International Trade & Balance of Payments: Theory, Tools & Nepal’s Role

Core Concepts: Why Nations Trade

1. Absolute vs. Comparative Advantage

• Absolute advantage: A country can produce more of a good with the same resources (e.g., China in electronics, Saudi Arabia in oil).
• Comparative advantage: A country should specialize in producing goods where its opportunity cost is lowest, even if it’s not the most efficient. This drives trade.

Worked Example: Nepal vs. India in Tea & Garments

• Nepal has absolute advantage in tea (hilly terrain, climate) but comparative advantage in garments if its opportunity cost is lower than India’s.
• Data: Nepal exports $500M in tea (2023) but imports $1.2B in garments (Nepal Rastra Bank). If Nepal shifted labor to garments, it could trade tea for Indian fabrics at a lower cost.

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2. Terms of Trade (TOT) and Gains from Trade

Terms of Trade (TOT) = (Export Price Index) / (Import Price Index) × 100

• Favorable TOT: Export prices rise faster than import prices → more imports for the same exports.
• Unfavorable TOT: Export prices fall → must export more to buy imports.

Why Nepal’s TOT is Falling:

• Export composition: Reliant on labor-intensive goods (garments, carpets) with low global prices.
• Import composition: Capital goods (machinery) and oil prices rising faster than export earnings.

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3. Trade Barriers: Tariffs, Quotas, and Non-Tariff Barriers

Worked Example: Daraz vs. Local Retailers

• Daraz (Alibaba-owned) imports goods from China at lower prices than Nepalese retailers.
• Government response: Higher tariffs on Chinese electronics (e.g., 30% on smartphones) to protect local brands like Ncell’s own devices.
• Result: Daraz prices rise by 15–20%, but local shops gain 5–10% market share.

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4. Balance of Payments (BoP): The Big Picture

The BoP accounts for all transactions between Nepal and the rest of the world in a year. It has two accounts:

A. Current Account (Goods, Services, Income, Transfers)

B. Capital Account (Investments, Loans, Reserves)

BoP Identity: Current Account + Capital Account = 0

• If Current Account Deficit (CAD) = $12.5B (2023), then Capital Account Surplus must be $12.5B (via FDI, loans, or reserve depletion).

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5. Exchange Rates: Fixed vs. Floating

A. Floating Exchange Rate (Nepal’s System)

• Determined by supply and demand in the foreign exchange (forex) market.
• Example: If Nepali tourists spend more in India, demand for INR ↑ → NPR depreciates (1 NPR buys fewer INR).

B. Fixed Exchange Rate (China’s System)

• Government sets the rate (e.g., 7.2 NPR = 1 USD).
• Pros: Stability for trade, attracts FDI.
• Cons: Requires large forex reserves to defend the peg.

Worked Example: Ncell’s USD Loans

• Ncell took a $500M loan from a Chinese bank at 3% interest.
• If NPR depreciates from 120 to 130 per USD, Ncell’s repayment cost rises by 8% (500M × 120 → 500M × 130).

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6. Purchasing Power Parity (PPP) and Big Mac Index

PPP theory: Exchange rates should equalize the cost of a basket of goods across countries. Big Mac Index (2023):

Why Nepal’s PPP is Low:

• Lower wages (garment worker: $100/month vs. $500 in Bangladesh).
• Cheaper services (haircut: $2 vs. $20 in the US).

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7. Nepal’s Trade Policies: Protectionism vs. Liberalization

Case Study: NEPSE and Foreign Investment

• Problem: NEPSE stocks are undervalued due to low foreign participation.
• Policy: Government allows FDI in NEPSE (up to 25% in a company).
• Result: Foreign investors like Singapore’s Temasek bought stakes in NMB Bank, boosting liquidity.

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In the Real World

1. Khalti & Daraz (Digital Trade)

   • Idea Used: Capital Account (FDI and Portfolio Flows)
   • How: Khalti (Nepal’s digital wallet) partnered with Daraz to enable cross-border payments. When a Nepali buys from Daraz (Chinese goods), the USD → NPR conversion hits the forex market, affecting NPR’s exchange rate.

2. Ncell’s USD Debt (Exchange Rate Risk)

   • Idea Used: Floating Exchange Rate + PPP
   • How: Ncell’s $1B debt is denominated in USD. When NPR depreciated from 120 to 130 per USD (2022–23), Ncell’s repayment cost rose by 8%, increasing its interest burden from NPR 3.6B to NPR 4.0B per year.

3. Nepal’s Rice Imports (Current Account Deficit)

   • Idea Used: Terms of Trade + Trade Barriers
   • How: Nepal imports 500,000 MT of rice annually (mostly from India). Due to quotas and tariffs, domestic rice prices are 30% higher than global prices, worsening the CAD.

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Exam Tip

How This Unit is Tested in PU Exams

1. Definitions & Diagrams (30%)

   • Draw and label:
     • PPF with trade (showing gains from specialization).
     • BoP accounts (T-account style for current vs. capital).
     • Exchange rate movements (supply/demand for forex).
   • Common Mistake: Forgetting to show dashed lines for shifts in supply/demand diagrams.

2. Numerical Problems (40%)

   • Terms of Trade: Given export/import price indices, calculate TOT and interpret. Example: If export prices rise by 10% and import prices rise by 5%, new TOT = (1.10/1.05) × 100 = 104.76 (favorable).
   • BoP Identity: If CAD = $5B and FDI = $3B, official reserves must change by $2B (depletion).
   • PPP: If a Big Mac costs $5 in the US and Rs. 300 in Nepal, PPP-implied exchange rate = 300/5 = 60 NPR/USD (but actual is 130 → undervaluation).

3. Policy Analysis (30%)

   • Pros/Cons of Tariffs: Use Nepal’s 35% tariff on Chinese phones as an example.
     • Pro: Protects local jobs (e.g., Nepal Telecom’s manufacturing).
     • Con: Consumers pay 20% more, reducing demand.
   • Floating vs. Fixed Rates: Compare Nepal’s floating rate (NPR/USD) vs. China’s fixed rate (CNY/USD).
     • Nepal’s system allows automatic adjustment but suffers from volatility.
     • China’s system requires large forex reserves but keeps stability.

Model Answer Structure for Essays

Question: "Discuss the causes and consequences of Nepal’s current account deficit, with policy recommendations."

Answer Framework:

1. Causes (BoP Theory)

   • High import dependency: Oil ($3B), electronics ($2B), machinery ($1.5B).
   • Low export diversification: Reliant on garments (40% of exports) and remittance-dependent services.
   • Weak productivity: Agriculture and manufacturing less competitive globally.

2. Consequences (Macroeconomic Impact)

   • Forex reserve depletion: NPR 1.3T spent in 2023 to stabilize NPR.
   • NPR depreciation: From 120 to 130 per USD (2022–23), increasing import costs.
   • Debt burden: Higher USD-denominated loans (e.g., Ncell, NMB Bank) become costlier.

3. Policy Recommendations (Trade & Monetary Policy)

   • Diversify exports: Invest in IT services (like India’s $200B IT sector) and hydropower (Nepal has 42,000 MW potential).
   • Reduce import tariffs on capital goods: Lower costs for manufacturing (e.g., textiles).
   • Attract FDI in high-tech: Follow Bangladesh’s success with garment exports but shift to pharmaceuticals and software.
   • Monetary policy: Higher interest rates to attract forex inflows (but risks slowing growth).

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Final Visual Summary

In the real world

• eSewa’s USD payment system: Uses liberalized forex policies to allow Nepalis to send remittances directly to Nepal Rastra Bank-approved platforms, reducing reliance on informal hawala channels (which cost 5–10% more in fees).
• Ncell’s Chinese loan (₹500M): Demonstrates exchange rate risk—if NPR depreciates further, Ncell’s ₹65B repayment (at ₹130/USD) could rise to ₹78B (₹15B extra), forcing higher mobile tariffs.
• Daraz vs. local retailers: The 35% tariff on Chinese electronics (e.g., Xiaomi, Oppo) pushed Daraz’s smartphone prices up by ₹2,000–₹3,000, boosting sales at Ncell’s retail stores by 8% in 2023 (per NRB data).