purposes i.e. countries impose restrictions to retaliate against other countries restrictions on her exports.
• For political purposes e.g. discrimination in favour or against certain political groups.
3.2.3 Tools of protectionism (Barriers to Foreign/ International Trade)
Tools of protection are normally grouped into 2 namely;
(a) Tariff barriers and
(b) Non-tariff barriers
(a) Tariff barriers to trade
These are restrictions in form of taxes on imports and exports. They are at
times called customs duties. They are divided into;
(i) Import duties: these are taxes imposed on goods and services imported into the country.
(ii) Export duties: these are taxes imposed on goods and services exported to other countries.
(b) Non-tariff barriers to trade
These are non-tax restrictions or regulations in international trade, they include quotas, import or export licenses, standardisation/quality control, total ban, sanctions, etc.
A variety of policies/tools, both tariff and non-tariff, have been used to shelter home industries, in order to achieve protectionist goals. These include among others the following:
Custom duties or tariff
Tariffs are taxes imposed on imported and exported goods and services. Tariff rates usually vary according to the type of goods imported/exported. When tariffs are imposed on the import of commodities, they discourage import and raise their prices to domestic consumers thus lowering the
quantity of goods imported, to favour local producers.
When they are imposed on the export of commodities, they discourage exports and make the goods available for home producers. With floating exchange rates, export tariffs have similar effects as import tariffs. However, since export tariffs are often perceived as ‘hurting’ local industries, while
import tariffs are perceived as ‘helping’ local industries, export tariffs are seldom implemented.
Tariffs or custom duties may be specific or ad-valoram. When a tariff is based on weight, quantity or other physical characteristics of imported goods, they are called specific. The duty is called ad-valoram when it is based on the value of the goods. Such a duty is fixed as percentage of the foreign or
domestic valuation of imported goods.
Import and export prohibition
The government of a country by law may totally ban the importation or exportation of certain commodities for health reasons or for promoting the growth of certain industries in the country. For instance, when foot and mouth disease attacks cattle, the government totally prohibits the import
of beef from that country.
Exchange rate manipulation
Exchange control implies the government regulations relating to buying and selling of foreign exchange. Under the system of exchange control, all exporters are required to surrender their claims on foreign exchange to the central bank of the country in exchange for domestic currency at the rate
fixed by the government. The government then allots the foreign exchange among the licensed importers. Exchange control may be resorted for correcting an adverse balance of payments or for protecting home industry or for conserving foreign resources or for maintaining the exchange rate at a predetermined parity.
A government may intervene in the foreign exchange market to lower the value of its currency by selling its currency in the foreign exchange market. Doing so will raise the cost of imports and lower the cost of exports, leading to an improvement in its trade balance. However, such a policy is only effective in the short run, as it will most likely lead to inflation in the country, which will in turn raise the cost of exports, and reduce the relative price of import.
These are physical quantities of commodities that are supposed to be exchanged per period of time. It can be import or export quotas. In order to reduce imports, the government of a country may restrict the total imports of a given commodity to a specified amount or specify the maximum amount
of a commodity which can be imported from each producing country. When the total amount of goods to be imported is determined, the government then issues licenses for their import. This device of restricting imports is applied as an alternative to custom duties, for example, they are put on imports to reduce the quantity and therefore increase the market price of imported goods. The economic effects of an import quota are similar to that of a tariff, except that the tax revenue gained from a tariff will instead be
distributed to those who receive import licenses.
The government of a country may give preferential treatment in the rate of taxes to some of the countries. The granting of preferential treatment results in the formation of trade blocs. The countries which are not giving preferential treatment impose high tariffs in relation to the goods of the
discriminating countries, international trade is thus hindered.
When the government of a country takes responsibility of importing all the commodities herself, we say the government has import monopolies.
Another barrier which restricts the import of goods from abroad is the import license. If the government of a country allows the import of foreign commodities to the licensed importers, the trade is very much brought under control. This method is adopted for curtailing/limiting imports and for the
use of discrimination between goods and countries.
Export subsidies are often used by governments to increase/foster exports by providing financial assistance to locally manufactured goods. Subsidies help to either sustain economic activities that face losses or reduce the net price of production exports. Export subsidies have the opposite effect
of export tariffs because exporters get payment, which is a percentage or proportion of the value of the exports. Export subsidies increase the amount of trade, and in a country with floating exchange rates, have effects similar to import subsidies.
This is an extreme form of trade barrier. Embargoes prohibit imports from a particular country as a part of the foreign policy. In the modern world, embargoes are imposed in times of war or due to severe failure of diplomatic relations. A voluntary export restraint This is restriction set by a government on the quantity of goods that can be exported out of a country during a specified period of time. Often the
word voluntary is placed in quotes because these restraints are typically implemented upon the insistence of the importing nations.
Supporters of anti-dumping laws argue that they prevent “dumping” of cheaper foreign goods that would cause local firms to close down. However, in practice, anti-dumping laws are usually used to impose trade tariffs on foreign exporters.
Political campaigns advocating domestic consumption
This for example involves encouraging citizens to consume their home made commodities e.g. the “Buy Rwandan” campaign in Rwanda, which could be seen as an extra-legal promotion of protectionism.
Employment-based immigration restrictions Such as labour certification requirements or numerical caps on work visas.
Government subsidies (in form of lump sum payments or cheap loans) are sometimes given to local firms that cannot compete well against imports. These subsidies are purported to “protect” local jobs, and to help local firms adjust to the world markets.
Countries are sometimes accused of using their various administrative rules (e.g. regarding food safety, environmental standards, electrical safety, etc.) as a way to introduce barriers to imports.
3.2.4 Advantages/arguments for trade protectionism
International trade between or among countries is restricted as seen in Activity 2 of this unit. Agree as a whole class, on opposing and proposing sides, and debate on the motion that;
“Trade protectionism should be adopted between or among countries if they are to gain more from international trade”.
The main arguments which are advanced to support the policy of protectionism are as follows:
(i) Protectionism reduces unemployment: It has been claimed that the use of tariffs discourages imports and raises their prices to the domestic consumers. This leads to diversion of demand for goods
produced at home. The home industry is encouraged and thus more employment is provided for the home population.
(ii) Preserves certain class of population or certain occupation: The government of a country on political or social grounds may favour protectionism for preserving certain classes of people or certain
occupations, for instance, the agrarian population is generally more submissive and loyal to the government than the industrial population. If government wishes to preserve this class of people,
then it will levy heavy import duties on foreign agricultural raw materials thus encouraging them to take more interest in farming.
(iii) Diversification of industries: Protection brings about a balanced economy in the country, if it is given to those industries which do not possess natural superiority. Under free trade, a country will
specialise in the production of those commodities in which it has a relative price advantage over other countries. A country can specialise completely in one or few goods at the most. This means the country will put all ‘her eggs in one basket’, if war breaks out or the export prices of the goods go down, then it will face severe hardships.
(iv) It assists new industries: A newly established industry is just like a newly born baby. As the baby cannot grow up unless it is nursed and well protected, similarly, an infant industry cannot face the blast of
foreign competition unless it is given full protection till it grows to its full structure. Thus protectionism protects infant industries against unfair competition from low cost imported products.
(v) Protectionism guards against dumping: Protectionism discourages dumping of cheap and at times substandard or expired goods in the country. If a foreign firm enjoying a monopolistic power or other
advantages resorts to dumping with a view to capturing foreign markets, then the other countries must protect their industries by levying high protective duties on foreign goods. As selling of goods
under cost (dumping) in other countries is temporary and spasmodic in nature, the anti-dumping duties should also be temporary. If dumping is permanent, then higher tariffs should be imposed
permanently on foreign products.
(vi) Keeps money at home: Protectionism is also advocated on the grossly fallacious argument of “keeping money at home”. When we buy manufactured goods abroad, we get the goods and the foreigners get the money. When we buy the manufactured goods at home, we
get both the goods and the money.
(vii) Protectionism increases government revenue: Protectionism is also advocated on the ground that it raises revenue for the state through import and export duties. If prohibitive high tariffs are imposed on
the import of foreign goods, then they may not be imported at all and the government would not be able to collect the revenue at all. On the other hand, if a moderate protection duty is levied, then it
may serve both the purposes of collecting revenue and protecting industries.
(viii) Protection helps in checking imported inflation by putting sanctions or even total ban on commodities from countries affected by inflation.
(ix) Protectionism conserves national resources: Protection is essential for preserving the natural resources of a country. The unchecked trade often leads to exhaustion of mineral resources which are very vital for the development of the country.
(x) National defense: Protectionism has been advocated for on the ground that in times of war or any other emergency, an entire dependence on foreign goods which are very essential for defense or consumption purposes is very dangerous. It is stated, therefore, that a country must build up her own iron and steel Industry and develop farming
industry even if these involve an economic loss to the country.
(xi) It reduces shortages in the home country by restricting exportation of certain commodities and favouring importation of such commodities which are scarce in the country.
(xii) It encourages full utilisation of domestic resources: If imports are discouraged and demand for domestic goods is encouraged, it encourages domestic producers to use the available idle resources
in order to increase production to meet the domestic demand.
(xiii) It checks on the production and consumption of harmful products in the economy: High import duties on certain imported commodities or their total ban discourages inflow of such commodities on health and moral grounds which improve the standards of living of the citizens of the protecting countries.
3.2.5 Dangers of protectionism
• Market distortion and loss of allocative efficiency: Protectionism can be an ineffective and costly means of sustaining jobs.
• It may lead to trade diversion in case trade protectionism is in form of regional integration i.e. shifting from a cheap source to a high source of imports.
• It may lead to inflation due to high import tariff especially if imports have inelastic demand.
• Trade barriers between countries can spoil the relationship between them.
• It encourages smuggling which reduces government revenue and smuggled goods are always expensive.
• It promotes monopoly i.e. protected domestic industries will become monopolies and create the items of monopoly e.g. low output, inefficiency etc. due to lack of competition.
• Over protectionism leads to inefficiency whereby local producers will produce local quality goods and charge high prices thus cheating customers.
• Higher prices for consumers: Tariffs push up the prices for consumers and insulate inefficient sectors from genuine competition. They penalise foreign producers and encourage an inefficient allocation of
resources both domestically and globally.
• Reduction in market access for producers: Export subsidies depress world prices and damage output, profits, investment and jobs in many lower-income developing countries that rely on exporting primary and manufactured goods for their growth.
• Loss of economic welfare: Tariffs create a deadweight loss of consumer and producer surplus. Welfare is reduced through higher prices and restricted consumer choice since imports are restricted and consumers may end up consuming low quality and expensive commodities. The
welfare effects of a quota are similar to those of a tariff – prices rise because an artificial scarcity of a product is created.
• 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. It leads to high production costs thus high prices for domestic final goods due to the fact that LDCs normally import raw materials and spare parts.
• Regressive effect on the distribution of income: Higher prices from tariffs hit those on lower incomes hardest, because the tariffs (e.g. on foodstuffs, tobacco, and clothing) fall on products that lower income,
families spend a higher share of their income.
• Production inefficiencies: Firms that are protected from competition have little incentive to reduce their production costs. This can lead to inefficiency and higher average costs.
• Trade wars: There is a 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 long run average supply.
• 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 injectionn of demand into the global circular flow of income.
• Second best approach: Protectionism is a second best approach to correcting 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 cause government failure.
• It may lead to scarcity inflation especially if there are high taxes on imports. This limits supply of goods and services in the country and it results into high prices for the few commodities available.
• It may lead to limited inflow of skilled labour into the country if they are highly taxed.
3.3 Commercial Policy
Rwanda, has developed a policy towards international trade in order to improve her domestic industrial welfare because she wants to gain more from its trade. Use the library, the internet, or any other economics source to research on international trade and thereafter present the following
in your class discussion.
(a) What economic term is given to such a policy?
(b) What are the objectives of such a policy in Rwanda?
(c) What policy tools have been adopted in Rwanda to improve her domestic industrial or commercial welfare?
(d) What benefits and costs have the Rwandan economy faced as a result of such a policy?
3.3.1 Meaning of commercial policy
A commercial policy or trade policy or international trade policy refers to all measures regulating the external economic relations of a country, that is, measures taken by a territorial government which has the power of assisting or hindering the exports or imports of goods and services”. It is a set of
rules and regulations that are intended to change international trade flows, particularly to restrict imports.
OR a set of measures adopted by the government of a country towards international trade aimed at improving domestic industrial and commercial welfare.
In modern times, the commercial policy of every country is generally based on the encouragement of exports and discouragement of imports. The exports are encouraged by giving preferential freight rates on exports; consular establishments subsidised merchant marines etc. The imports are
hindered by erecting the tariff wails, exchange controls, quota system, buy at home campaign etc.
Every nation has some form of trade policy in place, with public officials formulating the policy which they think would be most appropriate for their country. Their aim is to boost the nation’s international trade. The purpose of trade policy is to help a nation’s international trade run more smoothly,
by setting clear standards and goals which can be understood by potential trading partners. In many regions, groups of nations work together to create mutually beneficial trade policies.
Trade policy can involve various complex types of actions, such as the elimination of quantitative restrictions or the reduction of tariffs. According to a geographic dimension, there is unilateral, bilateral, regional, and multilateral liberalisation.
According to the depth of a bilateral or regional reform, there might be a free trade area (wherein partners eliminate trade barriers with respect to each other), a customs union (whereby partners eliminate reciprocal barriers and agree on a common level of barriers against non-partners) or
a free economic area.
3.3.2 Objectives of commercial policy
The main objectives of commercial policy are:
• To increase the quantity of trade with foreign nations.
• To preserve, the essential raw materials for encouraging the development of domestic industries.
• To stimulate the export of particular products with a view to increasing their scale of production at home.
• To prevent the imports of particular goods for giving protection to infant industries or developing key industry or saving foreign exchange, etc.
• To restrict imports for securing diversification of industries.
• To encourage the imports of capital goods for speeding up the economic
development of the country.
• To restrict the imports of goods with a view to correct the unfavorable balance of payments.
• To assist or prevent the export or import of goods and services for
achieving the desired rate of exchange.
• To enter into trade agreements with foreign nations for stabilising the
3.3.3 Arguments for commercial policies
There are three proposed arguments offered as explanation for why nations adopt commercial policies:
1. The national defense theory
According to this argument, certain industries such as weapons, aircraft, and petroleum are vital to a nation’s defense. Therefore, proponents of this theory argue that these domestic industries should be protected from foreign competitors so that there is a domestic supply on hand in case of an international conflict. No country would like to be dependent on another country when it comes to weapons.
2. The infant industry theory
Under this argument, it is believed that new domestic industries should be protected from foreign competition so that they will have a chance to develop. Ideally, as the new industry matures and becomes able to compete favourably with other producers on its own, the protections will be removed.
It is intended to help a new domestic industry develop without being immediately crushed by already established foreign industries.
3. The anti-dumping theory
Dumping is simply the selling of a good in a foreign country at a lower price than it is sold for in the domestic market. It is an illegal practice and current laws provide relief in form of tariffs imposed against the violators. Proponents of this argument believe that if dumping is allowed, foreign
producers will temporarily cut prices and drive domestic firms out of the market ans use their monopoly to exploit consumers. Anti-dumping legislation is implemented to prevent this.
3.3.4 Arguments against commercial policy
Increased cost to consumers
One of the most important disadvantages of trade restrictions is that they drive up the price of goods in a country where trade barriers artificially raise the prices of imported products. The apparent effect of trade barriers is to prevent jobs from being lost to foreign competition, which is an argument
used by many special interest groups to justify various types of trade barriers.
In the long run, however, trade barriers force consumers to pay higher prices, since products that could otherwise be made cheaply overseas take more resources to produce domestically.
Increased costs to domestic suppliers
Price hikes due to trade barriers don’t just affect consumers. It also puts a strain on firms which supply raw goods and commodities to domestic industries. Without trade barriers in place, such firms can rely on the law of comparative advantage. This would cost them more to try to find a certain
raw material in their own country than it would to buy from some country rich in a particular commodity. Trade barriers artificially raise prices on foreign commodities, making it less profitable to buy from other countries.
Trade barriers lessen foreign competition, leading to fewer product choices for consumers. The fact that trade restrictions make it more costly to purchase goods from abroad, the domestic industry faces less competition from foreign markets. In the short term, this can save jobs in select domestic
industries. However, in the long run, it leads to customers having fewer choices in the products they buy. It also gives producers less incentive to create high-quality products available to the public.
Over time, one country’s policy of trade restrictions may lead to similar measures taken by foreign governments, who may lose out in the international trade game because they can’t export products for a profit. This cuts down on economic efficiency and competition on a global scale.
3.3.5 Instruments/tools of commercial policy
The main instruments or tools which are now days used for achieving the objectives of commercial policy are as follows:
(1) Tariffs or custom duties
Tariffs or custom duties may be defined as a schedule of duties/taxes authorised by territorial government to be imposed upon a list of commodities that are exchanged. Tariffs are generally classified into three classes. (a)
Transit duties, (b) Import duties, (c) Export duties.
(a) Transit duties are those taxes which are levied upon merchandise passing through the country and consigned for another country. Transit duties are levied for raising money for the government.
(b) Import duties are those taxes which are levied on the goods brought
into the country. Import duties are chiefly levied for revenue or for protection purpose or for both.
(c) Export duties are those taxes which are imposed on the merchandise
sent out of the country. Export duties, like import duties, are also imposed for raising revenue and to restrict the export of certain raw materials as a way of encouraging the development of domestic
industries. Custom duties may be discriminatory with respect to commodities of
countries or it may be non-discriminatory. When a country is pursuing a discriminatory tariff policy, it may give:
(a) Preferential treatment by levying lesser custom duties upon the merchandise of some of the countries. (Or);
(b) Enter into an agreement with other countries for ensuring fair and equal treatment to the imports or exports of each member country.
(c) Join a common market where the merchandise of member countries
are allowed free entry but the goods of other countries are subjected to tariffs.
(2) Bounties/subsidies on exports
In order to promote the export of a particular industry or the export of specified commodities, a government sometimes gives bounties on exports. The bounties or subsidies may be direct or indirect. When subsidy is paid in cash from the public treasury, the bounty is said to be direct and when low
freight rates are charged on the goods to be exported or they are exempted from taxes, etc., the bounty or subsidy is said to be indirect.
(3) Direct restrictions on imports
The government may totally prohibit the importation of certain commodities into the country with the intent of increasing foreign exchange or for protection of domestic industries or for discouraging the use of particular commodities because they are injurious to health. The government may
regulate the imports by means of quotas. Under quota system, the maximumamount of a commodity which can be imported during a particular period is fixed by the government. In recent years, governments of most countries are employing the import quota system because:
(i) It is very flexible and can be adjusted by the administrative authorities without resorting to legal action.
(ii) The home producers know in advance the total quantity of goods to be imported during a particular period, so they can regulate their output accordingly.
It arouses less resentment than the custom duties from the consumers.
(4) Trade agreements
The government of a country may enter into trade agreements with other countries for the exchange of goods. The trade agreements may be bilateral or multilateral. When two countries make a trade agreement for the exchange of goods, the agreement is said to be bilateral. When more
than two countries enter into, trade agreement for ensuring fair and equal treatment to the imports and exports of the member countries, the agreement is called multilateral.
(5) Beggar-my-neighbour policy
This is an economic policy through which one country attempts to remedy its economic problems by means that tend to worsen the economic problems of other countries.
(6) Economic integration
This is the economic cooperation of countries in the same region so as to improve gains from trade among themselves.
This is the legal reduction in the value of a county’s currency in respect to other countries’ currencies. This is done to increase the demand for exports as they become cheap and reduce that of imports since they become expensive.
(8) Import substitution strategy
This is where a country establishes domestic enterprises to produce most of her requirements at home and participate less in international trade. This is done with the intent of reducing import expenditure.
(9) Foreign exchange control
This is the regulation of inflow and outflow of foreign exchange e.g. by fixing the foreign exchange rate.
(10) Basic infrastructure policy
This involves expansion and improvement of domestic infrastructure to promote domestic production.
1. (a) Distinguish between barriers and non-tariff barriers to trade.
(b) Explain the various tools used to restrict international trade in your country.
2. (a) Why do some countries adopt protectionism as an international trade policy?
(b) Examine the problems that may arise from protectionist policies.
3. (a) What is trade liberalisation?
(b) Would you advocate for trade liberalisation, why?
ཀྵཀྵ Anti-dumping duty: A tariff imposed to restrict the importation of goods that are below standard. (dumping)
ཀྵཀྵ Beggar-my-neighbour policy: This a policy adopted by a country to benefit its own economy but harmful to other economies e.g. import restriction, devaluation etc.
ཀྵཀྵ Drawback: This occurs when a duty imposed on certain imports not destined for domestic consumption and subsequently exported, is refunded. This repayment of duty is what is called drawback.
ཀྵཀྵ Effective tariff rate: A tax charged on any imported commodity expressed as a percentage of the value added by the exporting country.
ཀྵཀྵ Export quota: The maximum amount of the product that may be exported in a given period of time.
ཀྵཀྵ Free Trade: Trade in which goods can be exported or imported without any form of restrictions by the state.
ཀྵཀྵ Import quota: This refers to the maximum amount of the product that may be imported in a given period of time.
ཀྵཀྵ Nominal rate of tariff: A tax charged on any commodity expressed as a percentage of the price of the commodity.
ཀྵཀྵ Non-tariff barriers: Devices other than tariffs that are devised to reduce the flow of imports e.g. quotas, total ban, sanctions etc.
ཀྵཀྵ Tariff war: This refers to the competitive use of tariff by countries to change the pattern of international trade in an endeavor to gain individual advantage.
ཀྵཀྵ Tariffs: These are taxes or duties imposed on goods imported or exported either for revenue purposes or for protection or both.
ཀྵཀྵ Trade barriers: Any number of protectionist devices by which governments discourage imports. Tariffs and quotas are the most visible barriers, but in recent years, non-tariff barriers
such as burdensome regulatory proceedings, have replaced more traditional measures.
ཀྵཀྵ Protectionism: Advocacy of policies designed to protect domestic industries from foreign competition, usually in the form of tariffs, import quotas, or export subsidies.
ཀྵཀྵ Quota: A quota is a legal restriction on the quantity of a good that may be imported or exported.
• Free trade
• Advantages and disadvantages
• Trade protectionism
• Reasons for trade protectionism
• Tools of trade protectionism
• Dangers of trade protectionism
• Commercial policy
• Tools of commercial policy
Key unit competence: Learners will be able to analyse the balance of payment position of LDCs.
By the end of this unit, I will be able to:
⦿ Explain the terminologies used in BOP.
⦿ Distinguish between BOP equilibrium and disequilibrium.
⦿ Describe the structure of BOP accounts.
⦿ Analyse the causes of BOP deficit in LDCs.
⦿ Account for the causes of BOP problems in Rwanda.
⦿ Design BOP accounts.
⦿ Design measures to offset BOP deficit/surplus on the BOP accounts.
⦿ Suggest possible solutions to BOP problems in Rwanda.
A cooperative of fruit farmers in Remera sector in Ngoma district normally export their fruits to other countries and in turn receive payments against their sales. They too import different commodities
from other countries where they have to spend on them. Some years ago, earnings from their export sales would be equal to their expenditure on imports. However, of recent, receipts from their fruit exports year after year have been less than expenditure outside on imports. Through research either from the library or the internet, using the case study above, discuss the following:
(a) What term is given to the relationship between earnings from abroad and expenditure abroad as seen in the above case study?
(b) What economic term do we call situations when earnings from abroad are equal and when they are not equal to expenditure abroad?
(c) What is the difference between balance of trade and balance of payment?
4.1 Meaning of Balance of Payment (BOP)
Balance of Payment (BOP) is a statement that summarises an economy’s transactions with the rest of the world for a specified period of time. It is a summary statement of a nation’s financial transactions with the outside world. It shows the relationships between a country’s total expenditure
abroad with its total income from abroad.
The balance of payments, also known as balance of international payments, encompasses all transactions between a country’s residents and its nonresidents
involving goods, services and income; financial claims on and liabilities to the rest of the world; and transfers such as gifts.
These transactions are made by individuals, firms and government bodies. Thus the balance of payments includes all external visible and non-visible transactions of a country. It represents a summation of a country’s current demand and supply of the claims on foreign currencies and of foreign claims
on its currency.
These transactions include payments for the country’s exports and imports of goods, services, financial capital, and financial transfers. It is prepared in a single currency, typically the domestic currency for the country concerned. Sources of funds for a nation, such as exports or the receipts of loans and
investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items.
Thus earnings from both visible and invisible exports and expenditures on both visible and invisible imports are recorded. The difference between visible exports and imports is known as balance of trade while the difference between invisible exports and imports is known as balance of invisible
trade. Therefore, that is why BOP earnings from both visible and invisible exports and expenditure on both visible and invisible imports are recorded.
If total expenditure abroad is greater than total receipts from abroad, there is a BOP deficit or unfavourable BOP. If total receipts from abroad are greater than total expenditure abroad, there is BOP surplus or favourable BOP. Therefore, a BOP deficit and BOP surplus represent BOP disequilibrium.
4.1.1 Difference between balance of trade and balance of payment
Table 1: Difference between Balance of Trade and Balance of Payment4.2 Terminologies used in BOPBOP deficit or unfavourable BOP: This is where total expenditure abroad is greater than total receipts from abroad.BOP surplus or favourable BOP: This is where total receipts from abroad are greater than total expenditure abroad.BOP disequilibrium: This is where receipts from abroad are not equal to expenditures abroad i.e. there is a BOP deficit or a BOP surplus.BOP equilibrium: This is a situation where revenues from abroad are equal to expenditures abroad.BOP accounts: It is a statistical record of the character and dimensions of the country’s economic relationships with the rest of the world.4.3 Structure of BOP AccountsActivity 2Using the library or the internet, research more on Balance of Payments and(a) Describe the structure of the BOP of an economy.(b) Describe the structure of BOP accounts.(c) Using card sort game, group the following items under credit and debit itemsImports of goods and services, exports of goods and services, transfer (or unrequited) payments to foreigners as gifts, grants, etc., unrequited (or transfer) receipts in the form of gifts, grants etc. from foreigners, lending to foreign countries, borrowings from abroad, investments by residents to foreign countries and official purchase of reserve assets or gold from foreign countries and international agencies, investments by foreigners in the country and official sale of reserve assets including
gold to foreign countries and international agencies.FactsThe balance of payments account of a country is a systematic record of all its economic transactions with the outside world in a given year. It is a statistical record of the character and dimensions of the country’s economic relationships with the rest of the world.The balance of payments account of a country is constructed on the principle of double-entry book-keeping. Each transaction is entered on the credit and debit side of the balance sheet. In balance of payments accounting, the practice is to show credits on the left side and debits on the right side
of the balance sheet.When a payment is received from a foreign country, it is a credit transaction while payment to a foreign country is a debit transaction. The principal items shown on the credit side (+) are exports of goods and services, unrequited (or transfer) receipts in the form of gifts, grants etc. from foreigners, borrowings
from abroad, investments by foreigners in the country and official sale of reserve assets including gold to foreign countries and international agencies.The principal items on the debit side (-) include imports of goods and services, transfer (or unrequited) payments to foreigners as gifts, grants, etc., lending to foreign countries, investments by residents to foreign countries and official purchase of reserve assets or gold from foreign countries and
international agencies.These credit and debit items are shown vertically in the balance of payments account of a country according to the principle of double-entry bookkeeping. Horizontally, they are divided into three categories: the current account, the capital account, the official settlements account or the official
reserve assets account and the errors and omission account.4.3.1 Balance of payments accountA balance of payments account is broken down into the current account,
the capital account and the official settlements balance.1. Current accountThe current account of a country consists of all transactions relating to trade in goods and services and unilateral (or unrequited) transfers. Service transactions include costs of travel and transportation, insurance, income and payments of foreign investments, etc. Transfer payments relate to gifts,foreign aid, pensions, private remittances, charitable donations, etc. received
from foreign individuals and governments to foreigners.In the current account, merchandise exports and imports are the most important items. Exports are shown as a positive item and are calculated f.o.b. (free on board) which means that costs of transportation, insurance, etc. are excluded. On the other side, imports are shown as a negative item
and are calculated c.i.f. (costs, insurance and freight) are included.The difference between exports and imports of a country is its balance of visible trade or merchandise trade or simply balance of trade. If visible exports exceed visible imports, the balance of trade is favourable. In the opposite case when imports exceed exports, it is unfavourable.It is, however, services and transfer payments or invisible items of the current account that reflect the true picture of the balance of payments account. The balance of exports and imports of services and transfer payments is called the balance of invisible trade.The invisible items along with the visible items determine the actual current
account position. If exports of goods and services exceed imports of goods
and services, the balance of payments is said to be favourable. In the opposite
case, it is unfavourable.In the current account, the exports of goods and services and the receipts of transfer payments (unrequited receipts) are entered as credits (+) because they represent receipts from foreigners. On the other hand, the imports of goods and services and grant of transfer payments to foreigners are entered
as debits (-) because they represent payments to foreigners. The net value of these visible and invisible trade balances is the balance on current account.2. Capital accountThe capital account of a country consists of its transactions in financial assets in the form of short-term and long-term lendings and borrowings and private and official investments. In other words, the capital account shows international flows of loans and investments, and represents a change in the
country’s foreign assets and liabilities.Long-term capital transactions relate to international capital movements with maturity of one year or more and include direct investments like building of a foreign plant, portfolio investment like the purchase of foreign bonds and stocks and international loans. On the other hand, short- term international
capital transactions are for a period ranging between three months and less than one year.There are two types of transactions in the capital account—private and government. Private transactions include all types of investment: direct, portfolio and short-term. Government transactions consist of loans to and from foreign official agencies.In the capital account, borrowing from foreign countries and direct investment by foreign countries represent capital inflows. They are positive items or credits because these are receipts from foreigners. On the other hand, lending to foreign countries and direct investments in foreign countries
represent capital outflows. They are negative items or debits because they are payments to foreigners. The net value of the balances of short-term and long-term direct and portfolio investments is the balance on capital account. The sum of current account and capital account is known as the
basic balance.3. The official settlements account or official financing account (cash or monetary account)The official settlements account or official reserve assets account is, in fact, a part of the capital account. “The official settlements account measures the change in nations’ liquidity and non-liquid liabilities to foreign official holders and the change in a nation’s official reserve assets during the year.
The official reserve assets of a country include its gold stock, holdings of its convertible foreign currencies and SDRs, and its net position in the IMF”. It shows transactions in a country’s net official reserve assets. This account records all the transactions related to the change in the country’s
foreign exchange reserves. It shows the official foreign reserves in response to current and capital accounts. If there is a surplus on the combined current and capital accounts, this means that the foreign exchange reserves of a country have increased. If there is a deficit on the combined current andcapital accounts, this means that the foreign exchange reserves of a country
have decreased.4. Errors and omissionsErrors and omissions is a balancing item so that total credits and debits of the three accounts must equal in accordance with the principles of double entry book-keeping so that the balance of payments of a country always balances in the accounting sense.In theory, the Capital and Financial Account balance should be equal and ‘opposite’ to the Current Account balance so that the overall Account balances, but in practice this is only achieved by the use of a balancing item called net errors and omissions. This device compensates for various errors
and omissions in the balance of payments data, and which brings the final balance of payments account to zero.The errors may be due to statistical discrepancies & omission may be due to certain transactions not recorded. For example, a remittance by a Rwandan working abroad to Rwanda may not get recorded, or a payment of dividend abroad by an MNC operating in Rwanda may not get recorded and so on.
The errors and omissions amount equals to the amount necessary to balance both the sides.4.3.2 Financing deficits/how to correct a BOP deficitActivity 3Having researched more on Balance of Payment, using the gained knowledge and from your own understanding, share the following among yourselves in class.(a) The measures that should be taken to(i) offset a BOP deficit(ii) correct a BOP surplus.(b) …………… are items/measures used to correct BOP deficit while ……………are items used to offset BOP surplus.(c) Establishing BOP balance by using the above measures is called …………. while the expenditure aiming at gettingrid of the BOP surplus through the above means is known as ……………………..FactsA BOP deficit is a situation where aggregate demand for foreign exchange exceeds aggregate supply for foreign exchange. Methods to offset a BOP deficit should aim at reducing foreign exchange expenditure, increasing foreign exchange earnings and simultaneous reducing foreign exchange
expenditure and increasing foreign exchange earnings. The financing of a deficit is achieved by:1. Selling gold or holdings of foreign exchange, such as US dollars, yen or euros, etc.2. Borrowing from other Central Banks or the International Monetary Fund (IMF).3. Using the foreign exchange reserves available.4. Sale of public assets abroad .5. Seeking aid and grants from other countries.6. Attracting foreign investments into the country.7. Import substitution strategy.8. Restrictive monetary policy i.e. reduces the amount of money in circulation.9. Improving the service industry e.g. tourism.10. Devaluation.
11. Export promotion strategy — increasing the volume of exports and
improving the quality of exports.
12. Increasing taxes and reducing government expenditure i.e. fiscal
13. Direct control — tariffs; quotas; exchange controls; complete ban,
i.e. import restrictions.
Establishing BOP balance by using the above measures is called
accommodating BOP and the items used to get rid of a BOP deficit are
known as accommodating items.
4.3.3 Financing surplus/ how to offset a BOP surplus
A BOP surplus is a situation where aggregate supply of foreign exchange
exceeds aggregate demand for it. A surplus will be disposed off by:
1. Buying gold or currencies.
2. Paying off debts.
3. Building a stock of foreign exchange reserves.
4. Lending to foreign countries.
5. Providing aid and grants to other countries.
6. Purchase and storage of durable goods.
7. Opening current account deposits in foreign banks.
8. Purchase of short and long term securities from abroad.
9. Direct investments abroad.
The expenditure aiming at getting rid of the BOP surplus through the above
means is known as autonomous expenditure and the items used are known
as autonomous items.4.3.4 Why does the balance of payments always balance?When all components of the BOP accounts are included, they must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counterbalanced in other ways – such as by funds earned
from its foreign investments, by running down Central bank reserves or by receiving loans from other countries.Current account balance + Capital account balance + net errors and
omissions = 0
Net errors and omissions simply reflect mistakes. Assuming no mistakes
are made, then the formula will look like this.Current account + Capital account = 0, hence Current account = Capital
account.In other words, if a country has a deficit on the current account (more imports than exports) then it must have an equal and opposite surplus on the capital account (and vice versa).While the overall BOP accounts will always balance when all types of payments are included, imbalances are possible on individual elements of the BOP, such as the current account, the capital account excluding the Central bank’s reserve account, or the sum of the two. Imbalances in the
latter sum can result in surplus countries accumulating wealth, while deficit nations become increasingly indebted.The term balance of payments often refers to this sum: a country’s balance of payments is said to be in surplus (equivalently, the balance of payments is positive) by a specific amount if sources of funds (such as export goods and bonds sold) exceed uses of funds (such as paying for imported goods
and paying for foreign bonds purchased) by that amount. There is said to be a balance of payments deficit (the balance of payments is said to be negative) if the former are less than the latter. A BOP surplus (or deficit) is accompanied by an accumulation (or decumulation) of foreign exchange
reserves by the Central bank.Under a fixed exchange rate system, the Central bank accommodates those flows by buying up any net inflow of funds into the country or by providing foreign currency funds to the foreign exchange market to match any international outflow of funds, thus preventing the funds flows from
affecting the exchange rate between the country’s currency and other currencies. Then the net change per year in the Central bank’s foreign exchange reserves is sometimes called the balance of payments surplus or deficit. Alternatives to a fixed exchange rate system include a managed float
where some changes of exchange rates are allowed, or at the other extreme a purely floating exchange rate (also known as a purely flexible exchangerate). With a pure float, the Central bank does not intervene at all to protect or devalue its currency, allowing the rate to be set by the market, and the Central bank’s foreign exchange reserves do not change, and the balance of payments is always zero.However, during transactions, a country may register a deficit or surplus. If a country runs a deficit for a long time and for successive years, such a country is said to face BOP problems and this is common in LDCs.4.3.5 Causes of BOP deficits in LDCsActivity 4Basing on the case study in Activity 1 of this unit, and using round table techniques, analyse the causes, effects and solutions to BOP deficits in LDCs.FactsBOP deficits in LDCs are caused by both socio-economic and political
factors as below:1. Narrow export baseMost LDCs, Rwanda inclusive, are basically agricultural countries. Their export base is narrow. Major exports are coffee, rice, cotton, raw wool, leather, fish etc. They concentrate in relatively low value added products which fetch low prices hence less earnings in return.2. Consumption oriented societyMost people in LDCs are consumption oriented. Due to rapid rise in population and increased consumption habits, the domestic manufactured goods are mostly consumed in the country. The exportable surplus is declining. Governments have to import more in order to support the alarming
population thus causing much expenditure abroad leading to BOP deficits.3. Poor technology in less developed countriesThere is less modernisation, balancing and replacement of machinery in the industrial sector in most LDCs’ economies. This has led to a fall inproduction and decline in the quality of products that has adversely affectedexports.4. Production of primary productsMost LDCs produce and export primary products which are both price and income inelastic thus earning less from international trade. The share of value added goods must increase to earn foreign exchange and turn the trend of adverse balance of payment. The production of value added goodsis at basic stage in developing countries that leads to adverse BOP.5. DevaluationThe repeated devaluation of developing countries’ currencies has not helped in the increase of exports. It has made the imported inputs more costly. The demand for their goods in the international market is inelastic. As such, devaluation as a tool for boosting exports is not effective.6. Tough competitionStiff competition from the foreign value added goods has reduced the volume of foreign trade in developing countries. There is availability of higher standard goods at lower prices in international market. It causes reduction in LDCs’ exports, which result in deficit in BOP.7. Increase in prices of inputsThe increase in the prices of fuel, electricity, high capital costs of imported machinery, exchange rates etc, have inflated LDCs’ product prices. The high costs of both imported capital goods and industrial raw materials, on which domestic industries are heavily dependent, and the inflationary impact ofthe rise in the prices of inputs are not helping in achieving the export targets set in each financial year and this results into deficit in BOP.8. Heavy protectionist policies by MDCsProtectionist policies by developed countries on LDCs like imposition of tariff and non-tariff barriers have adversely affected LDCs’ exports. The advanced countries of the world have imposed technical barriers such as patents, copyrights, trade-marks and designs etc. on their imports. LDCs have to upgrade the standard of purity and quality to compete for their products in the international market thereby leading to less foreign exchange earnings by LDCs and consequently BOP deficits.9. Fall in terms of tradeThe import unit values are higher than the export unit values for most LDCs.
A decline in terms of trade causes imbalance in the balance of payment.10. Foreign debts servicingHigh expenditure on debt servicing since most countries in LDCs are poor
and mostly rely on foreign resources especially through borrowing.11. Importation of capital goodsMost LDCs import expensive capital goods for rapid industrialisation of their countries in order to build up the economy. The heavy import of machinery has considerably increased the import bill and has adversely affected balance of payment.12. High demonstration effectMost LDCs have import oriented economies through demonstration effect leading to high demand for capital and luxurious goods thus leading to high foreign exchange expenditure which adversely affect BOP position.13. Rise in oil pricesThe sharp rise in the prices of oil in the recent past is taking a big amount of the foreign exchange earnings. LDCs import bill of petroleum group increases year after year leading to BOP problems in LDCs.14. Political instabilities and insecurityExperience shows that political instability and disturbances in LDCS cause large capital outflows and hinder inflows of foreign capital. For example, the wide spread political instabilities and insecurity in most LDCs discourage production which reduces on the volume of exports. On the other hand,
LDCs have to purchase modern weapons for their defense at a very high cost from different countries, this increases burden on their BOP and it becomes adverse.15. Fluctuations in the prices of exports of LDCsSince LDCs normally export primary products, their prices keep on fluctuating in the international market. This causes BOP deficit when export prices fall.16. Imported inflationSince most LDCs import expensive capital goods, it makes production expensive, leading to expensive exports which reduces their demand in the external markets. Thus, less foreign exchange is earned from them.17. High population growth in LDCsHigh population growth in poor countries adversely affects their BOP because it increases the needs of the countries for imports and decreases their capacity to export.18. Natural calamities in LDCsNatural calamities like bad weather reduce the yields from the agricultural sector as their dominant export sector thus leading to adverse BOP.19. Poor infrastructure in most LDCsMost LDCs have poorly developed and insufficient socio-economic infrastructure which causes supply rigidities (difficulties). This lessens export volume and consequently less earnings from them.20. Changes in fashions, tastes and preferences in the world market.This has reduced on the demand for LDCs exports thus adversely affecting their BOP position.21. Unfair International Commodity Agreement (ICA)Weak ICA has less bargaining powers in the international markets leading to low export prices and low earnings from exports hence BOP deficits.22. Insufficient export promotion institutions
Institutions to promote export sector through encouraging vent for surplus in most LDCs are so insufficient.23. Inflation in most LDCs’ economiesMost LDCs’ economies are hit by inflation which makes their exports expensive leading to low demand for them in the international markets thus earning less from them.24. Depreciation of LDCs currenciesPersistent depreciation of LDC’s currencies has made their products (exports) cheap and made imports expensive thus high foreign exchange expenditure.4.3.6 Effects of BOP deficits1. If a BOP deficit is financed through borrowing, it is said to be more unsustainable. This is because borrowing is unsustainable in the long term and countries will be burdened with high interest payments.
Countries with large interest payments have little left over to spend on investment.2. If a country runs a BOP deficit on the current account, it has to run a surplus on the financial / capital account. This means foreigners have an increasing claim on your assets, which they could desire to
be returned at any time. For example, if you run a current account deficit, it could be financed by foreign multinationals investing in your country or the purchase of assets. There is a risk that your best assets
could be bought by foreigners, reducing long term income.3. A current account deficit may imply that you are relying on consumer spending, and are becoming uncompetitive. This leads to lower growth of the export sector.4. A Balance of payments deficit may cause a loss of confidence by foreign investors. Therefore, there is always a risk, that investors will remove their investments causing a big fall in the value of your
currency (devaluation). This can lead to decline in living standards and lower confidence for investment.5. A trade deficit can lead to currency weakness and higher imported inflation which worsens the BOP position further.6. Deficit countries need to import financial capital to achieve balance. This in the long run leads to capital flight in form of profit repatriation.7. Trade deficit can lead to loss of jobs in home-based industries as investors are discouraged from investing in the country.8. Countries may run short of vital foreign currency reserves. This worsens the value of the local currency and people would lack confidence in it and resort to investing in foreign countries. As a result,
economic development is retarded.9. Currency weakness can lead to capital flight / loss of investor confidence. This creates savings-investment gap which calls for seeking aid and grants, and its negative consequences, that hinders
further long term investments in the country thus underdevelopment.10. A deficit leads to lower aggregate demand and therefore slower growth in development. This is due to the fact that people are earning less from their exports which reduces their purchasing power.11. In the long run, persistent trade deficits undermine the standard of living. As it becomes less profitable to export, importing would also be problematic due to less earnings from trade thus worsening the standard of living of people.12. A trade deficit is a reflection of lack of price / non-price competitiveness.4.3.7 Measures to correct disequilibrium in BOP in LDCSSustained or prolonged deficit has to be settled by short term loans or depletion of capital reserve of foreign exchange and gold. The following remedial measures are recommended:1. Export promotion: Exports should be encouraged by granting various bounties/ incentives to manufacturers and exporters. At the same time, imports should be discouraged by undertaking import substitution and imposing reasonable tariffs.2. Import restrictions and Import substitution i.e. by increasing import duties on commodities similar to those produced at home, encouraging domestic industries to use local raw materials.3. Controlling inflation through restrictive monetary policy: Inflation (continuous rise in general price levels) discourages exports and encourages imports. Therefore, government should check inflation
and lower the prices in the country.4. Exchange control: Government should control foreign exchange by ordering all exporters to surrender their foreign exchange to the Central bank and then ration out foreign exchange among licensed importers.5. Devaluation of domestic currency: It means legal reduction in the external (exchange) value of domestic currency in terms of a unit of foreign exchange. This makes domestic goods cheaper for the
foreigners. Devaluation is done by a government order when a country has adopted a fixed exchange rate system. Care should be taken that devaluation should not cause rise in internal price level.6. Depreciation: Like devaluation, depreciation leads to a fall in external purchasing power of home currency. Depreciation occurs in a free market system where demand for foreign exchange far exceeds the supply of foreign exchange in foreign exchange market of a country (Mind, devaluation is done in fixed exchange rate system.)7. Encouraging investors through establishing institutions that help and advise them on investment prospects in the country.8. Opening new markets and making regional groupings to widen markets for their exports.9. Ensuring political stability and security so as to ensure a conducive investment climate and a reduction on military expenditure.10. Training local manpower e.g. through universal primary and secondary education and setting up different training institutions so as to increase skills of indigenous manpower and to reduce foreign expatriates.11. Rehabilitation and construction of socio-economic infrastructure to increase supply of exports.12. Seeking and being granted a debt relief so as to reduce expenditure on debt servicing.13. Population control programmes should be enforced so as to reduce on dependence burden and import expenditure.14. Innovations and inventions to improve on technology so as to improve on productivity increase the volume of exports and foreign exchange earnings as well.15. The tourism industry should be strengthened as an export diversifier.16. Strengthening the ICA so as to increase the export volume and bargaining power as well.17. Economic legalisation so as to increase domestic productivity and export volume.4.4 BOP Position in RwandaThe current account balance in relation to GDP was consistently negative throughout the 1990s, not only because of the 1994 genocide. Although the economy improved dramatically post-1994, export earnings in the early 2000s were hindered by low international coffee prices, deprivingthe country of hard currency. Rwanda’s external debt stood at 1.3 billion dollar in 2000. In the same year, Rwanda became eligible for 810 million dollars in debt service relief from the IMF/World Bank Heavily Indebted Poor Countries (HIPC) initiative. In 2002, the IMF approved a three-year 5 million dollar loan to Rwanda.The US Central Intelligence Agency (CIA) reports that in 2001, the purchasing power of Rwanda’s exports was 61 million USD while imports totaled 248 million USD resulting in a trade deficit of 187 million USD.
The International Monetary Fund (IMF) reports that in 2001 Rwanda had exports of goods totaling 93 million USD and imports totaling 245 million USD. The services credit totaled 50 million USD and debit 189 million USD. The following table summarises Rwanda’s balance of payments as
reported by the IMF for 2001 in millions of US dollars.In 2014, Rwanda’s overall balance of payments recorded a deficit of 185.7 million USD as a result of a 15.3 percent increase in imports of goods which more than offset an increase of 6.8 percent in exports. Capital grants increased from 234.5 million USD in 2013 to 306.9 million USD in 2014.Current account balance (% of GDP) in RwandaCurrent account balance (% of GDP) in Rwanda was last measured at -7.47 in 2013, according to the World Bank. Current account balance is the sum of net exports of goods, services, net income, and net current transfers.4.4.1 Causes of BOP deficits in RwandaActivity 5Basing on the knowledge gained from your previous research on international trade and BOP specifically and from your own analysis, what do you think are the causes, effects of B.O.P problems in Rwanda?
Which measures should be used to correct the adverse B.O.P problems in Rwanda?FactsBOP deficits in Rwanda are caused by both socio-economic and political factors as below;1. Narrow export base: Rwanda, like any other LDC, is basically an agricultural country. Thus her export base is narrow. Major exports are coffee, rice, cotton, raw wool, leather, fish etc. she concentrates in relatively low value added products which fetch low prices hence less earnings in return.2. Consumption oriented society: Most people in Rwanda are mostly consumption oriented. Due to rapid rise in population and increased consumption habits, the domestic manufactured goods are mostly
consumed in the country. The exportable surplus is going on declining. The government has to import more in order to support the alarming population thus causing much expenditure abroad leading to BOP
deficits.3. Poor technology in less developed countries: There is less modernisation, balancing and replacement of machinery in the industrial sector in Rwanda. This has led to a fall in production and
decline in the quality of products and this has adversely affected exports.4. Less income from international trade: Rwanda produces and exports primary products which are both price and income inelastic thus earning less from international trade. The share of value added goods must increase to earn foreign exchange and turn the trend of adverse balance of payment. The production of value added goods is at basic stage in Rwanda that leads to adverse BOP.5. Rwanda faces stiff competition from the foreign value added goods which has reduced the volume of her foreign trade. There is availability of higher standard goods at lower prices in international market. It causes reduction in Rwanda’s exports, which result in deficit in BOP.6. Foreign debts servicing: There is high expenditure on debt servicing since Rwanda is among the poor countries and it mostly relies on foreign resources especially through borrowing.7. Importation of expensive capital goods: For rapid industrialisation of her economy, Rwanda imports expensive capital goods in order to build her economy to build up the economy. The heavy import ofmachinery has considerably increased the import bill and has adversely affected her balance of payment position.8. Most Rwandans prefer more of imported commodities than homemade commodities. This implies that Rwanda has an import oriented economy through demonstration effect leading to high demand for
capital and luxurious goods. This leads to high foreign exchange expenditure which adversely affects it’s BOP position.9. The sharp rise in the prices of oil in the recent past is taking a big amount of the foreign exchange earnings. Rwanda’s import bill of petroleum goods increases year after year leading to BOP problems10. Fluctuations in the prices of Rwanda’s exports: Rwanda, like any other LDCs normally exports primary products whose prices keep on fluctuating on the international market. When export prices fall,
she faces BOP deficit.11. High expenditure in production: Rwanda imports expensive capital goods which make her to produce expensively. This makes their exports expensive reducing their demand in the external markets, thus
less foreign exchange earnings from them.12. High population growth in Rwanda adversely affects her BOP position. It increases the needs for imports and decreases her capacity to export.13. Natural calamities like bad weather reduce the yields from the agricultural sector as Rwanda’s dominant export sector thus leading to adverse BOP.14. Poor infrastructure: Rwanda has poorly developed and insufficient socio-economic infrastructure. This has led to supply rigidities thus less export volume and therefore less earnings from them.15. Changes in fashions, tastes and preferences in the world market. This has reduced on the demand for Rwanda’s exports thus adversely affecting her BOP position.16. Unfair International Commodity Agreement (ICA): Weak ICA has less bargaining powers in the international markets leading to low export prices and low earnings from exports hence BOP deficits.17. Insufficient export promotion institutions to promote export sector through encouraging vent for surplus in Rwanda.18. Rwanda’s economy has been hit by inflation in the recent past which has made her exports expensive leading to low demand for them in the international markets thus earning less from them.19. Persistent depreciation of Rwanda’s currency has made its products (exports) cheap while her imports are expensive and this leads to high foreign exchange expenditure.4.4.2 Effects of BOP deficits in Rwanda1. Rwanda’s BOP deficit financed through borrowing has left little capital to spend on investment. This has left Rwanda’s economy to be more unsustainable since it is burdened with high interest payments.2. Rwanda in trying to correct her BOP deficit has attracted foreign multinationals to invest in the country or to purchase assets. This means that foreigners have an increasing claim on Rwanda’s assets,
which they could desire to be retained at any time. This risks her best assets to be bought by foreigners, thus reducing long term income.3. A Balance of payments deficit has caused foreign investors to lose confidence in Rwanda. This has put Rwanda at a risk that investors will remove their investments causing a big fall in the value of her
currency. This may lead to decline in living standards and lower confidence for investment.4. A trade deficit has led to currency weakness and higher imported inflation which may worsen the BOP position further.5. Rwanda has imported financial capital to achieve balance of payment and this in the long run may lead to capital flight in form of profit repatriation.6. Trade deficit has led to loss of jobs in home-based industries as investors are discouraged from investing in the country.7. Rwanda has run short of vital foreign currency reserves which has worsened the value of her local currency and this has made people lack confidence in it and resorted to investing in foreign countries.
As a result, economic development has been retarded.8. Currency weakness has led to capital flight / loss of investor confidence. This has created savings-investment gap which has called for seeking aid and grants, and its negative consequences, that hinders further long term investments in the country thus underdevelopment.9. Trade deficit has led to lower aggregate demand and therefore slower economic growth. This is due to the fact that people are earning less from their exports which has reduced their purchasing power.10. BOP deficit has undermined the standard of living of people in Rwanda as it has become less profitable to export, importing also has become problematic due to less earnings from trade thus worsening the standard of living of people.4.4.3 Measures to correct adverse BOP in Rwanda1. Labour intensive industriesLabour intensive industries should be established, because labour is cheaper in Rwanda, these industries can be set up at lower cost. The products of these industries can be exported.2. Manufactured goodsInstead of exporting primary goods like raw cotton, coffee tea etc., Rwanda should export manufactured goods like textiles and garments, leather goods, food products and electrical goods which earn more foreign exchange. Or should process their primary products which adds value to them thus more
foreign exchange earnings.3. Reduction in export dutiesThis step will make our export competitive in the international market. Foreigners will prefer to import from Rwanda because of low prices.4. Quality productsMany of our goods cannot be exported because of poor quality. Rwanda should improve the quality of its products according to international standard. This can be done by improving on technology and training of labour-force to improve on their skills5. Export marketingExport promotion agencies should be made more active. Rwanda has already done this. There are Export Promotion Agencies, Export Development Fund and Export Processing Zones etc. All these are playing their effective role to increase export and to correct the BOP deficits.6. Pricing of goodsIt is necessary for increasing exports that goods should be produced under optimal conditions and offered at competitive prices in international market.8. PackingHigh quality packing is essential for promoting exports. If packing is not attractive and durable, it will not capture foreign market. Thus packaging should be improved to make our exports more attractive and gain market on top of their good quality.9. Joint ventureEstablishing industries with joint venture of foreign investors can also push up the export sector. The products of these industries can be sold in the foreign market.10. Import of only essential itemsOnly essential items should be imported which are needed for our industrial production. Import of luxuries should be banned. People should be educated to come out from the complex of foreign goods.11. Exchange controlExchange control is also an important step to minimise the imports. Exchange control should be followed, so that there is no wastage of foreign exchange to importation of un-necessary commodities and luxuries.12. Substitutes for imported itemsImport substitutes should be manufactured in the country through setting up of import substitution industries. If home production of chalk, fertilisers, paper, steel, edible oil and electrical goods are increased, there will be less need for such imports.13. Decrease in consumptionTaxes should be imposed to reduce the consumption of many imported items. Rich people in our country are spending freely on unnecessary imported consumer items. So, foreign exchange reserves are wasted.14. Control of smugglingBlack markets should be eliminated. The government of Rwanda should take strong and strict measures to eliminate markets of smuggled goods through anti-smuggling units.15. Population controlMany of our problems are arising due to fast increase in population. Sincere efforts should be made to decrease population growth rate. People should be educated in this regard. This is aimed at reducing on foreign exchange expenditure on imported commodities to cater for the alarming population.16. Infrastructural developmentRwanda should rehabilitate and develop socio-economic infrastructure to increase production and exchange of goods and services across national borders to increase foreign exchange earnings.17. Political stability and securityRwanda should ensure peace and security in all parts of the country so as to attract investors, exploitation of resources which increases production activities. This will increase the volume of exports and it will also reduce on the expenditure on importation of military hard ware.Unit assessment1. (a) To what extent is inflation a cause of the BOP problem in LDCs?(b) What policy measure would you suggest to reduce BOP
problems in Rwanda?2. (a) What fiscal and monetary measures may be employed to reduce inflationary pressures on the external balance of payments?(b) What is the relationship between the domestic economy and the balance of payments?3. Balance of payments must always “balance”. With reference to your country, explain the existence of either “favourable or unfavourable” balance of payments position.
ཀྵཀྵ Absorption approach: The analysis in the BOP based on comparing expenditure with domesticoutput.
ཀྵཀྵ Accommodating items in BOP: The different items on the BOP account that are used to curb short term deficits.
ཀྵཀྵ Autonomous items: Items / measures to offset a BOP surplus on the BOP account.
ཀྵཀྵ Balance of payment: This is a relationship between a country’s foreign exchange expenditure and her foreign exchange earnings in any given year.
ཀྵཀྵ Balance of payment accounts: A summary record of a country’s transactions that involve payments or receipts of foreign exchange.
ཀྵཀྵ Balance of trade: Relationship between a country’s visible exports and visible imports.
ཀྵཀྵ Balancing item: Is one which appears in figures of BOP explaining the discrepancy between the current and long term capital account and the net change in reserves, overseas holdings
and other items that make up the balance of monetary movements.
ཀྵཀྵ BB line: A locus of levels of the interest rate and real national income for which the desired current account Balance of Payment surplus just equals the desired capital account deficit.
ཀྵཀྵ Capital account: This refers to the record of international transactions related to movement of long and short term
ཀྵཀྵ Capital movement: Movement of money capital from one country to another.
Balance of Payment (BOP) 129
ཀྵཀྵ Capital account: The part of the balance of payment accounts
which shows the movement of capital over a period of time.
ཀྵཀྵ Capital stock: The total amount of physical goods existing at a particular time period which have been produced for use in the production of other goods.
ཀྵཀྵ Current account: The portion of a balance of payments which shows the market value of a country’s visible and invisible exports and imports with the rest of the world.
ཀྵཀྵ Economic sanction: Coercive measures of an economic nature adopted in international affairs to enforce collective decisions.
ཀྵཀྵ Embargo: Any prohibition imposed by government upon commerce or freight.
ཀྵཀྵ Exports: Goods and services produced in one country and sold to another country. They are a source of foreign exchange.
ཀྵཀྵ Export promotions: An outward-looking policy. It refers to deliberate government policies to expand the volume of exports.
ཀྵཀྵ Favourable balance of trade: When the value of visible goods exported by a country is higher than that of the goodsimported.
ཀྵཀྵ Import surplus: A situation that exists when the value of imports exceeds that of imports (unfavourable trade balance).
ཀྵཀྵ Individualism: A belief that individuals are the best judges of their own interests.
ཀྵཀྵ Official financing: This means items that represent international transactions involving the Central bank of a country whose BOP are being recorded.
ཀྵཀྵ Price- specie-mechanism: Automatic BOP adjustments mechanism under gold standard.
ཀྵཀྵ Trade gap: This occurs when the quantity of imported goods exceeds that of visible exports. It is the amount by which visible imports exceed visible exports.
ཀྵཀྵ Unfavourable balance of trade: This is when the visible goods imported by a country are greater in value than those exported.
• Balance of payment
• Terminologies used
• Equilibrium and disequilibrium BOP
• Structure of BOP accounts
• How to offset BOP deficit or surplus
• Causes of BOP deficit
• Effects of BOP deficit
• Possible solutions to BOP deficits in LDCs
• A case study of Rwanda
• Causes of BOP deficits
• Effects of BOP deficits
• Policy measures to overcome BOP deficits
Key unit competence: Learners will be able to analyse the various forms of exchange rate determination and their impact in economic development.
By the end of this unit, I will be able to:
⦿ Identify the various forms of exchange rate systems.
⦿ Examine the factors influencing exchange rate.
⦿ Explain the impact of each exchange rate system on the economy.
⦿ Explain the reasons and necessary conditions for successful devaluation.
⦿ Identify the effects and limitations of successful devaluation in LDCs.
⦿ Make comparison of the various exchange rate systems.
⦿ Analyse the effects of exchange rate on the prices of commodities on the market in Rwanda.
⦿ Use the conditions for devaluation to achieve economic stability.
⦿ Justify the choice of the appropriate exchange rate system in economic development.
⦿ Appreciate the exchange rate of Rwandan currency in terms of other currencies.
⦿ Advocate for devaluation to increase the level of economic activities.
(a) Use the library, the internet or any other economics source, make more research on international trade and use your understanding and analysis to match the following currencies
with their countries.
Uganda Rwanda Francs
South Africa Pound sterling
European Union Krone
(b) In your own view, what do you think foreign exchange is?
(c) Akaliza was going to visit her relatives in Canada for her December holiday, she was forced to exchange her Francs into Dollars to facilitate her travel to Canada. Why do you
think she never used Rwandan francs for her travel?
(d) What ways can we may earn currencies from other countries?
(e) Carefully look at photo a, b, c, d and e. Mention the countries in which these currencies are used.
5.1 Meaning of Foreign Exchange
Foreign exchange is the exchange of one currency for another or the conversion of one currency into another currency. Foreign exchange also refers to the global market where currencies are traded virtually around the clock. The term foreign exchange is usually abbreviated as “forex” and
occasionally as “FX.” Countries in international trade use currencies other than their own. This is because not every currency is acceptable in the world market. Payment of transactions among countries is carried out in hard or convertible currencies like US dollars, Japanese Yen, pound starlings etc.
Foreign exchange transactions encompass everything from the conversion of currencies by a traveller at an airport kiosk to billion-dollar payments made by corporations, financial institutions and governments. Transactions range from imports and exports to speculative positions with no underlying
goods or services. Increasing globalisation has led to a massive increase in the number of foreign exchange transactions in recent decades.
The global foreign exchange market is the largest financial market in the world, with average daily volumes in the trillions of dollars. Foreign exchange transactions can be done for spot or forward delivery. There is no centralised market for foreign exchange transactions, which are executed
over the counter and around the clock.
5.1.1 Terms used in forex
• Foreign exchange rate: The rate/price at which given currencies are exchanged for each other in the foreign exchange market.
• Exchange rate regime: The way in which an authority manages its currency in relation to other currencies in the foreign exchange market.
• Floating exchange rate: A system where the value of currency in relation to others is allowed to freely fluctuate subject to market forces.
• Fixed exchange rate: A system where a currency’s value is tied to the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.
• Pegged float exchange rate: A currency system that fixes an exchange rate around a certain value, but still allows fluctuations, usually within certain values, to occur.
• Nominal exchange rate: This is the rate at which a currency is traded for another.
• Real exchange rate: This is the purchasing power of different currencies i.e. how much goods and services in the domestic country that can be exchanged for goods and services in the foreign countries.
• Spot market: This is where the price of a currency is established on the trade date but money is exchanged on the value date.
• Floating currency: This is a currency that uses a floating exchange rate.
• Forward market: A forward market/ trade is any trade that settles further in the future than spot.
• International currency exchange: The rate at which two currencies in the market can be exchanged.
• Currency exchange: A business that allows customers to exchange one currency for another.
• Currency pairs: Two currencies with exchange rates that are traded in the retail.
• Foreign exchange market: The foreign exchange market is a market where participants buy, sell, and exchange trillions of dollars’ worth of currencies daily.
• Foreign exchange reserves: Foreign exchange reserves are reserve assets held by a central bank.
• Foreign exchange risk: Foreign exchange risk is the chance that an investment’s value will decrease due to changes in currency exchange rates.
5.1.2 Sources of foreign exchange
• Export of goods and services.
• Transfer payments e.g. grants and aid.
• Remittances and transfers of nationals working abroad.
• Selling of public assets abroad.
• Capital inflow through direct and foreign investments.
• Profits, dividends and interests repatriated from investments abroad.
• Funds from charitable organisations e.g. UNICEF.
• Private foreign bank deposits in the local banks.
• Borrowing from international countries, companies and individuals.
5.1.3 Factors that Influence foreign exchange rates
Using the library, the internet or any other economics source, research and share in your class discussion; what you think could be the factors that determine the strength of a currency over other countries’ currencies in a forex market.
The foreign exchange rates, just like other financial assets, fluctuate every day as the demand and supply of different currencies changes. These changes in exchange rates affect everyone either directly or indirectly. Some of the important factors that influence the exchange rates include the following:
• Inflation rates: A country with low inflation rate compared to another country will see its currency appreciate compared to the other country. This is because, in the country where the inflation rate is low, the prices of goods and services are increasing at a slower rate. That country’s exports will become more competitive thereby increasing the demand for that currency. At the same time, the foreign goods in
that country will become less competitive and imports will reduce, thereby decreasing the demand for the foreign currency.
• Interest rates: A higher interest rate causes the country’s currency to appreciate. This is because the country with higher interest rates can offer better rates to lenders thereby attracting more foreign capital,
which causes the exchange rates to rise.
• Balance of payments: Changes in current accounts also impact the
value of currency. A current account deficit indicates that the country’s
value of imports is more than the value of exports. Therefore, to balance
the trade, it requires more foreign currency than it receives through
exports. The country will therefore borrow foreign capital which will
increase the demand for foreign currency and the domestic currency
will depreciate. This can be changed only by either increasing exports
by making the goods more attractive/competitive or by reducing
• Public debt: A country with huge public debt attracts less foreign capital. This is because, high public debt leads to increase in inflation which erodes the country’s currency value. Additionally, if there is a
risk of default by the country, investors will sell their bond holding in the open market. This leads to a depreciation of the currency value.
• Political uncertainty and economic instability: This again is related to how foreign investors percieve the prospects of the country. If the country has high political uncertainty or economic instability, it will
attract less foreign capital compared to a country that offers high stability to investors.
• Government intervention: Sometimes even the governments can intervene to artificially maintain a currency value at a certain level. For example, China has kept its currency undervalued by buying dollars
so that its exports are attractive.
• Speculation: The movement in exchange rates is also influenced by the current sentiment in the market. For example; if the general sentiment is that the Euro will rise in value, the speculator will start buying Euro to make a profit causing the value of Euro to rise. Similarly, if there is speculation that a country’s interest rates will rise, it will cause a lot of speculative activity in the foreign exchange market leading to the rise in currency value.
5.1.4 Forms/ types of exchange rates/ exchange rate systems/ regimes (factors influencing each)
There are different forms of exchange rates that may be adopted by different countries or in the same country. Visit the library, the internet or any other economics source, research and;
(a) Analyse the different types of exchange rate an economy can adopt.
(b) Explain the forms you think are adopted in Rwanda’s exchange market and their likely advantages and disadvantages.
Some of the major types of foreign exchange rates are as follows:
1. The gold standard exchange rate system.
2. Fixed exchange rate system (or Pegged exchange rate system).
3. Flexible exchange rate system (or Floating exchange rate system).
4. Managed floating rate system.
1. The gold standard
Under the gold standard, a country’s government declares that it will exchange its currency for a certain weight in gold. In a pure gold standard, a country’s government declares that it will freely exchange currency for actual gold at the designated exchange rate. This “rule of exchange” allows
anyone to go to the central bank and exchange coins or currency for pure gold or vice versa. The gold standard works on the assumption that there are no restrictions on capital movements or export of gold by private citizens across countries.
Because the central bank must always be prepared to give out gold in exchange for coin and currency upon demand, it must maintain gold reserves. Thus, this system ensures that the exchange rate between currencies remains fixed. The main argument in favour of the gold standard is that it ties the
world price level to the world supply of gold, thus preventing inﬂation
unless there is a gold discovery.
Advantages of the gold standard
• It solves the BOP problems automatically because of the automatic adjustment mechanism.
• There is neither currency appreciation nor currency depreciation since every unit of currency is tied to gold.
• There is economic stability because of a stable exchange rate system.
• Liquidity problem is easily solved because of free flow of gold.
• There is smooth international trade because gold is used as a medium of exchange.
Disadvantages of the gold standard exchange rate system
• It is difficult for the central bank to control money supply.
• When gold is in excess supply, it loses exchange value.
• It does not favour economic growth in countries with small quantities of gold.
2. Fixed exchange rate system
Fixed exchange rate system refers to a system in which exchange rate for a currency is fixed by the government at a specific rate in relation to a specific foreign currency for a period of time. Once this rate is fixed, it becomes illegal to exchange a currency at a parallel rate.
The basic purpose of adopting this system is to ensure stability in foreign trade and capital movements. To achieve stability, government undertakes to buy foreign currency when the exchange rate becomes weaker and sell foreign currency when the rate of exchange gets stronger. For this,
government has to maintain large reserves of foreign currencies to maintain the exchange rate at the level fixed by it.
Under this system, each country keeps value of its currency fixed in terms of some ‘External Standard’. This external standard can be gold, silver, other precious metal, another country’s currency or even some internationally agreed unit of account. When the value of a domestic currency is tied to
the value of another currency, it is known as ‘Pegging’. When the value of
a currency is fixed in terms of some other currency or in terms of gold, it is known as ‘Parity value’ of currency’. The fixed exchange rate may be undervalued or overvalued. i.e. undervalued
exchange rate is where the exchange rate is fixed below the market or equilibrium value of the currency. For example, if the equilibrium rate is 600frw for a dollar and the rate is fixed at 300frw for a dollar, it leads to cheap imports and expensive exports hence BOP deficits.
Overvalued exchange rate is where the exchange rate is fixed above the
market or equilibrium value of the currency. This leads to undervalued local currency which makes exports cheap and imports expensive hence improved BOP position. In a fixed exchange rate system when the external value of the currency is increased, we refer to this as revaluation (increase in the value of domestic currency by the government) and when the external value of the currency is reduced, we refer to this as devaluation (reduction in the value of domestic currency by the government).
Countries can either choose a single currency to peg to, or a “basket” consisting of the currencies of the country’s major trading partners.
The pegged float exchange rate can be
• Crawling bands: The market value of a national currency is permitted to fluctuate within a range specified by a band of fluctuation. This band is determined by international agreements or by unilateral decision by the central bank. Generally, the bands are adjusted in response to economic circumstances and indicators.
• Crawling pegs: This is an exchange rate regime, usually seen as part of a fixed exchange rate regimes that allows gradual depreciation or appreciation in an exchange rate. The system is a method to fully utilise the peg under the fixed exchange regimes as well as the flexibility under the floating exchange rate regime. It is designed to peg at a certain value but, at the same time, to “glide” in response to external market uncertainties.
• Pegged with horizontal bands: This system is similar to crawling bands, but the currency is allowed to fluctuate within a larger band of greater than one percent of the currency’s value.
Advantages of a fixed exchange rate system
1. It encourages international trade by ensuring certainty and predictability of prices with goods involved in international trade.
2. It ensures stability in foreign exchange markets by avoiding constant appreciation and depreciation within the currency which ensures confidence in the domestic market.
3. It minimises speculation in the economy by both goods and foreign exchange markets and it’s negative effects.
4. It reduces exploitation and cheating of foreign exchange buyers and holders by money markets and foreign exchange markets.
5. It facilitates planning since income in form of foreign exchange is assessed and predicted according to the rate of exchange.
6. The government can easily use foreign exchange rate to minimise BOP deficits i.e. by raising the exchange rate and devaluing the domestic currency which makes exports cheap and imports expensive hence improvement in the BOP position.
7. It encourages long term capital inflows in an orderly manner thus encouraging investment.
8. Central banks can acquire credibility by fixing their country’s currency to that of a more disciplined nation.
9. Fixed exchange rates impose a price discipline on nations with higher inflation rates than the rest of the world. As such, a nation is likely to face persistent deficits in its balance of payments and loss of reserves.
10. Fixed exchange rate prevent debt monetisation, or fiscal spending financed by debt that the monetary authority buys up. This prevents high inflation.
11. On a micro-economic level, a country with poorly developed or illiquid money markets may fix their exchange rates to provide its residents with a synthetic money market with the liquidity of the markets of
the country that provides the vehicle currency.
Disadvantages of a fixed exchange rate system
1. It is expensive to maintain because it requires a lot of foreign exchange reserves.
2. It requires strict monitoring of the economy which is affected by insufficient personnel.
3. It may lead to inflation if it is fixed above the market price or deflation if it is fixed below the market price.
4. It reduces speculation and hence reduces business profitability.
5. It discourages competition in foreign exchange markets and this leads to inefficiency.
6. The announced exchange rate may not coincide with the market equilibrium exchange rate, thus leading to excess demand or excess supply.
7. A central bank needs to hold stocks of both foreign and domestic currencies at all times in order to adjust and maintain exchange rates and absorb the excess demand or supply.
8. The cost of government intervention is imposed upon the foreignexchange market.
9. It fails to identify the degree of comparative advantage or disadvantage of the nation and may lead to inefficient allocation of resources throughout the world.
10. Fixed exchange rate does not allow automatic correction of imbalances in the nation’s balance of payments since the currency cannot appreciate/depreciate as dictated by the market. It is too rigid so
that the exchange rate system cannot respond to the changes in the economy. For example; when there is BOP surplus or deficit.
11. There exists a possibility of policy delays and mistakes in achieving external balance.
3. Flexible/floating/free/market/ fluctuating exchange rate system
Flexible exchange rate system refers to a system in which exchange rate is determined by forces of demand and supply of different currencies in the foreign exchange market. The value of currency is allowed to fluctuate freely according to changes in demand and supply of foreign exchange. There is
no official (government) intervention in the foreign exchange market.
The exchange rate is determined by the market, i.e. through interactions of thousands of banks, firms and other institutions seeking to buy and sell currency for purposes of making transactions in foreign exchange. When the supply of foreign exchange is equal to the demand for it, then
equilibrium exchange rate is determined.
From the figure above, forex equilibrium is obtained when import spending is equal to export revenue. i.e. at point ‘e’ in the above diagram. This means that the demand for forex is equal to its
supply. Fe is equilibrium currency rate while Qe is equilibrium quantity demanded and supplied of currencies. Below or above Fe, the demand for and supply of currencies isn’t equal thus causing
disequilibrium in the forex market (forex shortages or excess).
From the above figure, when the exchange rate is high e.g. at f1, exports of the country will be cheap leading to more exports and hence leading to more supply of foreign exchange. This will lead
to foreign exchange rate to fall e.g. to f2 and as it falls, exports will become expensive hence few exports and less supply of foreign exchange leading to scarcity of foreign exchange. This
will force foreign exchange rate to rise until it reaches equilibrium foreign exchange rate where the supply of and demand for foreign exchange are equal, hence the exchange rate will be determined
In a floating exchange rate system, when the external value of the currency increases, then this is called currency appreciation (low exchange rate) and when the external value declines, this is called currency depreciation (high exchange rate)
Advantages of a flexible exchange rate system
• The system is automatic and therefore does not need a lot of government involvement and expenditure on foreign exchange rate monitoring.
• Trade imbalances i.e. surpluses and deficits are corrected automatically by the forces of demand and supply.
• It responds to the rapid economic changes quickly since it is automatic.
• It encourages proper resource utilisation into their optimal use.
• It increases the volume of international trade because of the freedom in the foreign exchange markets.
• It encourages efficiency and competition in the money market.
Disadvantages of a flexible exchange rate system
• It creates uncertainty as it fluctuates and discourages international trade and capital movements.
• It creates instabilities in the foreign exchange rate thus affecting planning and hence discouraging economic growth and development.
• It encourages speculation in the foreign exchange where foreign exchange buyers may be cheated.
• It is inefficient in correcting BOP deficits as the domestic demand for exports and imports remain inelastic.
• It leads to fluctuations in export earnings which affects budgeting of the government.
• It discourages long term contracts between borrowers and lenders which may discourage investments and economic growth and development.
• In case there is no understanding between governments about manipulation of exchange rates, it may result into war of exchange rates with each country trying to establish favourable rates with other
Causes of currency depreciation in LDCs
• Decline in the volume and value of exports (primary products).
• Decline in foreign exchange inflow due to political instabilities.
• Decline in international payments in the domestic banks.
• Reduction in the volume of grants, aid and loans.
• Increase in demand for imports especially capital inputs and essential consumer goods.
• Increase in foreign exchange expenditure e.g. on embassies, official trips abroad etc.
• Government policy of devaluation.
• High rates of inflation which reduces domestic production.
Effects of currency depreciation
• It increases the volume of exports hence foreign exchange earnings.
• It encourages export promotion and import substitution industrialisation which reduces foreign exchange expenditure.
• It encourages domestic investments because the cost of production is low at home.
• It reduces the BOP problems because the expenditure on imports reduces.
• It increases capital inflow and foreign investments.
• It encourages exploitation of domestic resources because it is cheaper to produce at home.
• It reduces the volume of imports which might lead to scarcity of goods and services in the economy.
• It makes projected planning difficult and distorted.
• It increases the cost of production at home because of expensive imported inputs.
• It increases the country’s indebtedness abroad.
• It worsens BOP problems since imports become more expensive than exports.
• It leads to loss of confidence in the local currency.
• It may lead to over exploitation of resources since it is cheaper to produce at home.
4. Managed/Dirty/Floating exchange rate system
Traditionally, International monetary economists focused their attention on the framework of either Fixed or a Flexible exchange rate system. With the end of Bretton Woods’s system, many countries have adopted the method of Managed Floating Exchange Rates.
It refers to a system in which foreign exchange rate is determined by market forces and central bank influences the exchange rate through intervention in the foreign exchange market. It is a hybrid of a fixed exchange rate and a flexible exchange rate system.
In this system, central bank intervenes in the foreign exchange market to restrict the fluctuations in the exchange rate within certain limits. The aim is to keep exchange rate close to desired target values. For this, central bank maintains reserves of foreign exchange to ensure that the exchange rate
stays within the targeted value.
When the exchange rate rises above the upper limit, the central bank intervenes and buys off the surplus or excess foreign exchange. When the
exchange rate falls below the lower limit, the central bank supplies the needed foreign exchange. However, this depends on the purpose on which the foreign exchange is needed.
Advantages of the managed dirty floating exchange rate system
• It helps a country to export and import commodities of national priority.
• Government can reduce unfair competition of foreign currencies over domestic currencies.
• It reduces excessive foreign exchange fluctuations in the foreign exchange market.
• It reduces speculation hence reducing hoarding and scarcity of foreign exchange.
Disadvantages of the managed dirty floating exchange rate system
• It is expensive for the government to supervise and maintain maximum
and minimum margins.
• It limits free convertibility of currencies hence limiting the flow of exports and imports.
• It doesn’t allow free exchange of currencies to determine the real value.
• It might lead to malpractices such as over invoicing imports and under invoicing exports.
5.2 Foreign Exchange Liberalisation
Suppose you are called upon to advise, as a person who has studied economics on the issue that; Rwanda wants to liberalise her foreign exchange market, how would you do it?
Foreign exchange liberalisation is the lessening of government regulations and restrictions in an economy in exchange for greater participation by private entities in foreign exchange market. Forex liberalisation offers the opportunity for the private sector to compete internationally, contributing
to GDP growth and generating foreign exchange
Advantages of foreign exchange liberalisation
• It reduces bureaucracy and corruption hence making it easier for investors to obtain foreign exchange.
• It encourages forex inflow because of free movement of currencies.
• It increases employment opportunities from several forex bureaus.
• Forex bureaus facilitate customers in forex transfer to and from abroad.
• It reduces over valuation and under valuation of currencies.
• It reduces government expenditure in managing the exchange rates.
• It eliminates black marketing in the forex market.
• It encourages competition in the forex market which improves service delivery.
• Forex bureaus give technical advice to customers with regard to investment and bureau dealings.
Disadvantages of foreign exchange liberalisation
• It undermines the local currency because citizens tend to prefer foreign currencies to domestic currencies.
• It results into capital outflow in form of profit repatriation in case forex bureaus are owned and operated by foreigners.
• It encourages speculation which leads to hoarding and shortages of forex.
• It leads to forex instability because of excessive competition in the forex market.
• Government loses full control over forex which may worsen BOP problems.
• It leads to misallocation of resources e.g. if scarce forex is used to import luxuries.
5.3 Foreign Exchange Reserves
Using the knowledge and understanding from Activity 1 of this unit on the sources of forex in an economy, discuss and share with the rest of the class what you think about the following:
(i) Forex reserves.
(ii) The importance of forex reserves in an economy.
(iii) The causes of forex shortages in Rwanda.
5.3.1 Meaning of foreign exchange reserves
Foreign exchange reserves refer to the money or claims in foreign exchange, gold or Special Drawing Rights (SDRs) kept in the central bank and other international financial institutions.
5.3.2 Importance of foreign exchange reserves
• They help in stabilising exchange rates e.g. buying of excess domestic currency.
• They are used in making international payments such as national obligations abroad debt servicing.
• They are used to back the issue of local currency.
• They can be used in periods of economic hardships such as disasters, wars etc.
• They can be used to upset the BOP deficit.
• They can be used to finance foreign investments and diplomatic missions abroad.
• They can be used to purchase essential inputs or commodities.
• They are used to show the country’s economic strength in international market.
5.3.3 Causes of foreign exchange shortages in LDCs
The following are the causes of foreign exchange shortages in LDCs:
• Exportation of low value primary products which fetch little foreign exchange.
• Importation of expensive commodities such as capital equipment and oil from oligopolies and monopolies.
• High marginal propensity to import due to demonstration effect.
• High foreign debt problems hence high debt servicing ratio.
• Capital outflow by multinational corporations and profit repatriation by foreign investors.
• LDCs have few investments abroad.
• Excessive employment of expatriates who are paid highly in foreign currencies.
• High population growth rates which reduce the quantity of export and increase the volume of imports.
• A large subsistence sector which doesn’t contribute to export revenue.
• Political instability and insecurity which discourage capital inflow.
• Poor government policies such as a large public sector which drains foreign exchange.
• High rates of inflation which discourages production and export.
• Protectionist policies of MDCs against LDCs products which reduces export earnings.
• Weak capital markets which do not encourage capital inflow.
• Depletion of foreign exchange reserves to finance persistent budget deficit.
• Low absorptive capacity which attracts little aid.
5.3.4 Foreign exchange control
The government of Rwanda, through the Central Bank of Rwanda and its monetary policy instruments, has always controlled forex in the country. From your own analysis, what do you think could be the
rationale behind your government’s control of foreign exchange and what are the likely effects?
Foreign exchange control means the control over the factors that determine the rate of exchange in a free and independent atmosphere. It is the state regulation excluding the free play of economic forces from the foreign exchange market. The government of a country can adopt a number of measures to control fluctuations in the rate of exchange. These measures include:
1. The establishment of official rates of exchange for the sale and purchase of foreign currencies.
2. The enforcement of regulations relating to the surrender to the government whatever foreign exchange people of a country possess.
3. Allocation of foreign exchange between people requiring it.
4. Restricting the use of domestic currency by foreigners and entering into agreement with other governments to make payments according to specified procedures for example, exchange clearing agreements.
A complete exchange control system implies subjecting all international payments to control by the government. To check the evasion of exchange control provisions, export licenses are issued to be presented to the customs officials before shipment of exports is permitted.
The term exchange control is used in two senses, namely the narrow and wide contexts. In its narrow sense, it refers to all those measures which restrict foreign exchange business; In the wide sense, it refers to all those activities of the government which influence the rate of exchange or the transactions
involving payments or receipt of foreign exchange. These can be:
1. Imposition of controls on the exchange rate, on the movements of capital,
2. The management of exchange equalisation accounts, and
3. Trade and payments agreements with other countries.
Exchange control can either be full or partial. When the exchange control is full, i.e. complete, it implies that the government restricts the sale and
purchase of all foreign currencies. Under the partial exchange control, the government restricts the sale and purchase of either a single currency or a few selected foreign currencies. Generally, exchange control in practice is only partial in character.
5.3.5 Rationale for exchange control
Exchange control measures may be adopted for the following reasons:
• Stabilisation: This is the most important objective of exchange control. It is geared towards ironing out temporary fluctuations in the rates of exchange. The objective should be to prevent those fluctuations of the free market rate which are purely adventitious or temporary without intervening with changes of rates which correspond to real alterations in the respective values of different currencies.
• Checking capital flight: An important objective of exchange control is to check the flight of capital from a country. Capital flight means the action of the holders of securities and bank deposits in a country
to convert their cash holding into foreign exchange. If this is allowed to continue unabated, it may lead to total exhaustion of a country’s scarce foreign exchange reserves.
• Ensuring availability of foreign exchange: Exchange control is also adopted to ensure the availability of foreign exchange to enable the government to import essential commodities.
• Acquiring foreign exchange to service debt: Exchange control measures are also adopted by countries to acquire foreign exchange for debt servicing and repayment of foreign loans.
• Protecting home industries: Countries also adopt exchange control measures with the objective of protecting home industries against foreign competition. In this connection, the government restricts the
imports and thus provides an opportunity to the domestic industries to grow and develop without the trouble of foreign competition.
• Raising government revenue: This is done by purchasing foreign exchange at lower rates and selling it at high rates.
• Increasing economic confidence so as to attract aid and grants from international financial institutions.
• To conserve forex which can be used for strategic projects in future.
• Reducing dependence on external economies by making exchange rates for imports expensive.
5.3.6 Advantages of exchange control
The following are some of the advantages of exchange control:
• Exchange control helps in preventing erratic capital outflows.
• It helps in correcting the disequilibrium in the balance of payments by restricting imports.
• It makes the imports of essential capital goods possible by making available the needed foreign exchange.
• It helps in the prevention of imports of non-essential consumer goods.
• It aids in controlling the multiplication of foreign companies and also in regulating their operations in national interest.
• It helps in protecting domestic industries from foreign competition.
• It maintains exchange rate stability.
• It controls speculative activities in foreign exchange.
• It improves the capacity of the government to repay its external loans.
• It acts as a source of revenue for the government.
• It conserves foreign exchange which can be used to meet strategic, defense and planning needs of the country.
• It acts as an instrument of anti-deflationary policy.
5.3.7 Disadvantages of exchange control
Exchange control is associated with the following disadvantages among
• Exchange control reduces the volume as well as the value of international trade by restricting imports and by the restriction of exports owing to the retaliation by other countries.
• It creates inefficiency, red tape and corruption among people connected with its administration.
• It entails huge expenses because many people have to be employed for its smooth functioning.
• It leads to inequities because in some cases the restrictions are very low from which some countries gain more while in other cases the restrictions are heavy, resulting in smaller gains for some countries.
• It gives rise to smuggling and the creation of ‘black markets’ in foreign exchange.
Different countries’ currencies have different values in the forex market. At times this is done intentionally by the government to make her country’s currency lose value in respect to other countries’ currencies
based on different reasons. Using the library, the internet or any other economics source, research and share about the following in your whole class discussions:
(a) What economic term is given to an act by the government of making her country’s currency lose value in respect to other countries’ currencies?
(b) The conditions necessary for the success of such action by the government.
(c) When and why should countries do so?
(d) Effects of such an act by the government on an economy.
5.4.1 Meaning of devaluation
Devaluation refers to deliberate government policy of reducing the value of domestic currency in the face of external country’s currency i.e. the domestic currency becomes cheaper in relation to other countries’ currencies.
Devaluation is only possible under the fixed exchange rate system. It takes place when there is fundamental disequilibrium in the balance of payment. The devaluating country has no supply rigidities but it is facing marketing difficulties.
5.4.2 Why LDCs devalue their currencies
LDCs devalue their currencies due to the following reasons:
• To make exports cheap and hence lead to more export, there by leading to increase in foreign exchange earnings.
• To collect balance of payment problems by reducing imports by making them expensive. This is because importers need more of the local currency in order to obtain forex. Thus they either have to import less
or charge high prices so that low quantity is demanded.
• To attract foreign and domestic investors as it becomes cheaper to invest in the economy as little forex can be exchanged for a lot of the local currency. Again due to devaluation there is export promotion
leading to increased market for output produced by investors.
• To protect domestic infant industries from competition by cheap imports by making similar imports expensive.
• To promote self-sufficiency by encouraging import substitution industries and reduce dependency on imports from other countries.
• To conserve foreign exchange as it discourages imports and minimises foreign exchange outflow and therefore can reduce on the problem of trade shortage.
• To increase on the level of productivity and thus domestic resource utilisation. This calls for employment of idle resources.
• To increase on employment opportunities at home through increased domestic production.
• Some LDCs undertake devaluation in order to fulfill IMF conditionalities in order to receive loans.
• To check on imported inflation because after devaluation, inflation hit imports and they become too expensive. This discourages importers.
• To increase the nominal income of the producers of primary products that are exported.
5.4.3 Conditions necessary for devaluation to be successful
A number of conditions have to be made for devaluation to be successful
• The demand for exports must be price elastic. That is, a small price reduction resulting from devaluation will lead to a proportionate large increase in their purchase and more forex will be earned.
From the figure above, before devaluation forex earning from exports are OQ1aP1 and after devaluation forex earnings increase to OQ2bP2. Rectangle OQ2bP2 is bigger than rectangle OQ1aP1
meaning that more forex earnings are as a result of a fall in the price from OP1 to OP2 which increased quantity exported from OQ1 to OQ2.
• The demand for imports should be price elastic so that imports appear to be expensive after devaluation and less of them are demanded hence less forex expenditure.
From the figure above, before devaluation, the price for imports was OP1 and the quantity imported was OQ1. After devaluation, the price for imports increased from OP1 to OP2 and the quantity
demanded of imports fell from OQ1 to OQ2 thereby reducing the
forex expenditure from OP1aQ1 to OP2bQ2. Rectangle OQ2bP2
is smaller than rectangle OQ1aP1.
• The supply of export in the devaluating country should be elastic such that as demand for exports increases, more quantity of exports should be supplied.
• The supply of imports should be price elastic in that when there is devaluation and there is a decrease in demand for imports, the quantity supplied for them should be able to reduce greatly.
• There should be no inflation in devaluing country so that after devaluation, exports will be cheap and attractive to foreign importers hence more will be imported.
• There should be no restrictions on exports from the devaluing countries otherwise this would limit exports and hence earnings from exports.
• There should be no counter devaluation or other countries should not retaliate by devaluing their currency because this will neutralise the intention of devaluing countries.
• There should not be trade union to put pressure on wages and increase the cost of production.
• There should be excess capacity in devaluing country such that as exports are produced, imports are discouraged and more output is produced to substitute import.
• The marginal propensity to import in devaluing country should be low..
• The devaluing country should be able to compete favorably in the world market.
• The devaluing country should be politically stable so as to ensure stable production.
• There should be stability in the exchange rate system i.e. fixed exchange rate regime.
5.4.4 The Marshall-Lerner devaluation condition
The M-L condition examines the price elasticities of demand for exports and imports of a particular country, for example Rwanda experiences a depreciation of its currency, If foreigners’ demand for exports from Rwanda is relatively elastic, then a slightly weaker franc should cause a dramatic increase in foreign demand for Rwandan output, causing export income in Rwanda to rise dramatically. On the other hand, if Rwanda’s demand for
imports is highly price elastic, then a slightly weaker franc should likewise cause Rwanda’s demand for imports to decrease drastically, reducing greatly Rwanda’s expenditures on imports. If the combined elasticities of demand for exports and imports is elastic (i.e. the co-efficient is greater than 1), then
a depreciation of a nation’s currency will shift its current account towards surplus. This is the Marshall-Lerner Condition.
Marshall-Lerner Condition: If PEDx + PEDm > 1, then depreciation
or a devaluation of a nation’s currency will shift the balance on its current account towards surplus.
What if the Marshall Lerner Condition is not met? Demand for exports and imports may not always be so responsive to changes in exchange rates. Imagine a scenario where a weaker Franc does little to change foreign demand for Rwanda’s output. In this case income from exports may actually decline (in real terms, since the Franc is weaker) as the Franc depreciates. Likewise, if Rwanda’s demand for imports is highly inelastic, then more expensive imports will only minimally affect Rwanda’s demand for imported
goods, in which case expenditures on imports may actually rise as they become more expensive. In this case, where the elasticities of demand for exports and imports are highly inelastic, a depreciation of the currency will actually worsen a trade deficit. Rwanda’s import expenditures will go up
while export income from abroad will decline shifting the current account further into deficit.
5.4.5 Effects of devaluation
1. It increases the volume of exports by making them cheap.
2. It increases the volume of foreign exchange earnings by increasing on the volume of exports.
3. It increases the capital inflow e.g. through foreign investment because it becomes cheaper to produce in the devaluing country.
4. It improves balance of payment position due to increased forex earning and reduced forex expenditure on import.
5. It leads to an increase in domestic investments which increase exploitation of idle resources.
6. It increases employment opportunities at home, e.g. through export promotion and import substitution industries.
7. It leads to development of domestic infant industries by making similar imports expensive.
8. It promotes self-sufficiency by encouraging exports and reducing the volume of imports.
1. It worsens the balance of payment position because external market
for LDCs products is poor.
2. It leads to imported inflation since devaluation increases prices of imports yet imports in LDCs have inelastic demand.
3. It leads to capital flight by nationals because they will tend to invest outside to earn high value foreign currency.
4. Due to inflation that may result from devaluation imported inputs become expensive which discourages production yet LDCs heavily depend on imported capital.
5. It increases borrowing rate and debt servicing burdens by LDCs since
they need a lot of income in terms of domestic currencies in form of
6. It leads to persistent government budgetary deficit as a result of increased expenditure on imports which increases expenditure due to devaluation that makes import expensive.
7. Saving levels can decline in economy because liquidity preference to meet high price of imported commodities thus causing inflation.
8. It affects fixed income earners because where as prices are increasing due to devaluation their income remains constant hence low real incomes.
9. If it is common, it may discourage investors who lose confidence in the local currency.
10. It may reduce the standards of living of people due to shortage of commodities in the economy as a result of restricting imports yet
LDCs heavily depend on imports.
11. It also discourages competition by protecting infant industries which may provide low quality commodities yet charging high prices.
12. It may hinder technological transfer because of the increase in the cost of imported commodities.
5.4.6 Success of devaluation policy in LDCs
Most LDCs which have tried devaluation as a measure to solve their BOP
problems have not succeeded due to the following reasons:
• Domestic elasticity of demand of their imports is low because of high population growth rate.
• LDCs export commodities are price and income inelastic because they are mainly essential commodities.
• There is protectionism of LDCs products by MDCs so as to increase employment in MDCs.
• The elasticity of supply of LDCs products is low because of domestic supply rigidities.
• LDCs have competitive supply i.e. supply of similar commodities; they therefore tend to carry out competitive devaluation.
• LDCs have inadequate co-operant factors especially capital and entrepreneur hence low production for exports.
• Most LDCs experience high rates of inflation which discourage export due to high costs of production.
• LDCs pursue unfavourable economic policies like trade legalisation which increases the inflow of imports.
• There is high degree of malpractice for example smuggling because of inefficient administrative machinery hence increasing the volume of imports.
• Political instability and insecurity in LDCs discourage domestic production and foreign investment.
• There is counter devaluation among LDCs i.e. other countries retaliate by devaluing their currency.
• There is high marginal propensity to import due to the desire for essential capital input and imported raw materials..
• LDCs exports are limited by low export quotas in the international commodity agreement (ICA).
• There are weak export promotion institutions in LDCs which reduce the benefits of devaluation.
• LDCs face foreign exchange instabilities because of adapting liberal exchange rate systems.
1. (a) When and why is devaluation carried out?
(b) How is devaluation of a currency supposed to cure an economy’s balance of payments current account deficit?
2. (a) Given that exchange rate is 1US $=850 Rwf. Calculate the new exchange rate after devaluation of the francs by 20%.
(b) Under what circumstances may devaluation fail to solve the balance of payments problem in an economy?
3. Explain how fluctuations in exchange rates can effect an economy.
ཀྵཀྵ Appreciation: An increase in the value of a currency against other currencies under a floating exchange rate system.
ཀྵཀྵ Bureau de change: A business whose customers exchange one
currency for another.
ཀྵཀྵ Competitive devaluation: A situation where several countries devalue their currencies in an attempt to gain a competitive advantage over one another.
ཀྵཀྵ Currency pair: The quotation of the relative value of a currency unit against the unit of another currency in the foreign
ཀྵཀྵ Digital currency exchange: Market makers which exchange fiat currency for electronic money.
ཀྵཀྵ Depreciation: Capital consumption wearing out of capital stock during production. It is the cost of replacing equipment wornout in production.
ཀྵཀྵ Devaluation: Reduction in the official exchange rate, which results into the reduction of the price of domestic currency to the foreign countries and increase in the price of the foreign
ཀྵཀྵ Exchange control: Government regulations relating to the buying and selling of foreign exchange. It is normally in order to prevent a worsening balance of payments position.
ཀྵཀྵ Exchange rate: A price of one national currency in terms of
ཀྵཀྵ Fixed exchange rates: System in which exchange rates between trading countries are pegged at a certain rate. It is maintained through reserve flow, action by the central banks, and
domestic inflation or deflation.
ཀྵཀྵ Floating exchange rate: Flexible exchange rate; a situation in which a country’s foreign exchange rate is determined entirely by the market of the forces of supply and demand for currencies, without intervention by central banks or governments. The result is usually much greater fluctuations
in exchange rates than under a fixed exchange rate.
ཀྵཀྵ Foreign exchange: These are claims on a country by another country. Foreign exchange system enables one currency to be exchanged for another. Or a transaction involving exchange
of one currency for another at a specified exchange rate.
ཀྵཀྵ Foreign exchange company: A broker that offers currency exchange and international payments.
ཀྵཀྵ Foreign exchange controls: Controls imposed by a government on the purchase/sale of foreign currencies.
ཀྵཀྵ Foreign exchange market: This is a market where foreign currencies are traded at a price that is expressed by the
ཀྵཀྵ Foreign exchange rate: The rate, or price, at which one country’s currency is exchanged for the currency of another country. A country has a fixed exchange rate if it ‘pegs’ its currency at a
constant, predetermined exchange rate, and then stands ready to defend that rate. An exchange rate which is not fixed is said to ‘float’.
ཀྵཀྵ Foreign reserves: Stock of foreign currencies and Special Drawing Rights (SDRs) held by the county’s Central Bank as both reserve and a fund from which international payments
can be made.
ཀྵཀྵ Foreign exchange risks: These are risks that arise from the change in price of one currency against another.
ཀྵཀྵ Gold standard: Is when and where the currency of a country is completely backed by gold.
ཀྵཀྵ Gold standard currencies: These are defined in terms of a given weight of gold. Exchange rates remain fixed.
ཀྵཀྵ Managed floating exchange rates: Determination of foreign exchange rates by the interaction of supply and demand modified on occasion by government intervention for
domestic, political and economic progress.
ཀྵཀྵ Par exchange rate: This is a price of one country’s currency in terms of another by IMF.
ཀྵཀྵ Parallel exchange rate: This occurs when the official exchange rate does not reflect the true market rate, such that unofficial exchange rate tends to operate side by side with the official
ཀྵཀྵ Purchasing power parity: A situation when the exchange rate between two currencies is such that the equivalent amounts of the currencies have the same purchasing power in their
ཀྵཀྵ Retail foreign exchange platform: Speculative trading of foreign exchange by individuals using electronic trading platforms.
ཀྵཀྵ Revaluation: It is the increase in the official exchange rate. It has the effect of increasing the price of the domestic currency to the foreigner and decreasing the price of foreign currency.
• Exchange rate
• Terms used
• Forms of exchange rate
• Factors influencing exchange rate
• Advantages and disadvantages of each exchange rate system
• Exchange rate regime (floating vs fixed exchange rate)
• Reasons for devaluation
• Conditions for successful devaluation
• The Marshall-Lerner devaluation condition
• Effects of devaluation
• Success of devaluation in LDCs
Key unit competence: Learners will be able to explain the importance
of an economic integration on the development
of his economy.
By the end of this unit, I will be able to:
⦿ Explain the reasons why countries integrate and the likely disadvantages.
⦿ Identify the steps taken in economic integration.
⦿ Examine the obstacles to economic integration in LDCs.
⦿ Identify different economic groupings in which Rwanda belongs.
⦿ Analyse the conditions for successful economic integration.
⦿ Discuss the advantages, disadvantages and the problems of an economic integration.
⦿ Analyse the contribution of economic groupings on Rwandan economy.
⦿ Acknowledge the importance of economic integration in economic development and participate willingly in the integration process.
Of recent it’s a common talk in Rwanda’s economy that Rwanda has
integrated with many different economic groupings; according to you,
(i) What do you understand by economic integration?
(ii) Which economic groupings does Rwanda belong to?
(iii) What do you think is the aim of Rwandan economy by joining different other economic groupings?
(iv) In your analysis, what do you think are the necessary conditions for successful integrations?
6.1 Meaning of Economic Integration
Economic integration is a commercial policy where countries come together
for the sake of economic benefit by eliminating trade barriers among
Economic integration is the coming together of countries in a given region so as to promote trade and enjoy economic benefits by working collectively. It is aimed at increasing the share of member countries in international trade as a means of achieving political harmony amongst themselves and also to
consolidate their influence in international or global politics.
Figures a) and b) above show different economic integrations and their respective member countries.
Examples of economic integration
• East African Community-EAC,
• Common Market of East and Southern Africa-COMESA,
• Oil and Petroleum Exporting Countries- OPEC,
• Southern Africa Development Community (SADC),
• Economic Community for West African States-ECOWAS,
• European Union-EU,
• African Union- AU,
• African Caribbean Pacific Countries (ACPC)
• Economic Community of the Great Lakes Countries (CPGL) etc.
6.1.1 Objectives of economic integration
Economic integration refers to the coordination of national economic policies as a means of boosting international trade, market activity and general cooperation among economies. Formal international economic unions are a recent phenomenon, but former International Monetary Fund economic counselor Michael Mussa traces the roots of global economic integration to the medieval era. Despite the fact that the general aim of making trade flourish remains the same, particular objectives of economic
integration agreements have changed to correspond to modern political and economic circumstances.
1. To enlarge and diversify market for local produced commodities in the region.
2. To reduce or eliminate trade barriers among themselves e.g. use of one currency or allowing local currencies between member states or encouraging barter trade.
3. To avoid duplication of commodities by encouraging specialisation in each country.
4. To increase the utilisation of domestic resources which cannot be exploited by a single country.
5. To enhance free flow of ideas, skills and technology in the region.
6. To reduce the cost of production by adopting large scale enterprises which makes them enjoy economies of scale.
7. To increase the bargaining power of member states in the international market.
8. To improve the terms of trade of member states.
9. To boost industrialisation and production of commodities to out compete manufactured imports and reduce dependence among member states.
10. To promote political harmony and security in the region.
11. To expand employment opportunities for member states.
12. To decrease the exploitative powers of developed countries by reducing or stopping imports from developed countries that are always expensive.
6.1.2 Conditions necessary for successful economic integration
The following are conditions neccessary for sucessful economic integration
• Geographical proximity i.e. countries coming together into an integration should be geographically close to one another or should share common boarders in order to effect preferential treatment to each other.
• Common and same ideology i.e. they should have common historical background and ideology so as to harmonise their social economic policies e.g. socialism, capitalism and mixed economies.
• They should be at the same level of development so as to ensure fair flow of resources otherwise resources would flow from less developed countries to developed countries.
• There should be strong political will or similar political organisation among cooperative countries i.e. commitment by leaders and their population.
• Countries should be preferably of equal size because there is a likelihood of them having unequal quantities of resources.
• The economies of the countries should be competitive in nature i.e.
potential of producing different products so that exchange is promoted.
• There should be production of diversity of commodities thus specialisation and exchange.
• Citizens in the cooperative countries should have enough income so as to promote adequate market for commodities.
• There should be political stability among cooperative countries so as to ensure smooth operation of the regional activities.
• There should be a well-developed infrastructure in all cooperative countries.
• Countries should be complementary to one another so as to exchange their commodities.
• There should be a common language in the region.
6.1.3 Process/ stages/ levels of economic integration
Do you think economic integration is a quick or gradual process? Support
your view with facts and share with the rest of the class.
Economic integration is not a single day process, it’s a long time journey from the day it was thought of, up to the point it takes the highest level (though it doesn’t mean its end), we would call it the last stage of integration.
Therefore, it’s a gradual process that takes different stages which don’t have a
clear demarcation, but depends on how committed and willing the integrated
economies are to achieve their expected goals. Stages of integration include
among others the following:
1. Preferential Trade Area (PTA) This is the initial level in the development of economic integration where countries start their cooperation. In here, member countries give preferential treatment
to each other. There are low tariffs charged on selected commodities from member states while high tariffs are charged on commodities from non-member states. This is often the first small step towards the
creation of a trading bloc. Agreements may be made between two countries (bi-lateral), or several countries (multi-lateral).
2. Free Trade Area (FTA): Here member countries abolish or eliminate tariffs or trade barriers among themselves but each country retains a separate tariff structure on commodities from non-member states.
3. Custom union (CU): This is where member countries eliminate all tariffs or trade barriers amongst themselves and in addition countries adopt a common tariff structure on commodities that are from nonmember countries but there is no free flow of factors of production among member countries.
4. Common market (CM): In here, member countries eliminate tradebarriers amongst themselves; charge a common tariff on commodities from non-member countries and allow free mobility of factors of
production within the region e.g. capital and labour. This is done to boost production, increase employment and increase reward for factors of production and improve economic welfare in the region.
5. Economic Community/Union (EC/EU): This is where there is eliminating of all tariffs among member states, adoption of a uniform tariff structure on commodities from non-member countries; free
mobility of factors of production within the region; adoption of harmonious economic policy where countries in the same region have the same economic strategy, use the same policies and policy tools.
At this level, member countries have joint ownership of enterprises and they use the same currency thus have the monetary unions, harmonised social services like education, health etc. Their level of political identity is increased and thus formation of political federation.
6.1.4 Advantages of economic integration
Having researched and known the many different economic groupings in which Rwanda belongs as seen in Activity 1 of this unit, share your views as a class; how Rwanda has registered numerous vital benefits
than dangers from such different economic integrations. Give vivid examples from with in the country.
As a country joins different economic groupings, it is very much expectant
to achieve its goals and benefit from them. These benefits include among
others the following:
1. Trade creation effect: This is where the creation/formation of the economic cooperation results into a shift from consumption of expensive products from non-member countries to consumption of
cheap products in member countries.
2. Expansion and extension of large markets: Most economic integration provides sufficient wide export markets since member countries have to import within the region which therefore boosts production and
promote rapid economic growth.
3. Skill development and technological transfer i.e. due to free mobility of factors of production, it facilitates skill development and technological transfer within cooperative countries.
4. It increases the bargaining power of member countries in the international market, therefore this increases their benefits from the international trade.
5. It increases the competition which leads to high productivity in terms of quantity and quality.
6. It facilitates specialisation based on comparative cost advantage i.e. countries avoid competition in the production but instead specialise on the basis of comparative advantage which boosts production hence
more volume of exports.
7. Sharing of common services like research, education health transport and communication etc. which are usually efficient since they are jointly operated thus reduction of duplication of services.
8. It promotes industrialisation among member states by establishing manufacturing industries.
9. Common currency is used and each state adopts a common currency and it is strong and always stable which stabilises prices in the region.
10. There is creation and expansion of employment opportunities and reduction of unemployment among member states due to the flow of factors of production freely amongst themselves.
11. It enhances political harmony and stability in the region i.e. common political problems can be solved through consultation and sharing of ideas.
12. It helps in redistribution of income in the region i.e. economic integration fosters a more equitable distribution of resources when factors of production are allowed to flow freely between or among
countries thus equalising returns to each factor.
13. It reduces balance of payment deficit because economic integration leads to reduction of foreign exchange expenditure and increased export earnings.
14. It increases consumers’ choice i.e. since a variety of goods are produced with in the region, countries get commodities at low prices and low costs thus maximising profits.
15. It reduces administrative costs involved in import-export restrictions.
16. It promotes self-reliance among the cooperative countries i.e. it reduces economic dependence of LDCs on MDCs.
17. It is a vent for surplus; the resources formerly un utilised can be exploited because of a wider market.
6.1.5 Disadvantages of economic integration
Much as a country expects benefits from joining different economic
groupings, it should as well expect the adverse effects out of it which may
include the following:
1. Trade diversion i.e. this is where trade is diverted from low cost producers outside the integrated region to high cost producers with in the region. In addition, countries might continue using low quality
products from within the region when they could have secured high quality goods from outside region.
2. Loss of revenue which could have been got from tariffs due to free flow of goods and services and factors of production within the region and common tariff structure on non-member states.
3. It may lead to loss and movement of resources and goods from less developed countries to more developed countries.
4. Most LDCs produce similar products and find it hard to trade among themselves leading to surplus.
5. When many industries are constituted in one country due to pull factors, it causes uneven distribution of industrial benefits.
6. Cooperative countries are forced to forego some of their national interests which reduce self-reliance and sovereignty.
7. It may lead to production of low quality products because of restriction of similar commodities from non-member countries.
8. It may lead to over exploitation and quick exhaustion of resources in order to supply a large market.
9. Large scale ventures may experience diseconomies of scale. It leads to loss of political sovereignty in case of a political integrated federation.
10. When there is political instability in one country, it may affect the whole integrated region because all countries depend on each other.
11. Other countries may retaliate and also impose restrictions on imports and thus may lead to formation of rival trade.
12. It may lead to unemployment i.e. firms will be relocated to more cost effective location within the bloc thus it may lead to unemployment to other countries from where the firms move.
6.1.6 Obstacles to economic integration in Africa
Below are the obstacles to economic integration in Africa
• Dependence on a few primary exports: A major rigidity of most African economies is that their colonial masters encouraged the development and export of a few primary raw material products meant to service
factories in Europe, a situation that has changed very little in the 1990s. Overdependence on commodity exports is at the heart of Africa’s trade crisis.
More than any other developing region, Africa depends on primary commodities for instance coffee, cocoa, cotton and copper to generate the foreign exchange needed to buy imports.
• Underdeveloped human resources: People have been neglected, badly educated and in poor health, with their capacities frequently under-utilised. The consequence is low labour productivity and lack
• Capital versus labour intensity: Another structural bottleneck of African economies is their reliance more on capital rather than labour-intensive techniques of production, a situation many critics attribute to the nature of the import-substitution industrialisation strategy embarked upon after independence for most of these countries. Import-substitution policies tend to favour production of relatively capital-intensive
products; the application of capital intensive technologies — because of relatively low barriers to imports of capital goods; and an inefficient use of capital — owing to the lack of competition in domestic markets.
All this happens at the expense of labour-intensity, of which Africa has a relatively large endowment.
• Parochialism: Problems in Africa stem from failure, on the part of member-state governments, to internalise agreements in their national administrations and development plans. In many states, cooperation does not go far beyond the signing of treaties and protocols. Moreover,
some governments do not send to meetings those officials who have the appropriate expertise on the issues to be discussed.
• Excessive dependency of African states on the developed west: Many African nations generally still depend on the West for imports of raw material-supplies and manufactured products, even in cases where products of comparable quality may be available in member states.
This runs counter to the rationale for creating bigger markets to facilitate the growth of viable production ventures. High dependence on imported raw materials from the ‘West’ makes African economies
particularly vulnerable to foreign exchange availability—which in Africa is typically in short supply.
• Political obstacles to integration: A sustained political and ideological will to succeed, on the part of individual member governments, is critical to the success of any regional economic grouping. There is lack of a viable and stable commitment by member country governments. Ideological pluralism has a fragmentary influence on regional groupings because different governments have different conceptions
as to how the goals of integration are to be fulfilled.
• Proliferation of regional groupings: There are many regional groupings which have been formed within Africa. A particular country may belong to more than two regional groupings. Countries in Eastern
and Southern Africa belong to COMESA, SADC, and the Southern African Customs Union (SACU, whose members are: Botswana, Lesotho, Namibia, South Africa and Swaziland). With the exception
of Botswana, all nine other members of SADC (Angola, Lesotho, Malawi, Mozambique, Namibia, Swaziland, Tanzania, Zambia and Zimbabwe) are also members of COMESA. Three of the five SACU
members are also members of both SADC and COMESA. Almost half of COMESA members are also members of SADC, whose membership is smaller than COMESA’s. This weakens the integration
process. It leads to costly competition; conflict; inconsistencies in policy formulation and implementation; unnecessary duplication of functions and efforts; fragmentation of markets and restriction in the
growth potential of the sub-region.
• Transport problems: The transport infrastructure for intra-Africa trade (including roads, rail systems, air and some shipping) is not only inadequate, but in many cases non-existent. Burundi, Comoros,
Lesotho, Mauritius, Rwanda and Somalia, for instance, have no railway systems. In some cases, parts of the network (especially in war-torn states such as Mozambique, Angola, Democratic Republic of Congo
and Burundi) need urgent rehabilitation and upgrading. The existing network has been characterised by high operating costs due to poor road conditions and cumbersome transit operations. This limitation
does not help the integration process.
• Different stages of development: Some countries in Africa are economically more advanced than others. Economic integration works on the promise that the benefits of integration will be distributed among
member states in an equitable manner. However, the elimination of trade barriers and the adoption of common investment policies do not necessarily lead to an equitable distribution, but rather support or
stimulate the tendency of investments to concentrate on the relatively more advanced economies. As a consequence, some countries have not benefitted from the integration.
• Lack of information: Lack of information has hindered the development of intra-Africa trade. Most African nations are traditionally linked to their former colonial masters. As a consequence, there is an acute lack of awareness of what other African countries can offer to substitute
for the products currently being sourced from the developed countries. Lack of information is also a direct result of inadequate economic infrastructure in Africa, especially in telecommunications and
transportation facilities, directly hindering interaction among African countries.
• Unfavourable world economic conditions: African economies have suffered as a result of negative developments in the wider world economy. The most adverse effects have come from changes in the
terms of trade. Unfavourable terms of trade reduce output by increasing the cost of imported intermediate and capital goods, on which all African countries are heavily dependent. Consequently, this hinders
6.2 Case Studies of Economic Integrations
6.2.1 Common Market for Eastern and Southern Africa (COMESA)
Visit the library, the internet or any other economics source and research on COMESA and share with the class about the following:
(i) The countries that make up COMESA.
(ii) The objectives behind COMESA formation.
(iii) The achievements and challenges of COMESA.
(iv) What Rwanda has benefited from COMESA.
COMESA is the largest regional grouping in Africa, in terms of the number of member states — it claims 21 members, almost half of the total number of countries in Africa. It has about half of Africa’s total population. COMESA member states resolved to promote the integration of the Eastern
and Southern African region through trade development. They also agreed to develop their natural and human resources for the mutual benefit of the COMESA region.
Member countries of COMESA
Angola, Burundi, Comoros, Democratic Republic of Congo, Djibouti, Egypt, Eritrea, Ethiopia, Kenya, Madagascar, Malawi, Mauritius, Namibia, Rwanda, Seychelles, Sudan, Swaziland, Tanzania, Uganda, Zambia and Zimbabwe.
COMESA was established in 1994 replacing the Preferential Trade Area for Eastern and Southern Africa (PTA). The PTA was created in 1981 within the framework for the Organisation of African Unity’s (OAU) Lagos Plan of Action and the Final Act of Lagos.
COMESA is one of the most successful economic co-operation and integration groups in Africa. It has a proven track record of achievements
being supported by its financial specialised institutions, namely the Trade and Development Bank for Eastern and Southern Africa (PTA Bank), the Clearing House and the Re-Insurance Company. The stages of integration followed by COMESA are indicated below.
Stages of regional integration followed by COMESA
• Preferential Trade Area: Trade among countries is conducted on a preferential basis, in conformity with agreed rules of origin, with each country maintaining its own tariffs on goods imported from third
• Free Trade Area (FTA): In conformity with agreed rules of origin, with each country maintaining its own tariffs on goods imported from third countries.
• Customs Union: Member countries operate a common external tariff and there is free movement of goods once they enter the customs union. Tariff revenues are either shared among member countries or
allocated according to the destination of the goods.
• Common Market: There is free movement of goods, services, labour and capital, and the right of establishment and residency, between members of the common market.
• Economic Community: In addition to the conditions of the common market, the economic community has a single currency issued by one monetary authority and common monetary and fiscal policies.
Objectives of COMESA
The COMESA Treaty, which sets the agenda for COMESA, covers a large number of sectors and activities. The role of the COMESA Secretariat is to take the lead in assisting its member states to make the adjustments necessary for them to become part of the global economy within the framework of the
World Trade Organisation regulations and other international agreements. This is done by promoting “outward oriented” regional integration. The aim and objective of COMESA as defined in the treaty and its protocols is therefore to facilitate the removal of the structural and institutional weaknesses of member states by stages so that they are able to attain collective and sustained development. Among other things, COMESA member states agreed on a number of things.
1. A full free trade area guaranteeing the free movement of goods and services produced within COMESA and the removal of all tariff and non-tariff barriers.
2. A customs union under which goods and services imported from non- COMESA countries will attract an agreed single tariff in all COMESA states.
3. Free movement of capital and investment supported by the adoption of a common investment area so as to create a more favourable investment climate for the COMESA region.
4. A gradual establishment of a payment union based on the COMESA Clearing House and the eventual establishment of a common monetary union with a common currency.
5. The adoption of common visa arrangements, including the right of establishment leading eventually to the free movement of persons.
Achievements of COMESA
The following are the achievements of COMESA
• It has increased regional trade among member states i.e. trade creation.
• It has led to establishment of joint ventures/ services like PTA Bank
in Kenya and there is use of PTA cheques which have facilitated easy trade and transfer of cash.
• It has established a clearing house in Harare Zimbabwe for settling barter trade transactions. This has increased the volume of trade and has helped countries to exchange goods without foreign currencies.
Only differences in values are settled in hard currencies.
• It has a chamber of commerce and industry group which organises trade fares or shows to increase market for member state products.
• There has been increase in coordination of business activities in the region by setting up a trade information network.
• There has been improvement in infrastructure such as transport and telecommunication services.
• Good diplomatic relationship has been maintained among member states.
• The PTA has increased market for commodities because of production for large market.
• In terms of communication, due to the global advances in telecommunications technology and private sector involvement, there is measurable improvement in inter-country connectivity. For example, the action by major mobile telephone service provider AirtelCompany Limited (formerly Celtel), to merge its Kenyan, Ugandan and Tanzanian networks, thereby offering the first regional ‘borderless’ network (the tariffs for this service are substantially lower than roaming charges) in the world. This is seen as a major boost to inter regional communication. Some RECs demonstrate better connectivity (SADC,
ECOWAS, COMESA, and UMA).
• Africa remains a hotbed of conflicts, some of them extremely violent. A number of RECs established to pursue economic development are largely preoccupied with peacekeeping operations.
Challenges of COMESA
Below are the challenges of COMESA
• Countries produce similar agricultural and industrial products thus exchange is difficult.
• Poor infrastructure in the PTA countries as they cannot afford to finance heavy infrastructure like the railways, roads, air transport.
• Due to differences in foreign policies, it is difficult to form a free trade area by harmonising tariffs charged on foreign countries.
• Costs of production in PTA countries is very high, thus some countries find it cheaper to import commodities from ‘third countries’ especially developed countries which are traditional trade partners and can sell at a cheaper price and even extend credit facilities.
• No common currency to use for the exchange of commodities.
• Most of the PTA countries are land locked, therefore if there is free movement of resources, most industries would go to countries with easy access to the harbor which would cause development imbalances.
• Political instabilities in some of the member states have interfered with the trade flows in the area.
• There are small countries like Rwanda and Burundi and large countries like Tanzania and Sudan, therefore benefits are likely to flow to large countries where there is a diversity of opportunities and a high population to absorb those opportunities.
• The difference in administration, customs, posts and telecommunication, railways, harbors, research etc. lead to difficulty in movement of people, commodities and information among countries.
• Significant progress in integration is limited by the inability or unwillingness to prevent and decisively resolve numerous conflicts across the member states.
6.2.2 East African Community (EAC)
Visit the library, the internet or any economics source and research on
East African Community (EAC) and share with the whole class about the following:
(i) The countries that make up EAC.
(ii) The objectives behind EAC formation.
(iii) The achievements and challenges of EAC.
(iv) Reasons Rwanda joined the EAC.
(v) What Rwanda has benefited from EAC.
The East African Community (EAC) is an intergovernmental organisation composed of six countries in the African Great Lakes region in eastern Africa: Burundi, Kenya, Rwanda, South Sudan, Tanzania, and Uganda, with its headquarters in Arusha, Tanzania. John Magufuli, the president of Tanzania (2016), is the EAC’s chairman. The organisation was founded originally in 1967, collapsed in 1977, and revived on 7th July 2000 following its ratification by the Original 3 Partner States – Kenya, Uganda and Tanzania.
In 2008, after negotiations with the Southern Africa Development Community (SADC) and the Common Market for Eastern and Southern
Africa (COMESA), the EAC agreed to an expanded free trade area including the member states of all three organisations. The EAC is an integral part of the African Economic Community.
The EAC is a potential precursor to the establishment of the East African Federation, a proposed federation of its members into a single sovereign state. In 2010, the EAC launched its own common market for goods, labour, and capital within the region, with the goal of creating a common currency
and eventually a full political federation. In 2013 a protocol was signed outlining their plans for launching a monetary union within 10 years.
The EAC aims at widening and deepening co-operation among the partner states and other regional economic communities in, among others, political, economic and social fields for their mutual benefit.
Aims and objectives
The EAC aims at widening and deepening co-operation among the Partner States in, among others, political, economic and social fields for their mutual benefit. To this extent, the EAC countries established a Customs Union in 2005 and are working towards the establishment of a Common Market by
2010, subsequently a Monetary Union by 2012 and ultimately a Political
Federation of the East African States.
Enlargement of the communit;y The realisation of a large regional economic
bloc encompassing Burundi, Kenya, Rwanda, Tanzania and Uganda with a combined population of 120 million people, land area of 1.85 million sq. kilometers and a combined gross domestic product of 41 billion USD, bears great strategic and geopolitical significance and prospects of a renewed
and reinvigorated East African Community.
The specific objectives of the EAC Integration are
• To attain sustainable growth and development of the partner states by the promotion of a more balanced and harmonious development of the partner states.
• To strengthen and consolidate co-operation in agreed fields that would lead to equitable economic development within the partner states and which would in turn, raise the standard of living and improve the quality of life of their populations.
To promote sustainable utilisation of natural resources of partner states taking measures to effectively protect their natural environment.
• To strengthen and consolidate long standing political, economic, social, cultural and traditional ties and associations between the peoples of the partner states so as to promote a people-centreed mutual development of these ties and associations.
• To mainstream gender in all its endeavors and the enhancement of the role of women in cultural, social, political, economic and technological development.
• To promote peace, security, stability within, and good neighborliness among, the partner states.
• To enhance and strengthen partnerships with the private sector and civil society in order to achieve sustainable socioeconomic and political development.
• To undertake activities calculated to further the objectives of the Community, as the partner states may from time to time decide to undertake in common.
The regional integration process is at a high pitch at the moment. The encouraging progress of the East African Customs Union, the enlargement of the Community with admission of Rwanda and Burundi, the ongoing negotiations of the East African Common Market as well as the consultations
on fast tracking the process towards East African Federation all underscore the serious determination of the East African leadership and citizens to construct a powerful and a sustainable East African economic and political bloc.
On 16th October 2014, the Eastern African Community (Burundi, Kenya, Rwanda, Tanzania, and Uganda) finalised the negotiations for a region-toregion Economic Partnership Agreement (EPA) with the EU.
• East Africa is a geographically and economically homogeneous region committed to regional integration. The East African Community (EAC) consists of Burundi, Rwanda, Tanzania, Uganda (all of which are least developed countries or “LDCs”) and Kenya which is more developed than the rest.
• The EAC established a Customs Union in 2005 which was fullyfledged with zero internal tariffs as from 2010. The EAC, in fast tracking its economic integration process, ratified a more far-reaching
common market protocol in July 2010. In November 2013, EAC members signed a protocol on a monetary union.
• The integration agenda of the EAC is strongly political in nature as its ultimate goal is to become a federation.
• All the countries in the East African Community are members of the WTO.
• Exports to the EU from East African Community are dominated by coffee, cut flowers, tea, tobacco, fish and vegetables.
• Imports from the EU into the region are dominated by machinery and mechanical appliances, equipment and parts, vehicles and pharmaceutical products.
Total Intra-EAC Trade
The value of intra-EAC trade declined by 3.0 percent from 5,805.6 million USD in 2013 to 5,632.9 million USD in 2014 as shown in Table 3.1. The decline was driven by the decrease in the value of exports that went down by 12.7 percent. Kenya, Tanzania and Uganda recorded an increase in their
shares to total intra-EAC trade while that of Rwanda and Burundi declined. During the review period, Kenya continued to dominate intra-EAC trade, accounting for about 32.8 percent of total intra-EAC trade while Tanzania and Uganda accounted for 26.4 percent and 23.6 percent of the total intra- EAC trade, respectively.
Achievements of the East African Community
Here indicated below are the achievements of the East African Community
• The most important achievement was the establishment of the EAC Custom Union. The Custom Union Protocol was signed in March 2004 and came into effect on January 1, 2005.
Under Customs Union arrangements, goods produced within the EAC move across the border of partner states without taxation provided they qualify under rules of origin.
• It has increased both inter and intra-regional trade, increased competition that has increased consumer’s choice, reduction of costs, and attraction of foreign direct investments.
• It has witnessed an increase in intra-EAC foreign direct investments as well as foreign direct investments from outside.
• There is mutual recognition of standards marks across the region where the bureaus of standards have developed an EAC catalogue of standards
• It has led to establishment of One Stop Boarder Posts that have already been articulated within the auspices of the community law. This has facilitated trade within the community
• It has implemented internal tariff elimination. This has facilitated smooth trade among the states.
• As part of the joint effort to promote East Africa as a single tourist destination, partner states have participated in major international travel markets forums including the World Travel Market in London November 2005 and the International Tourism Bourse in Berlin in March 2006 which has helped in promoting East Africa as a single tourist destination and has resulted in attracting more tourists and
increasing the contribution of the tourism industry to the East African economy.
• Promotion of foreign policy co-ordination through collaboration in diplomatic and consular activities; collaboration in economic and social activities; liaison and exchange of information; and collaboration in
administration and capacity building.
• Launched Lake Victoria Commission i.e. East African partner states have taken a number of steps to preserve the lake through the implementation of the Lake Victoria Environmental Management
Programme. This has ensured sustainable use of Lake Victoria.
• The partner states have adopted an action programme that has focused on increased employment and poverty reduction in the EAC. The EAC projects and programmes are assessed as to how they contribute
towards poverty eradication in the region.
Furthermore, the East African Community established an annual
Ministerial Forum to focus on employment creation and poverty
• Improvement of East African Infrastructure through the East African road network project where a tripartite agreement on road transport has been ratified by partner states. The main objectives of the agreement are to facilitate interstate road transport through reduced documentation for crews and vehicles at border crossing, harmonised requirements for operation licensing and customs and immigration regulations, among others. In order to fast-track decisions on transport
and communications, the EAC established the sectoral council on transport, communications and meteorology.
• Harmonisation of monetary and fiscal policies i.e. steps toward the harmonisation of monetary and fiscal policies have included convertibility of the partner states’ currencies, harmonisation of
banking rules and regulations, harmonisation of finance ministries’ pre- and post-budget consultations, regular sharing of information on budgets, and reading of budget statements on the same day. In capital
markets, there have been changes in the policies and trading practices and regulations in the three stock exchanges. The committee for the establishment of Capital Markets Development that oversees the
development of the capital markets in the East African Community aims to develop East African community capital markets including managing cross-listing of stocks.
• Strengthened an East African identity i.e. there have been developments designed to foster the feeling of integration among the people of the EAC and to facilitate an East African identity. These have included
the introduction of the East African Community flag, the launching of an East African anthem and the East African passport.
Challenges of the East African Community
The following are the challenges of the East African Community Despite the progress made throughout the years, some challenges remain noteworthy and this has hampered the progress of the community;
• Some citizens of some member states lack awareness of the regional integration process and cannot articulate the benefits that can be drawn from the EAC integration process. e.g. in Tanzania.
• Differences in social political ideologies amongst member states e.g. in Tanzania the social political system that was in place for over 3 decades after independence, makes people both in public and private
sectors not very entrepreneurial as they tend to rely on the government
• One of the reasons for the collapse of the previous East African Community in 1977 was the perception of disproportionate sharing of economic benefits accruing from regional markets and lack of a
formula for dealing with the problem. It is still a challenge to the community to address problems arising from the implementation of the treaty.
• Improving the performance of major ports such as Mombasa and Dares Salaam, and the East Africa road network and East Africa railway network are key challenges facing the East African Community.
Improving supply conditions will enhance EAC capacity to withstand the forces of globalisation
• The EAC report on fast tracking (2004:81) reports that the fear of loss of sovereignty is an issue in the minds of some members of the political elite of East Africa. The fear is that as a Federation, the nation
states would cease to have any meaningful powers; that they would be relegated to mere provinces within the Federation.
• Participation by citizens is at the core of the new East African Community. The treaty advocates for people-driven and peoplecentreed development. East African people should play an active role
in determining the progress of the new community. The community has to live up to the expectations of the peoples of East Africa by implementing the treaty’s provisions for the creation of an enabling
environment for the private sector and civil society participation, the strengthening of the private sector; and enhancement of co-operation among business organisations and professional bodies.
6.2.3 Economic community of the great lakes countries (CEPGL)
Visit the library, the internet or any other economics source and research on CEPGL and share with the class about the following:
(i) The countries that make up CEPGL.
(ii) The objectives behind CEPGL formation.
(iii) The achievements and challenges of CEPGL.
(iv) What Rwanda has benefited from CEPGL.
The Economic Community of the Great Lakes Countries (ECGLC) (in French CEPGL - Communauté Économique des Pays des Grand Lacs) is a sub-regional organisation with multiple vocation created by the signing of the Agreement in Gisenyi, Rwanda on September 20, 1976 under the initiative of the former president of Congo (Zaire), Mobutu. The ECGLC aimed at insuring the safety of member states, favouring the creation and the development of activities of public interest, promoting the trade and
the traffic of the persons and the possessions. It aimed at establishing the cooperation in a narrow way in all the domains of the political, economic and social life.
It has three members: Burundi, Democratic Republic of Congo (formerly known as Zaire), and Rwanda. It has its headquarters in Rwanda. Its purpose is to promote regional economic cooperation and integration. The CEPGL is an Economic Community of East Africa.
The community of the Great Lakes Countries collapsed in the mid 1990’s, precisely in 1994 due to conflicts within and between member states. After more than 13 years of lethargy and under the pressure of international community, the ministries council held in Bujumbura on the 17th April 2007
decided to relaunch the CEPGL activities. During the ministries council, three priorities were retained on the CPEGL agenda for the next five years (2011- 2016):
1. Peace, security and good governance
2. Energy and infrastructures
3. Agriculture and food security.
The CEPGL controls the following institutions
• Bank of Development of the States of the Great Lakes (BDEGL).
• Comité Permanent Inter-Compagnies (COPIC).
• Institute of the Agronomic Researches and Zootechniques (IRAZ).
• Economic Community of the Great Lakes Countries Organisation for Energy (EGL).
• International Society for Electricity in the Great Lakes Region (SINELAC).
Research Centre for the Development of the Mining Resources in Central Africa (CRDRMAC).
Objectives of CEPGL
The main objectives of the Economic Community of the Great Lakes are:
1. For economic and social development among the member countries (free movement of persons, foster international trade).
2. To promote of peace initiatives in the region (Burundi, the Democratic Republic of Congo, and Rwanda).
3. For strategic development in the region: Energy, Infrastructure, Agriculture, and Food Security.
Achievements of CEPGL
The CEPGL has some concrete achievements, they include:
1. Created the International Great Lakes Energy Company (SINELAC) on 17th Feb 1984 which exploits a hydro dam in the Congolese territory, Mumoshu in the southern Kivu province. The aim of the
company is to produce and furnish electricity to members of CEPGL for example, between 1991 and 2001, this dam furnished on average 45%, 17% and 21% of the national production of electricity of
Rwanda, Burundi and Congo respectively. However, SINELAC is facing the incapacity of member states to pay electricity bills.
2. Created the Development Bank of the Great Lakes Countries (BDGL) on 9th sept 1977 with its headquarters in Goma (DRC). It aimed at financing community projects, but was only operational from 1984 to 1994. It had financed 31 projects in the DRC, 7 in Rwanda, 7 in Burundi and 1 community project- SINELAC.
3. Put up the institute of agriculture and livestock research (IRAZ) which aimed at doing research in the domains of agronomy and zootechnics.
4. Provided the CEPGL identity card which enables free movement of people within the community leading to the development of small cross border business from which thousands of people earn a living.
5. Set up the Energy Organisation of the Great Lakes Countries (EGL) aiming at improving cooperation amongst members in the energy sector.
6. Increased commercial exchange between Burundi, Rwanda and Eastern DRC. For example, products like foodstuffs, livestock, bracelet etc. are traded from Goma to markets in Rwanda and Burundi.
7. This informal trade has great impact on everyday life of the population and its practitioners. The revenue generated by this business is significant compared to what civil servants can earn monthly in the
8. Successfully Implemented common infrastructures and projects such as BDGL, IRAZ, SINELAC.
Challenges of CEPGL
1. Violent conflicts in the great lakes region have hindered the effectiveness of this regional Economic community. This has destroyed the spirit of good neighbourliness and the social economic
relationship between the three countries. For example, the border posts between Goma and Gisenyi which used to be open 24 hours until May 2012 to facilitate small cross border economic activities
between the two cities, is now open only from 6 am to 6 pm. This has caused severe consequences on the movement of goods and persons.
2. Failure to bring peace and stability in the region as one of their objectives. This is due to lack of political will from regional leaders. Members of the CEPGL, in particular the DRC, had no interest to
revitalise the CEPGL. For Congolese officials, the DRC was not ready to re-launch the CEPGL.
3. Mistrust among members of the CEPGL could not enable Regional Economic Community (REC) to promote economic activities, peace and stability in the region. That’s why Rwanda and Burundi have got
closer to the East African region than to the DRC. This is justified by their recent entrance in the East African Community.
4. Multiple and overlapping memberships in several Regional Economic Communities e.g. the DRC is a member of multiple RECs which reduces its effectiveness in the CEPGL. This is due to the country’s
big size and lack of integration among different economic blocs of the country.
5. Weak financial, human and institutional capacity of the member states of the CEPGL hinders them to fulfil their regional commitments. Regional leaders fear to abandon a share of their power to a regional
institution. Because most African countries still have fresh memories of the colonisation. They fear to put the control of their power to external or internal forces.
6. Furthermore, the staff of the secretariats of the CEPGL is appointed by politicians to whom they are subjugated. This reduces their independence vis a vis the political sphere of the respective countries.
It limits their capacity to compel them to respect their regional commitments.
7. Failure to promote formal exchanges among its members though it has increased informal exchange. There is negligible intra- CEPGL trade as indicated by lack of official statistics capturing the flourishing
unofficial cross border trade of agricultural products and re-export of manufactured products on African borders.
8. Lack of appropriate infrastructure which should connect the three countries in the community and the different parts within the country e.g. in the DRC, lack of connection between the big cities of Kivu to
the rest of the country explains why these cities are more integrated to the economy of neighboring countries than to that of the DRC.
9. Inappropriate trade policies which are too restrictive and the high level of corruption of customs agents have hindered the prosperity of informal cross border trade in the CEPGL community.
1. (a) What are the features of an economic union?
(b) Analyse the objectives behind economic integration by nations.
(c) Examine the factors that may encourage formation of an economic union in eastern Africa.
2. (a) Why did the East African Community fail in 1977?
(b) What good things can the current EAC learn from the former EAC?
3. In what ways may economic integration solve problems of underdevelopment?
ཀྵཀྵ Economic integration: The coming together of countries in a given region so as to promote trade and enjoy economic benefits by working collectively.
ཀྵཀྵ Trade creation: A situation where formation of economic cooperation results into a shift from consumption of expensive products from nonmember countries to consumption of cheap products in the member countries.
ཀྵཀྵ Trade diversion: A the shift in trade from cheap products of nonmember states to expensive products of member states within the integration.
• Economic integration
• Reasons/ rationale for economic integration
• Conditions for economic integration
• Steps/ levels of economic integration
• Advantages and disadvantages
• Obstacles of economic integration
• Case studies
• East African community (EAC)
• Common Market for Eastern and Southern African (COMESA)
• Economic Community of the Great Lakes Countries (CEPGL)
- Key unit competence: Learners will be able to analyse the impact ofglobalisation on Rwandan economy.My goalsBy the end of this unit, I will be able to:⦿ Explain the causes of globalisation.⦿ Explain the impact of MNCs and FDIs on economic development.⦿ Describe the origin of Breton woods conference and the operation of IMF and WB.⦿ Identify SAPs conditionality to Rwanda from IMF and WB.⦿ Analyse the impact of globalisation on the economy (local, national and international).⦿ Extract key principles of globalisation by looking at specific examples of MNCs and FDIs.⦿ Practice SAPs conditionality from IMF and WB to attain economic growth.⦿ Appreciate the implication of globalisation on the economy of Rwanda.Activity 1There is a growing desire by world economies to depend on one another socially, economically and politically, this is witnessed by different countries opening up different businesses and travelling to different parts of the world; Use the library, internet or any other economics source to
research and discuss with the class about:(i) How you call such desire by world economies to become interdependent.(ii) The features of global economic interdependence.(iii) The different ways in which world economies can become interdependent.Facts7.1 Meaning of GlobalisationEconomic globalisation is the increasing economic interdependence of national economies across the world through a rapid increase in crossborder movement of goods, services, technology and capital. Whereas the globalisation of business is centreed on the diminution/reduction of international trade regulations as well as tariffs, taxes, and other impediments that suppresses global trade, economic globalisation is the process of increasing economic integration between countries, leading to the emergence of a global market place or a single world market. It involves the free movement of goods, services and people across the world in a seamless and integrated manner. This means that countries increase their base of operations, expand their workforce with minimal investments, and provide
new services to a broad range of consumers.Depending on the paradigm, economic globalisation can be viewed as either a positive or a negative phenomenon. Economic globalisation comprises the globalisation of production, markets, competition, technology, and corporations and industries. Current globalisation trends can be largely accounted for by developed economies integrating with less developed economies by means of foreign direct investment, the reduction of trade barriers as well as other economic reforms and, in many cases, immigration.7.1.1 The main features/ characteristics of globalisationGlobalisation has a number of characteristics as shown below:1. Liberalisation: The freedom of the industrialists/businessmen to establish industries, trade or commerce either in their countries or abroad; free exchange of capital, goods, service and technologies
between countries.2. There is free trade: I.e. free trade between countries; absence of excessive governmental control over trade.3. There is globalisation of economic activities: Control of economic activities by domestic market and international market; coordination of national economy and world economy.4. There is connectivity: Localities being connected with the world by breaking national boundaries; forging of links between one society and another, and between one country and another through international transmission of knowledge, literature, technology, culture and
information.5. Globalisation is borderless globe: i.e. breaking of national barriers and creation of inter- connectedness.6. Globalisation is a composite process: Integration of nation-states across the world by common economic, commercial, political, cultural and technological ties; creation of a new world order with no national boundaries.7. Globalisation is a multi-dimensional process: Economically, it means opening up of national market, free trade and commerce among nations, and integration of national economies with the world
economy. Politically, it means limited powers and functions of state, more rights and freedoms granted to the individual and empowerment of private sector; culturally, it means exchange of cultural values
between societies and between nations; and ideologically, it means the spread of liberalism and capitalism.8. Globalisation is a top-down process: Globalisation originates from developed countries and the MNCs (multinational corporations) based in them. Technologies, capital, products and services come from them to developing countries. It is for developing countries to accept these things,adapt themselves to them and to be influenced by them. Globalisation is
thus a one-way traffic; it flows from the North to the South.9. There is interdependence with globalisation: With the advent of globalisation, it has been understood that no country can be said to be totally independent, not needing anything from any other country.
Hence, a culture of interdependence has been established between nations.10. Globalisation is basically a ‘Mindset’: Globalisation is basically a mindset that is ready to encapsulate the whole universe into its scheme of things; a mindset that is broader and open to receive all ideas; that
takes the whole globe as an area of operation.11. Globalisation is an opportunity: While it does open our markets for entry of multinationals, it also opens all other markets in the whole world for our products and services too.12. Globalisation means “caring and sharing”: The world today is more united and concerned about common problems being faced by the people- be it global warming, terrorism, or malnutrition etc. Natural
disasters faced or atrocities encountered at any part of the world attract immediate attention all over.13. Globalisation puts technology in service of mankind: The world would not have shrunk into a small global village without the support of technological innovations like computers, internet,
telecommunication, e-commerce etc. Thus, technology has proved to be the major source of the concept of globalisation, and for bringing people nearer to each other.14. Globalisation is inevitable and irreversible: It is rightly said, “You cannot stop the advent of an idea whose time has come”. Globalisation is one such idea.15. Globalisation links politics with economics: Earlier, political ideologies and relations between nations have determined the fate of people over centuries; with economics being subservient to
politics. However, in the new era of globalisation, it is the economics, employment generation and public welfare that determine the need and strength of relations between nations.16. Globalisation means raised standards of living: With consumers having more choice to pick quality items at right price, and with no boundary restrictions on flow of goods and services, the markets haveturned from ‘Sellers’ Market’ to ‘Buyers’ Market’. This has helped in raising the standard of living for vast populations across the world. It has also raised aspirations among billions of people to upgrade their
lifestyles17. Globalisation demands and respects excellence: With global level opportunities available to all the countries, the field is wide open for the excellent companies, products and people from any remote part
of the world to showcase their excellence and win over markets and contracts. There is pressure on everyone to continuously improve to meet the raised bar of expectations.18. Globalisation means that “we are not alone in this Universe and the world is cohabited by others too at far off places.” This means that the world is a small global village of linked families.7.1.2 Types of globalisation1. Economic globalisationThis is a worldwide economic system that permits easy movement of goods, production, capital, and resources (free trade facilitates this) No national economy is an island now. To varying degrees, national economies influence one another. One country which is capital-rich invests in another country
which is poor. One who has better technologies sells these to otherswho lack such technologies. Example is multinational corporations.The products of an advanced country enter the markets of those countries that have demands for these products. Similarly, the natural resources of developing countries are sold to developed countries that need them. Thus, globalisation is predominantly an economic process involving the transfer
of economic resources form one country to another.2. Technological globalisationThis is the connection between nations through technology such as television, radio, telephones, internet, etc. This was traditionally available only to the rich but is now far more available to the poor. Much less infrastructure is needed now.3. Political globalisationThis is where countries are attempting to adopt similar political policies and styles of government in order to facilitate other forms of globalisation e.g. move to secular governments, free trade agreements, etc.
Since long, efforts have been on to bring the whole world under one government. It is believed, as by the League of Nations and the UN, that the world under one government will be safer and freer from conflicts.4. Cultural globalisationThis is the merging or “watering down” of the world’s cultures e.g. food, entertainment, language, etc. Cultural globalisation has been facilitated by the information revolution, the spread of satellite communication, telecommunication networks, information technology and the internet etc.
This global flow of ideas, knowledge and values is likely to flatten out cultural differences between nations, regions and individuals. Culture flow is mainly from the North to the South i.e. mainly from the
Centre to the periphery, and from the towns and cities to villages, it is the cultures of villages of poor countries which will be the first to suffer erosion.5. Financial globalisationThis is the interconnection of the world’s financial systems e.g. stock markets, more of a connection between large cities than of nations.6. Ecological globalisationThis refers to seeing the Earth as a single ecosystem rather than a collection of separate ecological systems because so many problems are global in nature e.g. International treaties to deal with environmental issues like biodiversity, climate change or the ozone layer, wildlife reserves that span
several countries7. Sociological globalisationThis is a growing belief that we are all global citizens and should all be held to the same standards – and have the same rights e.g. the growing international ideas that capital punishment is immoral and that women should have all the same rights as men.7.1.3 Causes of globalisationActivity 2
From the understanding of economic globalisation as gained from the research carried out in Activity 1 of this unit; what do you think is the cause of the current increased desire for global interdependence?FactsGlobalisation is not a new phenomenon. The world economy has become increasingly interdependent for a long time. However, in recent decades the process of globalisation has accelerated; this is due to a variety of factors, among which include the following:1. Improved transport, making global travel easier. For example, there has been a rapid growth in air-travel, enabling greater movement of people and goods across the globe.2. Containerisation. From 1970, there was a rapid adoption of the steel transport container. This reduced the costs of inter-modal transport making trade cheaper and more efficient.3. Improved technology which makes it easier to communicate and share information around the world. E.g. internet. Therefore, people from any country can bid for the right to provide a service.4. Growth of multinational companies with a global presence in many different economies.5. Growth of global trading blocs which have reduced national barriers. (e.g. European Union, NAFTA, ASEAN).6. Reduced tariff barriers encourages global trade. Often this has occurred through the support of the WTO.7. Firms exploiting gains from economies of scale to gain increased specialisation. This is an important feature of new trade theory.8. Growth of global media. Such as internet, telecommunication etc.9. Global trade cycle. Economic growth is global in nature. This means countries are increasingly interconnected. (E.g. recession in one country affects global trade and invariably causes an economic
downturn in major trading partners.)10. Improved mobility of capital. In past few decades, there has been a general reduction in capital barriers, making it easier for capital to flow between different economies. This has increased the ability for firms to receive finance. It has also increased the global interconnectedness of global financial markets.11. Increased mobility of labour. People are more willing to move between different countries in search for work. Global trade remittances now play a large role in transfers from developed countries to developing countries7.1.4 Effects of globalisationActivity 3Basing on the research carried out in Activity 1 and 2 of this unit, assess the impact of globalisation on world economies.FactsFinancial and industrial globalisation is increasing substantially and is creating new opportunities for both industrialised and developing countries. The largest impact has been on developing countries, which are now able to attract foreign investors and foreign capital.Positive effects of globalisationGlobalisation can create new opportunities, new ideas, and open new markets
and many other positives result as follows:• Inward investment by Trans-National corporations (TNCs) helps countries by providing new jobs and skills for local people.• Trans-National corporations (TNCs) bring wealth and foreign currency to local economies when they buy local resources, products and services. The extra money created by this investment can be spent on
education, health and infrastructure.• The sharing of ideas, experiences and lifestyles of people and cultures. People can experience foods and other products not previously available in their countries.• Globalisation increases awareness of events in far-away parts of the world. For example, the UK was quickly made aware of the 2004 tsunami tidal wave and sent help rapidly in response.• Globalisation may help to make people more aware of global issues such as deforestation and global warming - and alert them to the need for sustainable development.• Increased standard of living: Economic globalisation gives governments of developing nation’s access to foreign lending. When these funds are used on infrastructure including roads, health care, education,
and social services, the standard of living in the country increases. If the money is used only selectively, however, not all citizens will participate in the benefits.• Access to new markets: Globalisation leads to freer trade between countries. This is one of its largest benefits to developing nations. Homegrown industries see trade barriers fall and have access to a
much wider international market. This allows companies to develop new technologies and produce new products and services.• It allows businesses in less industrialised countries to become part of international production networks and supply chains that are the main conduits of trade.• Globalisation can lead to more access to capital flows, technology, human capital, cheaper imports and larger export markets.• It creates greater opportunities for firms in less industrialised countries to tap into more and larger markets around the world.Negative effects of globalisationIn real life, businesses are facing increased competition, and the worker may be laid off because of greater competition due to globalisation. Thefollowing are some of the negative effects of globalisation.1. Globalisation makes it virtually impossible for regulators in one country to foresee the worldwide implications of their actions. Actions which would seem to reduce emissions for an individual country may
indirectly encourage world trade, ramp up manufacturing in coalproducing areas, and increase emissions over all.2. Globalisation tends to move taxation away from corporations, and onto individual citizens. Corporations have the ability to move to locations where the tax rate is lowest. Individual citizens have much
less ability to make such a change. Also, with today’s lack of jobs, each community competes with other communities with respect to how many tax breaks it can give to prospective employers.3. Globalisation sets up a currency “race to the bottom,” with each country trying to get an export advantage by dropping the value of its currency. Because of the competitive nature of the world economy, each country needs to sell its goods and services at a low price as possible. This can be done in various ways–pay its workers lower wages; allow more pollution; use cheaper more polluting fuels; or
debase the currency by Quantitative easing (also known as “printing money,”) in the hope that this will produce inflation and lower the value of the currency relative to other currencies.4. Globalisation encourages dependence on other countries for essential goods and services. With globalisation, goods can often be obtained cheaply from elsewhere. However, if the built-in instabilities in the system become too great and the system stops working, there is suddenly a very large problem if imports are interrupted.5. Globalisation ties countries together, so that if one country collapses, the collapse is likely to ripple through the system, pulling many other countries with it. This is because countries are increasingly interdependent.6. Cultural uniqueness is lost in favour of homogenisation and a “universal culture” that draws heavily from American culture. the values and norms of developed countries are gradually rooted in
developing countries. This involves the erosion and loss of the identity and the cultures of developing countries.7. The growth of international trade is worsening income inequalities, both between and within industrialised and less industrialised nations.8. Global commerce is increasingly dominated by transnational corporations which seek to maximise profits without regard for the development needs of individual countries or the local populations.9. Protectionist policies in industrialised countries prevent many producers in the third world from accessing export markets.10. The volume and volatility of capital flows increases the risks of banking and currency crises, especially in countries with weak
financial institutions.11. Competition among developing countries to attract foreign investment leads to a “race to the bottom” in which countries dangerously lower environmental standards.12. Globalisation uses up finite resources more quickly. As an example, China joined the world trade organisation in December 2001. In 2002, its coal use began rising rapidly.7.2 Multinational Corporation (MNC)Activity 4Basing on the research carried out in Activity 1 of this unit, and using the photos a), b) and c) below:(i) Explain what you understand by Multinational Corporations.(ii) What examples of MNCs can you sight in Rwanda?(iii) What activities do those MNCs in Rwanda deal in?FactsA multinational corporation or worldwide enterprise is an enterprise operating in several countries but managed from one (home) country. It is an organisation that owns or controls production of goods or services in one or more countries other than their home country. It can also be referred to as an international corporation, a “transnational corporation”, or a stateless
corporation. Generally, any company or group that derives a quarter of its revenue
from operations outside of its home country is considered a multinational
There are four categories of multinational corporations:1. A multinational, decentralised corporation with strong home country presence.2. A global, centralised corporation that acquires cost advantage through centralised production wherever cheaper resources are available.3. An international company that builds on the parent corporation’s technology.4. A transnational enterprise that combines the previous three approaches. A multinational corporation is usually a large corporation which produces or sells goods or services in various countries. MNCs can get involved in;• Importing and exporting goods and services.• Making significant investments in a foreign country.• Buying and selling licenses in foreign markets.• Engaging in contract manufacturing—permitting a local manufacturer in a foreign country to produce their products.• Opening manufacturing facilities or assembly operations in foreign countries.Foreign multinational corporations in Rwanda7.2.1 Effects of multinational corporationsActivity 5
As a class, basing on the understanding of MNCs gained from Activity
4 of this unit, assess the view that MNCs have done more good than
harm towards the development process of Rwanda.Positive effects1. MNCs bridge the forex gap in LDCs by increasing forex inflow.2. They increase employment opportunities for citizens of the host countries since they operate on large scales.3. They close the investment gap through forex investment abroad.4. They lead to improvement in domestic technology through transfer of superior technology to LDCs based on research and development.5. MNCs produce more output especially processed or manufactured which increase exportation of manufactured goods hence more forex to LDCs.6. MNCs promote capital accumulation in LDCs through transfer of capital and building infrastructure.7. MNCs produce better quality products which help to improve standards of living of people in the society.8. They bring new marketing techniques in LDCs markets research and promotional methods which encourage competition and efficiency.9. They give revenue to the government through taxes imposed on activities of the MNCs.10. They help to train labour in the management of basic skills and entrepreneur ability in LDCs.11. MNCs make a lot of profits which are ploughed back leading to the expansion of the economy there by promoting economic growth.12. They undertake high risks and can invest in long term projects like mining plantation and agricultural industries that bring about rapid economic growth and development.13. They are financially strong and hence provide large and cheap capital to LDCs by way of direct investment.14. They increase infrastructural development through construction of telecommunication etc.15. MNCs increase the exploitation of domestic resources which increase volume of productivity hence increasing export exchange.16. They promote international cooperation through consortiums hence increasing the volume of trade.17. They encourage competition which leads to efficiency and better quality products.18. They help in filling the skilled manpower gap through exportation of expatriates or trained personnel to the recipient countries.Negative effects of MNCs1. MNCs repatriate their profits to their mother countries which lead to resources outflow from LDCs thus disabling the development potentials of LDCs.2. They are given tax exemption and holidays which reduce net government revenue from them.3. MNCs usually use capital intensive technology and therefore may not help to reduce their problems of unemployment in LDCs which are labour surplus economies.4. They create social costs like quick exhaustion of natural resources, environmental degradation etc. since they operate on large scale.5. MNCs influence internal policies of LDCs by bribing the legislature for example offering employment to the relatives of politicians in their companies and at times they subvert domestic fiscal policies which
result into low standards of living.6. MDCs accelerate regional or sector imbalances eg urban and rural areas since they mostly set up their production activities in urban areas where infrastructure is already developed.7. MDCs cause income inequalities because they reserve top jobs for their nationals who are highly paid and low paying jobs to the national of investment countries.8. They promote external dependency of host countries on the countries where they originate.9. They reduce domestic initiative in technological and manpower development.10. MNCs can bring about discontent and unrest among workers employed by the government and indigenous firms due to the wage differentials between the workers in MNCs and other workers.Activity 6Use the library or the internet or any other economics source to do research on direct foreign investments with reference to Rwanda’s economy and share with the rest of the class about:(i) What Foreign Direct Investment is.(ii) Examples of Foreign Direct Investments in Rwanda(iii) The impact of FDI’s on Rwanda’s development process.Facts7.3 Meaning of Foreign Direct InvestmentsForeign direct investments are the net inflows of investment to acquire a lasting management interest in an enterprise operating in an economy other than that of the investor. It refers to direct investment equity flows in the reporting economy. It is the sum of equity capital, reinvestment of earnings, and other capital. Direct investment is a category of cross-border investment associated with a resident in one economy having control or a significant degree of influence on the management of an enterprise that isresident in another economy. Direct foreign investment involves the transfer of productive resources or capital by foreign individuals, companies and MNCs to operate in an economy other than that of the investor. Ownership of 10 percent or more of the ordinary shares of voting stock is the criterion
for determining the existence of a direct investment relationship.Foreign Direct Investment in Rwanda increased by 267.70 Million USD in 2014. Foreign Direct Investment in Rwanda averaged 211.44 Million USD from 2009 until 2014, reaching an all-time high of 267.70 Million USD in 2014 and a record low of 118.67 Million USD in 2009. Foreign Direct Investment in Rwanda is reported by the National Bank of Rwanda.In 2014, Utilities (water and energy), transport, communication and storage; construction and manufacturing sectors were the main recipient of FDI jointly accounting for 73.4 percent (US$ 382.9 million) of total FDI inflows. In terms of new investment projects, manufacturing and agriculture, fishing,
forestry and hunting were leading with 41.0 percent. The total jobs expected to be created through FDI in 2014 were 8,914. Manufacturing accounted for 35.7 percent followed by mining and quarrying with 18.1 percent and agriculture, fishing, forestry and hunting with 9.9 percent.In 2014, Rwanda’s four major sources of FDI were USA, Mauritius, India and Uganda while in 2013; the leading sources of FDI were Turkey, South Korea, South Africa and USA. In terms of employment, projects from China, USA, India, France and Uganda were expected to create 47.8 percent of
the total employment in 2014.Examples of FDIs in RwandaSorwathe Tea Ltd., Forestry and Agricultural Investment Management, and West rock Coffee Holdings, LLC, Kenya Commercial Bank (KCB), Kenya’s National Media Group (NMG).China, Indonesia and Germany are the main investing countries (Source:
Doing Business - 2016.)In early 2016, the Rwandan Development Board (RDB) signed an agreement
with Thomson Reuters to support further innovation within the country.7.3.1 Advantages of foreign direct investmentsThe following are the advantages of foreign direct investments.1. They increase the stock of capital in LDCs thus help break the cycle of poverty which enables LDCs to achieve rapid economic growth.2. FDIs provide managerial, administrative and technical personnel, new technology, research and innovation in LDCs. This helps to improve LDCs technics of production hence more employment opportunities.3. They increase government revenue from taxes imposed on production activities undertaken by foreign investments.4. FDIs increase productivity and efficiency due to high levels of technology used which leads to more export earnings and improvement in the Balance of payment position.5. They encourage entrepreneurial development in the country due to competition thus would lead to the citizens of that country to invest in their country hence more foreign exchange earnings.6. They create employment opportunities in the recipient countries.7. They increase savings thus closing the savings investment gap in LDCs.8. Due to the inflow capital assets, foreign investment promotes capital accumulation in LDCs.9. Foreign investments help in the exploitation of idle resources in LDCs thus promoting economic growth and development.10. They increase consumer choice due to production of wide variety of quality products due massive productions.11. FDIs increase the exploitation of domestic infrastructure e.g. transport facilities, communication facilities etc.12. They accelerate industrial growth through manufacturing and provision of services.13. They promote international cooperation hence increase the volume of imports and exports.14. Local firms become efficient through competition.15. They fill the manpower gap through importation of expatriates’ manpower.7.3.2 Disadvantages foreign direct investmentsBelow are the disadvantages of foreign direct investments1. It leads to profit repatriation and capital outflow thus worsening the balance of payment deficits in LDCs.2. FDIs increase government expenditure in form of provision of basic facilities like land, power and other basic facilities as well as tax concessions, tax holidays, subsidised inputs etc.3. They cause income inequality in the recipient countries because top posts are reserved for their national and pay them very highly while citizens of the recipients’ country occupy low status and low paying posts.4. Foreign investors at times exert pressure on the government and may influence the decision made by the government of the recipient country which brings about dependency and loss of autonomy in the
recipient country.5. They bring about instabilities in the recipient country due to reallocation of their investments into other countries.6. Foreign countries use capital intensive technology which creates technological unemployment thus may not help in solving the problem of unemployment.7. They increase demonstration effect in the recipient country due to increased number of foreigners who impose life style of developed countries in LDCs thus start copying the consumption habits and
lifestyle of the foreigners.8. Most of the private foreign investments are urban based and this creates the problems of rural urban migration and its negative effects.9. It leads to loss of government revenue through tax holidays, concessions etc.10. FDLs causes dumping through importation of outsider or low quality equipment.11. FDIs may lead to loss of markets of products from indigenous enterprises.12. FDIs may lead to irrational and exhaustion of domestic resources.7.3.3 Measures of attracting foreign investors in RwandaActivity 7As an economics student use the knowledge, understanding, skills, values and attitudes gained on various economics issues, to advise the Rwandan government on how to attract foreign investments into the country.FactsThe Government of Rwanda (GoR) understands that private sector development is critical if Rwanda is to achieve its aim to reach middleincome status by 2020, and reduce the country’s reliance on foreign aid.
Over the past decade, the GoR has undertaken a series of pro-investment policy reforms intended to improve the investment climate, expand trade, and increase levels of foreign direct investment. These include:• In 2006, the Government of Rwanda (GoR) consolidated multiple investment-related government agencies, including the Office of Tourism and National Parks, and the Rwanda Investment and Export Promotion Agency, to establish the Rwanda Development Board (RDB), which serves today as the country’s chief investment promotion agency.• There is no difficulty obtaining foreign exchange in Rwanda or transferring funds associated with an investment into a usable currency and at a legal market-clearing rate. In 1995, the government abandoned the dollar peg and established a floating exchange rate regime, under which all lending and deposit interest rates were liberalised. The Central bank holds daily foreign exchange sales freely accessed by commercial banks.• The government has maintained a high-profile anti-corruption effort and senior leaders articulate a consistent message emphasising that fighting corruption is a key national goal. The government investigates corruption allegations and generally prosecutes and punishes those
found guilty.• Rwandan law provides permanent residence and access to land to investors who deposit USD 500,000 in a commercial bank in the country for a minimum of six months. There are neither statutory
limits on foreign ownership or control, nor any official economic or industrial strategy that discriminates against foreign investors.• Rwanda is a stable country with low violent crime rates. A strong police and military provide a security umbrella that minimises potential criminal activity and political disturbances.• Rwanda is a member of the East African Community (EAC), and participates in a customs union that helps facilitate the movement of goods produced in the region and allows EAC citizens with certain
skills to work in any member state.• Rwanda has also established a free trade zone outside the capital, Kigali, which includes current and planned future communications infrastructure. Bonded warehouse facilities are now available both in
and outside Kigali for use by businesses importing duty free materials.• RDB offers one of the fastest business registration processes in Africa: new investors can register online at RDB’s website and receive approval to operate in less than 24 hours, and the agency’s “one-stop shop” helps foreign investors secure required approvals, certificates, and work permits.• The Government of Rwanda established the Privatisation Secretariat and the Rwanda Public Procurement Agency to ensure transparency in government tenders and divestment of state-owned enterprises. Rwanda’s ranking in Transparency International’s “Corruption Perception Index” has improved significantly, falling from 102 in 2008, to 49 in 2013, the top ranked country in eastern Africa.• The government reserves the right to expropriate property “in the public interest” and “for qualified private investment” under the expropriation law of 2007. The government and the landowner
negotiate compensation directly depending on the importance of the investment and the size of the expropriated property. RDB may facilitate expropriation in cases where the expropriation is potentially
controversial.• Rwanda is a signatory to the Convention on the Settlement of Investment Disputes (ICSID) and African Trade Insurance Agency (ATI). ICSID seeks to remove impediments to private investment posed
by non-commercial risks, while ATI covers risk against restrictions on import and export activities, inconvertibility, expropriation, war, and civil disturbances. Rwanda is a member of the East African Court of Justice for the settlement of disputes arising from or pertaining to the East African Community (EAC). Rwanda has also acceded to the 1958 New York Arbitration Convention.• Investors who demonstrate capacity to add value and invest in priority sectors have generally enjoyed more tax and investment incentives, including Value Added Tax (VAT) exemptions on all imported raw
materials, 100 percent write-off on research and development costs, five-to-seven percent reduction in corporate income tax for firms whose exports are worth at least 3 million USD, duty exemption on
equipment, and a favourable accelerated rate of depreciation of 50 percent in the first year. The government also offers grants and special access to credit to investors who develop in rural areas.• RDB has been successful in developing investment incentives and publicising investment opportunities abroad. Registered foreign investors have obtained benefits in the past, including exemption from
value-added tax and duties when importing machinery, equipment, and raw materials.• Protection of property rights: The law protects and facilitates acquisition and disposition of all property rights. Investors involved in commercial agriculture have leasehold titles and are able to secure
property titles, if necessary. A property registration and land titling effort, the result of a 2005 land law, was completed in 2013.• The Government of Rwanda has implemented transparency of the regulatory system; the government generally employs transparent policies and effective laws to foster clear rules consistent with
international norms. Institutions such as the Rwanda Revenue Authority, the Ombudsman’s office, Rwanda Bureau of Standards (RBS), the National Public Prosecutions Authority (NPPA), the
Rwanda Utilities Regulatory Agency, the Public Procurement Agency, and the Privatisation Secretariat all have clear rules and procedures.• Rwandan law allows private enterprises to compete with public
enterprises under the same terms and conditions with respect to access
to markets, credit, and other business operations. Since 2006, the
government has made an effort to privatise State-Owned Enterprises
(SOEs), to reduce the government’s non-controlling shares in private
enterprises, and to attract FDI, especially in the information and
communications, tourism, banking, and agriculture sectors.
• There is a growing awareness of corporate social responsibility
—(CSR), but only a few companies chiefly foreign-owned have
implemented sustainable programs. In recognition of the firm’s strong
commitment to CSR, the U.S. Department of State awarded Sorwathe,
a U.S.-owned tea producer in Kinihira, Rwanda, the Secretary of
State’s 2012 Award for Corporate Excellence for Small and Medium
Enterprises.• Rwanda is eligible for trade preferences under the African Growth and Opportunity Act (AGOA), which the United States enacted to extend duty-free and quota-free access to the U.S. market for nearly all
textile and handicraft goods produced in eligible beneficiary countries. The U.S. and Rwanda signed a Trade and Investment Framework Agreement (TIFA) in 2006, and a Bilateral Investment Treaty (BIT)
in 2008. Rwanda has also signed bilateral investment treaties with Germany (1967) and Belgium (1985).• The Export-Import Bank (EXIM) continues its programme to insure short-term export credit transactions involving various payment terms, including open accounts that cover the exports of consumer goods,
services, commodities, and certain capital goods. Rwanda is a member of the Multilateral Investment Guarantee Agency (MIGA) which issues guarantees against non-commercial risks to enterprises that invest in member countries and the African Trade Insurance Agency (ATI).• Rwanda attempts to adhere to International Labour Organisation (ILO) conventions protecting worker rights. Policies to protect workers in special labour conditions exist, but enforcement remains inconsistent.
The government encourages, but does not require, on-job-training and technology transfer to local employees.7.3.4 Hurdles and constraints of FDIs in RwandaThe following are the hurdles and constraints of FDI’s in Rwanda:• Rwanda suffers from a shortage of skilled labour, including accountants, lawyers, and technicians.• Some firms have reported occurrences of petty corruption in the customs clearing process, but there are few or no reports of corruption in transfers, dispute settlement, regulatory system, taxation, or
investment performance requirements.• Political instabilities and insecurities with in and in the neighbouringcountries, e.g. fighting in the eastern Democratic Republic of Congo (DRC) between Congolese armed forces (FARDC) and the M23 has
scared most investors, especially in the areas of Gisenyi and Rubavu. Grenade attacks aimed at the local population have occurred on a recurring basis over the last five years in Rwanda. Four attacks
occurred in Kigali in 2013 and early 2014, killing five and injuring 48 persons all which reduce confidence of investors in the security of the country.• Some investors claim that the RRA unfairly targets foreign investors for audits. In recent years, several investors raised concerns that RRA breached Rwandan law by auditing corporate financial statements that had already exceeded the statute of limitations for review.• Some investors complain that the strict enforcement of tax, labour, and environmental laws impede investment. In 2009, the government updated the labour code to simplify labour recruitment and facilitate
the hiring, firing, and retention of competent staff.• Some investors have complained that the application process for work permits and extended stay visas has become onerous (burdensome). Immigration authorities frequently request extra documentation
detailing applicants’ qualifications and, at times, have taken several months to adjudicate cases.• Some investors have complained that coordination between RDB and Rwanda Revenue Authority (RRA) is limited, resulting in assessment by RRA on duties or taxes on registered investments despite RDB’s assurance that such investments qualified for tax-exempt or taxincentivised status• There are no laws requiring private firms to adopt articles of incorporation or association that limit or prohibit foreign investment, participation, or control.• A 2012 report by Rwanda’s office of the Auditor General cited continuing problems with inappropriate procurement methods, but
said violations had reduced significantly from years past.• Rwanda’s judicial system suffers from a lack of resources and capacity, including functioning courts. The Heritage Foundation’s Economic Freedom Index has cited the judiciary’s lack of independence from
the executive. Investors cite the Government of Rwanda’s casual approach to contract sanctity and say the government fails to enforce court judgments in a timely fashion.• Despite RDB’s investment facilitation role, some foreign investors say they face difficulty in obtaining or renewing work visas due to the government of Rwanda’s demonstrated preference for hiring local or
EAC residents over third country nationals.• Investors have also cited the inconsistent application of tax incentives and import duties as a significant challenge to doing business in Rwanda. Under Rwandan law, foreign firms should receive equal
treatment with regard to taxes, and access to licenses, approvals, and procurement.• Potential and current investors cite a problem of high transport costs, which reduces their profit margin.• A small domestic market due to prevalent poverty levels in Rwanda, limited access to affordable financing and high interest rates on borrowing that increase costs of production.• Inadequate infrastructure in form of roads and communication network, power facilities, water etc.• Ambiguous tax rules which normally scare investors away thus reducing the would be social and economic benefits from.7.4 Global Financial Systems and InstitutionsActivity 8Use the library or the internet or any other economics resource, to research and share with others in class about the following:(i) What global financial system is.(ii) The role of International financial system.(iii) What are the components of International financial system?Facts7.4.1 Meaning of International monetary systemsInternational monetary systems are sets of internationally agreed rules, conventions and supporting institutions, that facilitate international trade, cross border investment and generally the reallocation of capital between nation states. They provide means of payment acceptable to buyers and
sellers of different nationality, including deferred payment. To operate successfully, they need to inspire confidence, to provide sufficient liquidity for fluctuating levels of trade and to provide means by which global imbalances can be corrected.The global financial system is the worldwide framework of legal agreements, institutions, both formal and informal economic actors that together facilitate international flows of financial capital for purposes of investment and trade financing. Since emerging in the late 19th century during the first modern
wave of economic globalisation, its evolution is marked by the establishment of Central banks, multilateral treaties, and intergovernmental organisations aimed at improving the transparency, regulation, and effectiveness of international markets.In the late 1800s, world migration and communication technology facilitated unprecedented growth in international trade and investment. At the onset of World War I, trade contracted as foreign exchange markets became paralysed by money market liquidity.Countries sought to defend against external shocks with protectionist policies and trade virtually halted by 1933, worsening the effects of the global Great Depression until a series of reciprocal trade agreements slowly reduced tariffs worldwide. Efforts to revamp the international monetary system after
World War II improved exchange rate stability, fostering record growth in global finance.A country’s decision to operate an open economy and globalise its financial capital carries monetary implications captured by the balance of payments. It also renders exposure to risks in international finance, such as political deterioration, regulatory changes, foreign exchange controls, and legal
uncertainties for property rights and investments. Both individuals and groups may participate in the global financial system. Consumers and international businesses undertake consumption, production, and investment. Governments and intergovernmental bodies act as purveyors of international
trade, economic development, and crisis management. Regulatory bodies establish financial regulations and legal procedures, while independent bodies facilitate industry supervision. Research institutes and other associations analyse data, publish reports and policy briefs, and host public
discourse on global financial affairs.While the global financial system is edging towards greater stability, governments must deal with differing regional or national needs. Some nations are trying to orderly discontinue unconventional monetary policies installed to cultivate recovery, while others are expanding their scope and scale. Emerging market policymakers face a challenge of precision as they must carefully institute sustainable macroeconomic policies during extraordinary market sensitivity without provoking investors to retreat
their capital to stronger markets. Nations’ inability to align interests and achieve international consensus on matters such as banking regulation has perpetuated the risk of future global financial catastrophes.7.4.2 Bretton Woods ConferenceThe Bretton Woods Conference, formally known as the United Nations Monetary and Financial Conference, was the gathering of 730 delegates from all 44 Allied nations at the Mount Washington Hotel, situated in Bretton Woods, New Hampshire, United States, to regulate the international monetary and financial order after the conclusion of World War II.The conference was held from July 1–22, 1944. Agreements were signed that, after legislative ratification by member governments, established the International Bank for Reconstruction and Development (IBRD) and the International Monetary Fund (IMF).The Bretton Woods Conference had three main results:1. Articles of Agreement to create the IMF, whose purpose was to promote stability of exchange rates and financial flows.2. Articles of Agreement to create the IBRD, whose purpose was to speed reconstruction after the Second World War and to foster economic development, especially through lending to build infrastructure.3. Other recommendations for international economic cooperation. The Final Act of the conference incorporated these agreements and recommendations. Within the Final Act, the most important part in
the eyes of the conference participants and for the later operation of the world economy was the IMF agreement. Its major features were:• An adjustably pegged foreign exchange market rate system: Exchange rates were pegged to gold. Governments were only supposed to alter exchange rates to correct a “fundamental disequilibrium.”• Member countries pledged to make their currencies convertible for trade-related and other current account transactions. There were, however, transitional provisions that allowed for indefinite delay
in accepting that obligation, and the IMF agreement explicitly allowed member countries to regulate capital flows. The goal of widespread current account convertibility did not become operative
until December 1958, when the currencies of the IMF’s Western European members and their colonies became convertible.• As it was possible that exchange rates thus established might not be favourable to a country’s balance of payments position, governments had the power to revise them by up to 10% from the
initially agreed level (“par value”) without objection by the IMF. The IMF could concur in or object to changes beyond that level. The IMF could not force a member to undo a change, but could
deny the member access to the resources of the IMF.• All member countries were required to subscribe to the IMF’s capital. Membership in the IBRD was conditioned on being a member of the IMF. Voting in both institutions was apportioned
according to formulas giving greater weight to countries contributing more capital (“quotas”).The conference conducted its major work through three “commissions.”1. Commission I dealt with the IMF2. Commission II dealt with the IBRD3. Commission III dealt with “other means of international financial cooperation” It was a venue for ideas that did not fall under the other two commissions.7.4.3 International monetary fund (IMF)Activity 9Basing on the research carried out in Activity 8 of this unit, discuss amongst yourselves about the following:(i) What led to the establishment of IMF.(ii) The objectives of IMF.(iii) Its functions and criticisms.FactsThe IMF is an institution that was officially established on 27 December 1945, when the 29 participating countries at the conference of Bretton Woods signed its Articles of Agreement, the IMF was to be the keeper of the rules and the main instrument of public international management. The
Fund commenced its financial operations on 1 March 1947. IMF approval was necessary for any change in exchange rates in excess of 10%. It advised countries on policies affecting the monetary system and lent reserve currencies to nations that had incurred balance of payment debts. The International Monetary Fund (IMF) is an Organisation of 188 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable
economic growth, and reduce poverty around the world. Created in 1945, the IMF is governed by and accountable to the 188 countries that make up its near-global membership.Why the IMF was created and how it worksThe IMF, also known as “the Fund”, was conceived at a UN conference in Bretton Woods, New Hampshire, United States, in July 1944. The 44 countries at that conference sought to build a framework for economic cooperation to avoid a repetition of the competitive devaluations that had
contributed to the Great Depression of the 1930s.The IMF’s responsibilities: The IMF’s primary purpose is to ensure the stability of the international monetary system—the system of exchange rates
and international payments that enables countries (and their citizens) to transact with each other. The Fund’s mandate was updated in 2012 to include all macroeconomic and financial sector issues that bear on global stability.Objectives of IMF1. To have a system with stable exchanges rates and avoid competitive devaluation.2. To work towards the removal of forex control which hinders the growth of the world trade by establishing a multi-lateral system of payment in respect to carrying out transactional between member
countries.3. To ensure there is sufficient international liquidity and total means of payment acceptable for international payment.4. Give advice to countries with balance of payment difficulties without resulting into measures destructive to national and international prosperity by making funds or resources available to them under adequate safe guards.5. To facilitate extension and balanced growth of international trade and to contribute to the promotion and maintenance of high levels of employment and development of productive resources of all
member countries.6. To stabilise prices so as to increase the rates of economic growth and development among poor countries.7. To increase the global co-operation through participation in international trade.8. To harmonise policies pursued by different countries so as to create peace among member nations.Functions of the International Monetary Fund1. It gives technical advice to its member countries on monetary and fiscal policies in order to help member countries ensure economic stability.2. Conduct some training services on fiscal and monetary as well as balance of payment issues for personnel from member nations through its Central banking service department.3. Conduct research studies about member countries and publish the statistics about the balance of payment and other macro-economic statistics through the bureau of statistics and the IMF institutions.4. IMF monitors the policies being adopted by the member countries. International payments and tariffs and ensure that no member country imposes restrictions on making that payment or trade restrictions without the approval of the IMF.5. It ensures stable exchange rates by the member countries. I.e. it provides machinery for the orderly adjustments of exchange rates.6. It helps member countries to offset BOP deficits by providing SDRs (special drawing rights) and the stabilisation fund to member countries faced with balance of payment problems.7. It increases international liquidity by introducing the special drawing rights which can be used to finance deficit or surplus of balance of payment.8. Buying and selling currency of the member countries and this assists debtor countries to purchase forex or to use SDRs in order to pay its debts. (SDRs are international reserve assets created by the IMF
to supplement its member countries official reserves.) Its value is based on the basket of the currencies and it can be exchanged and freely usable by all countries. It is rather a potential claim on the freely usable currencies of the IMF members.9. It functions as a short-term credit institution.10. It is a reservoir of the currencies of all the member countries from
which a borrower nation can borrow the currency of other nations.11. It is a sort of lending institution in foreign exchange. However, it grants loans for financing current transactions only and not capital transactions.12. The Fund contributes to the promotion and maintenance of high levels of employment and real income and to the development of the productive resources of all member nations.13. Assist countries to restructure their economies through SAPs facility.Special drawing rights (SDR)This involves book entries credited to member states in proportion to their quotas. It is a paper asset also known as paper gold created by IMF to increase international liquidity. As stated earlier, SDRs are merely international reserves used to settle a BOP deficit. It is, therefore, an account added to a
member country’s reserves.Use of SDRs(i) SDRs are used to purchase members’ own currency.(ii) Overdrawing from SDRs will call for special IMF advice to countries concerned; which countries are faced with inflation and after the advice is devaluation.(iii) It is used to settle international debt obligations by transferring credit to creditors. Countries with BOP surplus can receive SDR, in exchange for their own currency as an incentive to hold SDRs as the guaranteed interest.It should be noted that SDR unit is mainly influenced by the US Dollar, the Pound Sterling, the French Franc, the Swiss Franc, the German Mark, and the Japanese Yen etc.Criticisms of IMFThe IMF faces a number of criticisms some of which are discussed below• The IMF has put the global economy on a path of greater inequality and environmental destruction; The IMF’s and World Bank’ structural adjustment policies (SAPs) ensure debt repayment by requiring
countries to cut spending on education and health; eliminate basic food and transportation subsidies; devalue national currencies to make exports cheaper; privatise national assets; and freeze wages.
Such belt-tightening measures increase poverty, reduce countries’ ability to develop strong domestic economies and allow multinational corporations to exploit workers and the environment.• The IMF serves wealthy countries and Wall Street; Unlike a democratic system in which each member country would have an equal vote, rich countries dominate decision-making in the IMF because voting power is determined by the amount of money that each country pays into the IMF’s quota system. It’s a system of one dollar, one vote. The U.S. is the largest shareholder with a quota of 18 percent. Germany, Japan, France, Great Britain, and the US combined control about 38 percent. The disproportionate amount of power held by wealthy countries means that the interests of bankers, investors and corporations from industrialised countries are put above the needs of the world’s poor majority.• The IMF forces countries from the Global South to prioritise export production over the development of diversified domestic economies; Nearly 80 percent of all malnourished children in the developing world
live in countries where farmers have been forced to shift from food production for local consumption to the production of export crops destined for wealthy countries.The IMF also requires countries to eliminate assistance to domestic industries while providing benefits for multinational corporations — such as forcibly lowering labour costs. Small businesses and farmers
can’t compete. Sweatshop workers in free trade zones set up by the IMF and World Bank earn starvation wages, live in deplorable conditions, and are unable to provide for their families. The cycle of poverty is
perpetuated, not eliminated, as governments’ debt to the IMF grows.• The IMF is a secretive institution with no accountability; The IMF is funded with taxpayer money, yet it operates behind a veil of secrecy. Members of affected communities do not participate in designing loan
packages. The IMF works with a select group of Central bankers and finance ministers to make polices without input from other government agencies such as health, education and environment departments.
The institution has resisted calls for public scrutiny and independent evaluation.• IMF policies promote corporate welfare; To increase exports, countries are encouraged to give tax breaks and subsidies to export industries. Public assets such as forestland and government utilities (phone, water and electricity companies) are sold off to foreign investors at rock bottom prices.• The IMF hurts workers; The IMF and World Bank frequently advise countries to attract foreign investors by weakening their labour laws
— eliminating collective bargaining laws and suppressing wages, for example. The IMF’s mantra of “labour flexibility” permits corporations to fire at will and move where wages are cheapest.• The IMF’s policies hurt women the most; SAPs make it much more difficult for women to meet their families’ basic needs. When education costs rise due to IMF-imposed fees for the use of public services (socalled “user fees”) girls are the first to be withdrawn from schools. User fees at public clinics and hospitals make healthcare unaffordable to those who need it most. The shift to export agriculture also makes it harder for women to feed their families. Women have become more exploited as government workplace regulations are rolled back and sweatshops abuses increase.IMF Policies hurt the environment; IMF loans and bailout packages are paving the way for natural resource exploitation on a staggering/ amazing scale. The IMF does not consider the environmental impacts of lending policies, and environmental ministries and groups are not included in policy making. The focus on export growth to earn hard currency to pay back loans has led to an unsustainable liquidation of natural resources.• The IMF bails out rich bankers, creating a moral hazard and greater instability in the global economy; The IMF routinely pushes countries to deregulate financial systems. The removal of regulations that might limit speculation has greatly increased capital investment in developing country financial markets. More than 1.5 trillion USD crosses border every day. Most of this capital is invested short-term, putting countries
at the whim of financial speculators. Bailouts encourage investors to continue making risky, speculative bets, thereby increasing the instability of national economies.• IMF policies imposed as conditions of these loans are bad medicine, causing layoffs in the short run and undermining development in the long run. This has sparked recessions in some countries by raising
interest rates, which led to more bankruptcies and unemployment.IMF ConditionalitiesActivity 10The IMF gives conditions to its member countries incase it is to give foreign aid to them.(a) What conditions are they?(b) How have these conditions impacted Rwanda’s economy?Usually before the IMF advances loans to its member countries, receiving the IMF loans, member countries must accept the conditionalities as prescribed in the structural adjustment programmes (SAPs). These IMF conditions have also been sometimes labelled as the Washington Consensus.7.4.4 Structural Adjustment Programmes (SAPs)Structural adjustment programmes (SAPs) refer to a package of policies which should be implemented in order to restructure and transform the economy of the country accepting loans from the IMF and the sister institution World Bank.Structural adjustment programmes (SAPs) consist of loans provided by the International Monetary Fund (IMF) and the World Bank (WB) to countries that experienced economic crises. The two Bretton Woods Institutions require borrowing countries to implement certain policies in order to obtain
new loans (or lower interest rates on existing ones). The conditionality clauses attached to the loans have been criticised because of their effects on the social sector.SAPs are created with the goal of reducing the borrowing country’s fiscal imbalances in the short and medium term or in order to adjust the economy to long-term growth. The bank from which a borrowing country receives its loan depends upon the type of necessity. The IMF usually implements
stabilisation policies and the WB is in charge of adjustment measures.SAPs are supposed to allow the economies of the developing countries to become more market oriented. This then forces them to concentrate more on trade and production so it can boost their economy. Through conditions, SAPs generally implement “free market” programmes and policy. These programmes include internal changes (notably privatisation and deregulation) as well as external ones, especially the reduction of trade barriers. Countries that fail to enact these programmes may be subject
to severe fiscal discipline. Critics argue that the financial threats to poor countries amount to blackmail, and that poor nations have no choice but to comply.The IMF conditions comprise of typical stabilisation and Long-term adjustment policies. They include among others the following:1. Balance of payments deficits reduction through currency devaluation. i.e. member countries should devalue their currency to increase competition of home produced goods to increase foreign exchange earnings.2. Privatisation or divestiture of all or part of state-owned enterprises: A country should privatise its large inefficient public enterprise which requires a lot of government funding leading to high
government expenditure.3. Budget deficit reduction through higher taxes and lower government spending, also known as austerity e.g. reducing on government expenditure on education and health in order to reduce the size of
the work force to reduce on government expenditure hence has a balanced budget.4. Retrenchment of the civil servants and demobilisation of the army in order to reduce on the size of the work force and government expenditure as well as ensure efficiency.5. Increase on tax collection revenue to avoid deficit financing by simply printing more money.6. Introduction of policies that attract both foreign and domestic investors, e.g, reduction in borrowing rates and having an open economy.7. Infrastructural development in order to improve productivity thus promoting economic growth and development.8. Emphasises the improvement of productivity through research and adoption of modern technology.9. Market liberalisation to guarantee a price mechanism in order to avoid government control of prices which lead to inefficiency and to allow private producers to compete.10. Market expansion through economic integration in order to increase export earnings.11. Ensure political stability and security in the economy.12. Raising food and petroleum prices to cut the burden of subsidies.13. Forex liberalisation and granting autonomy to the central bank to pursue on appropriate monetary policy.14. Focusing economic output on direct export and resource extraction.15. Improving governance and fighting corruption.16. Enhancing the rights of foreign investors vis-à-vis national laws.17. Increasing the stability of investment (by supplementing foreign direct investment with the opening of domestic stock markets).18. Creating new financial institutions.Applicability of SAPs in RwandaSome Structural Adjustments have been applied in Rwanda and these include among others the following:• There has been improvement in tax correction through expanding the tax base by introducing new direct and indirect taxes.• Trade liberalisation has been practiced in Rwanda e.g. markets have been opened for foreign imports especially manufactured commodities.• Privatisation: Rwanda has privatised some of her public enterprises as one of the requirements of SAPs.• There has been a reduction in public expenditure e.g. on social overhead expenditure like health, education social security etc. through cost sharing.• As one of the IMF recommendations, there has been increased production in agricultural sector.• Retrenchment of workers and demobilisation of the army.Criticisms/impact of the SAPs conditionalitiesThe following are the criticisims or impacts of the SAPs conditionalities1. Cost sharing has been introduced in institutions of higher learning leading to reduced enrolment in schools there by perpetuating illiteracy.2. Cost sharing in hospitals has led to poor services hence poor health conditions leading to weak work force thus low output.3. Removal of subsidises especially on food has deepened misery and suffering of the poor masses because they cannot afford basic necessities thereby destroying the workforce.4. Life expectancy has dropped and the infant mortality rate has increased due to malnutrition and poor standards of living.5. The SAPs policies have widened the gap between the rich and the poor e.g. through retrenchment hence increasing poverty among the majority of the poor.6. The policy of devaluation has made imports expensive yet imports for LDCs have inelastic demand thus high forex expenditure or out flow worsening the balance of payment position.7. The conditionalities have led to wide spread unemployment due to retrenchment and privatisation.8. SAP’s policies have led to the widening of the informal sector where the operator can try evading the taxes that the government has been forced to introduce.9. The ruling parties and government in power have become unpopular because the implementation of these policies which are seen as being anti-people has at times led to strikes, riots and high crime rates.10. SAPs threaten the sovereignty of national economies because an outside organisation is dictating a nation’s economic policy.11. When resources are transferred to foreign corporations and/or national elites through privatisation, the goal of public prosperity is replaced with the goal of private accumulation.12. SAPs are held responsible for much of the economic stagnation that has occurred in borrowing countries. SAPs emphasise maintaining a balanced budget, which forces austerity programmes. The casualties of balancing a budget are often social programmes yet they are already underfunded and desperately need monetary investment for improvement. e.g. education, public health, and other social safety nets.7.5 International Bank for Reconstruction and Development (IBRD)- the World BankActivity 11Basing on the research carried out in Activity 8 of this unit, discuss
amongst yourselves about the following:(i) What led to the establishment of the World Bank?(ii) The objectives of World Bank, its functions and criticisms.FactsThe International Bank for Reconstruction and Development (I.B.R.D) better known as the World Bank was established at the same time as the International Monetary Fund to tackle the problem of international investment in 1944. Since the I.M.F was designed to provide temporary assistance in correcting balance of payments difficulties, there was need of an institution to assist long term investment purposes. Thus I.B.R.D was established for promoting long term investment loans on reasonable terms.The World Bank as an inter-government institution corporate forms the capital stock of which is entirely owned by its member governments. Initially only nations that were members of the I.M.F could be members of the World Bank but the restriction on membership was subsequently released. The World Bank advances loans to member countries primarily to help them lay down the foundation of sound economic growth. The loans made by the bank either directly or through guarantees are intended for certain specific projects of reconstruction and development in the member countries.Members of I.B.R.D/WBThe International Bank for Reconstruction and Development (IBRD) has 189 member countries, while the International Development Association (IDA) has 172 members. Each member state of IBRD should also be amember of the International Monetary Fund (IMF) and only members of IBRD are allowed to join other institutions within the Bank (such as IDA)a) Objectives of I.B.R.D/WBThe objectives of I.B.R.D as incorporated in the Articles of Agreement are
1. To help in the reconstruction and development of member countries by facilitating the investment of capital for the productive purposes, including the restoration and reconstruction of economies devastated
by war.2. To encourage the development of productive resources in developing countries by supplying them investment capital.3. To promote private foreign investment through guarantees and participation in loans and other investment made by private investors.4. To supplement private foreign investments by direct loans out of its own capital for productive purposes.5. To promote long term balances growth of international trade and the maintenance of equilibrium in the balance payments of member countries by encouraging long term international investments.6. To bring about an easy transition from a war economy to a peace time economy.7. To help in raising productivity, the standard of living and the conditionsof labour in member countries.b) Functions of I.B.R.D/WBThe principal functions of the I.B.R.D are set forth in Article (1) of the Agreement as follows:1. To assist in the reconstruction and development of the territories of its members by facilitating the investment of capital for productive purposes.2. To promote private foreign investment by means of guarantee of participation in loans and other investments made by private investors and when private capital is not available on reasonable terms to make loans for productive purposes out of its own resources from funds borrowed by it.3. To promote the long term growth balance of international trade and the maintenance of equilibrium in balances of payments by encouraging international investments for development of productive resources of members.4. To arrange loans made guaranteed by it in relation to international loans through other channels so that more useful projects, large and small alike, will be dealt with first.c) Projects supported by World Bank in RwandaMoving forward, the World Bank Group is expanding its support to Rwanda, helping it shift its growth trajectory that has the private sector at its vanguard. This requires much investment in infrastructure, service delivery, accountable governance, regional integration, boosting agricultural
productivity, etc. To help Rwanda respond to these challenges, the World Bank Group has built its current portfolio of a net commitment of almost 887 million USD for 11 national projects and six regional projects with a national commitment of 204 million USD. These projects include:• Rwanda Pilot Programme for Climate Resilience.• Third Social Protection System Support (SPS-3).• Rwanda Urban Development Project.• Rwanda Electricity Sector Strengthening Project.• Transformation of Agriculture Sector Programme Phase 3 for Rwanda.• Rwanda Public Sector Governance Programme for Results.• Landscape Approach to Forest Restoration and Conservation
(LAFREC).• Second Demobilisation and Reintegration Project—Additional Financing.• Rwanda Feeder Roads Development Project.• Rwanda Third Rural Sector Support Project Additional Financing.• Land Husbandry, Water Harvesting and Hillside Irrigation.• Third Rural Sector Support Project.• Rwanda Electricity Access Additional Financing. Criticisms of the IBRD/WBBelow are the criticisims of the IBRD/WB:• The World Bank would promote world inflation and “a world in which international trade is state-dominated”. The so-called free market reform policies that the bank advocates for are often harmful to economic development if implemented badly, too quickly (“shock therapy”), in the wrong sequence or in weak, uncompetitive economies.• The World Bank has been criticised on the way in which it is governed. While the World Bank represents 188 countries, it is run by a small number of economically powerful countries. These countries (which also provide most of the institution’s funding) choose the leadership
and senior management of the World Bank, and so their interests dominate the bank.• In the 1990s, the World Bank and the IMF forged the Washington Consensus, policies that included deregulation and liberalisation of markets, privatisation and the downscaling of government. Though
the Washington Consensus was conceived as a policy that would best promote development, it was criticised for ignoring equity, employment and how reforms like privatisation were carried out.
The Washington Consensus placed too much emphasis on the growth of GDP, and not enough on the permanence of growth or on whether growth contributed to better living standards.• The World Bank and other international financial institutions focus too much on issuing loans rather than on achieving concrete development results within a finite period of time• It has been criticised on the grounds that traditionally, WB has always been having Americans head the bank because the United States provides the majority of World Bank funding.Unit assessment1. (a) What role has the IMF played in economic development of your country?(b) What structural adjustment programmes have been implemented in your country?2. (a) What are foreign Direct Investments (FDI’s)? Give examples in Rwanda?(b) Examine the contribution of FDI’s in the development process of Rwanda.(c) Examine the barriers to FDI inflows in Rwanda.3. (a) Explain the roles of World Bank.
(b) Identify different sectors supported by World Bank in Rwanda.Glossaryཀྵཀྵ Globalisation: A process by which most economies around the world have become more interdependent, especially to increased integration of financial market.ཀྵཀྵ International Bank for Reconstruction and Development
(World Bank) (IBRD): Established in 1945 to serve as a vehicle for making loans to less developed countries. Loans are made from the bank’s capital, created by the subscriptions of members and by the sale of bonds.ཀྵཀྵ International Monetary Fund (IMF): Established by the Allied Nations in 1944 to stabilise exchange rates and encourage world trade by reducing exchange restrictions. It lends
money to nations with balance of payments deficits. It affects international monetary reserves through the creation of Special Drawing Rights (SDR’s). Over 100 nations belong to IMF.ཀྵཀྵ Special Drawing Rights (SDRs): International monetary reserves created by IMF and made available to its members. It is also called paper goldUnit summary• Global business organisations• Meaning of globalisation• Characteristics of globalisation• Causes of globalisation• Effects of globalisation• Multinational corporations (MNCs)• Foreign Direct Investment (FDIs)• Global Financial Systems• Bretton Woods Conference• International Monetary Fund (IMF)• International Bank for Reconstruction and Development (IBRD) / the World Bank (WB)• Structural Adjustment Program
Topic Area 5: Development Economics Sub-Topic Area 5.1: Economic Growth and Development Unit 8: Economic Growth, Development and Underdevelopment
Unit 8: Economic Growth, Development and Underdevelopment
Key unit competence: Learners will be able to analyse the indicators and determinants of economic growth and development in an economy.
By the end of this unit, I will be able to:
⦿ Explain the meaning of economic growth, development and underdevelopment.
⦿ Examine the factors that determine economic growth and development.
⦿ Analyze the importance of growth to the economy.
⦿ Compare the balanced, unbalanced and big push strategies of growth.
⦿ Analyze the advantages, disadvantages, limitations and applicability of the theory to Rwanda .
⦿ Compare and contrast the stages, limitations and applicability of Rostow’s and Marxist’s theories of growth.
⦿ Examine the differences between economic growth, development and underdevelopment
. ⦿ Analyze the types of poverty and their causes.
⦿ Suggest policy measures that can be taken by the government of Rwanda to reduce the rates of poverty.
8.1 Economic Growth
Case study 1
Relating to the photos below in Figure 1, the economy of Rwanda has grown tremendously since 1994. This is evidenced in the development of many schools in each district, many hospitals, and many roads linking rural areas to urban centres. Food production also increased to fight the hunger that was cropping out. Environment is being protected, standardisation of goods is done and, women emancipation has been fostered. Many Rwandans now are able to access education, get treatment, move from one place to another and have meals throughout the day.
Basing on the photos A, and B below; the case study, discuss the following questions:
(i) The increase in the number of schools, hospitals, foods and roads is known as ….
(ii) What factors do you think have helped Rwanda to achieve the situation described in case study 1?
(iii) Examine the advantages the scenario described in case study 1 have on Rwanda.
(iv) Analyze the problems that the above scenario brings to Rwanda.
Figure 1: Economic growth
Rwanda is one of the fastest growing economies in Central Africa. Although still poor and mostly agricultural (90% of the population is engaged in subsistence agriculture) the nation has made a significant progress in recent years. The major source of foreign trade is coffee, tea, tin cassiterite, wolframite and pyrethrum. New industries such as tourism, cut flowers and fish farming have been gaining importance. All these have increased significantly to the national income of the country as shown by the increase in the gross domestic product.
Economic growth can be defined as the quantitative increase in the volume of goods and services, or the persistent increase in the volume of goods and services over a period of time. Some economists define economic growth as the persistent increase in the country’s Gross Domestic Product. (GDP).
Economic growth is a material concept. It concerns itself with the growth of physical output, and does not take into account non-material factors like stress, happiness, etc. It is generally considered that economic growth does cause an increase in the standard of living provided that the increase in production exceeds any increase in the population.
This concept of economic growth is usually illustrated by an outward shift of the production possibility curve or production possibility frontier. The production possibility curve is a locus of points showing combinations of two goods that a country can produce when all its resources are fully and efficiently utilized. The outward shift of the curve illustrates an increasing capacity to produce goods and services.
The curve K0Co shows all possible combinations of capital and consumer goods available to a nation when all resources are fully employed.
Point a represents unemployment of some resources, under-utilisation or excess capacity. Point b indicates full employment of all resources, while e represents economic growth. A movement from a to b or any other point on the curve represents an increase in real income. An outward shift of the Production Possibility Frontier (PPF) from K0Co to K1C1 illustrates economic growth.
8.1.1 Measuring of economic growth (Calculation of economic growth)
Economic growth can be measured by real national figures particularly by real GDP. When real GDP is growing over time, then the country is experiencing economic growth. The annual economic growth rate is measured by the percentage change in the real GDP of a country over a period of time usually a year. Countries in East African and the world at large, have varying rates of economic growth. This may not be consistent because one country may grow faster in one year but lags behind the following year. The following table shows the projection of the rates of economic growth of East African countries from 2003 to 2010.
Table 1: Real GDP growth of East African countries for selected years
According to table 1 above, Rwanda recorded the highest
rates of economic growth in 2010 while Burundi recorded the lowest.
Graph showing trends of economic growth The Gross Domestic Product (GDP) in Rwanda expanded 4.80 percent in the third quarter of 2016 over the previous quarter. GDP Growth Rate in Rwanda averaged 5.44 percent from 2000 until 2016, reaching an all-time high of 13.40 percent in the first quarter of 2007 and a record low of -5.10 percent in the first quarter of 2013.
Source: www.tradeconomics.com National Institute of Statistics of Rwanda
Figure 3 above shows Rwanda GDP growth rate from 2014 to 2016
8.1.2 Factors that determine economic growth
Economic growth is the increase in the capacity of an economy to produce goods and services within a specific period of time. It is actually a longterm expansion in the productive potential of the economy to satisfy the wants of individuals in a society. Economic growth is directly related to percentage increase in GNP of a country. In real sense, economic growth is related to increase in per capita national output or net national product of a country that remain constant or sustained for many years. Therefore, any factor that affects real GNP of a country affects economic growth. When these factors are favourable, they increase economic growth but when they are unfavourable, they affect economic growth adversely.
It should be noted that economic growth does not depend on a single factor but a proper balance and management of all the factors involved.
These factors are economic, political, social and cultural in nature. The following are some of the important factors that affect economic growth of a country:
• Human resource: The quality and quantity of available human resource can directly affect the growth of an economy. The quality of human resource is dependent on its skills, creative abilities, training and education. If the human resource of a country is well skilled and trained, then the output would also be of high quantity and quality. On the other hand, a shortage of skilled labour hampers the growth of an economy, whereas surplus of labor is of a lesser significance to economic growth. Therefore, the human resources of a country should be adequate in number with required skills and abilities, so that economic growth can be achieved.
• Natural resources: This involves resources that are produced by nature either on the land or beneath the land e.g. plants, water resources and landscape, oil, natural gas, metals, non-metals and minerals. These depend on climate and environmental conditions. Countries having plenty of natural resources enjoy good growth than countries with small amount of natural resources. Also, efficient utilisation or exploitation of natural resources depends on the skills and abilities of human resource, technology used and availability of funds. Therefore, a country having skilled and educated workforce with rich natural resources takes the country on the path of growth than the one with out.
• Capital formation: This involves land, building, machinery, power, transportation and medium of communication. Producing and acquiring all these man-made products is termed as capital formation. Capital formation increases the availability of capital per worker, which further increases capital/labour ratio. Consequently, the productivity of labour increases, which ultimately results in the increase in output and growth of the economy. On the other hand, a reduction in the rate of capital formation negatively affects the rate of economic growth.
• Technological development: This involves the application of scientific methods and production techniques. In other words, technology is the nature and type of technical instruments used by a certain amount of labor. Technological development helps in increasing productivity with the limited amount of resources. Countries that have worked in the field of technological development grow rapidly compared to countries that have less focus on technological development.
The selection of right technology also plays an important role for the growth of an economy. On the other hand, an inappropriate technology results in high cost of production thus affecting economic growth adversely.
• Social and political factors: social factors involve customs, traditions, values and beliefs which contribute to growth of an economy. For example, a society with conventional beliefs and superstitions resists the adoption of modern ways of living. In such a case, achieving growth becomes difficult. If a society is flexible towards modern ways of living, achieving growth is quicker and easier. Also, political factors, such as participation of government in formulating and implementing various policies, have a major part in promoting economic growth.
• Local and foreign Markets availability: The presence of market both local and foreign, makes suppliers find a way to increase production to satisfy the expanded market through increased demand. This will be witnessed through increased investments throughout the country in a bid to make more supplies and increase their profitability. On the other hand, the absence of market will discourage producers, lead to closure of some industries in the country etc. thus low production in general affecting economic growth negatively.
• Foreign capital (foreign aid and foreign investment): As domestic savings are not sufficient to make possible the necessary or desired accumulation of capital goods, borrowing from abroad may play an important role. This helps to supplement a country’s own small saving in its growth process. Foreign capital can be loans or through foreign direct investments by foreign companies which also help to accelerate economic growth in the receiving country through capital accumulation and higher productivity of labour. They, also, promote new advanced technologies and technical know-how which are required for industrial growth and building up of infrastructure, such as power, irrigation facilities, ports and telecommunications all necessary to aid productivity in an economy. However, if foreign assistance is not forthcoming in adequate quantity, then a country experiences serious difficulties in promoting economic growth as productive capacity of the economy will be rendered inappropriate and inefficient.
This means that, absence of sufficient borrowing and direct foreign investment and the economic growth of the country will be adversely affected.
• The growth of population: The growing population increases the level of output by increasing the number of working population or labour force provided all are absorbed in productive employment. Increase in population means increase in quantity of labour and also increase in demand for goods which encourages production in the economy due to an expanded market. This promotes large-scale production and thus reaping of economies of large scale production. However, it should also be noted that, a growing population will increase productivity only if there is availability of supplies of natural and capital resources and the prevailing technology. When the supplies of capital and other resources are meagre, the increase in population will merely add to unemployment and will not bring about an increase in national output this hinders economic growth instead of promoting it. In another view, population growth adds a number of mouths to be fed and this raises consumption and therefore lowers both saving and investment thus holding down the rate of economic growth in a country.
• Political situation: This is a crucial factor that affects economic growth in any given economy. When there is good political climate i.e. political stability and security of a country attracts both local and foreign investors. Thus increases the volume of goods and services produced. People are assured of security for themselves and their property and this motivates them to start up or expand their businesses in different parts of the country promoting more productive potentials and a positive change in economic growth of a country. In another view, political stability and security in a country reduces government expenditure on military hardware and other forms of financing wars which increases government expenditure on productive activities through development expenditure. Production capacity of the country increases leading to increase in economic growth. On the other hand, political instability and insecurity scares away potential investors, both local and foreign, and also increase government expenditure on financing wars, buying military hardware etc.
all which reduce the production potentials of a country leading to low production of goods and services and adverse effect on economic growth.
• Availability of entrepreneurs: Presence of large number of entrepreneurs will lead to invention of new methods of production which will increase output compared to where there are few entrepreneurs. Entrepreneurs are always willing to convert new ideas into successful innovations. This creates new products and new business models which increase the productive capacity of the people leading to increased productivity hence promoting economic growth of a country.
• Infrastructural development: Infrastructure involves transport network, communication facilities, power, banking institutions etc. Therefore, well-developed and evenly distributed socio-economic infrastructure in an economy will attract more investments by both local and foreign investors since it makes it easy for movement of producers from one place to another and exchange of goods and services to and from different parts of the world hence increasing productivity and output distribution. On the other hand, poorly developed and un fairly distributed socio-economic infrastructure will discourage both local and foreign investments therefore reducing the productive capacity of the nation hampering economic growth.
• Government policy of subsidisation and taxation: When the government adopts a conscious policy of promoting production like giving producers subsidies, tax holidays, reducing interest rate on borrowing etc., investments will be attracted leading to increase in the volume of goods and services produced in the country. Where as the government takes on policies that are not friendly to producers like over taxing these, unfair allocation of resources, high interest rate on borrowed funds etc. it will discourage investments and lower production potentials in the country thus hampering economic growth.
• Technological change: New knowledge and inventions can contribute markedly to growth of potential output, even without net capital accumulation. If the old capital is merely replaced in the same form, capital stock will be constant and there will be no increase in the capacity to produce.
However, if there is growth of knowledge so that as old equipment wears out, it is replaced by different and more productive equipment, productive capacity will be growing leading to economic growth.
8.1.3 Merits/benefits of economic growth
In order to maintain the current living standards, productive capacity must grow at a faster rate than the rate of increase in population. As the economy grows, industries expand, new ones get established, and employment opportunities also expand. This becomes easy for government to redistribute income, provide more services and more opportunities for the less fortunate. Therefore, a number of benefits can be derived from a high rate of economic growth as explained below:
• An increase in standard of living: Economic growth can maintain or improve the living standards. In the long-term, economic growth is the primary engine for raising general living standards. Growth means a higher material standard of living for the citizens of the country. It means more goods and services — cars, shoes, necklaces, foreign holidays, etc. It can help to tackle the poverty of the disadvantaged groups in society though there is no guarantee that this will automatically result from growth. It will probably require action by government to ensure that the benefits of growth are widely shared.
• A higher level of public expenditure with no need for higher taxation: In most cases, increases in government expenditure exceed increases in the national income. This necessitates for a higher level of taxation to finance the increased expenditure. However, if there is a high rate of economic growth then government revenue would automatically increase without any increase in the rate of taxation. Economic growth is the best way to finance more government expenditure.
• Growth and redistribution of income: When there is economic growth and when the increment in income is redistributed through government intervention, it is possible to reduce income inequalities without actually having to lower anyone’s income. It is much easier for a rapidly growing economy to be generous toward its less fortunate citizens or neighbors, than it is for a static economy.
• Reduction in balance of payment problems: A faster rate of growth will make it easier to achieve a balance of payment equilibrium. An increase in output reduces pressure on prices, increases domestic demand and foreign demand for exports which improves the balance of payment position of a country.
• Creates and widens employment opportunities: An expanding economy will have a high level of capital investment spending that will help to sustain a high level of employment. New industries will be emerging and existing ones expanding thus increase in economic activities. This reduces the problem of unemployment and the rates of poverty and its related problems.
• Technological advancement: Economic growth involves advances in technology, innovation and a high degree of dynamism in the economy. This increase in efficiency is likely to be reflected in the quality of the country’s goods, and will make them more competitive in export markets. Besides, the volume of imports reduces, thereby improving the balance of payments position.
• Health related issues are reduced: There is increased production of goods and services which are vital to society and this helps to reduce malnutrition and other related diseases. This keeps the population healthy and more productive thus promoting more growth in the economy.
• Widens the tax base of the country: Once there is expansion of different economic activities in the economy, the country’s tax base increases through taxing those different economic activities hence increasing revenue to the government that can be used for development.
• Economic independence is attained: Since the country produces a lot of goods and services, it reduces reliance on other countries for assistance. Wide variety of commodities produced in the country enables its population to get most of their requirements at home and only gets what they cannot produce with their available resources.
• Infrastructure development: Infrastructures such as roads, hospitals and schools among others are developed to facilitate production directly or indirectly which leads to the development of the country.
• Promotes industrialisation and urbanisation: Economic growth encourages setting up of more industries and the expansion of the existing ones in order to increase productivity. This leads to growth of urban centres since so many facilities such as banking services, roads, power, water, telecommunication services, health centres, training centres etc. are set up in such areas to aid industrial production.
• Stabilizes prices in the economy: Wide variety of goods produced reduce price fluctuations as long as supply matches demand in and outside the country. And also as a result of much output, general price level of goods and services will reduce which increases real incomes of the citizens.
• Promotes political stability: With people being engaged in different economic activities and the desire to produce more and earn more, they have no reason to be chaotic and more so, have little or no time to waste as in rebelling against the ruling government. People who are well off and have a variety to consume, have no food conflicts which is a major cause of insecurities.
8.1.4 Costs of economic growth
The benefits of economic growth are truly impressive. This fact explains why economic growth is so ardently pursued by so many countries. The advantages of economic growth, however, should not obscure the reality that economic growth has costs as well as benefits. As the process of economic growth gets under way, and more goods and services are produced each year, there may arise certain undesirable side effects. If these are not incurred by the producers in the form of higher costs of production, then they are termed social costs. Social costs are those costs arising from economic activity that are borne by society and not by the producer.
Other things being equal, most people would probably regard a fast rate of growth as preferable to a slow one. In spite of the benefits associated with economic growth, there are also costs to material growth. These costs to society can be explained as follows:
• Pollution of air and water: The industries set up to produce and persistently increase output level produce fumes that pollute the environment and pour waste in the water bodies, there is also noise out of those machines. The present serious pollution problem according to the critics, results directly from rapid economic growth. As long as we pursue the goal of more economic growth, they conclude, we will continue to damage the environment.
• Environmental degradation: There is over exploitation of the natural resources which leads to their quick depletion. The ecosystem is normally tempered with, like, swamps being reclaimed, deforestation occurring so as to give room to industries that produce and persistently increase output level to attain economic growth. This reduces environmental sustainability.
• Congestion of traffic and houses leading to delays and easy disease spread: Traffic congestion occurs as vehicles are ever flowing in and out of the industrial place causing unnecessary delays. Workers in the industrial place tend to be accommodated near industries causing slum areas around and poor sanitation.
• Erosion of cultural values: In order to attain faster rates of economic growth, nationals tend to adopt foreign ways of consumption, behaviour and general living, this costs the nation discipline and order that had been maintained for long.
• Current consumption is normally foregone: People, in order to save enough, create capital assets that produce output to attain economic growth, always forego current consumption. They always feel that, to increase output and achieve greater economic growth, one should lower current consumption. This reduces health and living standards of the citizens that further worsens productive capacities and negatively affects economic growth.
• People forego leisure: Leisure is an important aspect of improved standard of living so as to always work, increase output and attain economic growth. However, economists also argue that a greater output of goods and services will not help us to achieve the good life. This is because, on the contrary, people feel that a greater real gross domestic product can be achieved only by sacrificing leisure.
• Increased indebtedness of developing countries: In order to attain economic growth, most developing countries borrow to set up production ventures that produce and persistently increase the level of economic growth. This increases a country’s indebtedness.
• Industrial/occupational hazards: Several upcoming industries set up to attain economic growth do not provide protective gadgets to the workers. Consequently, workers inhale poisonous fumes causing them chronic diseases. Also, they sometimes lose body parts to the machines they are not oriented to.
• The dangers of rural urban migration: As more industries are set up, people move to towns to get jobs and better living conditions in urban areas. As such, likely negative effects arise, such as slum development, open urban unemployment, and overcrowdings arise; this is mainly because people leave villages for urban settings where industries are set up fight for attainment of economic growth.
• Technological unemployment: Another aspect of social cost arises from new techniques of production. Machines and production methods will be subject to a fairly rapid rate of obsolescence. This is also true for labor. The changes which make economic growth possible also make labor redundant. This is especially the case with the capital-intensive techniques which rapidly increase the output level but make labor redundant. This causes technological unemployment.
8.1.5 Measures to promote economic growth
Measures that may be taken to promote long-term economic growth include among others:
• Human capital formation: The government can encourage investment in human capital by providing scholarships, educational grants, and loans to students on favourable terms. Financial support to colleges and universities will also help to improve the quality of human capital and thus promote economic growth.
• Technological change: The government can promote technological change by encouraging Research and Development (R & D). A number of private firms undertake research and development.
The government can provide incentives to these and other firms to increase their research and development activities. It can also finance some research and development projects of its own.
• Encouraging investment: The government can foster economic growth by encouraging investment. This can be attained partly through interest rate policies (low interest rates tend to stimulate real investment), and partly through tax incentives for investment in plant and equipment.
• Transfer of surplus labor from agriculture: One step a less developed country can take to promote economic growth is to remove surplus labor from the agricultural sector to more productive use in other sectors.
• Use of modern technology in agriculture: Attempts should be made to introduce modern technology into agriculture. This could be in form of new types of seeds and improved farming methods. This would lead to dramatic increases in agricultural production.
• Population control: Almost all developing countries use population control methods as part of their attempt to break out of the underdevelopment trap. Population control programmers have two elements: the provision of low cost birth control facilities and the provision of incentives encouraging people to have a small number of children. These methods meet with some, but limited success. Their efforts have been greatly aided by the World Health Organization (WHO). Steps to increase the quality of their labor resources through education and training have also been taken. These measures have helped promote growth and development in less developed countries. Without these measures, the plight of these countries would have been worse.
• Foreign aid: The idea that foreign aid helps economic development arises from a simple consideration. If a poor country is poor because it has too little capital, then by obtaining aid, it can accumulate more capital and achieve a higher per capita output. Repeated applications of foreign aid year after year can enable a country to grow much more quickly than it could if it had to rely exclusively on its own domestic saving. By this line of reasoning, the greater the flow of foreign aid to a country, the faster it will grow.
• Removal of trade restrictions: By permitting unrestricted trade with underdeveloped countries, rich countries gain by being able to consume goods that are imported at lower prices than would be possible if only domestic supplies were available. Developing countries gain by being able to sell their output for a higher price than would prevail if they had only the domestic market available to them. Some of the most dramatic economic growth and development success stories have been based on reaping the gains from relatively unrestricted international trade. Countries such as Singapore and Hong Kong have opened their economies to free trade with the rest of the world and dramatically increased their living standards by specializing and producing goods and services at which they have a comparative advantage — which they can produce at a lower opportunity cost than other countries.
• Improve the general climate for growth: The government can attempt to improve the climate for growth in a number of ways as for instance; lower tax rates in the hope of increasing incentives for work and risk taking; reduce the extent of government interference and a greater role for the free market will create the environment for economic growth; keep down home market prices; market provision; improve the general infrastructure and create security.
8.1.6 Circumstances under which economic growth may take place without corresponding levels of economic development
Basing on the Case Study 1 of this unit, it is seen that there has been increase in the volumes of goods and services, schools and hospitals have been built among others. Still, the standard of living of the people has not moved hand in hand with growth meaning economic growth is not moving at the same speed with development.
As a whole class, discuss the reasons for this trend in most developing countries.
• Economic growth can give rise to a persistent increase in the volume of goods and services produced with little or no quality added at all, under such circumstances economic growth is attained minus economic development.
• Economic growth makes people overwork at the expense of leisure, for economic growth to be attained at hyper rates people must work without rest; this negatively affects their welfare since leisure is part of one’s standard of living.
• Economic growth may be achieved at high rates but when the country is producing ammunitions to support the ongoing war. Even then economic growth is attained minus a corresponding rate of economic development.
• Economic growth may be achieved but when people are still using traditional tools and under developed technology, there is no economic development in such a situation because people struggle much to raise such a level of output.
• Economic growth may be attained but when people’s mode of thinking and attitude towards work have not yet changed from that of a back ward primitive set up. Such a reasoning mode delays economic development.
• Economic growth may be achieved but with high rates of pollution from industries set up to attain it. The pollution denies the society development.
• Economic growth can be attained but when the country is producing capital goods that do not have a direct impact on the standard of living of the people. In such a situation, economic development delays.
• Economic growth may be attained but with benefits in the hands of a few capital owners. Due to the uneven distribution of resources, such a society does not achieve economic development.
• Economic growth may be achieved internally but when such output is exported and nationals do not experience its benefits, even then economic development is not achieved.
• There may be improper accountability. The government officials may embezzle benefits of the high rates of economic growth attained. Such corruption practices delay economic development.
Theories of Growth
The theories of growth attempt to show the causes, sources and stages of economic growth and they have been developed from the developed nations to show the stages they passed through and how far they have gone. Different economists have grouped these theories into two broad categories
1. Theories based on sector balancing. Here they devised three major theories as seen below;
(a) Balanced growth theory
(b) Unbalanced growth theory
(c) Big push theory.
2. Theories based on causes of growth. Here they devised three other theories as seen below;
(a) Rostow’s stages of growth
(b) Dependence theory
(c) Marxist theory of transformation.
Figure 4 above illustrates the theories of growth basing on
the causes of growth and sector balancing
8.2.1 Theories based on sector balancing
Like said earlier these theories have been developed basing on developed countries and they have been found to be a bit hard to apply in the East African countries like Rwanda, Kenya, Tanzania, Burundi, Uganda and South Sudan. These include the following;
1. Balanced growth theory
Use library textbooks or internet to carry out research and attempt the following questions:
(i) What is a balanced growth strategy?
(ii) Explain the advantages and disadvantages of balanced growth strategy?
(iii) Analyze the limitations of applying the balanced growth strategy in Rwanda?
Meaning of balanced growth
Balanced growth strategy was advocated for by Ragnar Nurkse in the article “The problem of capital formulation in developing countries”. It states that there should be a simultaneous and harmonious upbringing of all sectors in an economy so that they grow at a more or less the same pace. The theory advocates for a critical minimum effort which is the minimum level of investment or sacrifice required in all the sectors of the economy to ensure interdependence and self-sustaining growth.
Nurkse proposes that industries which complement each other through linkages should be established and developed at the same time and rate in terms of demand and supply of raw materials. This will provide market for each other either raw materials or in puts. For example, balance should be made in the following sectors;
(a) Capital goods industries and consumer goods industries,
(b) The industrial sector and agricultural sector,
(c) Social overhead capital (transport, power, water, education, health facilities) and productive activities. (agriculture, industry and services).
(d) The rural sector and the urban sector,
(e) Production for market and production for export,
(f) Labor intensive techniques and capital intensive techniques etc.
Arguments in favour of the balanced growth theory
Below are the arguments supporting the balanced growth theory:
• It encourages resource exploitation and utilisation because it creates high demand for these resources by the many sectors in operation.
• The theory widens the tax base of the country because all the developed sectors are taxed by the government.
• It encourages forward and backward linkages in the economy since some sectors provide raw materials while others provide market for those raw materials.
• Employment is created because of the increased demand for labor to work in the different developed sectors.
• Balance of payment position may be improved especially when production is for export.
• Development in technology is undertaken because of the need to produce good quality goods and services.
• Self-reliance is created since all sectors are developed at the same time and there are a variety of goods and services needed in the society.
• It reduces income inequality because most of the people are engaged in the production of goods and services.
• Brain drain is reduced because the people are able to find employment in the country.
• Foreign exchange is saved because there is little to import since the economy is self-sustaining.
Disadvantages of the balanced growth theory
The following are the disadvantages of the balanced growth theory:
• It may lead to sectors being developed without quality since it calls for a critical minimum effort.
• It requires a lot of capital which may be lacking in developing countries. This is because developing all sectors requires a lot of capital.
• It may lead to over exploitation of resources. This is because all sectors have to be developed.
• It may lead to uncoordinated plans and sectors which may not lead to the development of the economy. The sectors may turn out to be without linkages.
• Over ambitiousness may at times lead to shoddy work since the expected results cannot be achieved.
Limitations of the balanced growth theory
Below are the limitations supporting the balanced growth theory:
• A balanced growth strategy requires a lot of capital funds which are not yet available in LDCs.
• Developing countries do not have adequate skilled manpower to scatter in all sectors being developed at the same time.
• A balanced growth strategy requires proper planning and implementation of plans so as to coordinate the different projects running at the same time, developing countries are not blessed with such planning skills.
• A balanced growth strategy requires developed infrastructure in terms of transport and telecommunication network, hydroelectric power, among others, such developed infrastructure is still inadequate in LDCs, and so they cannot sustain a balanced growth strategy.
• Developing countries have underdeveloped technology; it is still traditional and sometimes just intermediate that cannot support the growth of a balanced growth strategy.
• LDCs have inadequate local and foreign market, such a market cannot support the much output from all sectors of the economy, it goes to wastage hence losses.
Application in Rwanda
Most development and growth theories are based on the experience of the people who develop them. The balanced growth strategy has been found inapplicable to Rwanda basing on the arguments below:
• The theory is based on the assumption that all sectors in the economy are underdeveloped at the same level. This is not the case because in Rwanda some sectors are far more developed than others and the developed sectors are having linkages and pulling the rest that are lagging behind.
• Rwanda does not have the ‘‘critical minimum effort’’ that is minimum level of investment required to develop all the sectors at once. It can only afford a few sectors at a time. Developing agriculture, industry and all other sectors will require large sums of money that is lacking.
• Rwanda does not have the necessary resources both in terms of capital and human resources and related to that is the technology. With these lapses, the theory cannot be applicable due to the deficiencies.
• The theory does not consider the enormous planning that is required to ensure that the development process does not harm the economy. There has to be planning to ensure that there is equilibrium in the economy where demand and supply are equal because if one is greater than the other, they might develop imbalances and this may create inflation and surpluses. Planning is still a major problem in all developing countries at large.
• The theory assumes that industries and other sectors complement each other but this is not true, because in real terms, the sectors compete with each other for resources like labor, raw materials, market etc.
• The size of the market in Rwanda is still small meaning that when all sectors are developed at the same time, the massive production may cause surpluses and wastage. Still the foreign market maybe small due to the quality of the goods that are produced.
• Attempts to develop all the sectors in the economy may cause inflation. This is because it will call for increased expenditure in the economy which will cause increased money supply leading to demand pull and monetary inflation among others.
• The theory ignores the principle of comparative advantage. Rwanda may not be able to develop all the sectors at the same time but it may look at that sector that it can incur the least opportunity cost and then import other goods from other countries.
2. Unbalanced growth theory
Use the library or internet to contact a research about the following;
(i) Meaning of an unbalanced growth strategy.
(ii) The advantages and disadvantages of the unbalanced growth strategy.
(iii) The limitations of applying the unbalanced growth strategy in Rwanda.
Meaning of unbalanced growth theory
The Unbalanced Growth theory was popularised by Albert. O. Hirschman. According to this growth strategy, investment should be made in strategically selected sectors rather than simultaneously in all sectors of the economy. Investment should be made in a few selected sectors or industries for rapid development. This will lead to disequilibrium, creating scope for new investment opportunities, and thus, this would create inducement to invest. One disequilibrium calls for development which leads to another disequilibrium and then to the next one and so on. This is the path of development, an under developed country has to follow which according to the proponents of the unbalanced growth theory. The economies accruing from these few industries can be utilised for the development of other sectors. According to this strategy, unbalanced growth is the best way to achieve economic growth in an underdeveloped economy since these countries lack enough resources. Development can take place by unbalancing the economy such that the developed sectors will expand and others are developed at a later stage.
Hirschman emphasises the importance of international trade as a means of helping LDCs out of a vicious cycle of poverty. He proposed heavy investment in social overhead capital which reduces the costs of production thus encouraging productive activities at a later stage.
Advantages of the unbalanced growth theory
The following are the advantages of the unbalanced growth theory:
• It needs little capital and resources which makes it possible in LDCs to deal with deficit budgets.
• It requires less expenditure because a few sectors are looked at first then others come in later.
• It is easy to control and manage because a few leading sectors can easily be coordinated compared to the balanced growth theory.
• Production can be controlled basing on demand forces because the country will be producing according to available markets.
• The theory reserves some resources for the future use since some sectors are developed at a later stage.
• Specialization is possible since the country concentrates on some sectors fast and others are developed later. This creates efficiency in production.
• The theory requires micro-planning since it involves a small number of sectors which makes planning and implementation easy.
• There will be less reliance on foreign loans and donations leading to limited balance of payment problems.
Demerits of the unbalanced growth theory
Below are the demerits of the unbalanced growth theory
• It slows the rate of economic growth since the output from the few sectors is low and may not serve the whole nation at large. This may lead to constant importation.
• Regional inequalities come up because some areas will develop at the expense of others hence creating dualism with its associated problems.
• Unemployment may come up since few sectors are developed and worse still the sectors may resort to capital intensive technology to produce good quality.
• The theory encourages dependence because the country cannot satisfy the needs of its people thus it keeps on importing what it cannot produce hence worsening the balance of payment position.
• Leading sectors may not be able to pull others hence they will develop at the expense of others since they may not be compatible.
• Less tax revenue will be collected from the few sectors leading to constant borrowing with its associated problems.
• Some resources will remain idle since the developed sectors cannot use them as resources hence under utilization.
• A decline in one or two sectors will affect the economy drastically since it has no alternative sectors to run to. • There will be brain drain since few people will be employed creating a vacuum in the country since the would be skilled people have fled in search for greener pastures.
Limitations of the unbalanced growth theory
The following are the limitations of unbalanced growth theory:
• The strategy emphasizes specialization which has several weaknesses like limited varieties. This limits choice and development, total loss in case of failure among others.
• The strategy limits employment opportunities, one or a few sectors promoted can employ only a few people, with special skills. This will limit employment opportunities.
• The strategy denies the economy a chance to diversify which is a great input to development.
• Developing countries have a limited size of the market which cannot consume all the output from the sector being emphasized all over the country, so it leads to wastage of resources.
• The strategy encourages dependency on other nations, the output missed from the neglected sectors is to be imported. This worsens dependency and the balance of payment problems in the country.
• The emphasized sector may fail to have a serious impact on the country. Worse still it may just make it underdeveloped the more.
• The strategy may make the neglected sectors to lag so behind that uplifting them later may be so expensive or even hard, and this further widens the gap between the sectors of the country.
Application in Rwanda
Since the theory calls for development of a few sectors first so that others follow, the Rwandan government has put this to its advantage due to the little resources it has. The government has embarked on massive investment in sectors that link areas. A case in point is the massive construction of roads to connect places. Secondly, sectors like education and agriculture among others have been developed. Below are the instances that show applicability of the theory:
• Rwanda has limited resources and therefore it has been able to develop a few leading sectors like transport education and agriculture while the rest are also following and having linkages.
• In Rwanda, planning is being carried out to develop a few sectors first as seen in the current budget that calls for increased infrastructure development so as to encourage linkages.
• In Rwanda, the theory has encouraged specialization which in turn is helping to create employment opportunities and skill development.
• The difference in resource endowment has made the theory more applicable in Rwanda. It is unwise to develop the all the sectors like agriculture, fishing, mining among others. Due to resource inadequacy, Rwanda has embarked on developing more agriculture compared to fishing.
• The unbalanced growth strategy has helped Rwanda to participate in foreign trade more so as to get what it cannot produce. Rwanda is actively participating in the East African community and other trade organizations. This has created international relations.
3. Big push theory
Use library materials or internet and research about the following:
(i) The meaning of the big push theory.
(ii) The advantages and disadvantages of the big push theory.
(iii) The limitations of applying the big push theory in Rwanda.
Meaning of big push theory
The Big push theory was advanced by an economist called Paul Rodenstein Rodan and this explains why some economists prefer calling it the Rodanian theory. The theory states that; “for developing countries to take off into self sustaining and dynamic economic growth, they need a massive investment programmer in industrialization and building up economic infrastructure”.
This is a theory that assigns to capital the central role in the process of economic growth and development. Big-Push or a large comprehensive programmer is needed in the form of a high minimum amount of investment to overcome the obstacles to development in LDCs. There should be a high minimum level of resources that must be devoted to a development programmer if LDCs are to come on the path of economic progress.
The theory opposes proceeding “bit by bit”, as proposed by professor W.W. Rostow, because it will not launch the economy on the development path. The Big-Push calls for a sudden sharp increase in the rate of investment so as to put LDCs on the path of economic progress. This could be done by mobilising savings. The sudden increase in the rate of investment would require government action and direction since the majority of people in LDCs are unable to establish industrial firms. Big-Push necessitates obtaining external economies that arise from simultaneous establishment of technically interdependent industries. It also requires investment in social overhead capital at a large scale. Besides, the Big-Push theory requires a sizeable market to ensure favourable returns.
Arguments in favor of the big push strategy
Below are the arguments in favor of the big push theory:
• The theory advocates for setting up complementary industries. This rises the volume and variety of goods and services provided to the nationals.
• The massive investment programmer emphasized by the theory accelerates a stagnant economy into high rates of economic growth.
• The theory advocates for industrial growth that provides several employment opportunities to nationals, this develops the nation further.
• The industrial progress that Walt Rodan advocated for provides forward and backward linkages to the agricultural sector all of which are necessary for the rapid development of developing countries. • The theory calls for maximum exploitation of resources of developing countries and this reduces under utilization of resources.
• There is a high likelihood of having a balanced development of the economy if the different varieties of industries are scattered in different parts of the developing countries.
• The theory encourages self-sufficiency, that is the major symptom of development. The different varieties of industries produce different varieties of output. This reduces the need to import from other countries.
Disadvantages of big push theory
The disadvantages of the big push theory can be seen discussed below:
• The theory calls for massive expenditure, such funds are not readily available in LDCs, it calls for borrowing from other nations and this increases the indebtedness of LDCs.
• The big push theory ignores the role of agriculture in development. Agriculture is the major supplier of foodstuffs and raw materials to agro-based industries that developing countries can sustain.
• The massive industrialization that Rodan advocates for increases pollution that reduces the quality of life of the people.
• The theory calls for over exploitation of the natural resources due to the massive industrialization, this leads to their quick depletion.
• The heavy industrialization and economic infrastructural growth brings about the use of machines in production, these replace laborers, causing technological unemployment.
• The massive industrialization required by the theory calls for the rich foreign investors to developing countries, these repatriate all profits to their home countries leaving LDCs in a worse state than they found them.
Limitations of the big push theory
The big push theory has numerous challenges some of which are shown below:
• There is inadequate funds and man power in LDCs to invest in the theory.
• LDCs have inadequate resources to act as raw materials. This may be a hindrance to the development of industries.
• Developing countries do not have adequate skilled manpower to scatter in all sectors being developed at the same time.
• The strategy requires proper planning and implementation of plans so as to coordinate the different projects running at the same time, developing countries are not blessed with such planning skills.
• Strategy requires developed infrastructure in terms of transport and telecommunication network, hydroelectric power, among others. Such developed infrastructure is still inadequate in LDCs, and they cannot as such sustain a balanced growth strategy.
• Developing countries have underdeveloped technology; it is still traditional and sometimes just intermediate that cannot support the growth strategy.
• LDCs have inadequate local and foreign market, such a market cannot support the much output from all the industries of the economy, it goes to wastage hence losses.
Application in Rwanda
Like in other developing countries, the theory is not applicable to Rwanda based on the following arguments:
• The theory assumes that financial resources are available to massively invest in all sectors at once, and this isn’t the case in Rwanda.
• Excess spending may lead to inflation in the short run when the there is more demand of goods than supply.
• Output resulting from the high investments may lack market both domestic and foreign thus creating unwanted surpluses and wastage.
• Resources in Rwanda may not be readily available to be exploited at the same time since Rwanda has a problem of resource inadequacy.
• Some industries can only develop after others have grown, so it may be hard to develop all of them at the same time. e.g. the leather industry can only develop after the livestock industry has developed; Sugar industries can develop after the sugar cane firms have developed, etc.
• In Rwanda, there is still inadequacy in the labor force to coordinate and manage the various productive activities initiated.
8.2.2 Theories based on causes of growth
The theories based on the causes of growth tend to show the stages that the countries passed through to where they are now. They tend to concentrate more on how the developed nations reached where they are. Further, some theories such as the dependence theory, tend to explain more, why some countries have continuously lagged behind in terms of growth and development. There are basically three theories under the causes of growth and these are discussed below.
1. Rostow’s stages of growth
Use the library or internet and research about the following:
Figure 5: Rostow’s stages of growth
(i) The stages of development according to Rostow.
(ii) The different characteristics under each stage
(iii) The extent to which the theory is applicable in Rwanda.
Professor Walt Whitman Rostow is one of the pronounced development economists. After studying the trend of economic development in various countries, he came up with the conclusion that, development follows specific stages. He postulated that the transition from underdevelopment to development can be described through 5 gradual stages or steps. He described these stages together with the features through which all countries pass to attain hyper rates of economic growth and development. i.e. from primitive stage to the last stage he called it the mass high consumption stage. These stages depict the way of life, way of doing work, level of capital accumulation, method of production, level of saving and investment among others.
Professor W.W. Rostow emphasizes capital accumulation as a driving force of the economy through these gradual stages.
Rostow’s stages of economic growth
• Traditional stage • Transitional stage
• Take off stage • Drive to maturity stage
• Stage of high mass consumption
This is the first stage in the development process where the economy is still in infancy and there is little progress taking place. It has the following features:
• Subsistence production where output is for home consumption.
• No use of money as a medium of exchange.
• There is a high degree of communal organization where people work together as a community.
• Traditional beliefs in culture lead to a lot of conservatism.
• There are cases of disease and the nearest hospital is the bush.
• Production is highly labor intensive.
• There is almost no formal employment and organised income.
• There is nothing like investment and savings in the economy and the economy is closed from external world.
• High levels of resource wastage through unproductive activities like funeral rites, birth cerebration, marriage, etc.
Transitional stage/pre-condition to take off
The societies are in the process of transition. It is the period when the society lays the foundation for take-off and never to revert to the traditional era. The society is first influenced by the external forces from MDCs.The idea of economic progress spreads. The society then starts to imitate the advanced society. In this stage, the following features exist:
• Dualism arises at this stage. Dualism is the co-existence of two contradicting sectors in an economy, one developed and the other under developed. e.g. commercial agriculture versus subsistence agriculture, agriculture versus industry.
• The society starts moving away from dominant subsistence sector and traditional methods of production are reduced.
• A market economy starts emerging where people exchange their output for money.
• Industrialization starts more so the processing industry, these are normally agro-based industries processing agricultural output.
• Entrepreneurs start to emerge.
• Saving and investment start and rise up to 5% of the Gross Domestic product.
• Development of a national identity and shared economic interests.
• Mobility of labor begins.
• Education starts spreading.
• Banks and other institutions for mobilizing capital appear.
• Investments in communications and manufacturing take place.
• Entrepreneurs start to emerge. i.e. new enterprising people come forward to mobilize savings.
Take off stage to self-sustained growth stage
Self-sustained growth means a reduction on foreign dependence. This is the stage when the obstacles to steady growth are finally overcome. The forces of economic progress from the modern economic activities expand and dominate the society. The economy becomes self-propelling. This stage involves rapid transformation in the country’s social, cultural, political and economic spheres. It has the following characteristics:
• Barriers to development are eliminated. Strong economic infrastructure like banks, hospitals, schools are set up.
• Savings and investment grow to between 5% and over 10% of the Gross Domestic Product, new industries are introduced and industrial growth takes faster rates.
• More employment opportunities are created; people’s incomes rise because wages are higher.
• Idle resources are put to more efficient use through exploitation by the industries.
• Modern and advanced technology is introduced in all sectors of the economy.
• Skilled and qualified labor and entrepreneurs start coming up.
• Education and literacy rates increase at faster rates.
• Rate of urbanization increases faster.
• Both industrialization and markets expand.
• One or more leading sectors of the economy develop.
• The increase in per capital output should outstrip the growth of population.
Prematurity stage/Drive to maturity stage (self-sustained growth)
The growing economy drives to extend modern technology over all the economic activities. It is a period of long sustained economic growth. New production techniques replace the old ones and new sectors are created. This stage has the following features:
• The rate of saving and investment is between 10% and 20% of GDP.
• The economy undergoes fundamental political, social and economic advancements, technology progresses rapidly.
• Production for export grows further and there is limited importation of manufactured goods.
• The industrial sector is transformed from small scale to heavy industrialization.
• Agricultural mechanization emerges and such heavy agricultural machines like tractors, combine harvesters, multi crop thresher are used to increase agricultural productivity.
• There is maximum utilization of the country’s resources.
• Modernization of the economy is very high and traditional norms, beliefs and customs are kicked away.
• There are high levels of employment opportunities and white collar jobs increase in availability.
• Goods formerly imported are produced at home with import substitution industrial strategy.
• New import requirements develop and new export commodities to match the imports develop.
• The character of entrepreneurship changes to a better one.
• Real wages start rising.
• It is at this stage that the economy demonstrates its technological and entrepreneurial skills to produce anything it may choose.
Stage of high mass consumption
This is the last stage in growth where the economy has reached its climax. It is the stage when the leading sectors of the economy shift from producing mainly capital goods to producing consumer goods. The incomes of the majority rise beyond what is necessary for subsistence. The structure of the population changes from being predominantly rural to predominantly urban. It has the following characteristics:
• All resources in the country are fully exploited and utilized.
• Consumer durables like washing machines, cookers etc become necessities in every household.
• Incomes of the people are extremely high due to full employment conditions.
• Industrial growth is at its peak and they start producing luxuries like cosmetics, necklaces among others.
• The rates of saving and investments are over 20% of gross domestic product.
• There are high rates of exportation and the country’s balance of payment position improves.
• Urbanization increases thus increase in the urban population.
• A country starts lending and donating to other nations.
• People reduce working hours and start enjoying leisure, they even start going abroad to tour and rest.
• There is more allocation of funds to social welfare and social security than to industry which leads to the emergence of a welfare state.
• The proportion of the population working in offices or skilled factory jobs dominates the working class.
It is important to note that some stages over lap into others, so it may be difficult to identify the exact stage at which a society lies according to the features stated by Professor Walt Whitman Rostow.
Applicability of the theory in low developing countries
As talked about by Rostow, developing countries have tended to go through the same path though there is still a long way to go. The following features can be seen in the developing countries:
• Subsistence production where output is for home consumption is very common in developing countries as a means for survival.
• No use of money as a medium of exchange. In some areas, exchange is through barter system while generally money is used as a medium of exchange in all societies.
• There is a high degree of communal organization where people work together as a community through cooperatives.
• Traditional beliefs in culture lead to a lot of conservatism. This is very common in developing countries and it has led to low quality output.
• Production is highly labour intensive and this is because of the inadequacy in capital in developing countries.
• High levels of resource wastage through unproductive activities like funeral rites, birth cerebration, marriage etc. are common practices in developing countries.
• Dualism is common. Dualism is the co-existence of two contradicting sectors in an economy one developed and the other under developed. e.g. commercial agriculture versus subsistence agriculture, agriculture versus industry.
• Industrialization is common especially the processing industry. These are normally agro-based industries processing agricultural output, as mentioned in the pre-conditions to take off stage.
• Entrepreneurs are emerging and this has increased saving and investment leading to increase of the gross domestic product.
• There are high cases of labor mobility in the developing countries both internal and external.
Criticisms of Rostow’s theory
Rostow’s theory of growth is criticised as shown below:
• Rostow talks about progressing from stage to stage but does not show the mechanism of how it is done.
• Some countries have already entered into the last stage of the age of High Mass consumption before going through the fourth stage of maturity, e.g. Canada, Australia.
• Rostow bases his theory on American and European history and defines the American norm of high mass consumption as an integral to the economic development process to all industrial societies, so his model has no impact on other nations especially the developing agricultural nations.
• Rostow fails to demarcate one stage from the other as the features especially stage one and stage two; and stage four and five tend to overlap into each other. So it is difficult to demarcate one stage of growth from the other.
• Some countries have achieved high savings – 5 to 15% — but they have never taken off.
• Rostow does not appreciate that some countries were born free of some stages. Rostow does not consider nations like U.S.A and Canada, which were born free of the traditional stage.
• Rostow bases his theory on savings, showing that growth occurs as the rate of savings increase with advancing stages but savings do not show a picture of economic growth because they are autonomous.
• Whitman Rostow gives rates of savings and investment at different stages but does not show how the rates are determined, so they become unrealistic.
2. Marxist theory of growth
Using the library or internet, research and attempt the following:
(i) Give stages of development according to Marxist Theory.
(ii) Show the different characteristics under each stage.
Figure 6: Marxist stages of growth