The Various Impacts of Global Financial Crisis on Trade Mechanisms - Case Study Example

?INTERNATIONAL TRADE AND COMPETITION Table of Contents Table of Contents 2 Introduction 4 2.Trade Theories 4 2.1Mercantilism 4 2.2Theory of Absolute Advantage 4 2.3Theory of Comparative Advantage 5 2.4Factor Proportions Trade Theory 5 2.5New Trade Theory 5 3.Global Financial Crisis (GFC) 6 4.Impact of GFC on World Trade 8 4.1Impact on Flows of Merchandise Trade 9 4.2Impact on the Prices of Commodities 12 4.3Impact on Service Sector 13 4.4Impact on Foreign Direct Investments (FDI) 16 5.Recommendations 17 6.Conclusion 19 References 20 1. Introduction Global Financial Crisis (GFC) had a significant negative impact on the world trade. All the nations in the world were affected by GFC in one way or the other. The various impacts of GFC on trade mechanisms of different nations worldwide have been discussed in this study. Certain policies that should be employed by different trading nations all over the world in order to combat the effects of GFC have also been studied. 2. Trade Theories 2.1 Mercantilism This theory of international trade existed in the mid of 16th century. It postulated that the wealth of a nation depends on its accumulated treasure mainly in the form of gold. Trade surplus was believed to be the key trade practice. However, it had disadvantages of having restrictions in the form of government intervention and impaired growth (Reynolds, 2000). 2.2 Theory of Absolute Advantage This theory is believed to be developed by Adam Smith. It was against the mercantilism trade theory and brought in the concept of free trade. Different countries can take advantage of their efficiency in producing different products and trade for the other products. Hence all the countries would have simultaneous advantages while practicing free trade (skidmore.edu, 2007, p.1). 2.3 Theory of Comparative Advantage This is an extension of the free trade mechanism theory. This theory takes into consideration two important concepts, namely opportunity cost and the frontier of production possibility. It believes in efficient utilization of existing resources leading to the increase in productivity. A country may be efficient in producing certain products but still it should import from other country if it is comparatively advantageous for the country (hawaii.edu, n.d.). 2.4 Factor Proportions Trade Theory It is also known as Heckscher – Olin Theory. This theory states that those goods should be exported which are locally available in plenty and that makes intensive use of factor endowments. Factor endowments are the main determinants of trade and not its productivity. Here the focus is more on relative advantage rather than absolute advantage. It takes into consideration two important factors of related to production. They are labor and capital (ups.edu, n.d.). 2.5 New Trade Theory The industries whose fixed costs are relatively high output are enhanced through specialization. The effects of learning are also quite high. Only few competitors will be supported through the world demand. International trade results in increased income and output for a country. This results in enhanced savings as well. Rise in competition amongst different countries results in gains in trade which are dynamic in nature. 3. Global Financial Crisis (GFC) Global Financial Crisis (GFC) that took place in 2008 proved to be a historical event in world economy. It had a substantial effect on most of the nations in the world. It has led to the debacle of big financial institutions like Lehman Brothers all around the world. It resulted in the decline of share markets all over the world. It all started in United States with the fall of its market involving sub-prime mortgages. Introduction of complex financial instruments has also been one of the prime reasons behind the crisis. Securitization of mortgage loans in US was done with the objective of mitigating risk but ultimately it led to the increase of risk through increased use of derivatives instruments in the market as speculative instruments and finally resulted in financial crisis. GFC have resulted in bailout of many large banks especially in US by the government and have resulted in huge losses for US and several European countries (Graph 1). Graph 1 Source: (Shah, 2010) Hence, three major facts that attributed to the onset of GFC are: 1. Capital reallocation, loss of wealth in households and reduction in consumption that resulted because of the housing bubble bursting out. 2. There was a significant rise in the risk premium associated with equities that resulted in increase of cost of capital, decline in the demand of goods which are durable in nature and sharp decline in private investment. 3. Risk appraisals made by households that resulted in reduced consumption and enhanced savings (McKibbin & Stoeckel, 2009, p.10). 4. Impact of GFC on World Trade GFC have affected world trade and its outcomes in various ways. Some effects are quite obvious in nature and some are not so obvious. The primary mechanisms that have affected the trade outcomes can be summarized with the help of the following chart (Chart 1): Chart 1 Source: (McKibbin & Stoeckel, 2009, p.5) All the mechanisms outlined in this chart results in affecting trade. 4.1 Impact on Flows of Merchandise Trade International trade includes imports and exports by different countries of the world and it involves cross border transaction of goods. GFC resulted in the decline of global demand and downturn in economic growth of the nations worldwide. Hence it resulted in curbing down the development of the developing nations of the world. International trade helps the developing countries to fight against poverty and increase the standard of living of the people. Exports to GDP ratio give an indication about the dependence on exports by the developing nations (Table 1). There was a rapid contraction in flows of merchandise trade soon after the onset of GFC (Chart 2). If we look at the pattern of imports in United States, GFC had an impounding effect on it and resulted in significant decline in trade flows (Chart 3). Chart 2 Source: (UNCTAD, 2009, p.11) Table – 1 Source: (UNCTAD, 2009, p.9) Chart 3 Source: (UNCTAD, 2009, p.15) 4.2 Impact on the Prices of Commodities A boom in the commodity prices was prevalent for 6 years before the GFC. It was in response to the sustainable growth of the world economy. The major part of the growth was because of rapid development of developing nations and increase in demand for commodities. However, soon after the start of GFC the commodity prices fell down drastically (Chart 4). Chart 4 Source: (UNCTAD, 1999, p.18) 4.3 Impact on Service Sector Trade in services sector also had a significant impact because of GFC. If we look at the transportation services it can be found out that world exports relative to transportation services increased significantly during the first half of the year 2008 but fell drastically in the second half of 2008 (Chart 5). The most immediate effect of GFC was on sea transportation. Chart 5 Source: (World Trade Organization, 2009, p.115) Next service sector after transportations sector that was severely hit by GFC was the international travel sector. Travel exports in almost all the regions were affected by GFC by the beginning of the year 2009 (Chart 6). Chart 6 Source: (World Trade Organization, 2009, p.116) The exports related to financial services were also greatly affected by GFC. There was a sharp decline in its export at the second half of 2008 and beginning of 2009 (Chart 7). Chart 7 Source: (World Trade Organization, 2009, p.118) 4.4 Impact on Foreign Direct Investments (FDI) A negative impact can be observed in international investment on account of GFC. Reduction in corporate profits and credit conditions being tight have significantly reduced the capability of companies to finance the overseas finance projects. The business confidence has also declined because of GFC. Foreign investments can be classified into three major types namely, Market seeking, resource seeking and efficiency seeking investments. All these three foreign investment types had a negative effect due to GFC. It has been estimated that there has been a decline of 15% in inflows of global FDI (UNCTAD, 2009, p.25). This significant decrease took place after a steady growth for 4 years before GFC (Chart 8). Chart 8 Source: (UNCTAD, 2009, p.26) Amongst many others, the flows of FDI to automotive industries, intermediate goods, financial services, etc. had a significant impact because of GFC. With respect to FDI inflows, it showed a sharp decline for both the developing and developed nations because of liquidity crisis that occurred in financial markets due to GFC. There has been a downturn in FDI outflows as well. 5. Recommendations The negative impact of GFC on international trade is an important issue that needs to be addressed by all the nations of the world for the betterment and development of trade practices worldwide. Depending on the circumstances in different countries, its economic policies should be revised accordingly. Countries which are fundamentally strong in their macroeconomic policies can afford to have stimulus in its fiscal and monetary policies. The economic activities of emerging nations can be developed by employing expansionary fiscal and monetary policies. Whereas, in case of countries which are not so much fundamentally strong and are having unsustainable fiscal deficits or having huge external debt should strive for the improvement in its fiscal accounts as its priority. Government policies providing subsidies which are not sustainable should be removed and the schemes related to social protections should be fine tuned. A comprehensive action is required in relation to the liquidity problems that have emerged in banking system as a result of GFC. The deficiencies in supervisory frameworks of different nations have been exposed due to GFC and must be revised. The financial systems in different countries are needed to be strengthened by structuring and implementing policies which should be based on four dimensions: a. The policy should strive for strengthening financial institutions individually. b. Contingency planning and the framework for crisis management should be strengthened. c. Risk mitigation policies should be employed in relation to cross-border transactions which are exposed to foreign exchange risks. d. A wide microeconomic orientation should be adopted for the surveillance of financial institutions (The World Bank, 2009). Hence trade policies adopted by different nations can help to address the issue of the negative effect of GFC in the following ways: 1. The governments of different nations can help to restore the confidence through its coordinated efforts in this matter. 2. Avoiding Protectionism: The adjustments that are needed to address the changing demand situation can be delayed if greater protectionism in trade policies is employed by nations of the world. A more protected economy will mean a requirement of greater costly adjustment. Recently, there has been increased growth in nations like India and China because of its adoption of open economy policies. Hence in the short run, protectionist trade policies should be avoided by the countries. 3. Stimulating Growth: Further opening of markets by the countries would create scopes for further development of the nations and would result in overall improvement of well-being economically. It is so because it would lead to more efficient utilization of resources through competition, innovation, specialization, international investment and economies of scale. Hence, the delivery of real opportunities would result in returning to stable growth of economy (OECD, 2010). 6. Conclusion Hence, it can be concluded that Global Financial Crisis (GFC) had an impounding effect on the international trade mechanisms. One of the most obvious effects of GFC on trade was the decline in demand for goods and services. The effect of GFC on merchandise trade flows was quite alarming in nature. There was a sharp decline in the import and export of merchandise products in nations all over the world. Although GFC started in developed nations like United States but it had its impact on the other developing nations as well. There was a boom in the prices of commodities but it decreased significantly since the onset of GFC. The services sector was also badly hit by the GFC. There was a sharp decline in the world exports relative to transportation services. Exports in financial services also decreased to a considerable amount because of the crunch situation created in liquidity position and credit worthiness of many financial institutions. Hence, it is the time for revision of macroeconomic policies to be followed by different countries in the world. The policies would depend on the prevailing economic conditions of a country. Country having robust fundamental policies should go for expansionary fiscal and monetary policies. The financial institutions should be more tightly regulated. However, trade protectionism should be avoided by different nations to ensure sustainable growth in future. References Hawaii.edu. (no date). The Theory of Comparative Advantage. [Pdf]. Available at: http://www2.hawaii.edu/~manicas/pdf_files/Unpub/The%20Theory%20of%20Comparative%20Advantage.pdf. [Accessed on April 27, 2012]. McKibbin, W. J. & Stoeckel, A. (2009). The Potential Impact of the Global Financial Crisis on World Trade. [Pdf]. Available at: http://www-wds.worldbank.org/external/default/WDSContentServer/IW3P/IB/2009/11/18/000158349_20091118083139/Rendered/PDF/WPS5134.pdf. [Accessed on April 26, 2012]. OECD. (2010). Trade Policy Response to the Global Economic Crisis. [Online]. Available at: http://www.oecd.org/document/62/0,3746,en_2649_37431_42218942_1_1_1_37431,00.html. [Accessed on April 27, 2012]. Reynolds, R. L. (2000). Mercantilism: An Outline. History of Economic Thought. [Pdf]. Available at: http://www.boisestate.edu/econ/lreynol/web/pdf_het/mercantilist.pdf. 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