International trade

1 Introduction to international trade

Almost every country trades internationally through importing and exporting both goods and services. Other international transactions also occur, such as when a company buys or sells a foreign subsidiary or whenever profits and interest are sent to international investors or lenders.

2 The balance of payments

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The balance of payments summarises all transactions between a country’s residents and its non-residents

Transactions include import and export of goods and services, payment of interest, payment and receipt of interest and dividends, investment and other transfers of cash and financial instruments.

The balance of payments can be thought of in terms of the following accounts:

• Current account: mainly flows from the effects of trade and income.
  

• Capital account: flows relating to investments and proceeds from the sale of investments.
  

• Financial account: flows of cash and financial instruments.
  

These accounts are related as follows:

Current account + capital account = Financial account

One word of caution when you read around this topic. Textbooks divide investment flows between the capital account and the financial account in slightly different ways, and international statistical standards draw the line differently again. The CIMA syllabus prescribes no split: what is examinable is that the accounts must balance overall, and that persistent imbalances inside them matter. Use the three-account description above, and do not be thrown if another source allocates a particular flow differently.

For example, if goods are imported, the current account and financial account will be equally affected because money is either paid to or is owed to suppliers. If investments are made abroad, both the financial account and capital accounts are affected. When dividends from the foreign investment are received, the current account and financial accounts are affected.

In practice, errors in data collection mean that the equilibrium is never seen.

Even though the equation should always balance, governments worry about imbalances in each part of the equation. In particular, they worry about trade deficits. A trade deficit is where a country’s imports are consistently higher than its exports.

2.1 Does a current account deficit matter?

The USA runs a huge current account deficit; China has a huge current account surplus. The USA is a large net importer of goods whilst China is a large net exporter. These conditions have been present for many years, so do persistent deficits and surpluses matter?

If the USA is a high net importer from China, then the USA needs continuous supplies of yuan, the Chinese currency, to pay suppliers. How can it obtain these supplies, given that exports to China are negligible? There are three methods:

• Sell assets to China. For example, companies, gold, other foreign currency holdings
  

• Borrow yuan from China eg issue government bonds to China.
  

• Sell US$ to China in exchange for yuan. However, with floating exchange rates this will have the effect of depressing the value of the dollar and increasing the value of the yuan
  

Countries run out of assets to sell; borrowing more will mean that there are vast interest payments and a risk of default by the country.

Deficits can be controlled as follows:

• Selling US$ for yuan should provide a self-regulatory mechanism to the deficit imbalance because imports will become more expensive, but this mechanism is often not enough to control exchange rates. Exchange rates depend on other factors also such as interest rates, speculators and economic stability.

• Deliberate devaluation (where exchange rates are fixed).

• Import controls to reduce the value of goods imported.

• Deflation – reducing domestic demand so that consumers buy less in general – including fewer imports.

• Producing goods that will successfully compete with imports and which can themselves be exported. This is known as a supply-side mechanism, because it works by adjusting the supply of goods rather than by suppressing demand.

3 Reasons for international trade

International trade occurs for the following reasons:

• Natural resources. If a country does not have the natural resources it requires it has to import them. For example, many countries do not have their own supplies of oil and gas so must import these from countries that do.
  

• Access to low labour costs for production.
  

• Economies of scale. Supplying, say, 10 million phones to the world is likely to be cheaper per phone than just supplying 1m to your home consumers. Research and development costs are spread more thinly and vast factories can be used for efficient production.
  

• Skills. Countries often develop particular skills to a very high level and this can make their products and services better than are available elsewhere. For example, the UK has high financial skills; the US and Europe have high civilian aerospace skills (Boeing and Airbus), Japan has high skills in optics (Nikon, Canon, Olympus etc).
  

• Unique products. If a pharmaceutical company in one country discovers a uniquely valuable drug, then doctors and patients in other countries will want to import it.
  

Many of the reasons for international trade can be explained by the theories of absolute advantage and comparative advantage.

Absolute advantage

A country has absolute advantage when it performs a task more efficiently than producers in other countries. For example, because of its climate, Spain is extremely efficient at producing oranges, lemons, olives and tomatoes. It will always be able to produce these goods more efficiently than they can be produced in countries such as the UK or Russia. It makes sense to import these goods from Spain rather than having to heat vast greenhouses artificially in your own country.

Comparative advantage

This is a more subtle concept, and it is the more important of the two: it explains why trade is worthwhile even when one country is better at making everything.

4 Advantages and disadvantages of international trade

International trade allows:

• Best use of resources: both absolute and comparative advantage.
  

• Development of specialisations.
  

• Economies of scale.
  

• Greater competition to drive both competitive pricing and innovation.
  

• Lower prices for consumers.
  

However, there can be disadvantages – certainly to individual countries:

• Increased transport cost and carbon footprint as goods are moved.
  

• The ‘export’ of jobs. Goods made abroad and imported will reduce home jobs for that sector.
  

• Strategic weakness. For example, dependence on other countries for food or fuel can be used politically.
  

• Balance of payment difficulties: imports imply that your own currency has to be sold to pay for imports and this can affect exchange rates. (See later.)
  

• Dumping. An exporter has surplus capacity, perhaps only temporarily, and ‘dumps’ goods by exporting them, affecting local companies and local employment.

5 Control of international trade

5.1 Policies to encourage free trade

A country’s trade policy has two sides, and the syllabus asks for both. On this side are the measures a government uses to make trade easier:

• Unilateral reduction of its own tariffs and quotas. A country can simply lower its barriers without waiting for anyone to lower theirs. Its consumers gain immediately from cheaper imports; its exporters gain nothing directly, which is why this is the rarest of the four.

• Bilateral and multilateral trade agreements. Treaties in which two or more countries reduce tariffs and quotas reciprocally, and agree common technical standards so that a product made to one country’s rules is accepted in the other.

• Customs unions and single markets. A deeper form of the same thing: members abolish barriers between themselves and adopt a common external tariff, and a single market goes further again by allowing goods, services, capital and people to move freely.

• Membership of the rules-based system. Accepting the multilateral rules on tariffs, quotas and subsidies, and the arbitration that goes with them, so that a trading partner cannot raise barriers arbitrarily.

The institutions that carry these policies — the trade agreements themselves, the trading blocs and the World Trade Organisation — are dealt with in chapter 3 §4, where they belong to a different learning outcome. What matters here is that they are instruments of national trade policy, and that they sit on the opposite side of the same page from the protectionist instruments below.

5.2 Protectionist instruments

Putting up impediments to international trade is known as protectionism ie home producers are protected from overseas competition.

Protectionist methods include:

• Quotas: maximum numbers of units of products that can be imported.
  

• Tariffs and customs duties: effectively a tax on imports making them more expensive and less attractive.
  

• Administration and legal procedures. For example, insisting on very strict inspection of imported goods which adds to cost and delay.
  

• Subsidies: these are given to exporters so that they can compete very effectively and undercut overseas manufacturers. Providing direct subsidies is often not permitted under world trade rules, but they can be provided subtly. For example, if an aircraft manufacturer makes both military and civilian aircraft, the government could pay high prices for military aircraft so that the manufacturer can use profits there to subsidise civil aircraft production.
  

In general, economists agree that international trade brings great advantages to the world economy. Politically, however, the issues are less clear-cut, and protectionist policy is a recurring feature of national politics rather than a historical curiosity. The United States raised tariffs on steel, aluminium and a wide range of Chinese goods from 2018 onwards, and again more broadly in 2025; the argument made for them each time was the repatriation of manufacturing jobs. The economics of such a measure are not in doubt: goods made in a high-labour-cost country cost more than goods made in a low-labour-cost one, so consumers as a whole pay more. The politics are that the higher prices are spread thinly across millions of consumers while the jobs are concentrated visibly in particular towns and industries.

The promise to repatriate jobs by placing impediments on importing is very powerful and seductive – particularly amongst blue-collar workers, a category which has suffered particularly from the off-shoring of manufacturing and from the free import of foreign goods.

6 Exchange rates

6.1 Quotes and spreads

An exchange rate shows how much one currency is in terms of another. For example:

• GBP1/USD = 1.34 or GBP1 = USD1.34 or just £1 = $1.34
  

• Means that 1 GB Pound can be changed for 1.34 US dollars
  

Banks quote exchange rates showing a spread as follows:

• GBP1 = $1.34 – $1.31

• One rate is for changing £ to $ and the other for changing $ to £. Banks always use the rate that leaves customers worst off, so if you went into a bank with £1,000 you would be given only $1,310 in exchange, not $1,340.

Some exchange rates are fixed (or pegged) but most float, so that they change constantly. Floating exchange rates present problems for importers and exporters when they are buying or selling in a foreign currency. The systems themselves — fixed, floating and managed rates, and single currency zones — are dealt with in chapter 9 §7, and the techniques for removing the resulting risk in chapter 11. What matters here is the size of the effect on a business’s profit.

6.2 The effect of exchange rate movements on a business

Apart from the uncertainty itself, a movement in the home currency reaches a business through four channels. They are symmetrical, so learn them as a pair:

Exchange rates are affected by the following:

• Speculation – dealers buying or selling large amount of currency (so affecting the exchange rate) in the hope of making profits.
  

• Sentiment – a change of government often affects a currency’s value.
  

• International trade affects the supply and demand for currencies and hence their values.
  

• Inflation erodes the purchasing power of a currency. High inflation in a country weakens a currency with respect to the currency of a low-inflation country.
  

• Interest rates – raising interest rates can attract hot money into a country as higher returns can now be earned now on bank deposits. The demand for the currency can be expected to strengthen the currency.
  

7 Tests

The six tests below are the chapter’s own. Work each one before you open its answer.

8 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.