International Trade & Exchange Rates: Types, Policies & Impacts

TAKEAWAYS:

• Trade types: Compare absolute vs. comparative advantage using Nepal’s tea (export) vs. China’s electronics (import) as examples.
• Exchange rates: Master fixed (Nepal’s old Rs. 1=USD 0.0074) vs. floating (current Rs. 150/USD) systems and their effects on imports/exports.
• Balance of payments: Trace how remittances (Nepal’s $10B/year) boost current account surpluses vs. oil imports causing deficits.
• Trade policies: Analyze tariffs (15% on Chinese solar panels) vs. quotas (Nepal’s 5000 kg rice import limit) using real data.
• Exchange rate impacts: Show how a 10% Rs. depreciation raises import costs (e.g., Daraz’s product prices) but helps exporters (e.g., Himalayan herbs).
• Globalization: Link WhatsApp’s cross-border payments to capital account flows and NEPSE’s foreign portfolio investments.

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1. Why International Trade? Absolute vs. Comparative Advantage

Countries trade because they cannot produce all goods efficiently. Two key theories explain this:

Absolute Advantage

• A country can produce more of a good than another using the same resources.
• Example: China produces 10 million smartphones while Nepal produces 10,000 in the same time. China has an absolute advantage in smartphones.
• Limitation: If a country has no absolute advantage in any good, it can still trade based on comparative advantage.

Comparative Advantage (David Ricardo’s Theory)

• A country should specialize in producing goods where its opportunity cost is lowest.
• Worked Example: Nepal vs. India

  Good	Nepal (Labor hours per unit)	India (Labor hours per unit)
  Tea (kg)	2	4
  Electronics	10	2

  • Nepal’s opportunity cost:
    • 1 kg tea = 5 electronics (since 10/2 = 5).
  • India’s opportunity cost:
    • 1 kg tea = 0.5 electronics (since 2/4 = 0.5).
  • Conclusion: Nepal should export tea (lower opportunity cost) and import electronics from India.

In the Real World

• eSewa: When you pay for a Daraz order in USD, eSewa converts Rs. to USD at the floating exchange rate (currently ~Rs. 150/USD). This relies on Nepal’s comparative advantage in services (like remittance processing) vs. other countries.
• NTC’s Fiber Imports: Nepal imports fiber optic cables from China because China has an absolute advantage in manufacturing them at scale. Nepal’s high labor costs make local production unviable.
• Nepal’s Hydropower Exports: Nepal sells electricity to India during peak demand (e.g., Rs. 3.8 per unit vs. India’s Rs. 6). This is based on comparative advantage—Nepal has abundant water resources but lacks domestic demand.

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2. Exchange Rates: Fixed vs. Floating Systems

Exchange rates determine how much one currency buys another. Two main systems exist:

Fixed Exchange Rate

• Government sets the exchange rate (e.g., Rs. 1 = USD 0.0074 before 1993).
• Mechanism: Central bank (Nepal Rastra Bank) buys/sells foreign currency to maintain the rate.
• Example: Nepal’s old system (1971–1993) pegged Rs. to USD at a fixed rate.
• Pros:
  • Stability for businesses (e.g., Daraz’s pricing).
  • Encourages foreign investment (predictable returns).
• Cons:
  • Shortages: If demand for USD rises (e.g., oil imports), Nepal Rastra Bank must spend foreign reserves to maintain the rate.
  • Overvaluation: If Rs. is overvalued, exports become expensive (e.g., Nepal’s tea less competitive).

Floating Exchange Rate (Current System)

• Exchange rate is determined by supply and demand in the foreign exchange (forex) market.

• Example: Today, Rs. 1 = ~USD 0.0067 (floating).

• Mechanism:

  • If demand for USD rises (e.g., oil imports), Rs. depreciates (weakens).
  • If supply of USD rises (e.g., remittances), Rs. appreciates (strengthens).

• Pros:

  • Automatic adjustment: If Rs. depreciates, exports (e.g., cardamom) become cheaper for foreigners.
  • No need to spend forex reserves.

• Cons:

  • Volatility: Sudden depreciation raises import costs (e.g., Daraz’s product prices).
  • Uncertainty for businesses (e.g., Pathao’s USD-based driver payments).

Managed Float (Nepal’s Current System)

• Nepal Rastra Bank intervenes to smooth extreme fluctuations.
• Example: In 2020, NRB sold USD 500 million to prevent Rs. from falling below Rs. 120/USD.

In the Real World

• Khalti’s USD Conversion: When you send money abroad via Khalti, it uses the floating exchange rate (e.g., Rs. 150/USD). If Rs. depreciates to Rs. 160/USD, your recipient gets fewer USD for the same Rs.
• NEPSE’s Foreign Investors: If Rs. depreciates, foreign investors in NEPSE (e.g., Meral Bank shares) see their rupee-denominated returns shrink. This is why NEPSE shares often fall when Rs. weakens.
• NTC’s Satellite Imports: Nepal imports satellites from China. If Rs. depreciates by 10%, the cost of importing a satellite increases by 10%, raising NTC’s expenses.

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3. Balance of Payments (BOP): Current vs. Capital Account

A country’s BOP records all transactions with the rest of the world. It has two main accounts:

Current Account

• Records exports/imports of goods and services + income transfers (e.g., remittances).

• Components:

  1. Merchandise trade (exports – imports).
  2. Services trade (tourism, software exports).
  3. Income transfers (remittances, foreign aid).

• Nepal’s Current Account Deficit (CAD):

  • Cause: Nepal imports more than it exports (e.g., oil, electronics, medicines).
  • 2023 Data:
    • Exports: ~$12 billion (tea, hydropower, garments).
    • Imports: ~$18 billion (oil, machinery, gold).
    • Remittances: ~$10 billion (offsets part of the deficit).
  • Impact: CAD requires borrowing from abroad (capital account).

Capital Account

• Records foreign investment, loans, and reserve changes.
• Components:
  1. Foreign Direct Investment (FDI): E.g., Ncell’s Chinese investors.
  2. Portfolio Investment: E.g., foreign buying of NEPSE shares.
  3. Loans: E.g., World Bank loans for infrastructure.
  4. Reserve Changes: E.g., NRB buying/selling USD.

BOP Equilibrium

For a country, Current Account + Capital Account = 0.

• If CAD exists, the capital account must have a surplus (e.g., foreign loans, FDI).
• Example: Nepal’s CAD (~$4.5B in 2023) is funded by:
  • Remittances ($10B).
  • Foreign loans ($3B).
  • FDI ($1.5B).

In the Real World

• NEPSE’s Foreign Investors: When foreigners buy shares in NEPSE (e.g., Global IME Bank), it increases Nepal’s capital account surplus, helping fund the current account deficit.
• World Bank Loans for Roads: Nepal borrows USD 500 million for the Prithvi Highway. This increases capital account inflows but adds to future debt repayments.
• Daraz’s Warehouses: Daraz’s Chinese owners invest in Nepal’s logistics. This is FDI, which boosts the capital account but may also lead to trade dependency on China.

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4. Trade Policies: Tariffs, Quotas, and Subsidies

Governments use policies to protect domestic industries or promote exports.

Tariffs (Import Duties)

• Definition: Tax on imported goods.
• Example: Nepal charges 15% tariff on Chinese solar panels.
• Effect:
  • Raises price of imports → reduces demand for foreign goods.
  • Protects domestic producers (e.g., Nepal’s small solar panel makers).
  • Revenue for government (e.g., customs duty on oil).

Quotas

• Definition: Quantity limit on imports.
• Example: Nepal allows only 5,000 kg of rice imports per month.
• Effect:
  • Reduces supply → higher prices for consumers.
  • Benefits domestic rice farmers (e.g., Terai region).

Subsidies

• Definition: Government pays part of production cost to lower prices.
• Example: Nepal subsidizes fertilizers for farmers to boost agriculture.
• Effect:
  • Lowers cost → more exports (e.g., Nepal’s tea becomes cheaper abroad).

Comparison Table

In the Real World

• NTC’s Oil Imports: Nepal imposes tariffs on diesel to protect local fuel distributors. This raises prices for Pathao drivers but keeps local businesses competitive.
• Nepal’s Tea Exports: The government provides subsidies to tea farmers in Ilam and Dhankuta, making Nepal’s tea cheaper than Sri Lanka’s in global markets.
• Daraz’s Chinese Goods: If Nepal imposes a quota on Chinese toys, Daraz’s inventory of toys would decrease, raising prices for Nepali consumers.

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5. Exchange Rate Pass-Through and Its Effects

When exchange rates change, import/export prices adjust, but not always 1:1.

Partial vs. Full Pass-Through

• Full Pass-Through: A 10% depreciation of Rs. leads to a 10% increase in import prices (e.g., oil, electronics).
• Partial Pass-Through: Only 50% of depreciation is passed to consumers (e.g., due to competition).

Impact on Businesses

1. Exporters (e.g., Nepal’s Tea, Hydropower):

   • Benefit: Depreciation makes exports cheaper for foreigners.
   • Example: If Rs. depreciates by 10%, Nepal’s tea becomes 10% cheaper for Indian buyers.

2. Importers (e.g., Daraz, NTC):

   • Hurt: Depreciation raises cost of imports (e.g., oil, machinery).
   • Example: If Rs. falls from 150 to 165/USD, NTC’s oil import bill increases by 10%.

Worked Example: Rs. Depreciation and Daraz’s Prices

• Scenario: Rs. depreciates from Rs. 150/USD to Rs. 165/USD (10% depreciation).
• Effect on Daraz’s Product Prices:
  • Assume a Chinese smartphone costs USD 200.
  • Before depreciation: Rs. 150 × 200 = Rs. 30,000.
  • After depreciation: Rs. 165 × 200 = Rs. 33,000 (10% increase).
  • But: Due to partial pass-through, Daraz may only raise prices by 5% (Rs. 31,500).

In the Real World

• NTC’s Electricity Bills: When Rs. depreciates, NTC must pay more USD for coal imports, raising electricity tariffs for consumers.
• Pathao’s Driver Payments: Pathao pays drivers in USD. If Rs. weakens, drivers’ rupee earnings fall, reducing their income.
• NEPSE Stock Prices: Foreign investors in NEPSE see their rupee-denominated returns shrink when Rs. depreciates. This is why NEPSE often falls during Rs. weakness.

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6. Trade Agreements and Globalization

Nepal participates in regional and global trade agreements to boost exports.

Key Agreements for Nepal

1. South Asian Free Trade Area (SAFTA):

   • Members: Nepal, India, Bangladesh, Sri Lanka, etc.
   • Benefit: Reduced tariffs on goods traded within South Asia.
   • Example: Nepal can export cardamom to India at lower tariffs.

2. BIMSTEC (Bay of Bengal Initiative for Multi-Sectoral Technical and Economic Cooperation):

   • Members: Nepal, India, Bangladesh, Myanmar, Thailand, etc.
   • Focus: Trade in services (e.g., IT, tourism).

3. WTO (World Trade Organization):

   • Role: Sets global trade rules (e.g., no discrimination between trading partners).
   • Challenge for Nepal: Competing with China and India in manufacturing.

Impact on Nepal’s Businesses

• Exporters (e.g., tea, hydropower):
  • Benefit: Lower tariffs in India/Bangladesh → higher demand.
• Importers (e.g., oil, electronics):
  • Challenge: Still dependent on China/India for key imports.

In the Real World

• eSewa’s Cross-Border Payments: eSewa partners with Indian banks to allow Nepali users to send money to India. This is facilitated by SAFTA’s financial integration.
• Ncell’s Chinese Investors: Ncell’s majority stake by China Unicom is an example of FDI under WTO rules, bringing technology but also dependency on China.
• Nepal’s Garment Exports to USA: Nepal’s garments (e.g., from Himalayan Fashions) get duty-free access to the US under WTO’s Generalized System of Preferences (GSP).

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Exam Tip

1. Define Key Terms Clearly:

   • Always start with definitions (e.g., "Comparative advantage is the ability to produce a good at a lower opportunity cost than another country.").
   • Marks tip: Examiners check if you distinguish between absolute and comparative advantage.

2. Use Real Nepal Examples:

   • Trade: Nepal’s tea exports to India, oil imports from India/China.
   • Exchange Rates: Rs. depreciation in 2023, NRB’s interventions.
   • BOP: Remittances ($10B), current account deficit ($4.5B).

3. Diagrams = Extra Marks:

   • Always draw:
     • Supply-demand for exchange rates.
     • Tariff/quota effects on imports.
     • BOP accounts (current vs. capital).
   • Label clearly: Equilibrium points, shifts, and real-world impacts.

4. Policy Analysis Questions:

   • If asked "Should Nepal impose tariffs on Chinese goods?", structure your answer as:
     1. Pros: Protects local industries (e.g., solar panels).
     2. Cons: Higher prices for consumers (e.g., Daraz products).
     3. Alternative: Subsidies for domestic production instead.

5. Numerical Problems:

   • Exchange rate pass-through:
     • If Rs. depreciates by 10%, and a product’s import price rises by 8%, explain partial pass-through.
   • BOP equilibrium:
     • If CAD = $4B, how can Nepal finance it? (Remittances, FDI, loans.)

6. Common Mistakes to Avoid:

   • ❌ Confusing fixed vs. floating exchange rates.
   • ❌ Forgetting to mention opportunity cost in comparative advantage.
   • ❌ Ignoring real-world data (e.g., Nepal’s CAD, Rs. depreciation).

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